Government spending and industrialization in a Schumpeterian economy

The goal of this study is to contribute to the debate on the role of government spending in shaping the growth process. We take the analysis in three new directions. First, we investigate the role of government spending in a scale-invariant Schumpeterian model of endogenous innovation. Second, we allow public spending to be the catalyst that precipitates the takeoff of the economy. Third, we postulate a production structure that violates the conventional condition for endogenous growth, namely, that the economy's reduced-form production function must be linear in the accumulated factor. With non-distortionary taxation, increasing productive government spending causes an earlier industrial takeoff and faster economic growth. With distortionary labor-income tax under elastic labor supply, instead, increasing productive government spending has a U-shaped effect on the timing of the industrial takeoff and an inverted-U effect on economic growth. Using cross-country panel data, we document an inverted-U relationship between productive government spending and economic growth. Calibrating the model to US data, we find that raising productive government spending from its historical value to to its growth-maximizing value causes an earlier industrial takeoff by over six decades and an increase in the long-run level of output by 129%. We also explore the robustness of our results under consumption tax and corporate income tax.