The main focus of this paper is to study the effects of fiscal policy on economic growth and income equality in a growing economy. As previously stated, a government simultaneously provides consumptive, productive, and redistributive spending. That is ...
The main focus of this paper is to study the effects of fiscal policy on economic growth and income equality in a growing economy. As previously stated, a government simultaneously provides consumptive, productive, and redistributive spending. That is, I explicitly decompose allocative and redistributive government activities. I then consider the relation between a particular policy instrument and economic growth when a set of policy instruments is chosen both exogenously and endogenously. When fiscal policy is endogenously determined, I also consider implementation conditions for a decentralized competitive economy. I am especially interested in the productivity associated with each policy instrument among the four categories of fiscal policy, as well as the net cost and benefit of government activities in terms of economic growth. I also explain the source of fragile empirical results of endogenous growth models by focusing on theoretical investigation of composition of government expenditure.
My analysis shows that an inverse U-shaped relationship exists between tax rates and growth rates when the fiscal policy is exogenous. However, when fiscal policy is endogenously chosen at a social optimum, the relation between the growth rate and tax rates is always negative. That is, the nonlinear hump relation between growth and taxes disappears. These two results imply that the different properties of exogenous and endogenous fiscal policy theoretically account for the difference in the relation between growth and fiscal policy in empirical studies. As argued by Rodrik (2005) and Cooley and LeRoy (1981), these differences show how empirical studies for growth and fiscal policies critically depend on the choice of independent policy variables in growth regressions. In addition, an alternative decomposition of government spending may affect the response of private sector investment to fiscal policy. This problem is fundamental for the identification of exogenous and endogenous variables in empirical studies in endogenous growth models.
This paper also demonstrates simple empirical evidence for the difference between exogenous and endogenous fiscal policy in cross-country data. As in exogenous fiscal policies, fiscal policy (here, income tax rates) has a nonlinear effect on the growth rate. For this regression analysis, I also include institutional variables (e.g., Barro, 1991; Mauro, 1995). The statistical significance of an index of effectiveness of institutions, including regional dummies, implies that a government’s implementation abilities conditionally affect economic growth and income distribution. As in endogenous fiscal policies, I also find a negative association between the growth rate and income redistribution, which is consistent with political economy literature (Benhabib and Rustichini, 1996), along with a negative relation between consumptive spending and income inequality (Chu, Davoodi, and Gupta, 2004). In addition, as expected both in endogenous and exogenous policies, I find a negative relation between tax rates and productive government spending. However, we need to be careful to interpret estimated coefficients from such empirical analyses in the presence of the policy endogenity problem.