Public capital and distributional dynamics in a two-sector growth model

Abstract

This paper mainly develops a joint theory of public capital, inequality, and growth, in a two-sector growth model that yields complete analytical solutions. Public capital plays an important role in long-run growth through enhancing productivity and complementing the accumulation of private inputs. Under certain conditions, it could also have important implications for income inequality dynamics. Inequality is bad for growth, when the credit market is imperfect and there is a diminishing marginal rate of return on private investment. Certain public services and investment may benefit the poor more than proportionally and thus improve the distribution of income, and hence, improve economic growth through an indirect channel. The key mechanism linking the distribution of income to public capital is its disproportional effect on the economy that affects factor shares of capital. The paper also studies the determination of optimal tax.