Macroeconomic effects of a 10-year tax-financed government investment plan

In this paper, we use the Diamond-Zodrow computable general equilibrium model of the U.S. economy to simulate the dynamic macroeconomic effects of a fiscal plan that uses revenues from various tax changes proposed by the Joe Biden 2020 presidential campaign ($3.3 trillion over 10 years, as estimated by the Tax Foundation [Watson, Li, and LaJoie, 2020]) to finance 10 years of public investment. Public investment leads to an increase in the public capital stock, which is assumed to enhance the productivity of private factors of production. Once the increase in public investment ends after 10 years, we assume that the tax changes are permanent and the revenues are used to cover depreciation on the incremental increase in the public capital stock so that the size of the public capital stock is held constant, with all remaining revenues used to finance increases in transfer payments. 

The macroeconomic effects of the plan reflect the net impact of (1) the rise in productivity associated with the increase in the public capital stock as well as the effects of the subsequent increase in government transfers, and (2) the increases in distortionary taxation of business, capital, and labor income used to finance those expenditures. Our simulation results indicate that these net macroeconomic effects depend significantly on the extent to which the increase in the public capital stock increases the productivity of private capital and labor, which depends on the output elasticity of public capital, q G. 

When this elasticity is set at the central estimate (q G = 0.05) used in a recent analysis of infrastructure investment by Ramey (2020), the increases in output associated with the increase in productivity due to the larger public capital stock are not quite large enough to offset the distortionary costs of the taxes used to finance the increase in public investment as well as the subsequent increase in transfer payments. As a result, GDP declines by 0.2% 10 years after enactment and in the long run, private investment falls by 5.3% 10 years after enactment and by 2.5% in the long run, and the stock of ordinary capital declines by 1.3% 10 years after enactment and by 1.4% in the long run, while labor supply increases by 1.0% 10 years after enactment and by 0.7% in the long run. Relatively mobile firm-specific capital declines by 2.9% 10 years after enactment and by 1.5% in the long run. 

By comparison, when the output elasticity of public capital is set at the higher end of the range of empirical estimates reviewed by Ramey (q G = 0.12), the increases in output associated with the increase in productivity due to the larger public capital stock more than offset the distortionary costs of the taxes used to finance the increase in public investment and subsequent transfer payments. In this case, GDP increases by 0.4% 10 years after enactment and by 1.1% in the long run, private investment falls by 5.2% 10 years after enactment and by 1.3% in the long run, and the stock of ordinary capital declines by 1.4% 10 years after enactment and by 0.3% in the long run, while labor supply increases by 0.9% 10 years after enactment and by 0.7% in the long run. Relatively mobile firm-specific capital declines by 3.7% 10 years after enactment and by 2.4% in the long run.