Policy Distortions, Size of Government, and Growth [report]

William Easterly
1989 unpublished
The dialogue that advocates of liberalization have with policymakers would improve if more were made of the structural factors that influence the effect of reducing distortions on growth. Tbs Policy, Plaming. and Reaearch Complex distributes PPR Wodring Papers to disseminate the findings of work in progress and to encourge the exchange of ideas anong Bank saff and all others intsted in developmea issue. Tlese papers cany the names of the autnor. reflect only their views, and should be used and
more » ... should be used and cited accordingly. The findingr. interprtations, and conclusions ar the authorn own. They should not be attributed to the World Bank. its Board of Dectos, iu managemnt. or any of is membercountns. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Plc,Planning, and Research | _ m^ i 1 ;r14 lz [E :^^l :I; : Maroeoonomic Adjustment and Growth Easterly analyzes the structural relationship tax on one form of capital. The tax revenue is between policies that distort resource allocation used to finance the acquisition of producdve and long-term growth. government capital. There is then a tradeoff He reviews briefly the Solow model in between two forms of distortionone resulting which steady-state growth depends only on ex-from distortionary taxadon and the other frQm ogenous technological change. Policy distor-insufficient public capital. tions do affect the rate of growth in the transition Increasing the tax from zero has a positive to the steady state in the Solow model. But effect on growth, but with further tax increases growth falls off so rapidly in the Solow transi-the relationship will eventually tum negative. tion as to make it unsatisfactory as a model of Tax revenue ("size of government") as a funclong-term growth, even over periods as short as tion of the tax rate will be given by a Laffer a decade. curve. Growth still remains above a certain Easterly proposes an increasing-returns minimum as the tax rate gets arbitrarily large. model in the spirit of the new literature on The relationship between tax revenue and economic growth. With increasing retums, growth for altemative tax rates can be positive, endogenous economic variablesand thus negative, or zero. The same is true of the relapolicywill affect the steady-state rate of tionship between public and private inm-estmnent. growth. Changes in the share of tax revenue dc\ oted to Easterly's model gives output as a linear capital accumulation ("government saving") will function of total capital, but a decreasing func-affect the results. tion of each of two types of capital. The distor- The results suggest that simple linear tion is defined as a policy intervention that relationships between distortions and growth, or incre.ases the cost of using one of the types of between size of government and growth, are capita. The relationship between this distortion untenable. The dialogue between advocates of and steady-state growth is negative but highly liberalization and policymakers could be ennonlinear. At very low and very high levels of riched by recognizing the structural factors that distortion, the effect on growth of changing the influence the effect of lowering distortions on distonion is close to zero. growth. Changes in structural parameters of the Easterly's model shows that reducing the economy the elasticity of substitution be-distortions does not have an equal effect on tween the two types of capital and the share of growth in all circumstances. The effect depends nondistorted capital in productionwill on how flexible the economy is (the elasticity of significantly affect the impact of the policy substitution), how large the share of the factor distortion on growth. being penalized in production is, and how high Easterly extends the model to an analysis of the distortions are initially. Small changes in the relationship between the size of government either very low or very high levels of initial and growth by treating the distortion strictly as a distonions have a minimal effect on growth.
doi:10.3386/w3214 fatcat:fwpdebxeo5cgrjl2dbgdqyvfuu