1. Government and Growth Francesco Daveri

2. Outline Some facts Theory Empirics Digging deeper: Kneller, Bleaney and Gemmell (1999) Conclusions

3. Common secular trend towards Bigger Government

4. Big Government: bad for growth? Not necessarily

5. Public good provision (rule of law) enhances factor accumulation …

6. … and efficiency

7. .. But taxes discourage market activities

8. .. and control of corruption is associated to high per capita GDP

9. Theory: summing up Some Govt-related items affect growth: Public goods (Productive expenditure)  good for growth Distorting taxation  bad for growth … while some others are irrelevant for growth: Non-distorting taxes (citizen tax) Unproductive expenditure (if financed with non- distorting taxes) MAIN MESSAGE: composition of spending and taxation matters

10. Empirical case Is the empirical case as apparent as the theoretical case ? Not really, unfortunately Barro (1991, 1997) –public consumption (Gov’t spending minus defense minus education) negatively related to growth. –Spending in public goods not robustly correlated with growth Koester- Kormendi (1989), Easterly-Rebelo (1993): –taxes unrelated to growth along cross-sectional dimension Stokey-Rebelo (1995) –taxes unrelated to growth along time series dimension in the US

11. Issue: how to measure tax rates Question: by how much is growth rate affected as Gov’t varies tax rates? Statutory marginal tax rates –Rarely used in cross-country growth regressions for they are awkward to compute and update –Moreover, nominal tax rates often different from effective tax rates Tax-to-GDP ratios –Marginal tax rate matters in theory; we only observe average –T/GDP = (T/tax base) * (tax base/GDP). Hence, tax-GDP ratios may change independently of Gov’t action if income distribution varies Average effective tax rates (AETR) –Best available indicators: T / (tax base). –Computed for capital and labor incomes as well as consumption.

12. What if effective rates used? Easterly and Rebelo (EER, 1993), AETR for 40 countries –No detected link with growth Mendoda, Razin and Tesar (JME, 1994), AETR for 14 Industrial countries. Updated by DAveri and Tabellini (Economic Policy, 2000) –Weak link with growth

13. Other methodological issues Gov’t spending in public goods may not reflect effective provision ‘Tax systems’ are hardly comparable, for tax structures, degree of enforcement and tax bases vary wildly across countries Kneller-Bleaney-Gemmell (KBG, 1999): most studies focus on just one side of the budget. Both sides should be included to avoid biasing results.

14. KBG (1999) Put the Govt budget constraints in the growth regression! Problem: if append spending, taxes and deficit variables  perfect collinearity among fiscal regressors … so? Leave out one fiscal variable … which one???  Theory helps: eliminate a “non-affecting growth item” to avoid the omitted variable problem

15. KBG (1999) Growth= c+  j=1,..,m  j X ij + d  controls + error …eliminate the mth variable: Growth= c+  j=1,..,(m-1)  j X ij + d  controls + error

16. KBG (1999) if the m variable is omitted: Growth= c+ + d  controls+ errors the null: coeff meaning: effect of a unit change in the relevant variable offset by a unit change in the omitted category the implicit financing element is the m th

17. Data 22 developed countries Annual data 1970-1995  five-year avarages to remove the effects of business cycle

18. KBG regression results

19. Non distorting taxation (rndis) and non productive spending (enprd): hypothesis of same coefficient not rejected Productive expenditure (eprd): positive and significant coefficient Distorting taxation (rdis) : negative and significant coefficient Budget surplus (sur): positive and significant coefficient

20. Mis-specifying the Budget Constraints A correct specification of the Government budget constraint is important for interpreting fiscal parameters Including tax rates without budget deficit biases estimated coefficient toward zero if tax cuts financed in deficit

21. Conclusion  Impact of fiscal policy on growth depends on the structure of taxation and expenditure Non productive expenditure and non-distorting taxation have a zero impact on growth Productive expenditure has a positive effect on growth if financed by non distortionary taxation Distorting taxation has a negative effect on growth