Fiscal Policy and Economic Growth at Different Stages of Development: An Eclectic Approach

Abstract

This study investigates if and how the economic growth effects of fiscal policy depend on the stage of development. In particular, it analyses the effects of different fiscal policy compositions (i.e. taxes on income and consumption, public spending on investments and consumption, and different modes of redistribution) on long-term growth and how these effects systematically change in countries with different levels of capital stock, population growth, capital market conditions, distance to technological frontier, etc., most of which can reasonably be captured by a country’s stage of development. The study includes the claim that different theoretical paradigms better guide us in the analyses of fiscal policy at different stages of development; namely, developing countries fit better to the assumptions of the Classical theory, whereas developed country conditions are better explained in the Keynesian theory.

The main argument can be summarised as follows: in developing countries, where the capital-labour ratio is very low and most productivity growth comes from capital formation, capital accumulation is the key mechanism for accelerating growth. In these economies, fiscal policies aiming to maximise savings are more supportive of growth as this raises investible funds for capital accumulation (Lewis, 1954). Developed countries, where the capital-labour ratio is high, however, are usually adversely impacted by a savings glut (Hansen, 1939). In these economies, savings capacity often far exceeds investment demand due to capital saturation, so fiscal policies designed to support effective demand are more effective in driving investments and thus growth. Furthermore, in developing countries, where investment demand is high but access to credit is limited, accumulation of resources by the capitalist class tends to have trickle-down effects, whereas in developed countries, where investment demand is low and capital markets are advanced, it contributes to the savings glut more than investments.

Therefore, in developing countries, modes of taxation which suppress consumption and public spending on capital investments are more supportive of growth because they accelerate capital accumulation, whereas in developed countries, taxation of income and public spending on consumption/services are more growth-enhancing as they support effective demand. Similarly, in developed countries, redistributive policies that increase effective demand by giving more purchasing power to lower classes increases growth more, whereas in developing countries, channelling more resources towards the investor class, are more growth-enhancing.