Abstract
Chapters 4 and 5 extended the two-period investment model to form a complete growth model. Here, we add endogenous theories of fiscal policy with selfish political motives, in the spirit of Chap. 3, to the growth model. First, we examine the consequence of a powerful kleptocracy for the economic growth of a developing country. Next, we consider a less drastic scenario, where there is interest group pressure on the government of a developing country that may bias policies against economic development. In Chap. 3, we saw how a proliferation of interest groups causes a rise in government transfers as democracies mature in the later stages of development. An important interest group during the early stages of development is comprised of large landowners. In this chapter we focus on the interaction between the political influence of landowners, the structural transformation, and the tax base that affects the growth in governments of developing countries. Finally, we examine the interplay between tax evasion and corruption by public officials and its consequences for private and public capital accumulation.
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Notes
- 1.
These sections are based on Ivanyna et al. (2016). Section 6.5 focuses on the baseline case from their research. The full paper includes several extensions of the model that are not discussed here, including alternative preference specifications, an income tax rather than a wage tax, and an open economy analysis.
- 2.
Mulligan and Tsui (2015) present a theory, based on the threat of political entry, that can be viewed as making γ endogenous.
- 3.
For notational simplicity only, we assume the government’s time discount factor is the same as that used by private households. One could allow the discount factor to differ from private households to study how the government’s time preference affects policy, as we did in Chap. 3.
- 4.
We assume that the government can commit to its policy choices in advance. For a discussion of commitment issues in regard to the setting of fiscal policy see Ljungquist and Sargent (2004, Chap. 22).
- 5.
See Das et al. (2018, Appendix to Chap. 5) for a sketch of the derivation in a somewhat more complicated economy that includes the current model as a special case.
- 6.
Taxing the return to capital, in addition, to wages would not alter the results much. In an open economy, the after-tax return to capital must remain equal to the after-tax world interest rate. Thus, country specific taxes cannot alter the after-tax return. However, higher taxes on capital in a given country will reduce that country’s capital-labor ratio. Thus, taxing capital in an open economy will be entirely shifted to labor by lowering before-tax wages. The primary difference between an income tax and a wage tax is that the economy reduces its capital-labor ratio as well as its total capital stock. See Problem 8.
- 7.
Galor et al. (2009) provide a theory and supporting evidence that larger landowners have acted to slow the accumulation of human capital for similar reasons.
- 8.
Our analysis ignores the growth in the size of government due to the growth in social transfers. This reason for the growth in government tends to occur in later stages of development as countries become more democratic. See Lindert (2004) for a thorough discussion of the connection between democracy and government size and Chap. 3, where we examined how a rise in interest groups increased transfer spending.
- 9.
For tractability, some features of the government must be taken as given in our analysis. However, we eventually discuss how changes in exogenous features of the government affect the results and even go as far as to indicate what may be considered the optimal levels of η and ε. In addition, note that when η = 1, the households are indifferent about working in the public or private sectors. However, this is not necessarily true after we introduce corruption and evasion. In the presence of corruption and evasion, we find that public officials are better off than private households as along as η ≥ 1 (even though we assume that public officials cannot avoid taxes on their official salaries). Thus, everyone would want a government job.
- 10.
In Chap. 8 we consider reforms that increase the pay of public officials.
- 11.
We assume that the fraction of money stolen generates the disutility rather than absolute amount. This specification will generate fractions of income that go unreported and fraction of public budgets that are diverted for private use that are independent of the level of income. This allows us to focus on institutional determinants of corruption because increases in income alone will not alter the rate of illegal activity.
- 12.
One can interpret θτ as the fraction of the before-tax market wage that a worker can earn in the untaxed underground economy. Too see this, let the technology used in the untaxed sector be the same as in the taxed sector except that the productivity index for labor is θτDt rather than Dt. This captures the idea that the government could lower access to productive public services for firms in the underground economy and thus lower the productivity of labor there. In this case, the profit maximizing wage offered in the untaxed sector is θτwtDt, where we have used the fact that if the return to capital is untaxed, then the capital to effective labor ratio must be equal in each sector. As the government clamps down on the untaxed sector by making it more difficult for those firms to use productive public services, θτ falls and the relative wage earned in the underground economy falls as well.
- 13.
Schneider and Enste (2000) and Johnson, Kaufmann, and Zoido-Lobaton (1999) provide evidence that higher tax rates increase the underground economy and tax evasion.
- 14.
Ivanyna et al. (2016) consider alternative specifications where tax evasion occurs without corruption. These specifications do not alter the main findings.
- 15.
Given the range of estimates, we also adjust φ to match a low target for v of 25 and a high target of 40 percent. Using these two targets did not alter the results significantly when compared to the intermediate case reported in the text. See Ivanyna et al. (2016) for the details.
- 16.
As explained, because the rates of taxation, evasion, and corruption do not vary with capital intensities, the transition is not particularly interesting.
- 17.
With no CC effect , in order to generate observed levels of tax evasion, the aversion to engage in illegal activity must be relatively high. When the aversion to engage in illegal activity is high, evasion is not very responsive to tax rate increases and the government can set high tax rates without concerns that evasion will lower the tax base. Thus, to match the observed evasion levels requires unrealistically large tax rates. When the CC effect is present, the level of tax evasion varies with corruption. The corruption-evasion interaction makes each variable more responsive to changes in parameters and helps target observed evasion levels without assuming a high degree of aversion to illegal activity. The corruption-evasion interaction and the lower aversion to illegal activity makes evasion more responsive to tax rates and causes the government to set much more reasonable tax rates.
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Ivanyna, M., Mourmouras, A., Rangazas, P. (2021). Politics, Corruption, and Economic Growth. In: The Macroeconomics of Corruption. Springer Texts in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-67557-8_6
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