General Fund Financing, Earmarking, Economic Stabilization, and Welfare

Abstract

Discussion has been made concerning the pros and cons of financing public projects via either earmarking or a general fund. The article studies the desirability of earmarked and general fund financing based on economic stabilization in a two-sector growth model. Regardless of the nature of public goods, earmarked taxes contribute to aggregate stabilization, while general fund financing may be destabilizing and cause fluctuations. The underlying mechanism in favor of earmarked taxes against general fund financing is that general fund financing creates intersectoral externalities and strategic complementarities that are sufficiently large to exert endogenously persistent and recurring fluctuations in aggregate activities in the absence of shocks to fundamentals. Earmarked taxing generates only sector-specific externalities that are too small to exert local indeterminacy. In a calibrated version, we compute the level of long-run welfare, and the results reflect favorably on the use of earmarked taxing.