Government Spending in a Simple Model of Endogenous Growth - Case Study Example

Taxation Institution Date Introduction Economists have been trying to come up with an optimal taxation system that can achieve the goal of maximizing social welfare and that of economic development. For years, tax policy has depended on the theory that there is a trade-off between equity and efficiency in the taxation system and each has to be sacrificed in the place of the other. Efficiency and equity of taxation are two concepts that are at odds with each other. Efficiency in the context of taxes refers to the maximization of the total size of the economic pie. On the other hand, equity is defined as fairness or equality in sharing the economic pie. Equity hopes to distribute the benefits of taxation fairly across the population. In this essay, literature that supports the idea of a trade-off between equity and efficiency in taxation is analyzed. Secondly, a new way of thinking about taxation that delinks equity from efficiency in taxation is also analyzed. Equity-efficiency trade-off One of the key points to support the equity efficiency trade-off theory is that there are substantial costs incurred in redistributing tax revenue. The redistributing agent incurs administration costs which make the taxation system less efficient. Okun (1985) argues that, taking tax income from the rich and redistributing it to the poor is like transferring water using a leaky bucket. Let take the instance of income tax one of the most popular method of wealth redistribution. HM Revenue and Customs have the responsibility of collecting income tax from citizens. HM Revenue incurs substantial administration costs in running its operations. It is generally agreed that taxation bodies incur huge administration costs in a bid to comply with existing tax laws. In recent year, the effectiveness of the taxation structure in economies has become a great concern to governments (Hsu, Anen and Quartz, 2008). Evidence from government records show that administrative costs run in excess of 1 per cent of the tax revenue collected or is sometimes substantially higher than 1 per cent. Some of the administrative inputs needed by faction departments include materials, personnel, information, procedures and laws. Taxpayers’ behavior is another indicator that taxation efficiency and equity are opposing goals. According to Le Grand (1990), charging income tax on individuals may cause them to change their productive behaviors. Le Grand (1990) argues that the amount of labor and capital available in the market decreases when income tax is charged. When individuals have their income taxed they tend to work less and save lesser money. By reducing the affinity to work and save, the income taxation regime reduces the efficiency of the taxation system. Thus income tax avails less money in the society but ensures that the money that is available in the society is distributed much more equally. This change of behavior means that equity is achieved at the cost of efficiency when collecting income tax revenue. However, the idea that taxes remove the incentive to work is highly debatable. The argument that taxation decreases incentive to work is highly flawed. Taxes basically reduce the total amount of money that a worker takes home. With taxes, a worker earns less for every hour worked. By reducing income, taxation basically produces either a substitution or an income effect (Le Grand, 1990). The substitution effects is supported by equity-efficiency tradeoff proponents who argue that people work fewer hours as the reward for work decreases with taxation. On the contrary, the income effect delinks equity from the efficiency of taxation. When people are taxed they become poorer and are thus forced to work for more hours to pay their bills and get the things they want. But which of the two effects are stronger. Many people believe the income effect is stronger than the substitution effect. Many people agree that they would put in more hours of work if they get a pay cut. Another group of people agree they would think of finding a second job if they had a pay cut. Le Grand (1990) argues that it is natural for people to try and earn as much money as they can in one day. Because of the natural urge to make money, the income effect seems to be stronger than the substitution effect. Secondly, people are working less despite wages going up dramatically over the last 200 years. If the substitution effect is true, people would be working more as income per hour has risen with time. Le Grand (1990) argues that people worked more in the past as they made less money per hour worked. Thirdly, statistics show that high income earners don’t work more than their low income counterpart. In past decades, low income people used to work much more than higher income people. However, once the income and substitution effects are balanced we find that high income people work harder. Nevertheless, the reasons for working hard are far more than just having more value for every hour worked. Working hard has other benefits including more experience, more education and increases the chances of getting promoted. People who work hard also have a more conscientious personality as working hard carries a degree of personal satisfaction. Since the late 1960s, new ways of thinking on the link between equity and efficiency in taxation policy emerged. The new thinking was based on the fact that some externalities were observed to influence growth. Named endogenous growth, the new theory linked lower levels of inequality with rapid growth in some countries. According to Romer (1986) nations with a greater stock of social knowledge were able to grow more rapidly in the postwar period. Firms benefit greatly and become more productive when the pool of skilled labor grows in the country. Some scholars argue that public services that increase labor productivity are responsible for the rapid growth in more equal societies (Barro, 1990). Recently, scholars have identified the development of human capital as the link between more equitable taxation and rapid economic development. Most literature that dismisses the equity-efficiency tradeoff emphasizes the importance of human capital. Sala-i-Martin (1994) provided empirical evidence that concurred with the view that countries with a well educated workforce do better economically (1994). Comparison of the global economies shows that those with higher average levels of education have grown more rapidly economically. Murphy and Welch (1993) show that the annual earnings of US citizens increased rapidly as more people became college educated. According to Le Grand (1990), an increase in earnings in the US in the 80s is owed to average differentials in earnings between high school and university educated workers. According to Buttress (1994), this is against a backdrop of a decrease in the average earnings of U.S high school graduate. This means that if the disadvantaged receive more education funded by tax revenue then their incomes will rise, economic inequalities will diminish and the overall size of the economy will grow. This point contrast sharply with the idea that their must be a trade off between equity and efficiency in the distribution of tax revenue. Eckstein and Zilcha (1994) conducted research that linked a more equal distribution of income to macroeconomic growth. Their model indicated that overlapping generations of intergenerational altruism were likely to result in faster rates of economic growth. The two authors assert that countries that distribute wealth more equitably develop more rapidly. According to Le Grand (1990), compulsory public schooling financed by public revenue helps to empower the masses with human capital they can use to aid in the country’s development. According Le Grand (1990), compulsory public schooling is founded on the ideals of equality. It allows for greater equality of opportunity and ensures that the children of parents who would find it difficult to educate their children in unfettered capitalist system receive adequate education. Eckstein and Zilcha (1994), support the idea that compulsory education contributes to accelerated economic growth. Over time, compulsory education raises the average literacy levels and improves the quality of human capital. This has the effect of reducing intergenerational inequality as income becomes more equal. Eckstein and Zilcha (1994) conclude that economic growth is accelerated where the governments interfere with the market and provides free compulsory education. Working from a political economy point of view, Persson and Tabellini (1994) conclude that inequality is harmful to growth. The two argue that economic growth is a result of accumulation of production knowledge and human capital. Persson and Tabellini (1994) use an intergeneration overlapping framework to illustrate that equal distribution of revenue results in increases in economic growth. When the previous generation accumulate human capital such as technical knowledge it has positive externalities and increases the income of subsequent generations. Conclusion Proponents of the idea that equity and efficiency are competing goals and one has to be sacrificed for the other to be achieved have dominated the formulation of taxation policy. Many arguments were used to show that equality in the distribution of tax revenue and its results cannot be achieved. Proponents of the equity-efficiency trade-off argue that substantial costs are incurred in collecting and redistributing tax revenue. Secondly, they argue that taxation causes individual to change their attitudes towards work. According to the proponents many people will work less when taxed as taxation decreases the amount of wages paid for every hour worked. However, this argument has been rebutted as many people tend to work more when their income is reduced. In fact, many people agree that they would put in more hours of work if they get a pay cut. Another group of people agree they would think of finding a second job if they had a pay cut. Since, the equity trade-off theory showed major weaknesses, some economist proposed a new framework for understanding the link between equality and efficiency in distribution of tax revenue. The new thinking was termed as the endogenous growth theory and was founded on observations that countries that were more equal in distributing income were able to increase the size of their economy more rapidly. The endogenous growth theorist uses a variety of explanations to show that equity and efficiency are not necessarily trade-offs in the distribution of income. The endogenous growth theory is still young but it is a more accurate construction of the relationship between equity and effectiveness in distributing tax revenue. Endogenous growth provides a discourse for explaining the relationship between equity and efficiency. Empirical evidence now show that the equity-efficiency trade off is a myth whose time as the dominant ideology followed in the distribution of resources has passed. Endogenous growth literature now argues that more equal societies grow much faster. Historical observation support this claim and scholars have conducted rigorous research to support the idea equality is good for economic growth. One of the factors associated with faster economic growth due to more equal distribution of resources is the development of human capital. A well educated workforce has enabled many countries to achieve rapid economic growth. In the 1980s, countries with high average levels of literacy recorded more rapid economic growth than countries with low literacy levels. An increase in the number of college graduates versus high school graduates also saw the size of average income increase in the US. This means that if the disadvantaged receive more education funded by tax revenue then their incomes will rise, economic inequalities will diminish and the overall size of the economy will go. This point contrasts sharply with the idea that there must be a tradeoff between equity and efficiency in the distribution of tax revenue. The equity-efficiency tradeoff analysis of the 1970s had significant influence on how taxation revenue was distributed in the 1980 and the 1990s. However, this flawed analysis could not be expected to come with good economic policies for distribution of taxation revenue. Today, the influence of endogenous growth literature is growing and many countries have invested in developing their human capital. To guarantee future growth, economic policy will have to prioritize compulsory education and concentrate efforts in developing human capital to optimum levels. Some countries have already succeeded in uplifting millions out of poverty by providing them with education and the skills to improve their productivity. References Barro, R.J. (1990) "Government Spending in a Simple Model of Endogenous Growth", Journal of Political Economy , Vol. 98, S103-S125, 1990. Burtless, G. (1990) A Future of Lousy Jobs? The Changing Structure of U.S. Wages , The Brookings Institution, Washington, D.C., 1990. Eckstein, Z. and I. Zilcha (1994) "The Effects of Compulsory Schooling on Growth, Income Distribution and Welfare", Journal of Public Economics , Vol. 54, May, 1994, pp. 339359. Hsu, M., Anen, C., & Quartz, S. R. (2008). The right and the good: distributive justice and neural encoding of equity and efficiency.science, 320(5879), 1092-1095. Kritikos, A., &Bolle, F. (2001). Distributional concerns: equity-or efficiency-oriented?. Economics Letters, 73(3), 333-338. Le Grand, J. (1990). Equity versus efficiency: the elusive trade-off.Ethics, 554-568. Murphy, K. and F. Welch (1993) "Inequality and Relative Wages", The American Economic Review , Papers and Proceedings, May 1993, pp. 104-109. Persson, G. and G. Tabellini (1994) "Is Inequality Harmful for Growth?", The American Economic Review , June, 1994, Vol. 84, No. 3, pp. 600-621 Romer, P.M. (1986) "Increasing Returns and Long-Run Growth", Journal of Political Economy , Vol. 94, 1002-1038, 1986. Sala-i-Martin, X. "Cross-Sectional Regressions and the Empirics of Economic Growth", European Economic Review , Vol. 38, 1994, pp. 739-747. Read More