Abstract
FISCAL POLICY has occupied center stage in recent policy deliberations in many developed, developing, and transition economies,1 as concerns with fiscal dimensions, such as high unemployment, inadequate national savings, excessive budget deficits and public debt burdens, and looming crises in the financing of pension and health care systems, have intensified. Timely policy responses to these concerns have taken on a sense of urgency. In these circumstances, issues relating to the appropriate scope, nature, and conduct of fiscal policy, in the context of both mitigating macro-economic instability in the short rim and fostering growth in the long run, have naturally come to the fore in policy debates.
FISCAL POLICY has occupied center stage in recent policy deliberations in many developed, developing, and transition economies,1 as concerns with fiscal dimensions, such as high unemployment, inadequate national savings, excessive budget deficits and public debt burdens, and looming crises in the financing of pension and health care systems, have intensified. Timely policy responses to these concerns have taken on a sense of urgency. In these circumstances, issues relating to the appropriate scope, nature, and conduct of fiscal policy, in the context of both mitigating macro-economic instability in the short rim and fostering growth in the long run, have naturally come to the fore in policy debates.
The division of fiscal policymaking into three hypothetical but interdependent branches—allocation, distribution, and stabilization—as first formalized by Musgrave (1959) almost 40 years ago, remains to this day a useful conceptual framework for discussing, analyzing, and evaluating alternative fiscal policy measures, even though the world today is much more complex than the one that existed at the time when Musgrave wrote on the subject. Musgrave’s framework has endured largely because it helps organize one’s thoughts, in an elegant way, on the fundamental issues of interest to policymakers—efficiency in resource utilization, equity in income distribution, and cyclical fluctuations.
This paper considers the positive and normative aspects of the impact on growth of different instruments of fiscal policy. These instruments fall broadly under the three conventional classifications of taxation, public expenditure, and aggregate budgetary balance. Each is analyzed from the perspective of Musgrave’s three economic branches. While a multiplicity of factors, some of which are of a noneconomic nature, could plausibly affect the performance of an economy from period to period, a country’s growth over a reasonably long period of time is ultimately determined by three factors: (1) given the state of technical know-how in that country, the efficiency with which any existing stock of resources is utilized (which would depend, among other things, on cultural, institutional, and political, as well as economic, parameters); (2) the accumulation over time of productive resources (which would include human and other forms of intangible capital): and (3) technological progress (which for most countries would depend, among other things, on their ability to absorb new technology from abroad).2
This paper traces various channels through which tax policy, expenditure policy, and overall budgetary policy could affect growth through their impact on the above three factors. While for ease of exposition the growth effects of different fiscal policy instruments are discussed separately below, it does not imply that they are independent of each other: the impact on growth of taxes would depend, for example, in addition to their level and structure, on how the tax revenue is spent (the composition of public expenditure), as well as on how taxes affect the overall budgetary balance (for any given total level of public expenditure). This interdependence underscores the danger in policy deliberations of focusing too narrowly on the value of one variable (for example, the budgetary balance) to the neglect of its underlying components—a conceptual equivalent to not properly controlling for relevant variables in empirical estimations. In general, the empirical growth literature has shown that estimation results could be materially affected by the presence or absence of controlled variables.
The relevance of considering the growth effects of fiscal policy must be predicated, of course, on the basic proposition that policy matters for long-run growth. Although this may seem intuitively obvious, it is in fact a relatively new idea: it became established in mainstream economic thinking only with the recent advent of the endogenous growth literature.3 As an alternative paradigm to the neoclassical growth theory of Solow (1956) and Swan (1956),4 in which long-run growth was completely determined by factors exogenous to the theory itself (and. therefore, is invariant lo policy),5the endogenous growth literature has been largely motivated as an attempt to overcome the former’s failure to reconcile theory with some of Kaldor’s (1961) six celebrated, stylized facts of growth, most notably the seeming absence in the data of any discernible sign of growth convergence along income levels across countries—a fundamental implication of the neoclassical paradigm.6 While this paper is not a survey per se of the variety of models, results, and policy implications of the voluminous endogenous growth literature,7 it takes as given the basic premise of this literature that a country’s growth performance in the long run is endogenously determined by a set of variables that are responsive to (and affected by) policy—in this particular case, fiscal policy.
A legitimate question that could be raised is the appropriateness of adopting national output, rather than welfare, as the yardstick for evaluating policy, since it is presumably welfare that is the ultimate concern of policymakers. The problem of the gap, and in more extreme circumstances that of changes in opposite directions, between output and welfare is well known: it follows from the omission in national income accounts of imputed values for household production, leisure, and environmental externalities, among other factors.8 Hence, it is theoretically possible for some policy measures to stimulate output and yet reduce welfare (for example, by providing excessive tax incentives to certain industries without properly taking into account the possible pollution costs associated with their activities). While this problem is conceptually important (and. hence, worth noting explicitly), its resolution in practice would present formidable measurement problems because the more encompassing welfare effects of policy are not directly and objectively observable. Moreover, in discussing issues of long-run growth, the bias in evaluating policy on the basis of output effects is somewhat lessened, as any persistent difference between changes in output and those in welfare is unlikely to be sustainable in the long run.9 Accordingly, this paper will adopt the conventional approach in assuming that output growth is positively correlated with welfare improvement.
In what follows, the impact of fiscal policy on growth will be taken up first from the point of view of allocative efficiency, then from that of stability. The relatively new literature on the growth effects of fiscal policy from an income distribution perspective will be considered last.
I. Allocative Efficiency and Growth
Tax Policy
Some of the clearest and most direct conceptual links between fiscal policy and growth have traditionally been associated with tax policy. These links have been made, of course, because the allocative impacts of taxation (for example, on labor-leisure choice, on consumption-saving behavior, and on the relative profitabilities of different industries, among others) are easily appreciated by theorists and policymakers alike and, consequently, have long been one of the best-researched areas in economics. The various links between taxation and growth have, however, different conceptual underpinnings, so it will be useful to consider them separately.
One link is built on the idea that all taxes are nonneutral, with the singular exception of lump-sum levies (which are largely irrelevant as a practical instrument, and may even be nonneutral in an intertemporal context if planning horizons ate finite or in open economies). With nonneutral taxes, private economic agents” allocative decisions will be different from those that would be made in the absence of such taxes. This tax-induced distortion in economic behavior results in a net efficiency loss to the whole economy, commonly referred to as the “excess burden of taxation,” even if the government engages in exactly the same activities—and with the same degree of efficiency—as the private sector with the tax revenue so raised.10It then follows that the higher the level of taxation, the larger would be this efficiency loss. Moreover, the loss typically grows disproportionately with increases in the tax level when there are other tax distortions in the economy. This result would hold even if the taxes were optimally structured, in the sense that, the excess burden of each tax is equalized (proportionally) across all taxes.11 It must be pointed out that, while it is straightforward to conceptualize a negative relationship between the level of taxation and the level of output, it is not clear why the level of taxation would adversely affect the long-run growth of output.12 To obtain a growth effect, the appropriate variable to consider should instead be the rate of change in the level of taxation.13
This link between taxation and growth is established on the basis of the former’s excess burden in a static context. A second and more conspicuous link has to do with the impact of taxation on factor accumulation, particularly capital; it relates, therefore, to the excess burden of taxation in a dynamic sense. Because in the neoclassical growth paradigm long-run growth is invariant to policy,14 as noted earlier, the focus of the traditional analyses of Capital income taxation employing such a paradigm is on the long-run lax impact on the level rather than on the growth of output.15
Policy implications are entirety different, however, when growth is responsive to policy, as in the case of the endogenous growth theory. Here, all other things being equal, a tax on income from (physical) capital would lower the after-tax return to savings and is, therefore, a disincentive to accumulate (physical) capital. But the ultimate impact of this tax on growth turns out to be a priori ambiguous; it is dependent on how the other factors, such as human capital, that cooperate with physical capital in the production process are affected by the tax (assuming these other factors are not taxed).16 A comparison between two simple cases, both with human capital as the only other factor of production, will illustrate the difference in outcomes in a particularly transparent manner.
In one case, assume that the production of human capital requires only human capital (Lucas, 1988). Then the growth-depressing effect of the tax on physical capital will be entirely offset by an increase in human capital accumulation. Hence, the net impact on growth is zero. Alternatively, suppose the production of human capital requires both human and physical capital. In this case, the offset will be only partial, and the net impact on growth is negative (Rebelo, 1991). This simple comparison underscores the important point that the growth effects of income taxation on (physical) capital are sensitive to the specification of production technology.17 In general, however, it can be reasoned that, the lighter the tax burden on the production of human capital relative to the tax burden on other sectors that are human capital intensive, the smaller will be the adverse impact on growth of taxing physical capital.18
The above discussion suggests that the structure of taxation could have important implications for growth. This consideration actually is not limited to simply the area of capital income taxation, or even to income taxation in general: it has, in fact, broad significance for the overall structure of the entire tax system. For a given total tax level, a relative shift from income to consumption taxation would, for example, reduce the disincentive to save and, consequently, boost capital accumulation.19 While a tax on consumption distorts labor-leisure choice, it is neutral with respect to the relative price of consumption today and tomorrow and, thus, can produce only a level (rather than growth) effect.20 In addition to its impact on resource accumulation, the structure of a tax system may have other growth consequences. A heavy reliance on trade taxes could, for example, impede an economy’s capacity to absorb or develop new technologies—thus harming its growth prospects—by reducing the exposure of domestic industries to international markets and competition; however, tax administration constraints may pose difficulties for their elimination.21
Another channel through which lax policy could have a significant impact on both resource accumulation and technological progress is the provision of tax incentives (also known otherwise as a form of tax expenditure), which in one form or another exist in almost all (developing and developed) countries, for promoting investment and research and development activities. While there is a broad consensus among economists that general, that is, nontargeted, incentives are of questionable value—relative to other factors such as the stability, simplicity, and neutrality of a tax system with internationally comparable tax rates—in achieving their stated objectives, there is much less agreement on targeted incentives.22 By their very nature, all tax incentives create distortions; however, if targeted incentives are designed to mitigate certain market failures, then the distortions that they cause may well he outweighed by the benefits that can be reaped from their use. For example, the social benefits from enhanced growth produced by many investments and research and development activities could exceed their private returns. Without corrective public measures, such activities would be below their optimal levels.23 Such arguments usually neglect, however, political economy costs of providing tax incentives, as they tend to encourage rent-seeking behavior, corruption, and the development of special interest groups.24 While these costs are not easy to measure, their adverse impact on growth may be significant.25
The empirical evidence of the impact of various aspects of tax policy on growth has so far been mixed.26 While there is some general indication that the relationship between either the total tax or the income tax level and growth is negative, this relationship is not robust and is sensitive to model specification, particularly with respect to the list of nontax variables that are controlled. Easterly and Rebelo (1993) experimented with thirteen different tax measures and found only one—a marginal income tax rate computed by a time-series regression of income tax revenue on GDP—lo be statistically significant in explaining growth variations among their sample countries. By including the initial real GDP per capita as a variable in the regressions, these authors found that the strikingly negative correlation between the ratio of income tax revenue to GDP and growth shown in Plosser (1992)— and subsequently much cited by others—to be statistically insignificant. Mendoza. Milesi-Ferretti. and Asea (forthcoming) constructed more-detailed effective income and consumption tax rates using corresponding data on tax revenues and tax bases for 18 OECD countries, following a methodology developed by Mendoza, Razin, and Tesar (1994); they found that, based on panel regressions, reductions in income (consumption) taxes would have a robust and statistically significant positive (negative) impact on investment. This impact is, however, quantitatively not sufficient to produce any statistically significant long-run growth effects. As noted earlier. Engen and Skinner (1992) found statistically significant relationships between growth and the rate of change in tax levels.
The most severe difficulty in isolating the impact of taxation on growth arises because key nontax fiscal variables, such as public expenditure and budget policies, that are often not independent of tax policy can also affect growth (see below); also, the complex interactions among the fiscal and other macroeconomic variables create difficulties.27 For example, some evidence also suggests that the growth effects of fiscal policy variables are dependent on income levels, and the negative relationship between tax levels and growth rates is strongest among the least developed countries,28Overall, the general conclusion can be drawn that the empirical evidence on the relationship between taxation and growth is much weaker than what the theory would have led one lo expect.
Public Expenditure Policy
The financing of any level of public expenditure,29 whether through taxation or borrowing, involves the absorption of real resources by the public sector that otherwise would be available to the private sector.30 From a purely static, allocative point of view, this absorption would improve overall efficiency if the social return (benefit) from public expenditure exceeds its private opportunity cost. While public expenditure may displace private sector output (the crowding-out effect), it may also improve private sector productivity (the externality or public good effect). Its total social return must, therefore, be interpreted as the sum of both of these effects.31 The net impact on aggregate output of the crowding-out effect of public expenditure clearly depends on the relative marginal productivities of the public and private sectors. There is a widespread belief that, absent externalities, public production tends to be less efficient than private production.32 Hence, on account of this effect alone, the higher the level of public expenditure, the greater the inefficiency and the lower the level of output. To relate public expenditure to long-run output growth, however, it should be the rule of change in the level of public expenditure that matters,33 a point that is analogous to the case noted above involving the level of taxation.
The externality effect of public expenditure, in contrast, enhances growth by raising private sector productivity. Here, a high growth rate could be achieved by a higher level of such expenditure. In the recent endogenous growth literature, the focus has been on the stock of public infrastructure (or the level of services that flows from it) as a productive input;34 conceptually, however, there is no reason why this effect should be limited to infrastructure spending only. For example, public expenditures, such as those on elementary education and vocational training, that enhance human capital (a key variable in endogenous growth) could have a similar impact.
The opposing natures of the crowding-out and externality effects implies that the structure of public expenditure, rather than merely its level, would be of considerable importance. In analyzing the composition of public expenditure, the traditional approach has been to divide it broadly into the categories of public consumption and public investment, with the idea that the former tends to retard, and the latter to promote, growth. While intuitively appealing, this classification can quickly become problematic. Many public investment projects could be wasteful, for example, in the sense that their marginal net present values could be negative for the society as a whole; at the same time, many public consumption expenditures, such as certain kinds of educational training, operations and maintenance spending on existing infrastructure, and even targeted funding for research and development activities, could be enormously beneficial for long-run growth. Hence, a more useful classification—one that has gained currency recently—would divide public expenditure into productive (that is, growth-inducing) and unproductive (that is, growth-retarding) categories, taking into consideration the levels and mixes of both the resources absorbed and the outputs produced by different expenditure programs.35
The usefulness of the productive-unproductive classification for growth analyses is particularly apparent in a dynamic context because it focuses one’s attention on the impact of public expenditure on private savings and investment and. hence, capital accumulation. There are three dimensions to this impact. First, public expenditure needs to be financed, and this reduces resources for private savings.36 Second, to the extent that public expenditure improves private productivity, it stimulates private savings. Finally, the degree of complementarity or substilutability between public and private expenditure is important. The lower (higher) the complementarity (substitutability), the smaller its impact on private savings.37 The combined impact of these effects on private savings would suggest that the relationship between the level of public expenditure and growth is typically not mono-ionic. For a given degree of complementarity or substitutabilily, growth may be enhanced by public expenditure up to a point, alter which the relationship between the two turns negative.38 This relationship has provided a basis for determining the growth-maximizing level of public expenditure, as well as of government intervention, in a decentralized economy.39
As with the case of taxation, the empirical evidence of the growth effects of public expenditure (as a share of GDP) is inconclusive. Using crosscountry regressions, Ram (1986) found that, although growth in general is positively correlated with the rate of change in total public expenditure, it is negatively correlated with the level of such expenditure. This latter result was also obtained by Levine and Renelt (1992). When public expenditure is broadly disaggregated, there is a stronger indication that growth is negatively correlated with public consumption net of defense and education spending (Easterly and Rebelo, 1993; Barro and Sala-i-Martin, 1995: and. to a certain extent. Levine and Renelt, 1992). One possible explanation for this negative relationship is that, in the aggregate, such public consumption is viewed by economic agents as a less-than-perfect substitute (or possibly even a complement) for private consumption, so private savings decline as a result. Karras (1994) found evidence of complementarity between public and private consumption.
As regards more specific categories of public consumption, Knight, Loayza, and Villanueva (1996) found a significant adverse impact of military spending on growth.40 while Aschauer (1989) found that the impact of such spending on private sector productivity in the United States, although negative, is insignificant,41 A significantly positive impact on growth of public spending on education was found by Barro and Sala-i-Martin (1995), who interpreted the result to represent the growth effect of improved quality in human capital. However, this positive impact is also consistent with the Tanzi (1995) argument that such spending increases a country’s ability to absorb technology from abroad and invent new technologies. Levine and Renelt (1992) found neither military nor public education expenditures as having a robust correlation with growth.
The finding by Aschauer (1989) of a strong and positive correlation between nonmilitary public capital stock and private sector productivity in the United States has been widely cited as evidence of the importance of public investment in promoting growth. Of particular interest here is the identification of a subset of core infrastructure (utilities and transportation facilities) as having the greatest impact. In a cross-country setting, Easterly and Rebelo (1993) also obtained strong support for a positive correlation between growth and public investment, especially that in transportation and communications, but Levine and Renelt (1992) found that the growth effects of public investment are not robust.
The difficulties noted above in properly estimating the growth effects of taxation clearly apply to public expenditure as well. Even if the correlation between growth and public expenditure (or a subset thereof) is found to be robust (in the sense that other relevant variables have been adequately controlled), the direction of causation underlying the correlation would still be unclear. Higher income growth may well generate higher demands for some or all types of public expenditure, which, in turn, may necessitate higher levels of taxation.42 Hence, it is at least plausible that the direction of causation could run from growth to public expenditure and taxation. To be sure, most researchers are aware of this problem of reverse causation, but the empirical growth literature has so far not dealt with it satisfactorily.
A further problem that has not been addressed in this literature is that the relationship between growth and fiscal variables may not be monotonic, either over the levels of the fiscal variables themselves or over income levels, or both. As noted above, it is analytically plausible to argue that increasing levels of public expenditure would first raise and then reduce growth. If countries pursue approximately growth-maximizing public expenditure policies, one would expect little correlation between growth and the level of public expenditure in a cross-country regression. Similarly, a case could be made that the growth effects of fiscal variables, if any, may well change direction as income rises.43 These and other problems suggest that there is much scope for further empirical research in disentangling the complex interactions among different fiscal variables.
Budget Policy
Another broad fiscal variable that could have implications for growth is budget policy, in the sense that the level of public revenue relative to that of public expenditure, that is, the budget balance, may have growth effects that are separate from those related to the absolute level of either taxation or public expenditure, as discussed above. One type of effect stems from the stability implications of budget imbalances; this is considered in Section II below. Another type is related to a possible behavioral response from the private sector triggered by such imbalances. If the private sector regards bud-gel deficits (even if financed by debt) simply as taxes delayed, for example, then it may choose to increase its own savings to neutralize the public dissavings, thus leading to an unchanged level of national savings. Alternatively, budget deficits might not induce a response in private sector savings, in which case national savings would be reduced and growth hampered,44
The question of whether there is neutrality between debt and lax financing has been the focus of much recent research.45 A crucial condition for the neutrality to hold is that, when the planning horizons of economic agents are finite (as would he the case under the intuitively appealing notion of life-cycle savings), there are operative private transfers (gifts and bequests) between generations, so that the implied tax burden of public dissavings on future generations is not ignored by the current generation. It is now widely recognized that strict neutrality would also depend on the absence of a host of other factors, such as tax distortions, income uncertainties, and imperfect credit markets.46
While conceptually intriguing, the importance of the above neutrality result clearly lies in the empirical evidence. Unfortunately, similar to the case of the growth effects of taxation and public expenditure, the empirical support for debt neutrality is mixed.47 On the whole, the evidence, particularly from cross-country data, seems to suggest that the response by private sector savings to public sector dissavings does not completely neutralize the latter. Direct tests of the impact of budget deficits on growth based on crosscountry data have also been recently performed by a number of studies: Easterly and Rebelo (1993) found the correlation between the two significant and negative: Martin and Fardmanesh (1990) found the correlation significant and negative only for middle-income countries: and Levine and Renelt (1992) found the correlation fragile.
II. Stability and Growth
Tax and Expenditure Policies
From the point of view of stability, the growth implications of tax and public expenditure policies are similar and. therefore, can be discussed jointly. The most direct link between tax policy and growth has to do with the volatility injected into the returns to an investment project by an uncertain tax regime. In the recent literature on investment under uncertainty, it has been established that, since most projects are to some extent irreversible, increased uncertainty about their returns would generally lead to a reduction (postponement) in investment.48 Hence, uncertainty about the tax regime, which, in turn, leads to uncertain after-tax returns, is likely to discourage investment and hamper growth.49
Tax regime uncertainty could be attributable to a number of factors. The difficulty in forecasting the direction of prospective tax reforms under political debate is one obvious example. Another example would be the possible changes to the tax regime necessitated by unexpected shocks to income or interest rates, or both, or by unforeseen public expenditure needs. A tax system that is not indexed or has significant collection lags, or both, would also give rise lo uncertain real effective tax rates in an unstable, inflationary environment.50 However, one type of uncertainty unrelated to such unanticipated factors could nevertheless arise even in a framework of an optimizing government whose objective coincides with that of the representative economic agent: if the optimal tax regime changes from one period to the next, there would be uncertainty as to whether the government would maintain the same regime over time.
This problem, which is generally known as the time inconsistency of optimal policy,51 can best be understood intuitively by considering a simple two-period model with endogenous savings and labor supply. The government in period 1 optimizes and determines the optimal tax tales on labor and capital for period 2. When period 2 comes around, savings undertaken in period 1 have become fixed capital (sunk cost) and, if taxed, would not give rise to any excess burden. Hence, it would be optimal for the government in period 2 to tax only capital, which is a policy that, in general, will not be the same as the optimal policy set by the government in period 1,52While it is tempting to interpret the foregoing result as simply another consequence of investment being irreversible, the time-inconsistency problem is in fact fairly general and can occur even in models without capital.53
The likely adverse impact on growth of tax regime uncertainty, irrespective of its origin, naturally raises questions about the possible ways by which the uncertainty (or at least some types of such uncertainty) could be alleviated. For the time-inconsistency problem, various potential mechanisms have been advanced to precommit the government in a given period to maintaining an optimal policy over time.54 If the uncertainty stems instead from unexpected shocks to income or interest rates, or both, or from unforeseen public expenditure needs, then an appropriate debt-management policy could obviate the need for altering the tax regime as a response to such occurrences.55 Finally, if inflation is the source of uncertainty about the real tax burden, the first-best solution is clearly to implement appropriate policies to reduce macroeconomic instabilities: indexing the tax system and adopting administrative measures to reduce tax collection lags are possible second-best solutions.
Based on cross-country regressions of a large sample of developing countries, Aizenman and Marion (1993) presented empirical evidence that suggests that, to varying degrees, there is a significant and negative correlation between growth and uncertainty in a number of fiscal variables, such as levels of revenue, public expenditure, and budget deficits.56 Easterly and Rebelo (1993) also found that the standard deviation in the ratio of domestic tax revenue to consumption and investment had a significant and negative impact on growth.
Budget Policy
Assume for the moment that monetary financing of budget imbalances is not available. In such circumstances, the evolution of the stock of real public debt is entirely governed by the path of cumulative real budget imbalances over time. If the economy is dynamically efficient (that is, its long-run real interest rate exceeds its long-run growth rate) and the government is to be solvent, then any indebtedness of the government would have to be eliminated eventually through appropriate budget policy that would bring the present value of the stock of public debt at some future date (which could be infinity) to zero.57 An important implication of this solvency requirement for the conduct of budget policy is that the government would be obligated to accumulate a sufficient level of net primary budget surpluses (in present-value terms) overtime to pay off its initial debt.58This implication, in turn, provides a natural basis for evaluating whether current budget policy, if maintained, is sustainable (Wilcox, 1989) and, if not, to what extent tax rates must be raised (for a given path of public expenditure) to ensure government solvency (Blanchard and others, 1990).
The relevance of policy sustainability for growth is twofold. If current policy is deemed to be unsustainable, then either a regime change in tax (and/or expenditure) policy would be expected to occur, or recourse would be had to monetary financing. A regime change would increase policy uncertainty, whose impact on growth has already been discussed. Monetary financing would lead to inflation, which raises the important issue of the possible growth effects of inflation.
There are a number of conceptual links between inflation and growth. One of the oldest is built on the idea that inflation can be viewed as a distortive tax on real money balances and, therefore, has efficiency consequences in much the same way as the other, more traditional distortive taxes discussed in Section I.59 As pointed out in that discussion, from a purely allocative perspective, any adverse growth impact from distortive taxes would have to stem from increases in the level of taxation, in this case an acceleration in inflation.60 From a stability perspective, however, arguments have been advanced that higher inflation rates would lead to greater uncertainty about future inflation (Okun, 1971; and Friedman, 1977); thus larger efficiency losses would result simply from higher levels of inflation.
The impact of inflation on growth has also been examined directly in growth models. In the earlier growth literature, the focus was on the issue of the superneutrality of money, that is, whether inflation could affect the steady state capital-labor ratio, rather than on the growth effects of inflation per se (as the long-run growth in these models is exogenous).61 With endogenous growth models, however, a number of direct channels through which inflation could affect growth open up, such as the potential impacts of inflation on both physical and human capital accumulation, as well as the interactions between inflation and a tax system that is based on nominal rather than real magnitudes.62 On the whole. However, the theoretical results in both the old and new growth models seem to be too dependent on model specifications to render them useful as yet for policy purposes.
While further theoretical explorations of the growth effects of inflation are certainly called for, increasing empirical evidence suggests that there exists a significant and negative correlation between high inflation and growth.63 Based on panel data, the inflation threshold above which growth effects become significant ranges from 8 percent to 40 percent.64 Furthermore, Judson and Orphanides (1996) found that inflation volatility is robustly and negatively correlated with growth at all levels of inflation. Hence, there seems to be a compelling case for believing that an expansionary budget policy resulting in high rates of inflation would most likely exact a growth penalty.65
III. Income Distribution and Growth
While economists may disagree on the relative importance of the allocative and distributional objectives of fiscal policy, most will accept the proposition that some trade-off is involved in pursuing the two policy objectives. The trade-off stems, of course, from the disincentive effects of distortive taxes that are required to finance direct or indirect transfer payments from the rich to the poor. Indeed, in a static framework, it is easy to demonstrate that, under fairly general assumptions about (heterogeneous) individual preferences regarding income and work effort, the efficiency cost of pursuing an egalitarian policy could be prohibitively high.66 Hence, in the traditional view, policies effecting a redistribution of income toward equality would exact an increase in the price of (aggregate) output loss that is likely to be larger than the reduction in income inequality achieved by such policies. When extended to a dynamic context, such a view leads quite naturally to the conclusion that there is an increasing marginal cost, in terms of growth forgone, of income redistribution, on account of the saving-depressing effects of taxation.
The validity of this traditional view has, however, been challenged recently by several strands of research. One strand argues that redistributive taxation and the expenditure that it finances are a form of social insurance over an economic agent’s lifetime against certain types of risk for which private insurance may not be available. Consequently, redistributive policies could stimulate productive risk taking and output growth, although such behavior does not necessarily result in greater equality in the after-tax distribution of income.67
A second strand emphasizes the importance of various aspects of financial market imperfections for growth. A central idea here is that the potential productivity of the poor cannot be fully realized unless they are given the opportunity to participate in financial markets. If financial markets were perfect, the poor would be able to borrow against their future earnings to acquire, for example, basic needs (including nutrition, health care, and education) and human capital. In the absence of such markets, however, redistributive policies are needed to raise the poor’s standard of living at least beyond some threshold so that they can become productive members of society and, consequently, contribute to output growth.68 Once gainfully employed, the poor could then begin to acquire assets, accumulate human capital, and gain access to financial markets to further raise their earnings potential. The financial markets, in turn, by benefiting from the increased participation in the intermediation process by economic agents, would become more developed, and the growth prospects for the whole economy would be enhanced as a result.69 An implication for fiscal policy from this strand of literature is clearly that redistributive policies that result in less income inequality could well promote growth.
Yet another strand of research focuses on the impact of various political economy factors on growth. While model structures differ across different studies, at the core of this literature is the idea that income distribution affects political outcomes, which, in turn, affect the kind of policies that are actually implemented through the voting process.70 By invoking the standard median-voter theorem, this literature is able to demonstrate that the greater the inequality of income, the higher will be the voted level of taxation, either for the provision of public goods (Alesina and Rodrik, 1994) or for purely redistributive transfers (Persson and Tabellini. 1994), as a poorer median voter faces a lower tax price of public expenditure than a richer one. Since higher taxes, in turn, lower growth by depressing either physical or human capital accumulation, or both, a direct causal effect of income distribution on growth is thus established.
This political economy approach takes as given the initial distribution of income (or wealth); consequently, it cannot be used to explain how such a distribution is arrived at in the first place. A potential solution to this limitation can be found in an older but voluminous literature, associated with the seminal work of Kuznets (1966), that focused on just the reverse causation, that is, the impact of growth on income distribution. Kuznets (1966) argued that growth would first increase income inequality and then reduce it after some level of income is reached. This relationship can often be derived from a two-sector economy setting comprising, say, a high-growth urban sector and a low-growth rural sector. As labor migrates from the rural to the urban sector with economic development, various conventional measures of inequality would first rise and then fall.71 By combining these two bodies of literature, and perhaps in conjunction with elements of the literature on financial market imperfections noted above, it is possible to derive a two-way causal relationship between income distribution and growth.72Hence, the trade-off between the allocative and distributional objectives of fiscal policy is not absolute: growth with redistribution is possible.73
Most of the above-cited studies employing the political economy approach present cross-country empirical evidence, based on various samples of developed and developing countries. This evidence supports to varying degrees a negative correlation between income inequality (measured in some base year close to the beginning of the sample period over which growth rates are computed) and growth. Clarke (1995) recently confirmed that this negative correlation is robust across a broad sample of countries and with alternative measures of inequality, after controlling for other variables that are standard in the endogenous growth literature.
While the evidence on the adverse impact of initial income inequality on growth seems compelling, what remains unclear is the precise channels through which this impact operates. In the models constructed by Alesina and Rodrik (1994) and Persson and Tabellini (1994), for example, a high degree of income inequality generates heavy taxation for high public investment expenditure or large public transfers, but Perotti (1993a) found rather weak support in the data for these chains of events. Recently, Alesina and Perotti (1996) identified an alternative transmission mechanism: income inequality creates social unrest and political instability, which, in turn, depress investment and growth. Their empirical analyses, which involved the construction of an index of social and political instability (SPI), found cross-country evidence for negative correlations both between income equality and SPI and between SPI and investment. This latter finding is consistent with other empirical studies that found a negative correlation between political instability and growth, for example, Barro (1991) and Mauro(1995).
IV. Concluding Remarks
Economists working in public finance have always believed that fiscal policy, interpreted as the manipulation of fiscal instruments to achieve specific objectives, can affect economic growth. This belief is reflected in the title of many books and articles that refer to the assumed connection between fiscal policy and economic growth. This connection has been thought to originate from various channels, such as the negative effect of distortive taxes, the negative effect of progressive taxes on the propensity to save, and the scope for mobilizing resources through use of additional resources from higher taxation lo increase the level of public investment.
While public finance economists seemed to have no doubts that they could influence growth through the policy changes that they recommended, the prevailing neoclassical growth theory did not leave much role to policy, except for relatively short-run effects on growth. This dichotomy resulted in part from various assumptions implicit in the theory and in part from the different time horizons contemplated by the public finance economists and the growth theorists. For example, while the neoclassical growth theory gives no role to policy for long-run growth, its definition of the long run could be long enough to leave ample scope for the effect of policy over the time horizon of interest to most governments and individuals.
The present paper has attempted to consider in a systematic and comprehensive way the relationship between various public finance instruments and the growth of countries’ economies. It has surveyed a large body of literature, both theoretical and empirical, in an attempt to reach conclusions as to the way in which taxes, public spending, and budgetary policy can influence growth by affecting the allocation of resources, the stability of the economy, and the distribution of income. The literature is very extensive and very rich, and, at times, it is hard to interpret. Yet it is much less definitive on some of these issues than one would have thought. In particular, the empirical literature is somewhat disappointing in its support of theoretically reached conclusions.
Despite the lack of robust results in the empirical literature, the conclusion of this paper has been that, when interpreted from the perspective of the new endogenous growth theory, fiscal policy could play a fundamental role in affecting the long-run growth performance of countries. Thus, economists should not hesitate to recommend changes in the instruments of public finance in the direction that theory has deemed important for enhancing growth, such as the adoption of policies to improve the neutrality of taxation, promote human capital accumulation, and lessen income inequality.
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See, for example, IMF (1996).
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 that 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).
While the early roots of this literature go back to Arrow (1962) and Uzawa (1965), its present analytics owe much to Romer (1986) and Lucas (1988).
The intertemporal utility-maximization-based neoclassical growth models that have become familiar today are actually due to Cass (1965) and Koopmans (1965).
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), Mankiw, Romer, and Weil (1992), Barro and Sala-i-Martin (1995), and Sala-i-Martin (1996a and 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 and 1996b).
For a textbook treatment of the literature, see Barro and Sala-i-Martin (1995).
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 use of output as a reference point in policy evaluation was defended by Aiyagari (1990).
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).
This is (heuristically) the celebrated Ramsey (1927) rule of optimal taxation, a modern reformulation and generalization of which can be found in Diamond and Mirrlees (1971).
If the period for output to adjust to any given change in the level of taxation is lengthy, the level of taxation would have, of course, an impact on the measured growth over the period.
This is a central result of Engen and Skinner (1992).
Policy can, however, have a transitory impact.
The voluminous literature on this subject was 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. This outcome is characteristic of the optimal taxation literature. In contrast, Chamley (1986), using an infinitehorizon 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 were surveyed in Xu (1994). Zee (forthcoming) showed 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, that is, 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 was 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 are heavily relied upon to produce revenue in many developing countries. On average, trade taxes (especially import duties) amount to about one-fourth of total tax revenue in a broad group of non-Organization for Economic Cooperation and Development (OECD) countries, compared to about 2 percent in OECD countries. See Zee (1996).
Many conceptual and analytical aspects of tax incentives, as well as country practices, are covered in OECD (1994) and Shah (1995).
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, Shleifer, and Vishny (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, Shleifer, and Vishny (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. See also Olson (1996) for a discussion of the relationships among economic incentives, institutions, and economic performance.
For surveys of this literature, see Levine and Renelt (1991), Easterly and Rebelo (1993), and Xu (1994).
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, that is, expenditures of a purely transfer nature (including subsidies and welfare payments) are excluded. This definition is also consistent with the national income accounts data on such expenditure on which most empirical studies are based. Transfers have, however, distributional implications, which are discussed in Section III.
The absorption of domestic resources will be delayed, of course, if foreign borrowings or unemployed resources are available.
For a clear separation of these two effects, see Ram (1986).
This belief is often the rationale for advocating privatization of public enterprises. See World Bank (1995).
Ram (1986) made this point explicit in his model.
See, in particular, Aschauer (1989) and Barro (1990). The analytics of endogenous growth models incorporating public expenditure as a productive input were surveyed in Barro and Sala-i-Martin (1992).
For a recent development of this argument, see Devarajan, Swaroop, and Zou (1996). See also Ghu and others (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, Loayza, and Villanueva (1996). However, not all public expenditure programs are designed to promote growth. Hence, some public expenditures could be unproductive in the growth sense while effective in the sense of achieving their objectives.
Bradford (1975) emphasized the importance of knowing whether the financing source is consumption, private capital formation, or unemployed resources. See also the discussion below on budget policy.
There is a voluminous literature on this last aspect of public expenditure, stimulated by the classic analysis of Bailey (1971). For a recent treatment and review, see Karras (1994).
Public expenditure may also become increasingly wasteful after a certain point, as argued by Tanzi and Schuknecht (1995).
See, in particular, Barro (1990) and Jones, Manuelli, and Rossi (1993).
One of the first to investigate the relationship between military spending and growth was Benoit (1973 and 1978), who stimulated much follow-up research on the topic. Some of this literature was recently surveyed by Ram (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—in particular, 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- and 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 were provided by Leiderman and Blejer (1988), as well as by two of the central debaters, Barro (1989), a proponent, and Bernheim (1989), a 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).
This result comes about because it may pay to wait for a favorable state of nature. Depending on the type of the uncertainty, however, uncertain returns could, in 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 (that is, 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 that tax regime uncertainty is modeled, see Hassett and Metcalf (1994).
Recent theoretical analyses that lend support to this conclusion include Aizenman and Marion (1993) and Dixit and Pindyck (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 and 1978).
The vast literature on the time-inconsistency problem had 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, Persson, and Svensson, 1988), and particular structures of government debt (Lucas and Stokey, 1983; and Persson, Persson, and Svensson, 1987).
This is the intertemporal consumption-smoothing argument of Barro (1979 and 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.
This is a widely invoked requirement in the literature. Notable recent examples are Wilcox (1989) and Blanchard and others (1990).
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)). If that is the case, the solvency requirement is no longer meaningful. This is because the government could sustain some positive stock of public debt forever simply through additional borrowing, without having to run budget surpluses (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 and others (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, Christiano, and Kehoe’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, the recent study by Lucas (1994) indicated that, employing the Bailey (1956) framework, the welfare cost of inflation in the United States is much higher than commonly believed. 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 was 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.
For recent surveys of the empirical literature, see Briault (1995) and Thornton (1996).
The threshold was found to be 8 percent in Sarel (1996), 10 percent in Judson and Orphanides (1996), 15 percent in Barro (1995a), and 40 percent in Bruno and Easterly (1995).
If the inflationary effects of an expansionary budget policy are countered by a restrictive monetary policy, then the growth penalty will 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 a particularly simple illustration of this result, see Baumol and Fischer (1969).
For this argument, see Sinn (1995 and 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 and others (1981). A recent analytical treatment of the linkage between such needs and redistribution and growth was 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 was 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 and 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) 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 endogenous terms of trade between the two sectors.
A recent attempt in this direction was made by Perotti (1993b), who considered tax and transfer policies explicitly as voting outcomes in a model with imperfect financial markets. He obtained versions of a Kuznets-like inverted-U relationship between degrees of income inequality and income levels.
This is the central policy conclusion reached by Bruno, Ravallion, and Squire (1996).