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This study investigates (i) the growth-maximizing, (ii) second-best, and (iii) first-best welfare-maximizing policies when the government produces productive public services using capital and private goods. When the production costs of public services are financed by income tax, the government spending-output ratio exceeds the output elasticity of public services (Pareto-optimal level) under the growth-maximizing or second-best welfare-maximizing policy. This leads to an over-use of resources by the government, over-provision of public services, and under-accumulation of capital in a decentralized economy. Subsidies on private investment, which is increasing in the contribution of publicly employed capital to final goods, can resolve these inefficiencies. |
