The Distributional Consequences of Government Spending

Santanu Chatterjee

University of Georgia

Stephen J. Turnovsky

University of Washington

July 2010

ABSTRACT

Government provision of public goods is an important mechanism through which wealth can be redistributed across society. This paper develops a model in which public capital is both an engine of growth and a determinant of the distributions of wealth, income, and welfare. Government spending increases wealth inequality over time, regardless of how it is financed. The time paths of both pre- and post-tax income inequality, however, are highly sensitive to financing policies, and in many cases are characterized by sharp intertemporal tradeoffs, where income inequality declines in the short run but increases in the long run. The growth-inequality relationship is shown to depend critically on (i) how externalities impinge on allocation decisions, (ii) financing policies, and (iii) the time period of consideration. Finally, public investment generates sharp trade-offs between average welfare and its distribution, with government spending improving average welfare, but also increasing its dispersion. These results underscore the friction between fiscal policies that target growth but may have consequences for inequality. Robustness checks are conducted for (i) the magnitude of the spillover effect of government spending, and (ii) the intratemporal elasticity of substitution between (a) capital and labor in production and (b) consumption and leisure in utility.

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