Public Policy and Economic Growth

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NBER WORKING PAPER SERIES

PUBLIC POLICY AND ECONOMIC GROWTH; OEVELOPING NEOCLASSICAL IMPLICATIONS

Robert G. King Sergio Rebelo

Working Paper No. 3338

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Masaarhusetts Avenue Cambridge, MA 02138 April 1990

This paper is part of NBER's research program in Growth. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research.

NBER Working Paper #3335 April 1990 PUBLIC POLICY AND ECONOMIC GROWTH: DEVELOPING NEOCLASSICAL IMPLICATIONS ABSTRACT Why do the countries of the world display considerable disparity in long term growth rates? This paper examines the hypothesis that the answer lies in differences in national public policies which affect the incentives that individuals have to accumulate capital in both its physical and human forms. Our analysis shows that these incentive effects can induce large difference in long run growth rates. Since many of the key tax rates are difficult to measure, our procedure is an indirect one We work within a calibrated, two sector endogenous growth model, which has its origins in the microeconomic literature on human capital formation. We show that national taxation can In particular, for small open substantially affect long run growth rates. economies with substantial capital mobility, national taxation can readily lead to "development traps" (in which countries stagnate or regress) or to "growth miracles" (in which countries shift from little growth to rapid expansion) This influence of taxation on the rate of economic growth has important welfare in basic endogenous growth models, the welfare cost of a 10 % implications: increase in the rate of income tax can be 40 times larger than in the basic neoclassical model.

Robert i"ing Department of Economics University of Rochester Rochester, NY 14627 and Rochester Center for Economic Research

Sergio Rebelo

Kellogg Graduate School of Management Northwestern University 2001 Sheridan Rd Evanston, IL 60201 and Rochester Center for Economic Research

I.

Introduction Economists have long suspected that there is a link between national

policies and

long

term rates of economic growth.

For example, Schultz [1981]

suggests that many public policies contain disincentives for growth because they reduce the rewards to accumulation of a comprehensive concept of capital encompassing human as well as physical capital. a In this paper, ye show that

basic Schultzian model has the property that modest variations in tax rates are associated with large variations in long run growth rates. Our model follows leads provided by Uzawa [1965], Lucas [1988b], and Rebelo [1987]. In our analysis, changes in public policy can potentially explain periods of secular stagnation or high economic growth. Public policy is particularly powerful in affecting small open economies with freely mobile capital. For these economies, taxes can easily shut down the growth process, leading to "development traps

in which countries stagnate or even regress for lengthy that we

periods.
The

specific
key

model

construct belongs to an important class of

endogenous growth models based on work by Uzawa [1965] and retains the following
proper-ties

on the basic neoclassical model of Solow
[1965]:

[1956]

Swan [1963], constant coincide this

Cass [19651, and Xoopmans

Ci)

the

existence of a

asymptotic growth

rate; and (ii) competitive and optimal allocations

in the absence of public interventions, class of o-dels is that ther. is a "core" of

The crucial attribute of capital goods which can be

produced without the direct or indirect contribution of non—reproducible factors. In developing our model we begin with the analysis of individual decisions at given prices and then consider the implications of production structure.

This path leads us to develop aspects of individual accumulation

technology not present in...
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