Optimal Fiscal Policy in a Small Open Economy Insights from the Growth Model with Human Capital and Public Debt

Abstract

This paper investigates the linkages between economic growth and fiscal
policy under perfect capital mobility. The model incorporates wide range of
fiscal policy instruments: the budget deficit, the structure of public debt, public
expenditures on education, public consumption, and four tax rates. We prove
that two tax rates – on consumption and interest on government bonds held
by domestic lenders – are neutral for economic growth: both for the balanced
growth path (BGP), and for transitory dynamics. All other parameters of fiscal
policy are not neutral. Theoretical results are illustrated with an empirical
analysis for Poland based on post-global financial crisis data for the Polish
economy (2009–2018). Numerical simulations show that if fiscal policy remains
unchanged, Polish economy will converge to the BGP with GDP growing at
2.3%. The best way to accelerate growth is to increase public investment in
education. The other budgetary policy instruments are less effective in shaping
economic growth.