How much do distortions affect growth?
The author presents a simple endogenous growth model (with two types of capital) that shows the sizable long-run effects on growth of distortionary policies. The model applies to many different types of distortions of relative prices common in developing countries - for example, price controls, black market exchange rates, and differential taxes and tariffs. The model shows that distortions of relative input prices can greatly affect growth and welfare. The magnitude of the effect depends on the production elasticity of substitution. With high substitutability, the effects on growth and welfare, although possibly large, are bounded, no matter how high the rate of distortion. Subsidizing inputs and investment goods can increase growth, even though it worsens welfare. But a subsidy to one capital good financed by a tax on another capital good unambiguously reduces growth. Empirical results show strong negative effects from variance in the relative prices of investment goods across sectors, while also confirming and extending earlier results showing that penalizing investment goods and distorting financial markets reduce growth.
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