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The Optimal Public Expenditure Financing Policy: Does the Level of Economic Development Matter?

  • N Bose
  • J A Holman
  • K C Neanidis

This paper explores how the optimal mode of public finance depends on the stage of economic development. The theoretical analysis is based on an overlapping generations growth model with an imperfect capital market. Random shocks create a demand for liquidity and establish a role for financial intermediaries. In this model, inflation matters because it affects the relative rates of return on assets in such a way that money becomes the preferred asset in the portfolio holdings of banks, causing a detrimental effect on economic growth. Such an effect is stronger (weaker) at lower (higher) levels of economic development due to the higher (lower) default risks associated with lending. Consequently, income taxation (seigniorage) is a relatively less distortionary way of financing public expenditure for low-income (high-income) countries. We provide empirical support for our model’s predictions using a panel of 21 OECD and 40 developing countries observed over the period 1972-1999.

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File URL: http://www.socialsciences.manchester.ac.uk/medialibrary/cgbcr/discussionpapers/dpcgbcr57.pdf
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Paper provided by Economics, The Univeristy of Manchester in its series Centre for Growth and Business Cycle Research Discussion Paper Series with number 57.

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Length: 31 pages
Date of creation: 2005
Date of revision:
Handle: RePEc:man:cgbcrp:57
Contact details of provider: Postal: Manchester M13 9PL
Phone: (0)161 275 4868
Fax: (0)161 275 4812
Web page: http://www.socialsciences.manchester.ac.uk/subjects/economics/our-research/centre-for-growth-and-business-cycle-research/

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  1. Chamley, Christophe, 1991. "Taxation of financial assets in developing countries," Policy Research Working Paper Series 651, The World Bank.
  2. N. Gregory Mankiw & David Romer & David N. Weil, 1990. "A Contribution to the Empirics of Economic Growth," NBER Working Papers 3541, National Bureau of Economic Research, Inc.
  3. Jovanovic, B. & Nyarko, Y., 1996. "Stepping Stone Mobility," Working Papers 96-26, C.V. Starr Center for Applied Economics, New York University.
  4. Asea, Patrick & Mendoza, Enrique G & Milesi-Ferretti, Gian Maria, 1996. "On the Ineffectiveness of Tax Policy in Altering Long- Run Growth: Harberger's Superneutrality Conjecture," CEPR Discussion Papers 1378, C.E.P.R. Discussion Papers.
  5. Robert G. King & Sergio Rebelo, 1990. "Public Policy and Economic Growth: Developing Neoclassical Implications," NBER Working Papers 3338, National Bureau of Economic Research, Inc.
  6. Chamley, Christophe, 1991. "Taxation of Financial Assets in Developing Countries," World Bank Economic Review, World Bank Group, vol. 5(3), pages 513-33, September.
  7. Stacey L. Schreft & Bruce D. Smith, 1994. "Money, banking, and capital formation," Working Paper 94-05, Federal Reserve Bank of Richmond.
  8. Marco Espinosa & Chong K. Yip, 1998. "Fiscal and Monetary Policy Interactions in an Endogenous Growth Model with Financial Intermediaries," Departmental Working Papers _094, Chinese University of Hong Kong, Department of Economics.
  9. Mark Gertler & Kenneth Rogoff, 1989. "Developing Country Borrowing and Domestic Wealth," NBER Working Papers 2887, National Bureau of Economic Research, Inc.
  10. Palivos, Theodore & Yip, Chong K, 1995. "Government Expenditure Financing in an Endogenous Growth Model: A Comparison," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1159-78, November.
  11. Pecorino, Paul, 1997. "The Optimal Rate of Inflation When Capital is Taxed," Journal of Macroeconomics, Elsevier, vol. 19(4), pages 657-673, October.
  12. Paul Cashin, 1994. "Government Spending, Taxes, and Economic Growth," IMF Working Papers 94/92, International Monetary Fund.
  13. Bhattacharya, Joydeep & Huybens, Elisabeth & Guzman, Mark G. & Smith, Bruce D., 1997. "Monetary, Fiscal, and Bank Regulatory Policy in a Simple Monetary Growth Model," Staff General Research Papers 5136, Iowa State University, Department of Economics.
  14. Brechling, Frank, 1973. "Wage Inflation and the Structure of Regional Unemployment," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 5(1), pages 355-79, Part II F.
  15. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  16. Drewes, Torben, 1987. "Regional Wage Spillover in Canada," The Review of Economics and Statistics, MIT Press, vol. 69(2), pages 224-31, May.
  17. De Gregorio, Jose, 1993. "Inflation, taxation, and long-run growth," Journal of Monetary Economics, Elsevier, vol. 31(3), pages 271-298, June.
  18. Fischer, Stanley, 1982. "Seigniorage and the Case for a National Money," Journal of Political Economy, University of Chicago Press, vol. 90(2), pages 295-313, April.
  19. Michael Bleaney & Norman Gemmell & Richard Kneller, 2001. "Testing the endogenous growth model: public expenditure, taxation, and growth over the long run," Canadian Journal of Economics, Canadian Economics Association, vol. 34(1), pages 36-57, February.
  20. Barro, R.J., 1989. "Economic Growth In A Cross Section Of Countries," RCER Working Papers 201, University of Rochester - Center for Economic Research (RCER).
  21. Kneller, Richard & Bleaney, Michael F. & Gemmell, Norman, 1999. "Fiscal policy and growth: evidence from OECD countries," Journal of Public Economics, Elsevier, vol. 74(2), pages 171-190, November.
  22. Jones, Larry E & Manuelli, Rodolfo E & Rossi, Peter E, 1993. "Optimal Taxation in Models of Endogenous Growth," Journal of Political Economy, University of Chicago Press, vol. 101(3), pages 485-517, June.
  23. Gupta, Sanjeev & Clements, Benedict & Baldacci, Emanuele & Mulas-Granados, Carlos, 2005. "Fiscal policy, expenditure composition, and growth in low-income countries," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 441-463, April.
  24. Yih-Chyi Chuang & Chi-Mei Lin, 1999. "Foreign direct investment, R&D and spillover efficiency: Evidence from Taiwan's manufacturing firms," Journal of Development Studies, Taylor & Francis Journals, vol. 35(4), pages 117-137.
  25. Bhattacharya, Joydeep, et al, 1997. "Monetary, Fiscal, and Reserve Requirement Policy in a Simple Monetary Growth Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(2), pages 321-50, May.
  26. Klein,Martin & Neumann,Manfred, . "Seignorage: What is it and who gets it?," Discussion Paper Serie B 124, University of Bonn, Germany.
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