Fiscal Policy in a Two-Sector Economy with Public Capital and Congestion

This paper focuses on the role of government capital as a critical productive input when the level of services that the agent derives from it is subject to congestion. I develop a two-sector “non-scale†production model in which there are two types of firms, conventional profit-maximizing private firms, and “public firms†, whose objective is to produce a specified quantity of government investment goods – determined by government policy – at minimum cost. Using this two-sector production set-up I assume that the positive externality of the public capital is associated with two types of congestion, proportional and aggregate. A variety of fiscal disturbances are analyzed. Because of the complexity of the model the analysis is carried out using simulations of a calibrated economy. The effects of tax policies are remarkably robust with respect to the relative capital intensities of the two productive sectors. In contrast, the effects of government investment are much more sensitive to this aspect. The introduction of congestion decreases the steady state growth rate of the economy. The relative congestion has stronger effects when the variation in the government investment is analyzed, whereas the absolute congestion is more relevant in the analysis of the change in the tax on capital income. The papers highlight the intertemporal dimensions of fiscal policy and the tradeoffs these involve for economic performance, especially growth and welfare.