Fiscal policy and growth: a survey

Marzo, Massimiliano (1998) Fiscal policy and growth: a survey. DOI 10.6092/unibo/amsacta/733.
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The lack of convergence of growth rates among the world economies is probably one of the most debated topics in the last few years in theoretical and empirical research. In this period we have observed a strong resurgence of the debate about long-run growth, starting from the initial contributions by Paul Romer (1986) and Robert Lucas (1988) who opened the so called "Endogenous Growth Theory" or "New Growth Theory". The reason of this resurgence of interest lies in two important aspects left unsolved by the theoretical attempts of the 60s and 70s: first, the need to explain long-run growth determinants and secondly, to provide a careful explanation to the lack of convergence of growth rates among world economies footnote . The biggest achievement of the Endogenous Growth Theory is represented by the reconciliation of the diminishing returns hypothesis with the typical finding of empirical analyses, i.e. a growth rate continuously increasing. There are many explanations of the lack of convergence of growth rates. Among the empirical studies on convergence we consider Barro and Sala-i-Martin (1992) who analyzed the different definition of convergence expressed as absolute and relative, according to the emphasis given to the initial endowments and the saving rate footnote . However, probably, one of the most important explanations for the divergence of growth rates lies in the heterogeneity of fiscal policies adopted by different countries. The present paper tries to explain the lack of convergence by invoking differences in fiscal policies, as explained by the more recent literature. Differently from the growth theory of 60s and 70s, the endogenous growth theory shows many interesting features to the link between fiscal policies and growth. When growth is endogenous, policy actions affecting the saving rate (fiscal policy can be though as a typical example of such a policy), have growth effects and not only level effects. This means that fiscal policy affects the steady state growth rate on a Balanced Growth Path (BGP, thereafter) and not only during the transition from one steady state to the other. Fiscal policy in growth models can be analyzed within a wide range of contexts: (i) representative agents models with infinite horizon; (ii) overlapping generations models; (iii) redistributive models with electoral competition about the level of fiscal pressure. Given the enormous degree of development reached in each of the above fields, the present survey will concentrate mostly on representative agent models with infinite horizon, with a special emphasis on two-sector models with human capital footnote . The reason of this choice has to do with the goal of analyzing the growth effect of flat rate taxes and how various assumptions on the production function for physical and human capital, will interact to assess the magnitude of fiscal policy. The models under point (ii)-(iii) focus more on the redistributional effects of fiscal policy, and they take as given the effect of fiscal policy on growth. A very important point concerns the endogeneity of public expenditure in endogenous growth models: unfortunately, not much work has been done in the infinite horizon framework apart the initial contribution by Barro (1990), Barro and Sala-i-Martin (1992) and the literature on redistributional issues. In this survey I will present both the aforementioned contributions and some extensions to the two-sector framework by Corsetti and Roubini (1996). In what follows the focus will be only on deterministic models, without exploring the implications of the stochastic growth models with fiscal policy. The goal of stochastic growth models is different: they take as given the existence of a BGP to explain the origins and causes of economic fluctuations originating around it. To do so, they try to replicate the observed behavior of time series of income, consumption, investment and other relevant macroeconomic variables, by adding to the model shocks - technological or fiscal - which could generate such fluctuations. The model is evalued according to its ability to replicate the observed behavior of time series. Those models are in the tradition of Real Business Cycles (RBC) literature. The difference with the RBC typical assumption is that a fiscal policy shock - together with a pure technological shock - is assumed to be the origin of economic fluctuations footnote around a BGP exogenously given. In the case of pure deterministic growth models, instead, we keep fluctuations as exogenous to the model and the goal is to explain the existence of an unceasing growth. I will not touch empirical aspects of the relationship between fiscal policy and growth. For a survey of the empirical results on fiscal policy and growth I address the reader to other surveys, like, fore example, Easterly et al. (1992), Engen and Skinner (1992), Levine and Renelt (1992). The remainder of this paper is organized as follows. Section 2 introduces the reader to the analytical context employed in the subsequent sections, by surveying the basic mechanisms underlying endogenous growth mechanisms. Section 3 analyzes endogenous growth models driven by human capital accumulation, while the role of the innovative activity as engine of growth is discussed in section 4. Income taxation is discussed in section 5 under the usual two formulation of an income tax and a tax on private inputs. In section 6 there is an extensive discussion on endogenous fiscal policy. In this context,. models without and with human capital are analyzed in order to evaluate different distorsive effects of taxation. Section 7 studies a growth model with monopolistic competition and differentiated goods. The effect of endogenous labor supply under various specifications is discussed in section 8. The effect of consumption and investment taxation is discussed respectively in section 9 and 10. Section 11 provides a brief discussion on optimal taxation issues. Concluding Remarks close the paper.

Document type
Monograph (Working Paper)
Marzo, Massimiliano
Deposit date
17 Jun 2004
Last modified
17 Feb 2016 14:02

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