Productive Government Spending, Patterns of Specialization and Economic Growth in a Small Open Economy

Constructing a two-sector small open endogenous growth model with productive government spending, this paper examines patterns of specialization and the growth effects of fiscal policy. It is shown in this model that a change in income tax rate can cause a change in an equilibrium pattern of specialization. Because of this property, the relationship between the tax rate and the growth rate yields either a humped shape or a two-humped shape, depending on world commodity prices. We also show that the growth maximizing tax rate is not necessarily equal to the tax rate that maximizes the level of social welfare.