Distortionary Taxation and Optimal Public Spending on Productive Activities

Using a general‐equilibrium model with endogenous factor supplies, this article investigates the provision of factor‐augmenting public inputs. Such inputs are intermediate goods that affect production functions in a collective manner and give rise to increasing returns. Unlike with collective consumption goods, deviation from the first‐best condition for a public input is inappropriate if taxes are set optimally. When taxes are not optimal, a second‐best rule must include a feedback effect on revenue as well as the deadweight cost of taxes. Implications for benefit‐cost analysis and for interpretation of estimates of the social returns to public capital are explored.