This paper develops an endogenous growth model of the influence of public investment, public transfers, and distortionary taxation on the rate of economic growth. Rather than use the flow of publicly provided private goods to proxy for government services, as in current models in the literature, the model introduces increments in the stock of congested public capital as a positive influence on economic growth. The growth-enhancing effects of both intragenerational and intergenerational transfer payments are also modeled, again differing from current models in the literature, which typically view transfers as having a negative effect on growth.
Transfers are argued to raise the marginal product of private capital by reducing the negative externalities flowing from (1) poor enforcement of private property rights, and (2) workers with a below-average stock of human capital. The model also highlights the growth-inhibiting effects of the levying of the distortionary taxes necessary to finance the provision of public transfers and public capital. A trade-off exists between the growth-enhancing provision of public capital and transfers and the growth-diminishing influence of distortionary taxes. For small government (where public spending is low), the growth-enhancing effect is likely to dominate; for large government (where public spending is high), the growth-diminishing effect is likely to dominate.
The theoretical implications of the model are then tested with data from 23 developed countries between 1971 and 1988, using a time-series cross-sectional model to take into account the potential influence of unobserved country heterogeneity. The empirical results offer support for the theoretical implications of the model, as the three public finance variables are significant and enter with signs consistent with a priori expectations of their respective influences on economic growth. Productive government spending, in the form of public investment and transfer payments, is demonstrated to enhance economic growth. In addition, distortionary taxation is shown to have a detrimental effect on economic growth. The convergence implications of the neoclassical growth model are also borne out in this data set, as initial incomes are significant and negatively correlated with subsequent growth rates.