This paper analyzes the optimal rate of monetary expansion when the government resorts to inflationary finance to support public investment for enhancing growth. When there are collection lags in the tax system, use of the inflation tax erodes real fiscal revenue, leading to a deterioration of the government’s current account balance, and reinforces inflationary pressures. As a result, the amount available for government investment is reduced, which impedes the process of capital accumulation and, in addition, increases the welfare cost of inflation, owing to the reduction in real balances. The analysis demonstrates that the optimal rate of monetary expansion and the corresponding capital-labor ratio, as well as output and consumption, are lower, while the marginal cost of using inflationary finance is higher than it would be without collection lags.
Simulations using the empirical evidence on collection lags and the demand for money indicate that the scope of inflationary finance is rather limited, and that it is further diminished with higher rates of private saving and the social discount. As indicated by the shadow price of capital, the marginal cost of inflationary finance is substantially higher than it would be without collection lags. In contrast, the use of taxation to finance government investment leads to higher growth with efficiency and price stability.
These results have important implications for fiscal policy and tax reform. A government that chooses the option of inflationary finance to generate additional investment must take into account the possible effect of real fiscal revenue erosion on the budget deficit. In general, the use of inflationary finance can threaten the objectives of growth with efficiency and price stability. These considerations substantially strengthen the case for improving tax administration and increasing reliance on fiscal revenue to finance an expansion in government expenditure, rather than relying on resources generated through inflation.