Income taxes, public investment and welfare in a growing economy

In a growth model with public capital and a spillover externality from private capital, we find that income taxes as part of an optimal fiscal policy is a more common result than usually thought. The commitment to finance an exogenous component of public expenditures in the form of an exogenous fraction of output may lead to the optimality of positive income taxes. This result is robust to alternative assumptions on depreciation rates and preferences. We show that welfare losses from deviations from the optimal policy are always smaller when compensated with changes in income taxes than when adjusting lump-sum taxes. (C) 2006 Elsevier B.V. All rights reserved.