II. How Fiscal Policy Can Affect Growth: Conceptual Issues and Evidence

George Mackenzie, Philip Gerson, and David Orsmond
Published Date:
April 1997
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A Basic Conceptual Framework4

Growth in actual output per person employed (productivity growth) can be attributed to one or more of the following sources:

  • a more intensive utilization of existing productive capacity;
  • a reallocation (more efficient use) of existing resources that reduces the gap between the economy’s potential and actual output levels; and
  • growth of the stocks of physical and human capital (relative to the growth of labor supply) or increased technological development.

The first two sources of productivity growth involve either more intensive or more efficient use of the existing stocks of the factors of production. They require some initial slack in the economy or the implementation of measures that reduce resource misallocation—for example, a well-conceived tariff reform or privatization program. The third source entails capital accumulation, whether physical or human, and thus can entail more than just short-lived increases in growth, unlike the first two.

The concern of this study is with the role of fiscal policy in stimulating the second and third sources of growth—especially the third, capital accumulation. Although economic theory provides a wealth of insights and a framework for thinking about growth, there are no conclusive rules that prescribe in any detail how to use fiscal policy to promote growth or that establish the relative importance of different fiscal policy measures. For example, although the optimal level of public investment in human and physical capital can be determined in principle, data deficiencies mean that calculating social rates of return on capital expenditure is generally not practicable.5

Nonetheless, the literature on economic growth, basic economic principles, and numerous empirical studies do offer some guidance on this question. Apart from pursuing a fiscal policy that is consistent with a low rate of inflation, an adequate amount of credit to the private sector, and a sustainable external position (that is, the macroeconomic aspects of fiscal policy), there are three ways in which the government can foster productivity growth:

  • by either financing or supplying directly the investments that the private sector will not supply in adequate quantity because of various market failures (in practice, this means certain kinds of infrastructure projects and basic education and health expenditure, which can directly boost private sector productivity);6
  • by efficiently supplying certain basic public services that are necessary to provide the basic conditions for entrepreneurial activity and long-term investment—that is, by minimizing the cost of producing a given volume of a public good or service; and
  • by financing its own activities in a manner that minimizes distortions to private sector saving and investment decisions, and to economic activity more generally.

These policies contribute to growth by their impact on the level of output that can be achieved with existing capital stocks and human resources, by their direct contribution to capital formation, and by their effect on the private sector’s decisions to save and invest, which contribute to capital accumulation. They are meant to be both growth enhancing and welfare enhancing.7

The rest of this section discusses in more detail the channels through which fiscal policy can affect growth—concentrating on its impact on capital accumulation—and summarizes the weight of the evidence of empirical studies. In addition, it deals with the importance of public administration for growth. Since some adjustment programs come to grief because fiscal measures cannot be sustained, it also discusses the sustainability of tax and expenditure measures.

Links Between Fiscal Policy and Growth

Investment in Physical and Human Capital8

Public Infrastructural Investment

Many infrastructural investments that can substantially increase the productivity of private sector activity cannot be undertaken profitably by the private sector, especially in countries without welldeveloped capital markets. These projects will be complementary to private sector investment, and not competitive with it. When projects have a social rate of return that is substantially higher than their private rate of return, there is a prima facie case for the state’s involvement. The large initial outlays that certain investments require, and the problems that can arise in charging for their output, can justify public sector involvement. One example is investment in roads, where private ownership, even with regulated tolls, is not feasible in most cases. For investment in other areas, however, no obvious case for public ownership can be made beyond what is necessary for the basic functions of government.

A recent study (Easterly and Rebelo, 1993) of 119 countries found that public investment in transport and communication is positively related to growth, but that investment in public enterprises has no effect, and public investment in agriculture a negative effect, on growth. Other studies, mainly dealing with the states of the United States, have also found a positive relationship between infrastructural investment and growth. Although this finding is not common to all studies, the weight of the evidence offers moderate support for the view that infrastructural investment fosters growth, but that public investment in general does not (Gerson, forthcoming).

Educational Expenditure

Expenditure on education is potentially a highly productive investment, and its provision by the public sector may be justified by market failures. Education is typically both financed and supplied by the private sector to some extent. There are, however, reasons for thinking that the private sector, left to its own devices, would not provide enough education.

  • Not all of the benefits of education accrue to the student alone, or, in the case of apprenticeships, to the employer financing the training; they may accrue also to the community at large and to subsequent employers.9
  • The parents of school-age children, or students themselves, may discount the benefits of formal education excessively, particularly when the family is poor, because its opportunity cost (the out-of-pocket costs of education and the temporary decline in the student’s productive time) appears to be too great.
  • It is typically not possible to obtain a loan to pay for the substantial expense of a formal education.

The preceding discussion offers some clues about the relative merits of governmental involvement in primary and secondary education as opposed to tertiary education. The first two levels are those where the constraint imposed by imperfect credit markets is most severe, and the positive externality effects, and thus the effects on growth, are possibly the greatest, because of the importance to society of some of the skills taught.10 For example, both basic literacy and numeracy are necessary for most jobs in a market economy and are associated with improved hygiene, better infant care, and lower birthrates (World Bank, 1990).

Many empirical studies of the relationship between education and growth have been made. Influential studies by Denison (1962, 1967), done at the aggregative level, implied that around 20 percent of the growth of U.S. GDP between 1930 and 1962 could be attributed to the increase in the workforce’s educational level. A large number of studies of wage differentials between persons with different levels of education have found that schooling has a high rate of return. Primary education is almost invariably found to have a higher return than secondary and tertiary education, even though in practice many developing countries subsidize the higher levels much more heavily than the primary level (Psacharopoulos, 1994).

Studies of the relationship between public spending on education (as opposed to the level of educational attainment) and growth are less clear-cut, perhaps because they typically aggregate education spending at all levels, and because they take little account of the long lag between the period of schooling and entry or reentry into the labor force. All in all, however, the literature supports the view that primary education deserves special emphasis, particularly in countries where literacy and primary school enrollment rates are low.


Health care expenditure increases human productivity, and the positive externalities associated with preventive and primary care mean that public expenditure in these areas can promote growth. Clearly, expenditure on health, like education expenditure, can be an investment in human capital because it can prolong a person’s productive life. As with education, the strongest case for intervention is in preventive and primary health expenditure (public health and clinics) because these expenditures either entail substantial externalities or have a very high social benefit-cost ratio. For example, it has been estimated that several of the most common diseases that afflict children in developing countries can be treated for only a few dollars per additional year of productive life gained (World Bank, 1993a). Because many people will not be able to afford even these comparatively simple treatments, the provision of free or subsidized treatment, by increasing productivity, can increase output, saving, and growth.11 Certain public health interventions, such as well-designed immunization programs, are also highly cost-effective (World Bank, 1993a). As is the case for education, however, the empirical evidence linking aggregate public expenditure on health and growth is not strong. The weakness of the link may in part reflect that, in practice, much health expenditure is devoted to high-cost curative medicine.

The discussion of education and health expenditure is a good place to note that it is typically much easier to compare the rates of return of expenditure within a sector than it is to make comparisons across sectors. This is particularly true of the health sector, where it is evident that in many countries the rate of return to preventive care or simple curative techniques—as measured in lives saved or years of productive life gained—is far higher than costly care in hospitals.

Comparisons across sectors are far more problematic, mainly because of the difficulty of measuring social costs and benefits. That said, even if the social rate of return of additional kilometers of roads is difficult to compare with the rate of return from new schoolrooms, rough rules of thumb (and common sense) can be used to determine when there is a clear imbalance. A basically healthy population and a capital city with three-hour-long traffic jams do not suggest that the economic infrastructure budget should be cut to boost public health, for example.

Basic Public Services

Spending on the Social, Institutional, and Political Fabric

A certain level of expenditure by the state on the basic institutions of a market economy is necessary for growth. Growth is not generated automatically by the mere existence of capital and labor. The environment must not be hostile to economic activity, especially entrepreneurial activity, so that investment is not discouraged. Among other things, this normally requires a legal code and tax system that are both stable and administered fairly, respect for the rights of property, and physical security. It also requires a reasonably well-functioning public administration.12

There is clearly an empirical link between political or social stability and growth.13 What is more difficult to ascertain is the role of government expenditure in this relationship. The maintenance of the social and institutional infrastructure that is necessary for a market economy requires some minimal amount of public expenditure on general public and tax administration, general regulatory activity, law and order, and, possibly, defense. Empirical studies have not found evidence, however, of a relationship between these expenditures and growth.

Civil Service

A civil service promotes growth by delivering basic public services (and regulating economic activity) in an efficient and reliable way at a reasonable cost. Compensation and employment policy for an educated and well-motivated civil service would be based on the following principles.

  • Civil service compensation should be comparable with that of the private sector (adjusting for security of employment and differences in other nonwage benefits of employment), with adequate salary differentials between different occupational groups within the civil service.
  • Pay should be related to productivity, not personal or political connections, and promotion should be based on merit.
  • Civil service employment should not be a tool of overall employment policy.

This is a description of a lofty ideal. Good pay policies alone will not eradicate corruption. Nonetheless, substantial deviations from these guidelines can do serious harm to a civil service’s productivity, as well as burdening the budget (Haque and Sahay, 1996).

The Social Safety Net and Transfers to Persons and Enterprises

Spending on social assistance and other transfers to persons can foster growth to the extent that it reinforces the political viability of the policies and the environment necessary for growth. These expenditures are sometimes justified on the grounds that they help to alleviate poverty and prevent the fraying of the social fabric, thus reducing crime and other antisocial behavior that impedes productive economic activity.14 There is some evidence of a positive link between transfer payments and growth (Cashin, 1995; and Sala-i-Martin, 1996).

Transfer payments, or possibly well-targeted commodity subsidies, can also serve to protect the vulnerable during adjustment. To the extent that such expenditure facilitates adjustment at a reasonable cost, it can thus be growth promoting. These expenditures and more permanent forms of social assistance can also promote growth by increasing the productivity of the poor. That said, social assistance and social safety net programs run the risk of encouraging overconsumption of the subsidized commodities and of making the effective marginal rate of taxation on welfare recipients so high that there is little incentive to seek work or keep a job (for a general exposition of IMF policy on social issues, see IMF, 1995a).

It is more difficult to argue for operating subsidies to business enterprises.15 As with untargeted general commodity subsidies, these can entail substantial distortions—in particular, inefficient and high-cost production techniques. One possible rationale for such operating subsidies is as a strictly temporary measure to facilitate restructuring or privatization; another is the need to cover losses resulting from production under conditions of decreasing marginal cost and marginal cost pricing.16

Financing Public Expenditure: The Tax System17

The effects of different tax regimes on the allocation of resources—in particular their effects on saving, investment, and labor supply—have been the topic of countless studies. Taxation creates distortions, essentially because it alters the relative prices of both final products and productive inputs so that they no longer reflect relative scarcities.18

The main object of tax policy is to design a system that raises enough revenue to meet a government’s revenue target while minimizing the level of associated distortions.19 Tax policy must also be mindful of the potential administrative complexity of a tax system, and of the burden of compliance imposed on the taxpayer. Its principal contributions to growth, aside from its contribution to macroeconomic stability, consist in minimizing the gap between actual and potential output—including its effect on the amount and allocation of work effort—and in minimizing the impediments to the productive investment of private saving.

How the balance between these differing, and to some extent conflicting, objectives should be struck will vary from country to country, especially given the limits that may exist on administrative capacity. A consensus has emerged, however, that the “ideal” tax system for a developing country would have the following characteristics (Stotsky, 1995):

  • heavy reliance on a broadly based sales tax, such as a VAT, preferably with a single rate and minimal exemptions, and excise taxes on petroleum products, alcohol, tobacco, and perhaps a few luxury items;
  • no reliance on export duties, except possibly as a proxy for income tax for hard-to-tax sectors such as agriculture;
  • reliance on import taxation for protective purposes only—since the domestic sales tax is assigned the revenue-raising function—with a low average rate and a limited dispersion of rates to minimize effective rates of protection;
  • an administratively simple form of the personal income tax, with exemptions limited, if possible, to personal dependents’ allowances, a moderate top marginal rate, an exemption limit large enough to exclude persons with modest incomes, and a substantial reliance on withholding; and
  • a corporate income tax levied at only one moderate-to-low rate, with depreciation and other non-cash expenditure provisions uniform across sectors, and minimal recourse to incentive schemes for new ventures.

Many of these features would be appropriate in both developing and industrial country settings. The special features of the tax system in the former are the lack of special emphasis on the personal income tax—an administratively demanding tax—and the emphasis on a simplified form of the VAT. The structure is seen as conducive to growth because, by striving for as broad a base and as uniform a rate structure as possible, it keeps top marginal rates down and avoids unnecessary rate differentiation.

The most likely channel through which taxation would affect growth is through its impact on saving and investment. As regards saving, the evidence suggests that tax regimes, by themselves, do not have a major impact on the average level of saving (Bovenberg and others, 1989; Smith, 1990; and Feldstein, 1994). There is considerable evidence, however, that the tax regime can affect the allocation of saving, mainly because not all forms of saving can be taxed equally. For example, it is generally easier to tax income from financial saving (that is, the accumulation of bank deposits, bonds, and shares) than income from real saving (investment in residential housing, art, and the like). One important consequence is that taxation of financial saving can promote financial disintermediation and excessive investment in real estate and other real assets. Because the income from financial assets is normally taxed without an adjustment for inflation, high rates of inflation can seriously exacerbate this distortion (Tanzi, 1984).

Studies of investment typically have found that it is moderately sensitive to a measure of the cost of capital, which is affected by the tax regime (Chirinko, 1993; and Mendoza, Milesi-Ferretti, and Asea, 1995). The tax regime is only one influence on the cost of capital, however, and the cost of capital only one influence on the investment decision. In the developing country setting, the evidence suggests that the effect of tax systems on investment is minimal. Other factors, such as political stability, play a more important role.20

Thus, the primary impact of fiscal policy on the level of investment may well originate on the expenditure rather than the revenue side of the budget. As with the saving decision, however, the tax regime has a greater influence on the composition of investment than on its level. In particular, when the structure of the corporate income tax varies across industries, because of, inter alia, differences in statutory rates or depreciation provisions, marginal effective rates of tax can vary substantially, which is highly distortional.21 The distortional taxation of saving and investment can be expected to lower the average rate of return to investment, thereby reducing growth.

The tax regime can also affect the supply of labor. The size of this effect and that of the perverse effect of a tax transfer system, already noted, is limited within a developing country setting when income taxpayers are generally a small minority of the population. Nonetheless, excessive personal income tax rates undoubtedly contribute to the growth of the underground economy (Tanzi and Shome, 1993).

There is no extensive empirical literature on the allocative effects of sales taxation. A broadly based sales tax with uniform effective rates, such as the VAT, should nonetheless be preferable on allocational grounds to a tax with many different effective rates, such as a cascading turnover tax with an excise component that applies to a large number of goods (Harberger, 1988).22 The extensive literature on tariffs and growth argues quite strongly for the view that, other things being equal, lower tariffs are good for growth.


Efficient tax administration and public expenditure management can reinforce the growth-promoting features of tax and expenditure policies. Conversely, expenditure policy, no matter how well designed, may see its intentions vitiated by bad public expenditure management. Good public expenditure management is a prerequisite for a competent evaluation of expenditure policies, for their effective execution, and for the timely monitoring of the budget. It is also essential to ensure that a change in the fiscal policy stance during the financial year can be effected in a way that minimizes the disruption to the most productive expenditure programs.

Good tax and customs administration gives a government more choice in designing a tax system, allowing it to rely on allocationally superior but administratively more demanding taxes. By ensuring that the tax system as actually administered coincides with the tax system of the statutes, good administration also contributes to the climate of stability and predictability that is a prerequisite for long-range investments and commercial activity. Efficient tax administration and public expenditure management also reduce the chance that a government’s actual fiscal policy will prove incompatible with its macroeconomic targets.

Public Expenditure Management

The features of a growth-promoting public expenditure management system will differ from one country to another, if only because countries differ in their ability to apply complex systems. However, a well-functioning public expenditure management system would include, at a minimum, the following elements:

  • use of a budget that integrates current and capital expenditure plans and relies on efficient appraisal techniques to decide among competing expenditure needs;
  • utilization of aggregate expenditure ceilings, with effective control over expenditure during the year, coordination of domestic and foreign-financed expenditure, and effective management of cash and public debt; and
  • a fiscal reporting system that compiles clear, reliable, comprehensive, and timely data on budget execution.

In a more advanced phase of development, the public expenditure management system would imbed the budgetary process in a medium-term macroeconomic framework. In its most sophisticated form, such a multiyear approach would include the following elements:

  • a medium-term fiscal policy forecasting model;
  • rolling forward cost estimates of continuing programs; and
  • a disciplined procedure for adding new programs to the forward estimates.

These more advanced forms of public expenditure management require considerable capacity for forecasting and analysis of short- and medium-term budget trends and priorities. They could be included, either in whole or in part, in the public expenditure management procedures of a country that had largely mastered the more fundamental procedures just described.

The final—and most advanced—phase involves the use of performance-based accountability to improve efficiency in the public sector through an allocation of resources that is more closely in line with local needs and conditions. In particular, in several advanced countries there has been a trend toward a decentralization of management authority to meet specified objectives within an (overall) budgetary ceiling.23 A reliable and accurate flow of data back to the center to maintain accountability is a critical component of this approach.

Tax Administration

The basic ingredients of a sound tax administration are as follows:

  • reliance, where feasible, on voluntary compliance and self-assessment, entailing, among other things, adequate education of taxpayers, simple forms and instructions, and simplified filing and payment procedures;
  • use, where possible, of final withholding;
  • efficient detection procedures for delinquent taxpayers, requiring an up-to-date and accurate tax-payer registration system that can detect “stopfilers” and delinquent taxpayers;
  • efficient and impartial enforcement and collection procedures (among them, the issuing of notices), including a system of penalties that maximizes the incentive to comply, together with simple procedures for the settlement of disputes; and
  • reliance on systematic audit plans and procedures (for example, the number of companies that will be audited each year), with use of single-issue and in-depth audits, modern information systems to select taxpayers for audit, and employment of qualified audit personnel.

The organization and procedures of an efficient system would have the following two basic features:

  • organization along functional lines (collection, enforcement, taxpayer education)—rather than by type of tax—to facilitate staff specialization and eliminate duplication and inefficiencies; and
  • reliance on the computer for clerical tasks, when justified by the number of taxpayers.

It is worth reemphasizing that tax system design must take into account both the administrative capacity of the tax department and the burden of compliance that the system imposes on taxpayers.


The introduction of sustainability as a criterion for the choice of fiscal measures adds an extra dimension to the analysis. Normally, fiscal sustainability refers to the notion that a given fiscal stance is compatible with a level of public debt to GDP that can be serviced without difficulty and without entailing an unsustainable buildup in either internal or external debt. But there is another important sense in which fiscal policy can be unsustainable: when it relies on cuts in expenditure or increases in revenue that cannot be maintained indefinitely. Although a stabilization program must sometimes rely initially on such unsustainable measures, eventually they will have to be replaced by measures that can be sustained (Tanzi, 1989).24

There are two principal reasons to think that sustainable measures are a sine qua non for growth. First, if adjustment cannot be sustained, internal and external stability will not be achieved. Second, unsustainable policies imply that there will be changes in policy regimes. For example, countries prone to high inflation and facing unstable debt dynamics may be tempted to adopt policies that impose what amount to confiscatory tax rates on holders of public debt; real interest rates then will be prone to substantial fluctuations; and fluctuations in aggregate output may be exaggerated. These conditions are inimical to the kind of stable policy environment in which investment and long-range planning can thrive.25

The question then arises whether there is a conflict between those fiscal measures that promote growth and those that are sustainable. This cannot be answered from first principles. Experience suggests, however, that the conflict may be minimal. Indeed, it is often the stopgap measures that are unsustainable, since they do not offer satisfactory solutions to more basic underlying problems.26

  • The short-run fiscal consequences of an overstaffed civil service—an increasing share of the wage bill in expenditure—are often addressed by an across-the-board wage freeze. Quite apart from the fact that such freezes will generally be reversed, they do not attack the basic problem—excess employment—and probably reduce public sector efficiency by lowering salaries and compressing salary scale differentials.
  • Across-the-board expenditure cuts or freezes, affecting all functional and economic expenditure categories, may be easy to implement but are clearly inefficient. They are less likely to lead to the permanent reduction in expenditure that results when specific programs are cut.
  • Increased statutory tax rates on an existing tax base can be quickly implemented but, if the rates are already high, can cause erosion of the tax base and increase distortions.

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