3 Fiscal Structure
We define fiscal structure as the composition of government expenditure, the structure of taxation, and the overall size of government. By opening up several avenues through which economic growth can occur, endogenous growth models have provided tools for investigating how fiscal policy can influence economic growth and have given impetus to the idea that the structure of fiscal policy matters for growth. In an early contribution to this development, Barro (1990) demonstrates that certain forms of government expenditure can in theory improve economic growth, whereas, if lump-sum taxation is ruled out, financing of that expenditure will typically have negative impacts on economic growth. Two important insights emerged from Barro’s paper. It explicitly demonstrated that in theory fiscal policy can impact on economic growth and, moreover, by incorporating the government budget constraint it revealed that the growth effects of fiscal initiatives were conditional on the method of financing.
These theoretical insights have been reinforced by empirical research distinguishing types of government expenditure and taxation and explicitly incorporating the government budget constraint. As Barro (1990) and Leeper and Nason (2005) have emphasised, theoretical work that takes seriously the restrictions imposed by the government budget constraint has established some important results. Accordingly, and following the work of Kneller, Bleaney and Gemmell (1999) and Bleaney, Gemmell and Kneller (2001), there is growing recognition that the robustness of empirical tests of the growth effects of different fiscal initiatives depends on the appropriate treatment of the government budget constraint. As Gemmell and Kneller (2003) state: “[T]he predicted effects of taxes and expenditures on growth rates depends on: (i) the type of tax or expenditure considered (and the tax/expenditure mix); (ii) the total level of expenditures; and (iii) how this is financed (compensating tax or expenditure change)” (page 2). Hence, fiscal structure will have a substantial influence on economic performance.
3.1 Fiscal structure and economic growth
3.1.1 The structure of expenditure
There is a long-standing debate in the economic literature about how and the extent to which government expenditure can raise long-run economic growth. According to neoclassical growth models, while taxation and government expenditure initiatives that influence the savings rate or incentives to invest in physical or human capital may affect the equilibrium factor ratios, they do not affect steady-state long-run growth. The source of economic growth in these models is exogenous, being unspecified technological change. Although not casting much light on the sources of growth, models of this form nevertheless help us to understand how some types of behavioural change, such as changes in labour force participation, may affect factor ratios and the level of income per capita. To the extent that fiscal policy can change these behaviours, it can affect the steady-state growth path and transition path but not the steady-state growth rate.
The fundamental long-run growth mechanism in endogenous growth models is constant or even increasing returns to scale for the factors of production which can be reproduced by savings and investments. Long-run growth becomes endogenous in that growth depends on investment decisions pertaining not just to physical capital but also to investments in knowledge, human capital, research and development and public infrastructure. These decisions may be influenced by the quality of institutions in the economy, including financial markets and government regulatory institutions. They can be influenced by fiscal policy, including public infrastructure investments. Fiscal policy may directly raise the marginal productivity of private input factors which encourages their accumulation and hence may induce output growth. This process may occur either through the effect on allocation decisions in the private sector or by influencing the productivity of factor inputs.
Public expenditure on various forms of economic and social infrastructure is an example of how allocation decisions of the private sector can be influenced by fiscal policy, as is apparent from Barro’s (1990) early model of growth which incorporated public infrastructure in the representative firm production function. Several studies have evaluated, for example, the effect on private sector productivity of public expenditure on transport and information systems (Auschauer, 1989 and 2000; Feehan and Matsumoto, 2002).
Public expenditures may also have the potential to influence the quality of production inputs to private production. For example if, as Lucas (1988) argues, investment in education increases the level of human capital and if the returns to education do not decline over time, education funding will be a source of long-run economic growth.
Although there are many areas where investment can, in theory, improve economic growth, the rationale for public provision of services or government funded incentives typically rests on the presence of either information asymmetries or externalities. For example, the presence of credit market imperfections and human capital externalities provides a rationale for government funding of education (Lucas, 1988).
Although fiscal policy can have positive impacts on long-run economic growth, fiscal policy can also change incentives in ways that are harmful to economic growth. These costs, such as the deadweight loss associated with government discouraging private activity, need to be taken into account in any consideration of government involvement.
Modern growth literature is therefore intended to clarify where it might be most fruitful for policy-makers to focus attention if the objective of fiscal policy is higher income growth. That research is not a substitute for robust cost-benefit analysis of fiscal proposals, but it may help identify where that analysis may be best applied.
