sou · H3B353en · 2015-06-04 00:00:00 — effect (Growth hill) The empirical challenge is formidable. The basic question is how the entire economy performs given the size and composition of public activities. Clearly this depends on a vast amount of other factors characterising the economy and its institutions. Microeconometric evidence is thus not directly relevant since it addresses partial questions; that is, if some tax or expenditure is changed given that all other aspects of the public sector are unchanged. The question here is a systemic or general equilibrium question on how the entire economy would perform in a hypothetical other situation with a different size or composition of the public sector. The literature therefore resorts to cross-country studies in an attempt to make inference from variation in performance and public sector structure across countries. This requires that it is possible to control for all other factors beyond Welfare state arrangements and economic performance Bilaga 4 till LU15 the public sector structure which may explain cross-country differences. Something which is very hard in empirical work, and the result should thus be interpreted with caution. specific empirical issues are discussed below. There is a vast literature exploring the empirical relationship between fiscal policy and economic growth. A first wave of analyses peaking in the late 1990s relied mainly on cross-country studies. The studies did not leave clear-cut results, and in a metastudy based on close to 100 published studies exploring the implications of the size of the public sector for growth Nijkamp and Poot (2004, p. 93) concluded that “we find broad support for the view that the empirical evidence on the effect of conventional fiscal policies is rather fragile, although the commonly identified importance of education and infrastructure is confirmed”. These studies suffered from a number of methodological problems (see e.g. and Henrekson (2011)). Recent empirical work on these issues have made two important advances in the form of panel studies and more explicitly on the hypothesis advanced by endogenous growth models. The latter implied that expenditures and revenues are disaggregated rather than focusing on the importance of the size of government measured either by total revenues or expenditures. A particularly severe problem is that regressions often do not take proper account of the public sector budget constraint, which implies that the interpretation of coefficient estimates is at best unclear and often confused. Regressions often include either some aggregate measure (public expenditures or tax burden) or some specific components of the two. However, these various components are related via the budget constraint, and a change in an expenditure component has to be matched by a change in a revenue component (or debt accumulation/decumulation).43 Since the mode of financing is critical (see also below), it follows that the effect of say a change in expenditures cannot be assessed 43 One may think of the budget constraint as stipulating equality between revenues and expenditures (long-run constraint) or including a budget balance item allowing for debt (de) accumulation. The latter approach is often pursued but is not unproblematic since it leaves unclear the debt level to which the economy may be converging or how future adjustments of the fiscal policy will be. Bilaga 4 till LU15 Welfare state arrangements and economic performance independently of how they are financed (Helms, 1985).44 At best a regression where output growth is made to depend on an aggregate expenditure or revenue measure tells us something about how a proportional scaling of all expenditures would affect growth if it is financed by a proportional scaling of all revenue components. Therefore regressions that do not take the budget constraint explicitly into account are hard to interpret (Bleaney et al., 1999). There are some studies which i) utilize panel estimation methods (pooled mean group analyses), ii) disaggregate expenditures and revenues, and which iii) explicitly take into account the public sector budget constraint summarized in Table 4.3. It is seen that in accordance with the classification in Table 4.1, distortionary taxation reduces growth while productive expenditure enhances growth. There is thus empirical evidence supporting that the composition of both expenditures and revenues matter for growth. This may explain why the earlier literature obtained less conclusive results. If e.g. expansions of the public sector in the form of productive expenditures have been financed by distortionary taxation, one would tend to find a negligible net effect on observed growth rates, see e.g. Gemmell et al. (2011). It is an issue whether the estimated effects are small or large. It should be noted that a change in the growth rate from say 2 to 2.3 percent may seem small, but after 50 years GDP has increased by factor 2.69 in the first case and 3.12 in the latter. Small differences accumulate and get large. It also points to a problem of interpreting empirical estimates since imprecision in estimates can have potential long-run effects. 44 A regression including as independent variables all public revenue and expenditure entries suffers from a multicollinearity problem since revenue minus expenditure equals the budget balance. This problem can be solved by leaving out one fiscal variable (say unproductive expenditures,) and hence the interpretation of the coefficients to the remaining fiscal variables is the growth effects of a change in the variable in question financed by a change in the left out variable. Welfare state arrangements and economic performance Bilaga 4 till LU15 Empirical studies – composition of public sector expenditures and revenues and growth Kneller, R., M.F. Bleaney, and N. revenues in % of Distortionary taxation = -0.41 Gemmell (1999) Productive expenditures = 0.27 (5-year averages) Bleaney, M., N. Gemmell, and R. revenues in % of Distortionary taxation = -0.41 Kneller (2001) Productive expenditures = 0.39 Bania, N., J.A. 49 US states 1962- Growth effect for personal income: revenues in % of Distortionary taxation: Level = 1.71 Squared = -0.03 panel model (5-year Top point of growth tax curve for tax Non-productive expenditures = -0.78 Financed by productive expenditures Gemmell, N., R. revenues in % of Distortionary taxation = -0.25 I. Sanz (2011) Productive expenditures = 0.26 Long-run elasticities of per capita tax = -0.98 Financed by revenue neutral adjustment of consumption and Gemmell, N., R. 15(12) Growth effect of statutory tax rates: Kneller and I. Sanz Cooperate tax rate = -0.02 Top personal income tax rate = -0.06 Note: The respective authors’ preferred regression is reported. Results are for the case where financing is via non-productive expenditures, non-distortionary taxation unless otherwise stated. The table gives coefficient estimates significant at conventional levels. A pooled mean group regression has an errorcorrection form and allows for country-specific short-run effects and differences in dynamics, but imposes the same long-run coefficients in the long-run relation (this restriction is tested). Bilaga 4 till LU15 Welfare state arrangements and economic performance Using the same methodology45, some studies have considered the more specific role of various forms of taxation. (2011) consider the effects of various taxes on per capita GDP for a given overall tax burden (see also (2008)). The long-run elasticity of per capita GDP to an increase in income taxes compensated by reduced consumption and property taxes is close to -1, showing that the tax structure matters for GDP levels in the long run.46 A shift from income taxes to consumption and property taxes for an unchanged overall tax revenue will thus have a sizeable positive effect on GDP. In et al. (2011) the following ranking of various taxes in terms of GDP levels in the long run is made: Corporate income taxes have the strongest adverse effect, followed by personal income taxes. Consumption taxes have less negative effects, while property taxes and in particular recurrent taxes on immovable property appear to be the least harmful! Gemmell et al. (2013) raise the point that studies using revenue shares (typically relative to GDP or the relevant tax base) may not capture the actual tax rates precisely, and definitely not the difference between average and marginal tax rates. They find robust evidence that increases in marginal rates of personal income taxes as measured by the top rate and (less robustly) the average labour tax rate is associated with adverse long-run growth outcomes. The macro average taxes – on consumption, labour and especially capital – generally appear to be less robustly associated with GDP or productivity growth than the micro-based marginal tax rates on personal and corporate income. They do not find any harmful long-run growth effects from increases in (average) consumption taxes. Notice that these studies consider tax reforms for unchanged tax burdens and thus expenditures (level and composition) in an attempt to isolate the tax distortions from other effects of public sector activities. 45A different methodological approach is taken by Yagan (2013) exploiting a 2003 reform in the US of dividend tax in a quasi-experimental design. This study does not find any evidence that the tax cut affected corporate investments. 46It should be noted that their estimation includes various control variables including physical capital, human capital and population growth. The long-run elasticity of per-capita GDP is in all estimations significant and above one. Welfare state arrangements and economic performance Bilaga 4 till LU15 Regressions where output growth is related to various fiscal variables (and other control variables) suffer from a number of problems: A crucial question is one of causality. There are two major problems or sources of endogeneity. the business cycle expenditures tend to be counter-cyclical and revenues pro-cyclical. Lower growth is thus associated with a higher expenditure share and a lower revenue share. Estimations which do not properly filter out business cycle fluctuations may thus have a downward bias in the assessment of the growth impact of expenditures, and vice versa for taxes. In the medium to long run, expenditures may be driven by so-called effects; that is, growth in income increases the demand for public activities, implying a positive relationship between growth on the one hand and expenditures and revenues on the other (tending to make expenditures appear to improve growth). Somewhat surprisingly, none of the studies referred to above address measurement issues in relation to the public sector and GDP, in particular in cross-country studies.47 As argued in Appendix, there are reasons why expansion of public sector activities may enhance GDP simply from the fact that activities are shifted from the non-market sphere into the market sphere and thus become included in GDP. time national account procedures for imputing the value of activities in the public sector may on the other hand imply that registered GDP growth is lower, the larger the share of activities conducted in the private sector. Finally, there is the issue of whether empirical evidence of the form summarized in Table 4.3 yields support to endogenous growth mechanisms. The results in the papers summarized in Table 4.3 may be taken to suggest that there are endogenous growth mechanisms at work. However, even though growth effects are found, the sample periods underlying the estimations are rather short. It follows that it may be very difficult to separate transitional dynamics from long-run or steady state effects. It is well known that exogenous growth models imply transitional 47 An early study by Mofidi and (1990) considers the effects of fiscal policy variables on private investments and employment. They find that taxes financing transfers reduce investment and employment, and expenditures financed by taxes are growth neutral. See also et al. (2011). Bilaga 4 till LU15 Welfare state arrangements and economic performance dynamics released by policy changes (see e.g. Turnovsky (2004)), and the interrelationship captured in the studies referred to above may capture this rather than the steady state effects associated with endogenous growth. While the early enthusiasm about endogenous growth models was great, the hype has subsequently been less strong48, and the empirical evidence is inconclusive on whether transitional dynamics or endogenous growth mechanisms have been uncovered. Where does this take us in relation to the question on the relationship between the public sector (size and structure) and economic performance? Even if revenues and expenditures are disaggregated, they remain in most studies measured in a way that does not directly relate to specific policy instruments, and this makes the specific policy implications less clear. But the empirical evidence clearly underpins the point that unconditional statements on the relationship between the size of the public sector and economic performance are highly problematic from both a theoretical and empirical point of view. The role of taxes and expenditures depends on designs and purposes, and therefore a more disaggregated perspective is warranted. The composition of expenditures and revenues is essential, and this calls for a more careful consideration of public sector activities. 48 For a general assessment of endogenous growth models, see e.g. (1995). The measures on economic performance considered above shed light on the income or wealth side of the efficiency-equity discussion, and the next step is thus the other side, inequality. The following focuses primarily on wage inequality, in particular problems for low income groups.49 Empirical work has explored the relationship between inequality and growth. A number of such studies find that more inequality is associated with lower growth (see e.g. and Tabellini (1994) and Alesina and (1994), and more recently Ostroy (2014)).These findings have been contested by work using panel methods on improved data sets (Li and Zou (1998) and (2000)). These studies find evidence of a positive relationship between inequality and growth. Both inequality and growth are endogenous variables depending on economic structures, policies and institutions. It is thus possible that certain changes may make inequality and growth move in the same direction (positive correlation), while others make them move in opposite directions (negative correlation). It is therefore not straightforward how to interpret empirical results on the comovement of inequality and growth. Even though some studies do attempt to control for various background variables, it is difficult to do so in a way allowing inference on causality from crosscountry studies; cf. also discussion in association with Figure 2.1 above. In order to identify whether policies can reduce inequality 49 For more general discussions of inequality as well as the debate on the functional distribution of income initiated by the work of Piketty (2014) see (2014) and (2014). Bilaga 4 till LU15 and increase growth at the same time, it is discussed below how inequality can affect growth.50 It is a well-known fact that the distribution of wages and thus income has become more unequal in recent years; see e.g. (2011b) and et al. (2011). It is a trend which has been ongoing for two or three decades, and in some countries intensified by the Great Recession. Market forces are a main driver. Technological changes in combination51 with globalization have affected labour markets and wage formation significantly. Moreover, policies have in some countries been changed in a less redistributional direction. This may follow from structural reforms aiming at strengthening the incentive structure or positioning countries differently on the trade-off between efficiency and equity. 50There is also an important political economy literature exploring how inequality may affect growth. In a more unequal society, there is larger support for redistributive policies, which in turn leads to higher taxation and regulation harmful for economic growth (see e.g. Barro (1990), and Tabellini (1994) and Alesina and (1994)). Another explanation focuses on market imperfections, and they are presented and discussed below. 51It may be debated whether the economics profession has clearly worked out the effects of these reforms in the efficiency-equity space. E.g. most studies of unemployment insurance systems focus on the incentive effects. In particular in the light of the Great Recession it has been questioned whether the right balance has been achieved. Bilaga 4 till LU15 Figure 5.1 Employment rate for low skilled, countries 2012 Note: Ratio of employment rate for individuals with highest level of education below upper secondary education relative to employment rate for individuals with upper secondary or post-secondary nontertiary education. Source: (2014). Skill-biases or educational divides have become clearer in recent years. Much of the widening inequality is driven by increases at the top and stagnating or even falling real wages at the bottom. In all countries employment rates of low educated groups are falling significantly short of the average employment rate, cf. In most countries about 1/5 of a cohort does not obtain an education providing labour market relevant qualifications, and the steady improvement in the qualifications of the labour forces has halted for many countries, see Figure 5.2. Bilaga 4 till LU15 Figure 5.2 Educational achievement – Population with at least an upper secondary school education by age group, 2010 Source: (2014). 5.1Active and passive redistribution The classical discussion of redistribution has its outset in the distribution of market incomes. Is the distribution fair and is there need for redistribution? However, the distribution of market income is endogenous and depends on labour demand and supply, and thus policies, most notably educational policies. Redistribution taking outset in realized marked incomes may thus be dubbed a passive redistribution policy, while educational policy in the broad sense of affecting the distribution of market incomes may be dubbed an redistribution policy. Clearly these two approaches to redistribution have widely different implications both in the short run by targeting different groups and in the long run for the overall level of living standards and for public finances. Cross-country evidence reveals an interesting link between the distribution of education, market incomes and disposable incomes. Countries with low inequality in disposable income also have a low inequality in the distribution of market incomes. And low inequality in market incomes is associated with low inequality in Bilaga 4 till LU15 education, cf. This does not imply that taxes and transfers do not play a role in redistribution52, but it stresses that the basis for an equal income distribution rests on low inequality in market incomes, which in turns depends on low inequality in education. Put differently, redistribution policies may be as important as passive redistribution policies in ensuring an equal income distribution. Figure 5.3 Inequality – education and market income, countries Inequality education and market income Inequality market and disposable income Note: Inequality in disposable income and market income measured by the Gini-coefficient. Inequality in education measured by the coefficient of variation for test of literacy and numeracy 2012 based on data from and . This point is particularly important in countries with strong egalitarian preferences ruling out working-poor. This implies that the levels of social transfers and minimum wages are relatively high53, which in turn implies a higher entry threshold in terms of qualifications to find a job. To ensure equal opportunities and to 52Clearly, taxes affect the distribution of market incomes via tax distortions. It is e.g. possible that a more progressive taxation system leads to less inequality in market incomes because fewer have high incomes. However, it is in general ambiguous whether the inequality in market incomes is increasing or decreasing in the tax rate. It depends, among other things, on what determines the wage distribution and whether low/high wage groups react most to a tax change. 53In the Scandinavian countries minimum wages are determined in labour market negotiations. Clearly, the level is related to transfer levels offered in the social system. Bilaga 4 till LU15 make an egalitarian outcome consistent with a high employment level, it is thus a requirement that the qualification structure is reasonably compressed (avoiding a too large population share with low qualifications). Maintaining a compressed wage structure and a high employment level requires that the qualification structure is such that supply of low skilled labour is small. To put it differently, it is becoming increasingly difficult to obtain egalitarian outcomes passively, and an equal distribution of education (qualifications) is a prerequisite for egalitarian labour market outcomes (employment and wages). Trends in the labour market put increasing burdens on passive redistribution policies and thus the financial viability of this policy strategy. Accordingly the perspective in a strengthening of redistribution policies. Interpreting redistribution policies in the perspective of the efficiency-equity trade-off also raises the possibility of making it possible to increase both efficiency and equity. This applies both when efficiency is interpreted in a static and dynamic sense. There is a large literature assessing the importance of education for employment and income at the individual level. The general findings (see e.g. (2014)) are that education is associated with higher labour supply/employment (longer working hours, less unemployment, less absence due to sickness, later retirement) and a higher wage. Education is also associated with better health, longevity, social outcomes and participation in social and political activities (, 2014). It is conceptually difficult to identify the causal links here, and there may be severe selection problems. However, some studies do find a causal link between education and health; see Conti, Heckman and Urzua (2010). Heckman et al. (2014) find that cognitive and socio-emotional skills are explaining labour market and social outcomes. It is well known that human capital has an important role for growth and thus the level of income (see also Section 3). There is a large literature exploring the role between education and productivity increases, see e.g. de Fuente (2011) and Hanushek and Woessmann (2011). In a first wave of empirical studies, education was measured quantitatively by e.g. the share of population reaching certain educational levels defined in terms of length of studies. These studies found a positive, though not very large productivity effect of education. A more recent second wave has Bilaga 4 till LU15 included both quantitative and qualitative measures of education, and they find a stronger role for education in driving productivity growth, see Figure 5.4. Quality of education measured by various tests is at least as important as education measured quantitatively (years of education/level of education). It is particularly noteworthy that education for broad groups in the labour market is at least as important as for the elite, see Hanushek and Woessmann (2011). This suggests that educational policies may have important effects on both efficiency and equity. Figure 5.4 Educational quality and productivity growth, countries