Poverty, prosperity, and fiscal policies in a two-sector model with human capital externalities

Abstract

This paper investigates the multiplicity and indeterminacy of balanced growth paths (BGPs) to capture coexisting poverty traps and prosperity across countries in an extended Lucas model incorporating physical inputs, human capital externalities, and decreasing returns to scale in education. We show that two BGPs can emerge, where the high-growth BGP devotes more resources to education than the low-growth BGP. Without taxes or subsidies, the two BGPs never display poverty traps. With taxes and subsidies, however, the two BGPs may display prosperity on one BGP and poverty traps on the other BGP that could be avoidable by suitable fiscal policies.