TAXES AND GROWTH: TESTING THE NEOCLASSICAL AND ENDOGENOUS GROWTH MODELS

1. INTRODUCTION Neoclassical and endogenous growth theories have substantially different implications about how economic growth is affected by changes in certain variables such as the saving rate, the population growth rate, and several government-policy variables. In particular, the neoclassical growth model developed by Ramsey (1928), Solow (1956), and Cass (1965) predicts that such changes, while permanently changing the steady-state level of output per capita, will alter its growth only temporarily, having no permanent effect on the economy's steady-state growth rate. On the contrary, endogenous growth models, such as those proposed by Romer (1986, 1990), Lucas (1988), Rebelo (1991), and others, predict that such changes will permanently change the growth rate of per capita output.(1) Theoretically, therefore, as Jones (1995) proposed, a test of the neoclassical versus the endogenous class of growth models can easily be constructed as follows. First, suppose permanent changes in a certain relevant variable, x, can be identified. Then, the endogenous paradigm will be supported if the effects of these changes on the growth rate of output per capita are found to be permanent (and in the predicted direction), while the neoclassical paradigm will be supported if the effects are found to be transitory (and in the predicted direction). For such a test to become empirically operational, however, variable x must satisfy the following two criteria: (i) in theory, it must have different effects on the growth rate in the neoclassical than in the endogenous growth theory, and (ii) in practice, it must be nonstationary so that it will exhibit permanent changes. The investment rate, which Jones (1995) selected as variable x, while clearly satisfying the first criterion, may or may not satisfy the second: there is no particular reason why changes in investment rates should be permanent rather than transitory. The present paper argues that the tax rate is a very good candidate for x. First, it is well known that the tax rate satisfies the first criterion: a permanent increase in the tax rate will permanently reduce the steady-state real growth rate in an endogenous growth model, but not in a neoclassical model, where growth will be affected only temporarily, the only permanent effect being a decrease in the steady-state level of output per capita.(2) In addition, there is good reason to expect that the tax rate is nonstationary. Barro's (1979) well-known "tax smoothing" hypothesis says that, if the marginal cost of raising tax revenue is increasing in the tax rate, the optimal tax rate (defined as the rate that minimizes the present value of the distortions due to the tax) is a random walk. Intuitively, just as the smoothing motive of consumers makes consumption a random walk (Hall, 1978), the smoothing of tax rates by the government makes the tax rate a random walk.(3) This means that changes in the tax rate will he permanent and, given their different effects on growth under the two types of growth models, very useful in empirically distinguishing between the neoclassical and endogenous models. This is the goal of the present paper, which empirically investigates the effects of the tax rate on economic growth using data from the 1960-1992 period for a panel of 11 Organization of Economic Cooperation and Development (OECD) economies. In this sample, real growth rates and tax rates have varied significantly both across countries and over time since 1960.(4) The first two columns of Table 1 report the annual growth rate of real GDP per capita and the total tax rate, averaged over the 1960-1991 period. Average growth has ranged from 1.83% in Switzerland to 5.32% in Japan; the total tax rate has varied from 25.30% of GDP in Japan to 47.62% of GDP in Norway. Figures 1 and 2 add a time dimension to these numbers. Note that for most of these 11 countries, total taxes as a fraction of GDP have increased almost monotonically. …