4 A limitation of the neoclassical growth model is that the steady state per capita growth rate is zero if the exogenously given rate of technological change is set to zero. The investment share does not affect steady state growth in the neoclassical growth model. Therefore, economic policy does not influence steady-state growth; economic policy only affects the level of economic output or the transition to the steady state. Since King and Rebelo (1989) demonstrate that interest rates in many countries would have to be absurdly high for transitional dynamics to explain the observed differences in cross-country growth rates, the standard neoclassical growth model does not appear to be the appropriate model for understanding sustained differences in cross country growth rates or the growth effects of policy.® Recent models seek to extend the neoclassical growth model such that growth is responsive to policy. Building on work by Arrow (1962) and Phelps (1966), Romer (1986) makes technological change endogenous by assuming that technology is a public good but that private investment in capital increases the level of technology available to all entrepreneurs. The externality associated with investment overturns the assumption of diminishing marginal returns to investment and yields a production function with increasing returns to scale, such that there is steady-state growth when there is sufficient investment. In Romer’s (1986) model a higher investment rate will accelerate economic growth. Therefore, economic policies that alter the investment rate will affect economic growth." Similarly, Lucas (1988) builds a model based on Uzawa (1962) with.increasing returns that arise from external effects associated with human capital. Lucas emphasizes that workers interact with colleagues such that each individual’s "productiveness” depends on the human capital of others. Thus, private investment in human capital by an individual increases his own productiveness but also increases the human capital and productiveness of others. The externality associated with human capital produces an aggregate production function that has increasing returns to scale. The resulting production function implies that if the economy invests a sufficient amount of resources in human capital accumulation, the economy will enjoy long-run steady state growth. Consequently, alterations in the incentives to invest in human capital have long-run growth implications. The importance of human capital in economic development has been the subject of massive theoretical and empirical study.

In the Romer (1986) and Lucas (1988) models, policy can reduce long-run growth by impeding investment in human and physical capital, so that the rate of technological advancement or human capital accumulation slows. In addition, because there are externalities to human and physical capital investment in these models, appropriate public policies can help private agents internalize these externalities and thereby accelerate long-run growth. Thus, the overall policy regime of a country, including taxes, property rights, and macroeconomic distortions, can alter savings and investment allocation decisions in ways that alter long-run growth. Nevertheless, policy can only have growth fankiw et al. (1990) find a larger role for transitional dynamics in the neoclassical mode! by assuming2 much higher capital share (including human capital). $1 In 9 different model, Scott (1969) argues that the act of investment itself creates new investment opportunities. Therefore, increasing investment can have dynamic effecte that raise the economy'sgrowth rate.

& See, for example, theoretical treatments by Schultz (1961, 1963), Becker (1964), and Ben-Porath (1967). Microeconomic evidence is provided by Psscharopoulos (198), Jamison and Lau (1982) and Griliches (1964, 1977). Rosenzweig and Evensoa (1977), Rosenzweig and Schultz (1963), and Psacharopoulos and Arriagads (1986) conduct detailed examinations of the effects of human capital accumulation in developing countries, and DeTray (1987) studies the implications of government policy. Lau, Jamison, and Loust (1990) empirically examine the roie of education in developing countries using an aggregate production function approach. Also, see the reviews by Schultz (1988) and Psacharopoulos (1988). Further work is beingdone for the World Development Report 1991.