This paper examines the effects of government spending under both lump-sum and income tax regimes. Under a lump-sum tax financing scheme, an increase in government spending induces a rise in the real interest rate and causes labor effort and real output to increase because of the income effect. This result is reversed under an income tax regime due to the dominating wage effect. The interest rate may rise or decline under an income tax scheme, depending on the persistence of government spending.
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