Optimal fiscal policy with a balanced-budget restriction: revisiting Chamley and Barro

Barro (J Polit Econ 98:S103–S126, 1990) established an endogenous growth model with taxed-financed public services that affect production or utility. Since there is only an income tax, the tax rate must be positive under a balanced-budget restriction. Then there arises a question as to whether the famous zero-capital-tax result of Chamley (Econometrica 54:607–622, 1986) applies in the Barro model if the government is allowed to tax capital and labor incomes, respectively. To examine this question, we develop a generalized Barro model, which combines characteristics of the Chamley model by incorporating elastic labor supply and capital and labor income taxation. By using the dual approach, we derive simple formulas for optimal income taxation and the second-best rules for public consumption and production services. In particular, we demonstrate that both capital and labor incomes should be taxed when the economy grows along a balanced-growth path. The intuition behind our positive capital tax result is that, under the balanced-budget constraint, the government has to minimize each time’s tax distortion by equating the marginal excess burdens of capital and labor taxation at any time.