Asymmetric Information, Government Fiscal Policies, and Financial Development

Abstract

Previous studies assert that the optimal share of public spending is equal to the output elasticity of public spending and that relying on capital income taxation to finance public spending is either beneficial or harmful to capital accumulation and economic growth. The authors incorporate asymmetric information into an endogenous growth model and reexamine how the presence of asymmetric information in financial markets affects the consequences of the government’s expenditure and financing policies. With this asymmetric information, the authors find an optimal tax rate for capital income and an optimal share of government spending that maximize economic growth. These two optimal levels are more reasonable in comparison with recent empirical works. The authors find that financial development, measured by a decrease in the information cost, is positively correlated with the optimal share of government spending and the optimal tax rate for capital income. Some preliminary evidence in support of these implications is also found.