Policy Destortions, Size of Government, and Growth
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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