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Policy Distortions, Size of Government, and Growth

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  • William Easterly

Abstract

This paper analyzes the structural relationship between policies that distort resource allocation and long-ten growth. It first reviews briefly the Solow model in which steady-state growth depends only on exogenous technological change. Policy distortions do affect the rate of growth in the transition to the steady state in the Solow model. However, growth falls off so rapidly in the Solow transition as to make it unsatisfactory as a model of long-ten growth, even over periods as short as a decade. The paper proposes an increasing returns model in the spirit of the new literature on economic growth. With increasing returns, endogenous economic variables - - and thus policy - - will affect the steady-state rate of growth. The model gives output as a linear function of total capital, but a decreasing function of each of two types of capital. The distortion is defined as a policy intervention that increases the cost of using one of the types of capital. The relationship between this distortion and steady-stste growth is negative but highly nonlinear. At very low levels and very high levels of distortion, the effect on growth of changing the distortion is close to zero. Changes in structural parameters of the economy - - the elasticity of substitution between the two types of capital and the share of nondistorted capital in production - - will affect significantly the impact of the policy distortion on growth. The model is extended to an analysis of the relationship between the size of government and growth by treating the distortion strictly as a tax on one form of capital. The tax revenue is used to finance the acquisition of productive government capital. There is then a tradeoff between two forms of distortion- -one resulting from distortionary taxation and the other from insufficient public capital. Increasing the tax from zero has a positive effect on growth, but with further tax increases the relationship will eventually turn negative. Tax revenue ("size of government") as a function of the tax rate will be given by a Laffer curve. Growth still remains above a certain minimum as the tax rate gets arbitrarily large, but the range between relationship maximum and minimum growth will be larger than in the original model. The relationship between tax revenue and growth for alternative tax rates can be positive, negative, or zero. The same is true of the relationship between public and private investment. Changes in the share of tax revenue devoted to capital accumulation ("government saving") will affect the results. The results suggest that simple linear relationships between distortions and growth or between size of government and growth are untenable. The dialogue between advocates of liberalization and policymakers could be enriched by a recognition of the structural factors that influence the effect of lowering distortions on growth.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3214.

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Date of creation: Dec 1989
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Handle: RePEc:nbr:nberwo:3214

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  1. Paul M Romer, 1999. "Increasing Returns and Long-Run Growth," Levine's Working Paper Archive 2232, David K. Levine.
  2. Robert J. Barro, 1989. "A Cross-Country Study of Growth, Saving, and Government," NBER Working Papers 2855, National Bureau of Economic Research, Inc.
  3. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(1), pages 3-42, July.
  4. Easterly, William R. & Wetzel, Deborah L., 1989. "Policy determinants of growth : survey of theory and evidence," Policy Research Working Paper Series 343, The World Bank.
  5. Findlay, Ronald, 1989. "Is the new political economy relevant to developing countries ?," Policy Research Working Paper Series 292, The World Bank.
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Cited by:
  1. Larry E. Jones & Rodolfo E. Manuelli, 1993. "Growth and the Effects of Inflation," NBER Working Papers 4523, National Bureau of Economic Research, Inc.
  2. Jones, L.E. & manuelli, R.E., 1994. "The Sources of Growth," Working papers, Wisconsin Madison - Social Systems 9428, Wisconsin Madison - Social Systems.
  3. Jones, Larry E. & Manuelli, Rodolfo E., 1992. "Finite lifetimes and growth," Journal of Economic Theory, Elsevier, Elsevier, vol. 58(2), pages 171-197, December.
  4. Shantayanan Devarajan & Vinaya Swaroop & Heng-fu Zou, 1993. "What do governments buy?," CEMA Working Papers, China Economics and Management Academy, Central University of Finance and Economics 513, China Economics and Management Academy, Central University of Finance and Economics.
  5. Shantayanan Devarajan & Vinaya Swaroop & Heng-fu Zou, 1996. "The composition of public expenditure and economic growth," CEMA Working Papers, China Economics and Management Academy, Central University of Finance and Economics 77, China Economics and Management Academy, Central University of Finance and Economics.
  6. Devarajan, Shantayanan & Swaroop, Vinaya & Heng-fu Zou, 1993. "What do governments buy? The composition of public spending and economic performance," Policy Research Working Paper Series 1082, The World Bank.
  7. Matías Berthelon, 2004. "Growth Effects of Regional Integration Agreements," Working Papers Central Bank of Chile, Central Bank of Chile 278, Central Bank of Chile.
  8. Korhan Gokmenoglu, 2013. "Re-Examination Of Wagner’S Law For Oecd Countries," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 1, pages 28-37, February.
  9. Hartler, Christina, 1991. "Agricultural Pricing and Growth," Working Paper Series, Research Institute of Industrial Economics 307, Research Institute of Industrial Economics.
  10. Solimano, Andres, 1991. "Inflation and growth in the transition from socialism : the case of Bulgaria," Policy Research Working Paper Series 659, The World Bank.
  11. Wacziarg, Romain, 2000. "Measuring the Dynamic Gains from Trade," Research Papers, Stanford University, Graduate School of Business 1654, Stanford University, Graduate School of Business.

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