Public Spending in a Model of Endogenous Growth with Habit Formation

This paper introduces habit-forming preferences in a Barro-type endogenous growth model with productive public services. Government expenditure, which may be subject to congestion, is financed by distortionary income taxation. Different from the standard time-separable model, the presence of habits makes the economy feature transitional dynamics, which are solved in closed form. Setting the income tax so as to equate the elasticity of public services in production is shown to maximize both long-run growth and welfare as in the standard model. This second-best solution coincides with the first-best outcome only in the presence of proportional congestion.