6 Main Public Policies to Promote Economic Growth

The following points highlight the six main public policies to promote Economic Growth. The Policies are: 1. Altering the Saving Rate 2. Reduction in Non-Plan Revenue Expenditure 3. Policies to Raise the Rate of Productivity Growth 4. Technological Progress 5. Reduction in Government Regulation 6. Industrial Policy.

Public Policy # 1. Altering the Saving Rate:

According to the Solow model of growth, the rate of saving and investment is a key determinant of a country’s rate of growth and standard of living of its citizens. In the Solow model the saving rate determines the steady-state levels of capital and output. Only one particular saving rate generates the Golden Rule steady state, i.e., the rate which maximises consumption per worker and, thus, economic well-being.

In order to ascertain whether an economy is at, above, or below the Golden Rule steady- state, we have to compare the net marginal physical product of capital (MP_K – δ) with the rate of growth of output (n + g). We know that at the Golden Rule steady state, MP_K – δ = n + g.

If the economy is operating with less capital than in the Golden Rule steady state, then, due to diminishing marginal product of capital, MP_K – δ > n + g. In such a situation an increase in the saving rate will ultimately lead to a steady state with higher consumption. In contrast, if the economy is operating with too much capital, then MP_K – δ < n + g, and the rate of saving has to be reduced.

According to the Solow model the rate of national saving is one of the most important determinants of long-run living standards. However, this does not mean that policy-makers should try to raise the saving rate. It is because more saving means less consumption in the short run.

In spite of these we cannot deny the importance of raising the saving rate. And one way of doing this is to reduce tax rates because taxes on saving reduce the return to saving.

(i) Reduction in personal income tax:

A tax cut imparts the needed dynamism to the economy.

As the US Supreme Court commented:

“The power to tax is not only the power to destroy but also the power to keep alive.” Tax cut promotes growth in various ways. It encourages people to work hard, save more and take more risks (i.e., invest more in venture capital).

Apart from reducing the nominal tax rate, it is necessary to index tax brackets to inflation to prevent ‘bracket creep’, i.e., an increase in the marginal tax rate. The application of supply-side economic policies in the 1980s under the dynamic leadership of Ronald Reagan has proved conclusively that tax cuts increase labour supply and, therefore, output.

Personal income tax cuts increase personal saving. Lower marginal tax rates improve incentives for labour supply, saving and investment.

(ii) Reduction in business taxes:

The tax policy should be such as to encourage capital formation by increasing the after-tax return to investment. An important component of the policy should be accelerated cost recovery system, which is a set of accelerated depreciation allowances for business plant and equipment.

For example, a piece of equipment that could have been depreciated over a 10-year period can be allowed to be depreciated over a 5-year period. In addition, the investment tax credit for certain types of equipment can be increased to encourage capital formation.

These business tax cuts aim at offsetting the inflation-induced increase in the effective tax rate on business profits. Such tax cuts are consistent with the supply-side view that the best way to encourage corporate capital formation is by increasing the after-tax return to investment. Even low capital gains tax is unlikely to have a favourable effect on saving and thus, on capital formation.

Advantages and disadvantages:

The aims of tax reforms are: first, to broaden the tax base by eliminating many deductible items and, second, to reduce marginal tax rate. The combination of these actions is offsetting in nature. So total tax revenues will neither rise nor fall.

However, to keep tax reform from reducing tax revenues, there is need to remove many reductions and eliminate a number of tax shelters. This is likely to encourage tax evasion and avoidance.

If savings are highly responsive to the real interest rate, tax cut that increases the real return to savings would be effective. So a judicial policy is to tax households on the basis of their consumption rather than on the basis of their savings. This means exempting that portion of income which is saved from taxation.

Government Saving:

The government can also save more by reducing the budget deficit. One way of doing this is to curtail government purchases. Alternatively, raising taxes to reduce deficit or increase the surplus will also increase national saving by forcing people to consume less.

However, the Barro-Ricardo equivalence theorem suggests that tax increases without changes in current or planned government purchases do not affect consumption or national saving.

There are two ways of raising the rate of saving. The government can directly increase the rate of saving by increasing its own saving, called public saving. Public saving is the excess of government tax revenue over government expenditure.

When government expen­diture exceeds its revenue, there is a deficit in the budget. This amounts to negative public saving¹. So it is necessary for the government to generate a surplus in the budget to ensure that public saving is positive. If the government generates a budget surplus it can repay some of the debt and stimulate investment.

The government can also affect national saving by influencing private saving — saving of the household sector and the corporate sector (i.e., retained earnings of corporations). This is largely a matter of incentives. Various public policies may be used to provide such incentives. However, economists differ in their opinion regarding how much private saving responds to incentives.

Public Policy # 2. Reduction in Non-Plan Revenue Expenditure:

No doubt personal and business tax cut should increase aggregate supply and, therefore, produce non-inflationary real output growth. Moreover, such growth would increase tax base and, therefore, increase tax revenues to offset, largely, or even completely, the revenue loss due to the lower tax rates.

However, to ensure that demand is not overly stimulated, the economy is not overheated and to keep the budget deficit as small as possible, there is need to cut non-plan revenue expenditure in areas such as housing and income support programmes (including subsidies) so as to reduce the magnitude of public debt.  

A fall in the size of public debt will also reduce the interest burden on such debt.

Disadvantage:

Failure to cut spending, together with tax reduction will lead to high government budget deficit. The consequent inflation may act as a growth-retarding factor.

Public Policy # 3. Policies to Raise the Rate of Productivity Growth:

Perhaps the most important factor affecting the long-run living standards is the rate of productivity growth. According to the Solow model only sustained growth in productivity can lead to continuing improvement in output and consumption per worker.

Government policy can attempt to increase productivity in three ways:

(i) Improving infrastructure:

The Solow model assumes that there is only one type of capital, viz., physical capital. While the private sector invest in plants, machinery, computers and robots, the government invests in various forms of public capital, called infrastructure.

There is a strong link between productivity and quality of a nation’s infrastructure — its highways, bridges, utilities, dams, airports and other publicly owned capital. Highways linking one state with others reduce the cost of transporting goods and stimulate tourism and other industries.

It is necessary for the government to recognise both the market’s efficiencies and its imperfections. So there is a case for a ‘stimulus package’ consisting of public investment in infrastructure, worker retraining and partnership between business and government to move resources from ‘sunset’ industries (i.e., industries losing comparative advantage) to sunrise industries (i.e., industries gaining comparative advantage).

(ii) Building human capital:

There is another type of capital — human capital — which is equally important in promoting growth and prosperity of nations. Such capital refers to the knowledge and skills that workers achieve through education and training which lead to skill formation, improved efficiency and enhanced productivity. Human capital, much like physical capital, enhances an economy’s ability to produce goods and services.

Raising the level of human capital requires investment. N. G. Mankiw and David Romer in explaining international differences in living standards have demonstrated clearly that human capital is at least as important as physical capital.

There is a strong connection between productivity growth and human capital. The government can affect human capital development through educational policies, worker training and health programmes.

However, such programmes are justified if benefits exceed costs. There is clearly a case for greater commitment to human capital formation as a way to boost productivity growth.

For promoting investment in human capital the government has to make investment on such capital. It is because such capital generates technological externality (or knowledge spill). Since social benefit from such investment exceeds private benefit the government has to take the lead in making investment in human capital or subsidise such investment.

(iii) Entrepreneurship Development:

One crucial form of human capital, ignored by the Solow model is entrepreneurial skill. Entrepreneurs or the captains of industries act as an engine of growth. It is because they are people with the ability to build a new product, business or introduce something new to the market.

Productivity growth may increase if the govern­ment were to remove unnecessary barriers to entrepreneurial ability (such as excessive red tape, rent seeking, bribery and corruption at all levels) and the people with entrepreneurial skills make intensive use of those skills.

(iv) Encouraging research and development (R&D):

The government may also stimulate productivity growth by affecting rates of scientific and technical progress. The benefits of scientific progress, like those of human capital development, spread throughout the economy.

Basic scientific research is always beneficial from society’s point of view. So the government should make more investment on such policy. Even more applied, commercially- oriented research deserves government support and financial aid.

Public Policy # 4. Technological Progress:

Various public policies are designed to promote technological progress. Most such policies encourage the private sector to allocate substantial amount of resources to techno­logical innovation. This can be done by the patent system which gives protection to intellectual property rights for a specific time period.

At the same time the government can play an active role in promoting a few specific industries which are the carriers of rapid technological progress, called knowledge-intensive industries or sunrise industries.

Public Policy # 5. Reduction in Government Regulation:

Excessive government regulation in the form of air quality, worker safety and consumer product safety often proves to be very costly and retards economic growth. So the aim of government policy should be to eliminate wasteful or outdated regulations and to make necessary regulations more efficient and flexible.

Some specific regulatory measures may be to decontrol petroleum markets, abolish licensing regulations, reduce monopoly control and stop excessive monopoly hunting and to introduce a cost-benefit analysis of government expenditure.

Public Policy # 6. Industrial Policy:

Apart from giving support for basic science and technology, the government can encourage technological development through industrial policy. In general, industrial policy is a growth strategy in which the government uses taxes, subsidies or regulations in order to influence the nation’s pattern of development.

To be more specific, the government should subsidise and promote ‘high tech’, industries, so as to try to achieve or maintain national leadership in technologically dynamic areas.

For at least two reasons free markets fail to allocate resources in case of high technology, viz., (i) borrowing constraints and (ii) spillovers.

Borrowing constraints refer to the limits imposed by lenders on the amounts that individuals or small firms can borrow. Due to borrowing constraints, private companies, especially start-up firms, may have difficulty in obtaining enough financing for some projects. Development of a new super-computer, for example, may require a huge amount of investment in R&D and involve a long period during which expenses are high and cash flows are unlikely to be generated.

Spillovers occur when one company’s innovation — say, the development of an improved computer memory chip — generates aggregate supply externality, i.e., it stimulates a flood of related innovations and technical improvements by other companies and industries.

The innovative company may thus enjoy only some of the total benefits of its breakthrough while bearing the full development cost. Since social benefit exceeds private benefit, without government subsidy such companies may not have a sufficiently strong incentive to innovate.

These two arguments in favour of government intervention assume that the government is skilled enough at picking ‘winning’ technologies. A danger of industrial policy is that wrong industries may emerge due to favouritism shown by the politicians. At the same time industries with the maximum economic promise may be neglected.

In general industrial policy is not desirable because, in choosing industries to target, governments have frequently backed the wrong industries; the costly attempt to develop those industries which are unlikely to show much promise in the long run. Alternative policies — such as a tax break for all research and development spending — promote technology without requiring the government to target specific industries.

However, government intervention may be desirable in some cases, notably in the early development stages of technologically innovative products, such as computers and CAT scanners. In reality, we find that the potential for beneficial spillovers in these cases is very large.

So there is a strong justification for government intervention in such areas, even though many projects the government may choose to support ultimately will not prove to be economically feasible.