We study the impacts of investment in public capital on equity and efficiency. Taking into account stylized facts on wealth accumulation, we model agent heterogeneity through differences in saving behavior, income source and time preference. We find that in the long run, public investment is Pareto-improving and that it reduces inequality in wealth, welfare, and income at the same time, if it is financed by a capital tax. Consumption tax financing is also Pareto-improving but distribution-neutral. Only for labor tax financing, a trade-off between equity and efficiency occurs. Additionally, we find that agents differ in their preferred tax rates.The results for capital and labor tax financing are valid for both, the case of decreasing and constant returns to accumulable factors.

This paper considers an endogenous growth model with public capital and heterogeneous agents. Heterogeneity is due to differences in discount factors and inherent abilities. This allows us to closely approximate the 2007 U.S. income and wealth distributions. Government expenditures, including public investment, are financed through a progressive income tax along with a flat tax on consumption. Three revenue-neutral fiscal policy reforms are considered: (i) an increase in the degree of progressivity of the tax schedule that reduces the after-tax income distribution Gini coefficient to its lowest value over the period 1979–2009, (ii) a reduction in the progressivity ratio that causes the Gini coefficient of the wealth distribution to come close to 1, and (iii) an increase in the fraction of output allocated to public investment that has the same positive impact on the growth rate as reform (ii). It is shown that increasing investment in public capital is the only type of policy that simultaneously enhances growth and reduces both types of inequality (income and wealth). We also find that the public-investment-to-output ratio that maximizes social welfare crucially depends on the elasticity of the labor supply. With a more elastic labor supply the optimal ratio is 4.40%, whereas with a less elastic labor supply it is 5.53%.

The choice between private and government provision of a productive public good like infrastructure (public capital) is examined in the context of an endogenously growing open economy. The accumulation of public capital need not require government provision, in contrast to the standard assumption in the literature. Even with an efficient government, the relative costs and benefits of government and private provision depend crucially on the economy's underlying structural conditions and borrowing constraints in international capital markets. Countries with limited substitution possibilities and large production externalities may benefit from governments encouraging private provision of public capital through targeted investment subsidies. By contrast, countries with flexible substitution possibilities and relatively smaller externalities may benefit either from governments directly providing public capital or from regulation of private providers. The transitional dynamics also are shown to depend on the underlying elasticity of substitution and the size of the production externality.

Public capital subject to congestion is introduced into an endogenous growth model and the transitional dynamic paths under alternative fiscal policies are characterized. Several new insights are obtained from this more general framework. During the transition, the two capital stocks always approach their common equilibrium growth rate from opposite directions. Government policy induces the more volatile response in the capital stock upon which it impinges most directly: private capital in the case of a tax, public capital in the case of expenditure. Finally, we characterize a time-varying income tax that enables the decentralized economy to replicate both the first-best transitional dynamics and steady-state equilibrium of a centrally planned economy. The steady-state component corrects for externalities that arise when government expenditure deviates from its social optimum, and the effects of congestion. The transitional component corrects for myopic behavior by the representative agent along the adjustment path.

This paper devises a fiscal policy by means of which the first-best optimal equilibrium can be attained as a market equilibrium in an endogenous growth model with public capital. The optimal equilibrium requires that public (private) investment be zero along the transition to the balanced growth path if the initial ratio of public to private capital is higher (lower) than its long-term value. We also show that the transitional dynamics can be determined by noting that the continuity of the shadow prices involves the continuity of the consumption path.