Fiscal policy in a stochastic model of endogenous growth

It is nowadays widely believed that public investments may contribute favourably to long-term economic growth. The income tax rates that are needed to finance government spending typically show an erratic time pattern. Such tax randomness could increase the intensity of the business cycle. Thus, government spending may spur economic growth, but the other side of the coin is that this may increase the intensity of cyclical fluctuations. These issues are discussed in the context of a stochastic endogenous growth model with learning-by-doing as well as schooling activity. The key results are: (i) income taxation may go hand in hand with increased economic growth under certain conditions; (ii) tax randomness is responsible for a modest fraction of cyclical variability; (iii) the inclusion of stochastic taxation brings the model closer to the US business cycle experience; (iv) the employment variability puzzle can be solved by introducing stochastic discounting; (v) the latter model can successfully pass a Wald-test; (vi) the interaction between long-term economic growth and the business cycle can be positive as well as negative; and (vii) the model typically suggests that capital taxes stabilise the economy. (C) 2001 Elsevier Science B.V. All rights reserved. JEL classifications: E32; E62; J24; O41.