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Schumpeterian Growth with Productive Public Spending and Distortionary Taxation

Schumpeterian growth theory eliminates the scale effect by positing a process of development of new product lines that fragments the aggregate market in sub-markets whose size does not increase with population or the size of the workforce. This entails the sterilization of the growth effects of selected fiscal variables. This insight is applied to shed new light on the role of distortionary taxes on consumption, household labor and assets income, corporate income, and of productive public spending. The framework allows the identification of which of these fiscal variables have permanent (steady-state) growth effects, and which ones have only transitory effects. It also allows the transitional dynamics to be solved analytically and thus the analysis of the welfare effects of revenue-neutral changes in tax structure. It is found that replacing taxes that distort labor supply with taxes that distort saving/investment choices raises welfare, and the intuition behind this surprising result is discussed.