Essays in fiscal policy: Computational accuracy and optimal investments in public, private, and human capital

The dissertation tries to answer three questions. First, how good are linearization and higher-order approximations in an endogenous growth model with public capital? Second, how important are transitional dynamics when assessing alternative fiscal policies when comparing long-run growth versus welfare? Third, is a consumption tax optimal in an economy with public and private human capital when the tax structure is time-invariant?Chapter 2 investigates the errors of linearization and higher-order approximations in comparison with the actual nonlinear solution of the dynamic general equilibrium model. The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. Recently quadratic approximations have been explored. This paper examines the accuracy of these and higher-order approximations in an endogenous growth model with public capital, thereby extending the work done in the current literature on the neoclassical growth model. I find that significant errors may persist in computed transition paths and welfare even after resorting to approximations as high as fourth order. Moreover, the accuracy of approximations may not increase monotonically with the increase in the order of approximation. Also, as in the previous literature, I find that achieving acceptable levels of accuracy when computing the welfare consequences of a policy change typically requires a higher order approximation than attaining similar levels of accuracy in the computation of the transition path: typically an increase in order of approximation by one is sufficient.Chapter 3 analyzes the effects of distortionary taxes on growth and welfare in an endogenous growth model with a public capital externality. The model is calibrated to the U.S. economy, and experiments are run under which the tax regime is shifted from the current mix of capital income, labor income, and consumption taxes to a fiscal policy regime with complete reliance on a single source of taxation, including a lump-sum tax. I find that tax policy changes that induce a higher growth rate do not necessarily result in a higher welfare due to different transitory effects. In fact, a shift to exclusive reliance on a capital income tax while delivering the highest long-run growth results in the lowest welfare. Furthermore, long-run gains take many years -- a generation -- to start getting realized. Among different sources of taxation, I find that, in the long run, complete reliance on a consumption tax dominates the current tax regime however, the current tax regime dominates an exclusive labor income tax, which in turn is less welfare-reducing than an exclusive capital income tax. These results are due to the fact that taxes on labor income and capital income distort investment decisions in reproducible capital, i.e., human capital and physical capital, and therefore have cumulative effects that do not result from a tax on consumption. Unlike previous studies, I account for the welfare effects of transition using optimal nonlinear decision rules all along the transition path.Chapter 4 builds on Chapter 3 by further analyzing the superiority of a consumption tax. There is a long-standing debate in the literature on the choice between consumption or expenditure taxes versus capital income taxes that goes back to Thomas Hobbes (1651), Mill (1871) and later Kaldor (1955) who advocated the consumption tax over the income tax. The advocacy of consumption tax has its solid empirical evidence as some studies indicated that the tax revenue collected in the United States includes a relatively small contribution coming from capital tax (Roger Gordon, Laura Kalambokidis, Jeffrey Rohaly and Joel Slemrod (2004)). This paper examines tax policy in an endogenous growth model with a public capital externality, where human capital serves as the engine of growth. In Chapter 3, this model was calibrated to the U.S. economy and experiments were run to calculate welfare gains from a shift in the fiscal regime from the current mix of capital income, labor income, and consumption taxes to complete reliance on consumption tax. In those experiments, government expenditures in public capital as a share of output was held fixed. The paper showed that the consumption-only tax regime was superior to the current tax regime and to other tax regimes relying solely on a single source of taxation. In this paper, the government tax revenues as a portion of output are varied in order to find the optimal level of investments in public capital under a consumption-only tax regime. I find that in the presence of a significant externality, a modest increase in the consumption tax with a greater investment in public capital can increase welfare. I also show that a slight shift in taxes from consumption to capital income can be welfare improving if the externality is high enough. (Abstract shortened by UMI.)...