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Working Paper Summaries (WP/94/1 - WP/94/76)
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Working Paper Summaries 94/38: Tax Policy Implications in Endogenous Growth Models

Author(s):
International Monetary Fund
Published Date:
August 1994
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The past few years have witnessed a rapid expansion of literature using endogenous growth models to explore the growth implications of tax policies. This paper reviews the main results of this literature. The growth implications of taxation depend on model specifications relating to the accumulation of human capital, technological innovation, and the way tax revenue is spent.

The incentive for agents to behave in a growth enhancing way is measured by the real rate of return to capital (both physical and human capital) in most endogenous growth models. A tax on income or investment will always have a negative direct effect on the long-run growth rate because it reduces this incentive. However, a tax on income or investment may have indirect growth effects through the steady-state factor ratio adjustment or productive tax revenue spending or both. The net long-run growth effects of income or investment taxation are negative if the positive growth effects from productive tax revenue spending and the steady-state factor ratio adjustment are small. The long-run growth effects of a consumption tax are generally believed to be insignificant, because a consumption tax will not affect the allocative decision between consuming today or tomorrow, that is, the incentive to accumulate capital, given the standard preference assumptions.

Empirical studies on the growth-taxation relationship do not show a consensus. Cross-country regressions seem to indicate a negative partial correlation between the economic growth rate and tax variables; however, this correlation is not strong. Moreover, the linear regression form used in cross-country studies cannot capture the possible nonlinear relationship between the growth rate and tax variables. Quantitative results from simulations are found to be very sensitive to the values of the elasticity of intertemporal substitution, the elasticity of labor supply, the depreciation rate of human capital accumulation, and che factor ratios in different sectors. Accurate estimates of these key parameters, however, are not yet available.

This paper also discusses the implications of endogenous growth models with tax policy endogenously determined by a political process and those of endogenous growth models with international capital mobility. In the case of endogenous tax policy, the adoption of a growth-enhancing tax policy depends on factors such as the status of income (wealth) distribution. Unequal income distribution tends to result in high taxation, hence it is harmful for growth. In the case of international capital mobility, the long-run growth effects of a national tax policy will be washed out under the source principle of international taxation, because, the real rates of return to capital across countries are equalized by international capital movements. Under the residence principle of international taxation, however, growth differentials across countries due to different national tax policies can be consistent with international capital mobility.

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