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While the second factor—resource accumulation—has traditionally been the focal point of growth economics, Schumpeter (1934) made the case for the first and third factors, which together imply productivity improvement, as the main ingredients for growth. Tanzi (1995) expanded on the Schumpeterian theme and emphasized the importance of a country’s social absorptive capacity (with respect to technology) in determining its development. The resource-accumulation versus productivity-improvement debate has raged in recent years as researchers have tried to understand the factors which have contributed to the impressive growth of a small number of East Asian economies. For an argument supporting the resource-accumulation thesis in this context, see Young (1995).
The policy invariance implication of the neoclassical growth theory applies only to the steady state, the attainment of which may take a period longer than most would regard as the long run. This point should be borne in mind when future references to the above implication are made in the rest of the paper.
For an illuminating discussion, see Romer (1989). There is, however, no consensus among researchers on the question of convergence. Studies by Baumol (1986), Barro and Sala-i-Martin (1995), Mankiw et al. (1992), and Sala-i-Martin (1996a, 1996b) tended to confirm the existence of convergence, provided that variables other than income (such as human capital) are properly controlled. For a dissenting view, see Quah (1996a, 1996b).
An early influential investigation into this problem was provided by Nordhaus and Tobin (1973). A different aspect of the problem commonly found in most centrally planned economies is that of the suboptimal mix of outputs—often heavily biased toward the production of capital goods.
The concept and measurement of excess burden has a long and controversial history in economics, dating in its modern formulation at least as far back as the work of Dupuit more than a century ago. For a recent comprehensive survey of this literature, see Auerbach (1985).
If the period for output to adjust to any given change in the level of taxation is lengthy, the latter would have, of course, an impact on the measured growth over the period.
Policy can, however, have a transitory impact.
The voluminous literature on this subject is succinctly surveyed in Sandmo (1985). Two well-known results from this literature are worth noting. Atkinson and Sandmo (1980) showed that, in a two-period, life cycle, overlapping-generations model, the optimal capital income tax rate in the long run is not necessarily zero, but instead would generally depend on the relative tax elasticities of labor supply and savings, as well as on their cross elasticities. The nature of this outcome is characteristic of the optimal taxation literature. In contrast, Chamley (1986), using an infinite-horizon model, demonstrated that the long-run optimal capital income tax rate is in fact zero. The two results differ because the intergenerational inefficiency resulting from taxing capital income is not fully capturable in a life cycle framework.
If all factors, including human capital, are taxed at the same rate, then long-run factor proportions are unchanged by the tax, in which case long-run growth would be unambiguously lowered as a result. See Rebelo (1991).
Many of these issues are surveyed in Xu (1994). Zee (1996b) shows that, in addition to the technology of production, the growth effects of income taxation will also depend on the specification of time preference. If time preference is endogenous, i.e., if one’s valuation of current relative to future consumption is responsive to the current levels of income and consumption, then an income tax would also affect savings through this time preference channel.
On this point, see Lucas (1990). A quantitative assessment of the growth effects of taxing both physical and human capital in a nonuniform manner under different technological specifications is provided by Stokey and Rebelo (1995).
It is common to note that, in the absence of a labor-leisure choice, the intertemporal budget constraint of an economic agent implies that taxing wage income (and inherited wealth) only (leaving interest income untaxed) is equivalent to taxing consumption (and bequests), with national savings unaffected by the choice between these two taxes (unless there are other distortions). Tanzi and Zee (1993) showed, however, that if consumption requires time, a wage tax would discourage savings in a manner similar to that of a tax on interest income.
For an extended discussion on the growth effects (or the lack thereof) of taxing consumption, see Stokey and Rebelo (1995).
Trade taxes are frequently the most administratively reliable tax handles, and consequently heavily relied upon to produce revenue, in many developing countries. On average, trade taxes (especially import duties) amount to about a quarter of total tax revenue in a broad group of non-OECD countries, compared to about 2 percent in OECD countries. See Zee (1996a).
Delong and Summers (1991) argued on just this basis for providing tax incentives to equipment investment, which they find to have strong growth effects. Murphy et al. (1989) showed that intersectoral spillover effects of industrialization would call for the implementation of investment promotion policies in a coordinated manner.
The growth-lowering effects of rent-seeking activities have been examined in Baumol (1990) and Murphy et al. (1991) in the context of how entrepreneurship and talent are allocated among alternative activities. Mauro (1995) found cross-country evidence that corruption retards growth.
It is common for advocates of tax incentives to point to the extensive use of such incentives in some high-growth Asian economies as evidence of their effectiveness. Tanzi and Shome (1992) speculated, however, that this positive association probably has less to do with the nature of the incentives themselves than with the characteristics of the countries where they are used, such as the quality of the civil servants and the efficiency of the public bureaucracy—characteristics that tend to minimize the political-economy costs of providing the incentives.
In their sensitivity analysis of cross-country growth regressions, Levine and Renelt (1992) found that the investment share in GDP is the only robust variable in explaining growth.
Public expenditure here refers to the exhaustive type, i.e., expenditures of a purely transfer nature (subsidies, welfare payments, etc.) are excluded. This is also consistent with national income accounts data on such expenditure on which most empirical studies are based. Transfers have, however, distributional implications, which are discussed in Section IV.
The absorption of domestic resources will be delayed, of course, if foreign borrowings or unemployed resources are available.
This is often the rationale for advocating privatization of public enterprises. See World Bank (1995).
For a recent development of this argument, see Devarajan et al. (1996). See also IMF (1995) for a discussion of the various aspects of the productive-unproductive classification of public expenditure. One type of unproductive public expenditure that has received much attention recently is military spending. See, for example, Knight et al. (1996). It should, however, be noted that not all public expenditure programs are designed to promote growth. Hence, some public expenditures could be unproductive in the growth sense, and yet simultaneously effective in the sense of achieving their objectives.
See, however, the discussion below on budget policy.
Public expenditure may also become increasingly wasteful after a certain point, as argued by Tanzi and Schuknecht (1995).
In the United States, military spending has often produced technologies potentially beneficial to the whole economy. This is less likely to happen in other, and particularly in developing, countries.
For example, higher growth may generate a higher demand for cars, which in turn may generate a higher demand for roads.
In an investigation of Wagner’s law, Tanzi and Zee (1995) found the correlation between the levels of public wage expenditure and income to be positive for middle-low income countries and negative for high income countries.
For the present discussion, assume that the public expenditure giving rise to the budget deficits does not entirely consist of public investment.
This neutrality is commonly referred to as the Ricardian equivalence, since the idea can be traced back to the writings of Ricardo, as well as to some early Italian public finance literature (see Buchanan (1958) for an account). Its modern revival is usually credited to Barro (1974). Bailey (1971) contained a clear discussion of its implications.
The literature on the Ricardian equivalence is too voluminous to even attempt a partial survey here. Recent assessments of relevant issues have been provided by Leiderman and Blejer (1988), as well as by two of the central debaters, Barro (1989) (proponent) and Bernheim (1989) (critic). In a recent analysis, Bailey (1993) derived the important result that if taxes are capitalized into property values, and properties are part of the bequest from one generation to another, then (approximate) Ricardian equivalence would hold even if generations are not linked by transfers over an infinite horizon.
In testing Ricardian equivalence, empirical works have largely focused on the impact of budget deficits on one or more of the following three variables: private consumption-savings; intergenerational transfers; and interest rates. For reviews of empirical evidence, see Bernheim (1987) and the associated comments of discussants; Leiderman and Blejer (1988); and Barro (1989).
The growth implications of tax and public expenditure policies are similar in the stability context, and, therefore, are discussed jointly.
This result comes about because it may pay to wait for a favorable state of nature to occur. Depending on the nature of the uncertainty, however, uncertain returns could, under some circumstances, stimulate investment. One reason is that the act of investing itself sometimes provides additional information that could act to reduce the uncertainty; another reason is that a mean-preserving spread of variance (i.e., an increase in variance with the same mean) with respect to returns would increase the expected value of a project, if the valuation function displays diminishing marginal value of returns. For a recent comprehensive treatment of this literature, see Dixit and Pindyck (1994); for an illustration that the impact of uncertainty on investment is dependent on the way tax regime uncertainty is modeled, see Hassett and Metcalf (1994).
Growth effects of inflation are considered below in connection with budget policy. For discussions of the impact of inflation on real tax revenue in the presence of collection lags, see Tanzi (1977, 1978).
The vast literature on the time-inconsistency problem has its origin largely in the seminal work of Kydland and Prescott (1977).
See Fischer (1980) for a particularly illuminating discussion of this example. Kydland and Prescott (1980) examined essentially the same example in greater generalities. The same demonstration can be made with respect to human capital investment, where a government could find it optimal to tax such investment lightly in the early periods of an individual’s life, but to tax the returns from human capital heavily once the capital has been formed.
See, for example, the well-known demonstration by Lucas and Stokey (1983). As it turns out, in a typical intertemporal model with endogenous labor supply but with no capital, whether an optimal tax regime is time-inconsistent or not depends critically on the tax instruments at the disposal of the government. If only an income tax (either on wages or on interest income, or both) is available, the outcome is time inconsistent (Turnovsky and Brock, 1980; and Lucas and Stokey, 1983). Rogers (1987) found that a consumption tax is time consistent under a Cobb-Douglas utility function. When the utility function has a general specification, however, Zee (1994) showed that an optimal tax regime would be time consistent only if both the income and consumption taxes are available. Moreover, Zee (1994) also showed that an optimal time-consistent tax structure could be distortive.
These mechanisms include imposing on the government reputational constraints (Barro and Gordon, 1983), social contractual obligations (Kotlikoff et al., 1988), and particular structures of government debt (Lucas and Stokey, 1983; and Persson et al., 1987).
This is the intertemporal consumption-smoothing argument of Barro (1979, 1995b). By varying the level and structure of public debt, tax rates could be smoothed over time and over states of nature to minimize the intertemporal excess burden of distortive taxes. The ability to restructure public debt varies, of course, across different countries. In many developing countries, this ability is often quite limited.
Aizenman and Marion (1993) measured uncertainty in a variable by the standard deviation of the residuals from a first-order autoregressive process of that variable.
Whether an economy is dynamically efficient or not is an empirical question; theory cannot rule out the possibility that its long-run growth rate could exceed the long-run real interest rate (see Diamond, 1965). In the latter case, the solvency requirement is no longer meaningful, as the government could sustain some positive stock of public debt forever simply through additional borrowing, without having to run budget surpluses (this phenomenon has sometimes been referred to as a Ponzi finance scheme), because by assumption the debt service cost is lower than income growth. The determination of a sustainable positive stock of public debt was examined by Zee (1988). Recently, however, Abel et al. (1989) found that most capitalistic economies are dynamically efficient.
The seminal work on measuring the welfare cost of inflation as the excess burden of a tax in a partial equilibrium framework was that by Bailey (1956), from which a vast literature ensued. The integration of the inflation tax into a standard optimal taxation model was first carried out by Phelps (1973). Chari et al.’s (1996) recent reexamination of this literature clarified a number of important theoretical points concerning the relationship between the inflation tax and other commodity taxes.
This point notwithstanding, it is worth noting that the recent study by Lucas (1994) indicates that, employing the Bailey (1956) framework, the welfare cost of inflation in the United States is much higher than what is commonly believed to be the case. A large welfare cost was also found by Dotsey and Ireland (1996), who extended the Bailey-type measure into a general equilibrium framework with endogenous labor supply.
The voluminous literature on the superneutrality of money has been recently surveyed by Orphanides and Solow (1990).
Jones and Manuelli (1995) addressed many of these issues. Inflation can render a previously optimal tax system suboptimal through a variety of channels: different collection lags of different taxes, differential tax impacts on different tax bases, and nonproportional tax rates.
If the inflationary effects of an expansionary budget policy are countered by a restrictive monetary policy, then the growth penalty would be exacted through high interest rates. Moreover, even though the statistical relationship between growth and low inflation is weak, Feldstein (1996) showed that the interactions between an existing distortive tax system and inflation would result in substantial welfare losses even at low inflation rates.
For this argument, see Sinn (1995, 1996). The link between redistributive taxation and social insurance was explored earlier in Eaton and Rosen (1980) and Varian (1980). While the connection between taxation and risk taking is not new, the existing literature on it by and large focuses on the impact of taxation on portfolio investment decisions (see Atkinson and Stiglitz (1980) for a review) rather than on issues of income redistribution.
There is a large basic needs-related literature in development economics. See, for example, Streeten et al. (1981). A recent analytical treatment of the linkage between such needs and redistribution and growth is that by Dasgupta (1993).
A notable recent study on the growth effects of income distribution in a framework of human capital accumulation constrained by imperfect financial markets is that by Galor and Zeira (1993). Greenwood and Jovanovic (1990) stressed the importance of the interrelationship among income distribution, financial market development, and growth.
For various surveys of this literature, which cover issues that go beyond fiscal policy in a number of directions, see Perotti (1992, 1994), Persson and Tabellini (1992), Alesina and Perotti (1994), and Verdier (1994).
For recent surveys of this literature, see Adelman and Robinson (1989) and Anand and Kanbur (1993). Bourguignon (1990) has recently found, however, that the Kuznets relationship does not hold up well under a more general two-sector specification with different classes of agents and an endogenous terms of trade between the two sectors.
A recent attempt in this direction is Perotti (1993b), who considered tax and transfer policies explicitly as voting outcomes in a model with imperfect financial markets, and obtained versions of Kuznets-like inverted-U relationship between degrees of income inequality and income levels.