Public Goods, Congestion, and Fiscal Policy: Do Consumption-Based Instruments Matter?

Santanu Chatterjee
University of Georgia

Sugata Ghosh
Brunel University

January 2009

ABSTRACT

We examine the impact of fiscal policy on macroeconomic performance when public goods play a dual role by simultaneously providing both productive and utility services to the private sector. When these services are subject to congestion, a consumption tax is distortionary, generating a dynamic adjustment that contrasts an income tax. The design of optimal fiscal policy demonstrates the possibilities for using both income- and consumption-based fiscal instruments as opposed to relying on the income tax alone. In correcting for congestion, an income tax-consumption subsidy combination is the preferred policy when factor-substitutability in production is limited. On the other hand, an increase in the elasticity of substitution in production raises the efficacy of a consumption tax as an alternative to the income tax. Not internalizing the dual benefits of public goods might lead to misleading predictions regarding the effect of public policies on welfare.

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