Fiscal Policy Can Have Direct Influence on Output Growth

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Page 57

Various macroeconomic models can be used to examine the impact of a range of variables on an economy's long-run output growth. Among these are recently developed "endogenous growth" models, which incorporate policies that affect the incentives to invest in physical or human capital and can have permanent impacts on the long-run rate of output growth. Inspired in part by the literature on endogenous growth models, a number of empirical studies have examined the impact of fiscal policy on output growth. However, most of these studies consider only aggregates, such as total expenditure or government revenues as a percent of GDP. In addition, they often fail to identify the channels through which fiscal policy can affect growth-for example, government spending on public education, which can affect human capital formation; the provision of public sector infrastructure, which can affect the productivity of private capital; or capital income taxation, which can help determine saving. In a recent IMF Working Paper, The Impact of Fiscal Policy Variables on Output Growth, Philip Gerson of the Fiscal Affairs Department surveys the theoretical and empirical literature on the relationship between fiscal policy variables and growth. He adopts a disaggregated approach, examining the effect of both expenditure and tax policies on labor productivity, capital productivity, and the cost and supply of labor and capital.

Fiscal Policy and Labor Productivity

Government expenditure on education and public health are two examples of fiscal policies that can raise long-run economic growth, since educated and healthy workers are not only more productive than uneducated and sickly ones, but also better able to be trained and to adjust rapidly to technological and other changes in the workplace. However, for these investments to raise the rate of growth, they must augment, rather than simply replace, private sector investment. This could occur if market failures exist. In the presence of imperfect capital markets, when, for example, a lack of collateral may mean that individuals are unable to borrow to finance their education-even if the prospect of higher future wages would justify the expense of schooling-government financing could ensure access to education. On a more basic level, if private returns to education are small relative to the cost of schooling, but social returns are large, students will tend to underinvest in education. Subsidized public education could ensure that the optimal number of...