Fiscal Policy & Growth

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Journal of Public Economics 74 (1999) 171–190 www.elsevier.nl / locate / econbase

Fiscal policy and growth: evidence from OECD countries
Richard Kneller a , Michael F. Bleaney b , *, Norman Gemmell b a b

National Institute for Economic and Social Research, London, UK School of Economics, University of Nottingham, Nottingham, UK

Received 1 October 1998; received in revised form 1 December 1998; accepted 1 December 1998

Abstract Is the evidence consistent with the predictions of endogenous growth models that the structure of taxation and public expenditure can affect the steady-state growth rate? Much previous research needs to be re-evaluated because it ignores the biases associated with incomplete specification of the government budget constraint. We show these biases to be substantial and, correcting for them, find strong support for the Barro model (1990, Government spending in a simple model of endogenous growth. Journal of Political Economy 98 (1), s103–117, for a panel of 22 OECD countries, 1970–95. Specifically we find that (1) distortionary taxation reduces growth, whilst non-distortionary taxation does not; and (2) productive government expenditure enhances growth, whilst non-productive expenditure does not. © 1999 Elsevier Science S.A. All rights reserved. Keywords: Growth; Government; Taxation JEL classification: H30; O40

1. Introduction Does the share of government expenditure in output, or the composition of expenditure and revenue, affect the long-run growth rate? According to the neoclassical growth models of Solow (1956) and Swan (1956), the answer is *Corresponding author. Tel.: 144-115-951-5464; fax: 144-115-951-4159. E-mail address: michael.bleaney@nottingham.ac.uk (M.F. Bleaney) 0047-2727 / 99 / $ – see front matter © 1999 Elsevier Science S.A. All rights reserved. PII: S0047-2727( 99 )00022-5

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largely ‘no’. Even if the government could influence the rate of population growth, for example by reducing infant mortality or encouraging child-bearing, this would not affect the long-run growth rate of per capita income. In these models, tax and expenditure measures that influence the savings rate or the incentive to invest in physical or human capital ultimately affect the equilibrium factor ratios rather than the steady-state growth rate. In endogenous growth models, by contrast, investment in human and physical capital does affect the steady-state growth rate, and consequently there is much more scope in these models for at least some elements of tax and government expenditure to play a role in the growth process. Since the pioneering contributions of Barro (1990), King and Rebelo (1990) and Lucas (1990), several papers have extended the analysis of taxation, public expenditure and growth, demonstrating various conditions under which fiscal variables can affect long-run growth (see, for example, Jones et al., 1993; Stokey and Rebelo, 1995; Mendoza et al., 1997). If the theory is reasonably clear, however, the empirical evidence is not. As Stokey and Rebelo (1995, p. 519) state, ‘‘recent estimates of the potential growth effects of tax reform vary wildly, ranging from zero to eight percentage points’’. In fact, virtually no studies have been designed to test the predictions of endogenous growth models with respect to the structure of both taxation and expenditure in the way that we do here (Devarajan et al. (1996) do so for the expenditure side only). Moreover, few researchers have recognised that partial studies (e.g. those that focus exclusively on one side of the budget and ignore the other) suffer from systematic biases to the parameter estimates associated with the implicit financing assumptions. This point has been demonstrated by Helms (1985), Mofidi and Stone (1990) and Miller and Russek (1993) for various data sets. We explore the implications of this argument for the regression specification and show that, if this...
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