Optimal fiscal policies in an economy with externalities from public spending

This paper examines the optimal fiscal policies in an economy with externalities from government expenditure. We extend Lucas (Oxf Econ Pap 42:293–316, 1990) two-sector endogenous growth model and consider the spillover effects from the public spending on infrastructure and education. We compare the optimal fiscal policies derived from the Ramsey allocation problem with those in the centrally-planned economy. The results of this paper are as follows. First, the optimal share of public spending on infrastructure is smaller than its relative contribution in the production function. Next, the optimal share of public spending on education is smaller than its relative contribution in the accumulation of human capital, and does not affect the tax rate of capital income. Finally, the optimal tax rate of capital income is positive if the externality from public productive spending exists.