Fiscal policy can have direct influence on output growth

Various macroeconomic models can be used to examine the impact of a range of variables on an economy's long- run output growth.

Among these are recently developed "endogenous growth" models, which incorporate policies that affect the incentives to invest in physical or human capital and can have permanent impacts on the long-run rate of output growth.

Inspired in part by the literature on endogenous growth models, a number of empirical studies have examined the impact of fiscal policy on output growth.

However, most of these studies consider only aggregates, such as total expenditure or government revenues as a percent of GDP. In addition, they often fail to identify the channels through which fiscal policy can affect growth -for example, government spending on public education, which can affect human capital formation; the provision of public sector infrastructure, which can affect the productivity of private capital; or capital income taxation, which can help determine saving.

In a recent IMF Working Paper, The Impact of Fiscal Policy Variables on Output Growth, Philip Gerson of the Fiscal Affairs Department surveys the theoretical and empirical literature on the relationship between fiscal policy variables and growth.

He adopts a disaggregated approach, examining the effect of both expenditure and tax policies on labour productivity, capital productivity, and cost and supply of labour and capital.

Labour Productivity

Government expenditure on education and public health are two examples of fiscal policies that can raise long-run economic growth, since educated and healthy workers are not only more productive than uneducated and sickly ones, but also better able to be trained and to adjust rapidly to technological and other changes in the workplace.

However, for these investments to raise the rate of growth, they must augment, rather than simply replace, private sector investment.

This could occur if market failures exist. In the presence of imperfect capital markets, when, for example, a lack of collateral may mean that individuals are unable to borrow to finance their education -even if the prospect of higher future wages would justify the expense of schooling -government financing could ensure access to education.

On a more basic level, if private returns to education are small relative to the cost of schooling, but social returns are large, students will tend to underinvest in education.

Subsidized public education could ensure that the optimal number of people go to school for the optimal amount of time. Government spending on health and nutrition can also lead to increases in worker productivity.

Not only can such spending reduce illness and absenteeism, it can also mean that workers are better able to absorb education and learn new skills.

As with education, however, government funding should not simply replace private expenditure, but increase access to services.

Empirical studies suggest that educational attainment and public health have significant, positive effects on per capita output growth. However, the evidence on education and health spending is far less conclusive.

This may be because government spending on education and health correlates poorly with actual achievement, either owing to gestational lags or because of inefficient allocation of resources.

Government spending on education may not result in improvements in the overall educational level of its population if, for example, a large share of the education budget is directed to universities.

Similarly, government spending on health care may not lead to improvements in the overall health status of its citizens if the health care budget is disproportionately allocated to services with lower rates of return.

These results argue for better targeting of social spending - in most cases, towards primary services and away from tertiary ones - for fiscal policy to be growth enhancing.

Capital Productivity

Fiscal policy can influence output growth through its effect on capital productivity. An increase in capital productivity will increase output both directly, by increasing the amount of output that the existing capital stock can produce, and indirectly, by encouraging additional investment that increases the capital stock.

Two classes of fiscal policy that can affect the productivity of physical capital are international trade policy and government expenditure on productive inputs, such as physical infrastructure or defense and public order.

Trade and Productivity: Economists have devoted considerable attention to the impact of international trade on the growth of domestic output, especially in developing countries.

The general consensus is that open economies grow faster than more closed ones. If, for example, innovations are embedded in new capital goods, then countries that restrict international trade -especially imports of capital goods - will restrict their access to technological improvements.

Competition from imports can also lead to increases in the rate of domestic innovation, as local firms are forced to raise their own productivity to compete with foreign producers.

In addition, in relatively small markets, indivisibilities or fixed costs may make it unprofitable to adopt more efficient production technologies. Export production may make it profitable to adopt some of these technologies, thus increasing growth rates.

And import competition may force firms to operate more efficiently; economies adopting more open trade regimes would narrow the gap between actual and potential output, leading to temporary increases in the rate of output growth.

Most of the evidence indicates that economic growth and openness are highly related. Accordingly, fiscal policies that encourage openness should also encourage growth.

Nevertheless, studies that have attempted to determine causality between growth and openness have not yielded definitive results- openness does not necessarily lead to growth.

Indeed, it is possible that as economies grow, they tend to become more open, so that growth causes openness. For example,as countries grow, they may be able to adopt lower cost, more efficient production technologies that allow them to compete in international markets.

Government Expenditure and Productivity. Unlike private investors, governments have the power to compel payment through taxes -even for the consumption of public goods, such as clean air, national defense, or flood control, whose benefits cannot be restricted to those people who are willing to pay for them.

Accordingly, some investments that might be profitable for the government to undertake might not be profitable for an individual.

If an investment is for a public good that would permanently raise the productivity of the private capital, stock, then government investment in physical capital could have a positive impact on the long-run growth rate of output.

A number of studies have looked at the impact of government capital expenditure on output growth, generally finding it to be small or even zero.

As with studies on the impact of health and education expenditures on growth, some variation stems from differences in data sets and specifications.

However these mixed results may also be explained by a lack of distinction among the various categories of government capital expenditure.

A weak empirical link between infrastructure expenditure and output growth, however, may also reflect the fact that not all infrastructure investments are equally valuable: building one sewer system in a city may increase growth, while building three such systems may decrease it.

Another type of government spending that may have growth- enhancing effects is sometimes described as maintaining the social fabric.

This consists of transfers to disdvantaged individuals, spending on defense and public order,and maintenance of a civil service. This may increase output growth if it contributes to political stability.

In many countries, present levels of spending on defense and public order may exceed the minimum necessary to maintain the social fabric, but there is no conclusive evidence that this has hurt their growth performance.

Labour Cost

The effects of taxes on economic growth are numerous and ambiguous. Taxes on labour income may increase or decrease work effort.

Taxes on cpital income may increase or decrease domestic saving in relatively closed economies, but in open economies, they may increase the rate of saving while decreasing the domestic capital stock.

Even in a closed economy, taxes on the use of capital in particular industries can make labour- not capital- worse off.

In any case, virtually all taxes distort economic activity. Consequently, they are best viewed as necessary evils to finance government expenditure or as an indirect means of improving social welfare.

Because the distortionary effects of a tax depend on the economic environment in which it is applied, there are strong interactions among taxes themselves.

It is therefore important to look at a tax code as a whole and not to focus too much on any single tax. In open economies, even the tax codes of trading partners and competitors need to be considered.

Empirical studies show that secondary workers - those who will work only if the offered wage outweighs other highly valued options outside of working -are much more sensitive to changes in personal income tax rates than are primary workers.

At the same time, cuts in income tax rates tend to increase the total volume of labour supplied, and progressive income taxes -which tax income at increasing marginal rates - discourage labour supply much more than do professional taxes -which tax all taxable income at the same flat rate.

Because secondary workers are much less numerous than primary workers, small changes in marginal tax rates are likely to have a minimal impact on labour supply and on growth.

Saving and investment appear to be relatively insensitive to changes in the rate of return, especially in developing countries.

This implies that increases in the personal and corporate income tax rates have a limited effect on saving, investment, and growth.

However, because individuals do not fully discount saving undertaken on their behalf by corporations, a revenue-neutral shift of the tax burden from corporations to individuals, or other policies that encourage firms to retain earnings rather than pay dividends, may increase saving, investment, and growth.

Growth

Gerson's study suggests that government expenditure policies have a more important effect on growth rates than do revenue policies.

That is up to a point, balanced-budget increases in spending on health, infrastructure, and the social fabric -if well -targeted - can be growth-enhancing.

Nevertheless, a country's growth performance is affected by the entire set of macroeconomic policies its government follows.

Moreover, a variety of factors -many of them exogenous -affect growth and can diminish the impact of even the best designed fiscal packages. In addition, while studies tend to focus on the impact of fiscal policy on growth, ultimately, it is welfare that governments should care about.

While growth and welfare are linked, they are not identical. For example, a measure that increases saving by forcing individuals to forgo all of current consumption may increase capital and growth, but it would reduce welfare: the payoff from higher future consumption would never fully compensate for the loss of currrent consumption.

As such, there may be some growth enhancing policies that a benevolent government may not wish to adopt.

(IMF Survey)

Moody's likely to upgrade Korea's ratings this month

Korea's currency crisis may soon turn the corner, as US credit-rating agency Moody's Investors Service Inc., will likely make upward adjustments of Korea's sovereign-rating outlook this month, government sources in Seoul said recently.

A ranking official at the Ministry of Finance and Economy said that Moody's is set to upgrade its assessment of Seoul's long-term credit outlook from "negative" to "stable" in March, reflecting improving sentiment towards the Korean economy.

"Following the recent rating upgrades by two other international agencies, Standard and Poor's Ratings Group and Fitch IBCA, a similar move by Moody's will further facilitate the nation's planned global bond offering," he said.

Moody's "negative" CreditWatch listing, to which Korea now belongs, means that the nation's sovereign credit rating is subject to downgrades in the near future.

In contrast, the "stable" outlook suggests that further ratings upgrades, including the rise to the "positive" outlook, will be possible.

Moody's seems motivated by Seoul's full support for the IMF recommended reforms and a debt rescheduling accord with international banks, to mull over outlook changes for Korea next month, the official explained.

Due to lingering financial sector uncertainties and the unstable won-dollar exchange rate, however, Moody's is not likely to upgrade Korea's rating itself for the time being, leaving it in the junk-bond status, he noted.

"Should Seoul implement for more sweeping economic restructuring and the exchange rate regain stability in the coming months, Moody's and other international rating firms will raise Korea's rating to the investment grade," he noted.

Last December Moody's pulled down Korea's rating to a junk-bond rating of Ba1 at the height of the currency crisis, from the previous A level.

Despite the latest rating upgrades by S&P and IBCA and Moody's possible outlook upgrade, the credit rating for Korean bonds and debts still remains one step below the lowest investment grade.

Investors are generally barred from buying financial instruments from countries with junk-bond ratings.

S&P, announcing its three-notch ratings upgrade for Korea February 17, said that Seoul has to place its capital account on a sounder footing and restore the health of its financial system to regain an investment grade rating.

It also warned that the restructuring reforms would exact a heavy coast and predicted that the economy would contract this year amid rising bancruptcy and unemployment.

Courtesy: Korea Weekly News

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