Institutions

Taxes and Economic Growth

The relationship between taxes and economic growth has been investigated by a number of economists over the years, and the evidence has not conclusively found that high taxes discourage economic growth. One reason that there is not a clear relationship between taxes and growth is that some of the things that tax revenue is used to pay for, such as education, transportation infrastructure, and the protection of property rights, have been found to stimulate economic growth. Hence, statistical studies could very well find that higher taxes are positively correlated with higher growth as governments spend their tax revenues efficiently.

     A recent article by Fabio Padovano and Emma Galli (2001), "Tax Rates and Economic Growth in the OECD Countries (1950-1990)", Economic Inquiry, Vol.39(1), pp. 44-57, improves our understanding of the relationship between taxes and growth by looking at marginaltax rates rather than the usual practice of comparing average tax rates and economic growth. That is, where most studies have taken the ratio of total tax revenue to GDP as an explanatory variable in the usual growth regressions, as we detailed in Chapter 5, Padovano and Galli carefully calculate the marginal tax rates and examine how they affect countries' rates of economic growth.

     Padavano and Galli conclude their article as follows:

     Our analysis of a cross-section time-series panel of 23 OECD countries for the 1950s-1980s decades show that high marginal tax rates and tax progressivity are negatively correlated with long-run economic growth. This finding contrasts the previous empirical literature, which concludes that there is no significant correlation between taxation and economic growth. We provide evidence that these results are due to a misspecification of the tax variables, which relied on average, rather than marginal, measures of fiscal pressure. In our model, when included with measures of average fiscal pressure, 		marginal tax rates turn out to be negatively correlated with the dependent variable [economic growth], while the other fiscal regressors show no significant correlation." (P. 50)

The implications of these results are several. First of all, Padovano and Galli essentially confirm that the level of taxation is not the real issue; high levels of taxation are compatible with both slow economic growth and rapid economic growth. No doubt, it comes down to how well the tax revenue is spent. But the finding that the marginal rate of taxation is negatively correlated with economic growth also makes sense because, ceteris paribus, the marginal tax rate acts as a disincentive to produce and generate income.

     Padovano and Galli's findings clearly reflect incentives better than did earlier studies of taxation and growth. They also seem to pose a dilemma: How can government collect enough taxes to perform all the needed tasks and yet maintain low marginal rates of taxation? The answer may not be as difficult as you think if you take into consideration Anne Krueger's application of comparative advantage to government (Case Study 12-1). The limitations to what government can do efficiently will probably tend to keep the overall need for tax revenue to a level where the marginal rates do not need to be very high either, even if taxes progressively place a higher burden on higher incomes.

Rent-Seeking: More Case Studies

Models of rent-seeking behavior generally suggest that rent-seeking wastes resources and reduces human welfare. This conclusion was further supported by a lot of evidence of rent-seeking activities, which seemed to be greatest in those countries that endured the lowest rates of economic growth. Recently there has been increasing
discussion about rent-seeking activity in Southeast Asia, which has been the fastest- growing region of the world over the past several decades. A new book containing a series of articles and case studies on rent-seeking in Asia provides a somewhat different viewpoint of rent-seeking: Mushtaq H. Khan and Jomo Kwame Sundaram (eds.) (2000), Rents, Rent-Seeking and Economic Development, Cambridge, U.K.: Cambridge University Press.

     According to the editors of the book:

...the simplifying assumption that all rents are always bad is questionable. In a world where learning and innovation have to be rewarded, distributive conflicts dealt with, where incentives have to be created to deal with asymmetric information and where scarce natural resources have to be conserved, many types of rents are socially desirable. (Chapter 1, "Introduction")

Rents are therefore a complex phenomenon, and an analysis of the costs of rent-seeking activity will depend not just on the static costs illustrated in the models in Chapter 12, but also on the efficiency and growth implications of the rents.

     The book contains studies on Thailand, Philippines, Indonesia, and Malaysia. Many of the articles suggest that rent-seeking has beneficial effects. The arguments of the authors are not always entirely convincing, but the complexity of incentives (institutions) that drive human behavior always make it difficult to pinpoint all the reasons why economies perform the way the do. The ideas presented throughout the edited book by Mushtaq H. Khan and Jomo Kwame Sundaram provide ample real-world evidence of rent-seeking. Anyone interested in a deeper understanding of the process of rent-seeking should look up this book.

Review of the New Institutional Economics

Oliver E. Williamson (2000), "The New Institutional Economics: Taking Stock, Looking Ahead," Journal of Economic Literature, Vol. 38(3), pp. 595-613, supplements the discussion on the new institutional economics in Chapter 11. 		The beginning economics student may find Williamson's review somewhat bewildering; in fact, even the advanced economics student will find many issues in the review difficult to grasp. Nevertheless, Williamson's review is very useful in that it makes it clear how complex institutions are. Williamson also lists all of the areas of study where more work needs to be done. He concludes:

The upshot is that, its many accomplishments notwithstanding, there is a vast amount of unfinished business–refinements, extensions, new applications, more good ideas, more empirical testing, more fully formal theory. (P. 611)

For graduate students, the field appears to be completely open with dissertation topics galore. If only it were easy to come up with useful "refinements, extensions, new applications, more good ideas, more empirical testing, more fully formal theory."

Patents: Creative and Uncreative Destruction

Frank Lichtenberg and Tomas Philipson (2000), "Creative vs. Uncreative Destruction of Innovative Returns: An Empirical Examination of the U.S. Pharmaceuticals Market," NBER working paper, July 28, estimate the costs on innovators of creative destruction. That is, they analyze how much innovators lose when they lose their monopoly either because another innovator creates a better product or because the innovator's patent (intellectual property right) runs out and others are free to copy the innovation. The first type of destruction is the usual creative destruction, and Lichtenberg and Philipson refer to the second type of destruction as uncreative destruction.

     Lichtenberg and Philipson find that losses from creative destruction to the monopoly are much greater, perhaps twice as great, as losses from expired patents and uncreative destruction. Of course, sociaty gains from a more rapid rate of creative destruction, and their results suggest that patents are doing what they are supposed to do: Patents create an incentive to come up with
new ideas rather than just copy existing ideas. They therefore conclude that "the theoretical analysis of the effects and desirability of intellectual property regulations should not only consider their direct impact on uncreative destruction but also the indirect impact through how they affect creative destruction.

     The extensive debate on whether pharmaceutical companies should make drugs available at low or zero cost to developing countries provides an example of how many people focus only on patents and copyrights' impact on uncreative destruction. Creative destruction is the key to technological progress; if uncreative destruction is too easy, there will be less creative destruction, to the detriment of long-run world economic growth.

     The issue of patents, profits, and drugs for poor countries was recently covered in the popular press. For example, you might look up:

David Pilling (2001), "GSK under Pressure Over Drugs to the Poor," Financial Times, February 12.

David Pilling (2001), "Oxfam Campaigns for Charitable Stance on Drugs Patents," Financial Times, February 12.

The Economist (2001), "Science and Profit," February 15.

Social Conflict and Economic Growth

Dani Rodrik (1999), "Where Did All the Growth Go? External Shocks, Social Conflict, and Growth Collapses," Journal of Economic Growth, Vol. 4, pp. 385-412, asks several important questions:

1. What accounts for the instability in economic performance that has characterized most developing countries over the last few decades?

2. Why did so many countries that grew at satisfactory rates during the 1960s and 1970s do so badly thereafter? 		3. Why were some countries hardly affected by the volatility during the second half of the 1970s while others suffered extensively?

4. Why do external shocks often cripple economic performance to an extent that is vastly disproportionate to the direct economic consequences of these shocks?

Rodrik contends that the answer to all four of these questions is the prevalence of social conflicts within many developing countries.

     As background, Rodrik present evidence that during the period 1960-1973, Latin America and the Middle East enjoyed rates of economic growth similar to East Asia. After 1973, economic growth collapsed in Latin America and the Middle East, it continued on the same 1960- 1973 path in East Asia. Writes Rodrik: "The reputation of the East Asian miracle rests entirely on the fact that productivity growth–and hence output growth–collapsed in the Middle East and Latin America after 1973 but not in East Asia. Why was this the case? Rodrik describes the adjustment to oil price shocks in Turkey, Brazil, and South Korea. Only in the latter were prices allowed to adjust quickly and the economy was encouraged to adjust equally quickly by means of a devaluation, a tightening of monetary policy, and a program to economize on energy. In Turkey, the government first compensated for the growing trade deficit caused by higher oil prices by borrowing overseas, then it let inflation rise sharply, and only later did the government use tighter monetary policy to try to stem inflation, which unfortunately created a recession rather than a decline in inflation. In Brazil, the government also borrowed overseas to cover the growing trade deficit, while price controls and strategic behavior by industries and worker organizations prevented the needed changes in relative prices to reallocate resources away from high-energy uses. Brazil ended up with a huge foreign debt and hyperinflation.

     Rodrik then contends that how each of these three countries reacted depended on the ability of the
government to coordinate the various interests and reach an implicit agreement on a solution. You should note that none of the three countries enjoyed a real democracy in the 1970s, but latent social conflicts still determined how each government was able to act.

     Moving on from the anecdotes on Turkey, Brazil, and Korea, Rodrik then uses statistical analysis to test how social conflict affects economic growth. He used indicators of the quality of government institutions, rule of law, democratic rights, and social safety nets as proxies for social conflict or potential for social conflict. Rodrik found that indeed it was the countries with the greatest potential for social conflict that suffered the greatest declines in economic growth after 1975. Rodrik concludes as follows:

An increasing number of developing countries are integrating themselves with the international economy....this will increase their exposure to shocks. Therefore it will be all the more important to develop institutions that mediate social conflicts. The results of this article indicate that participatory and democratic institutions, the rule of law, and social insurance are all components of a strategy to enhance resilience to volatility in the external environment. (P. 409)

Rodrik has in recent years repeated this theme in various articles and books. His hypothesis that long-run economic growth requires institutions that can ease economic adjustment and reduce the social conflicts surrounding economic change case is a compelling one. In this article, he backs up his ideas with solid statistical evidence.

     Related to Rodrik's hypothesis that well-governed nations adjust to shocks more efficiently is the recent study by Mancur Olson, Naveen Sarna, and Anand Swamy (2000), "Governance and Growth: A Simple Hypothesis Explaining Cross-Country Differences in Productivity Growth," Public Choice, Vol. 102, pp. 341-364. Olson, Sarna, and Swamy observe that:

In the 1870s the four fastest growing countries of continental Europe grew 0.3 of 1% faster than Britain and the top four countries of the 1880s also grew 0.3 of 1% faster than Britain. By contrast, in the 1970s the four 		fastest countries in the world grew 6.9% faster that the U.S. did, and the fastest growing four countries in the 1980s outdid the U.S. rate of growth by 5.3%. In other words the rates of catch up growth in the 1970s and 80s were more than fifteen times as fast as in the 1870s and 80s. (p. 357)

These observations lead Olson, Sarna, and Swamy to test the following hypothesis: "Differences in governance play an indispensable role in explaining why most developing countries fail to grow any faster than the high income countries at the same time that certain other developing countries grow far faster than the rich countries do."

     Olson, Sarna, and Swamy test whether various proxies for good governance can explain the residual that remains after regressing the growth of per capita income on the usual variables in the sources of growth equation, such as growth of labor, capital, and human capital (Recall our discussion of the sources of growth equation in Chapter 5). They specifically include indexes for (1) the risk of expropriation, (2) risk of repudiation of contracts by government, (3) quality of bureaucracy, (4) corruption, and (5) the rule of law.

     In their statistical tests, each of these variables turns out to significantly explain the variation in growth rates between countries. Olson, Sarna, and Swamy therefore conclude that the faster rates of catch-up by a few countries in the late twentieth century, as compared to those countries that caught up with the income leader in the nineteenth century, can be explained by the larger gap and the quality of governance:

The larger the gap in per capita incomes, technologies, capital stock per worker, between an undeveloped area and the leading country at the time, the greater the marginal product of capital, the larger the inflow of capital, and the rate of catch-up growth, if the undeveloped area is adequately governed. (P. 357)

Still No Property Rights for Russian Farmers

The plight of the Russian economy is well known, and the Russian farm sector is one of the worst contributors to the fall in per capita output. An article by Guy Chazan (2001), "Seeds Are Sown for a Russian Revolution,"Wall Street Journal, February 10, tells us that ten years after the fall of communism, only 7 percent of cultivated farmland in Russia is owned by independent farmers. One-third of all farmland is still owned by the government. This is despite a law that bans to sale of farmland to anyone other than the farmers that lived on the large state farms organized by Joseph Stalin back in the 1930s. These collective farms have now been mostly reorganized as independent cooperatives, but they are even less efficient than they were ten years ago.

     Farmers do not want to invest in land that they cannot sell, nor do large companies that might otherwise organize some large farms into viable agricultural enterprises. The fear is that permitting land-owners to freely sell their land will result in most land owned by a few well-connected businessmen from Moscow, which has happened to some extent with the privatization of industry and commerce. The sell-off of state businesses has been chaotic in Russia, to say the least. So Russian farms remain stuck in a "time warp" according to the article, unable to borrow because they have no useful collateral, unassisted by the central government because they are technically no longer state farms, and unattractive for outside investors because farmland cannot be purchased. In the meantime, Russia's food imports continue to rise.

Argentinian Institutions Deteriorate

According to Ann Zimmerman and Matt Moffett (2000), "Wal-Mart Faces Latin Floor-Space Squeeze," Wall Street Journal, November 28, the Buenos Aires legislature was planning to restrict the size of new supermarkets and discount stores to less 		than 20,000 square feet, about one-tenth the size of the other 11 Wal- Mart Supercenters already open in Argentina. Wal-Mart's biggest competitor, the French firm Carrefour, already operates over 250 stores throughout the country and 22 hypermarkets in the Buenos Aires region. This new law would therefore protect not only smaller stores, but also the market dominance of Carrefour.

     This is not a new approach for Argentina, which prior to its economic reforms in the 1980s and 1990s had a broad range of anti-competitive laws on the books, including one that limited the number of drug stores to one per neighborhood.

Farmers in India, Lobbyists in China, and Underground Economic Activity Everywhere!

The Economist ran two interesting articles related to institutions in its February 15, 2001 issue. "Prowling Tiger, Slobbering Dog" deals with India's farm support programs, which make it clear that developed economies are not the only ones that protect agriculture with protectionist and distortionary policies. "The Gentle Art of Lobbying in China" describes how lobbyists fare in dealing with a communist government. Finally, in its February 1, 2001 issue, The Economist published a table showing the size of the informal (underground) markets in the world's most developed economies. Only Switzerland, the United States, and Austria had informal markets that were less than 10 percent of measured GDP. Regulations, taxes, and bureaucratic procedures drive over 10 percent of all economic activity underground even in the so-called developed economies that are usually described as having relatively efficient institutions.