Fiscal Policy

Abstract

This chapter highlights the important role played by the government in jump starting and sustaining economic growth. The government provides the country’s infrastructure or public capital—laws, roads, education, public health, and utilities—that secure property rights and raise the productivity of private capital. Growth in public capital keeps the marginal return to private capital from falling dramatically during industrialization, helping to explain G1. The need for government to lay the foundation for growth helps explain the vast differences in experiences of developing countries after WWII, summarized in G6. Growth Miracles and Growth Disasters are largely driven by especially good and especially bad government policy.

Appendix

1.1 Tax Rates

In the text, we consider the value of the wage tax rate that maximizes the height of the transition equation for the private capital-labor ratio. Maximizing the growth in private capital intensity is not necessarily a reasonable objective. Instead we might consider the tax rate that maximizes state worker productivity (τ∗∗∗) or steady state household utility (τ∗∗). One can compute these tax rates as well (see Problems 9–11). The comparison of the three tax rates is

$$ \tau \ast \ast \ast =\frac{\mu \left(1-\alpha \right)}{\mu \left(1-\alpha \right)+\alpha }> $$

$$ \tau \ast \ast =\frac{\mu \left(1-\alpha \right)}{\mu \left(1-\alpha \right)+\alpha}\left(\frac{1+\beta }{\left(\frac{1}{\mu \left(1-\alpha \right)+\alpha}\right)+\beta}\right)=\mu \left(1-\alpha \right)\left(\frac{1+\beta }{1+\beta \left(\mu \left(1-\alpha \right)+\alpha \right)}\right)> $$

$$ \tau \ast =\mu \left(1-\alpha \right), $$

because μ(1 − α) + α < 1.

The tax rate that maximizes steady utility is perhaps the most compelling. It is higher than the tax rate that maximizes steady state capital intensity because there is a benefit to households of keeping the private capital intensity lower than the maximum. All households are savers, so a higher return to capital, other things constant, raises household welfare. The desire to keep the return to capital high creates an incentive to keep private capital intensity low. This consideration causes the policy maker to set the tax rate higher than the one that maximizes the steady state value of k.

The highest tax rate is the one that maximizes steady state worker productivity. This tax rate is higher than the rate that maximizes steady state utility because it does not account for the fact that a higher tax rate on wages lowers the after-tax wage that determines household consumption and instead only focuses on the before-tax wage associated with worker productivity.