Fiscal policy and indeterminacy in models of endogenous growth

This paper investigates the dynamic behavior of two-sector models of endogenous growth with sector-specific external effects, and government expenditure financed by distortionary taxation. When this type of external effect is combined with a sufficient degree of capital taxation in a Lucas–Uzawa endogenous growth model, continua of equilibria will emerge in the region of the balanced growth paths. By contrast, indeterminacy is not possible when either sector-specific external effects or factor taxation are added to the model in isolation. In the second part of the paper, we demonstrate that if labor supply is endogenous, indeterminacy can be consistent with much lower degrees of increasing returns to scale. Furthermore, certain types of fiscal policy will be associated with multiple balanced growth paths and the existence of a poverty trap. Finally, in the last part of the paper, we demonstrate that if physical capital is employed in both sectors of the economy, indeterminacy will emerge for varying combinations of factor taxation and external effects, even when returns to scale are constant at the social level.