Optimal Fiscal Policy when Public Capital is Productive: a Business-Cycle Perspective

Recent empirical evidence suggests that the stock of public-sector capital may be an important input to private production. This paper examines the business-cycle implications of productive public capital in a two-sector, dynamic general-equilibrium model with endogenous fiscal policy. In the model, public capital is a direct input to the - neoclassical production technology, and public consumption goods provide direct utility to households. The production of public and private goods takes place in separate sectors. At the optimum level of public capital, the rate of return on public investment is found to be less than that on private investment. In simulations, public investment and public consumption are procyclical, and the capital tax is more variable than the labor tax, features also observed in annual U.S. data. The introduction of stochastic shocks to households’ preference for public consumption helps the model to match certain features of the data, namely, the high variability and low correlation of public expenditures relative to their private-sector counterparts over the business cycle.