TAXES AND GROWTH: TESTING THE NEOCLASSICAL AND ENDOGENOUS GROWTH MODELS

Abstract

Changes in the tax rate alter real growth permanently in an endogenous growth model, but only temporarily in a neoclassical model, where the only permanent effect is a decrease in the steady‐state level of output per capita. Using data from the 1960'1992 period for a panel of 11 Organization of Economic Cooperation and Development economies, this paper's empirical results support the following conclusions. First, consistent with the tax smoothing hypothesis, tax rates have exhibited significant persistent changes while output growth rates have not. Second, a higher tax rate permanently reduces the level of output but has no permanent effects on the output growth rate. These findings are inconsistent with endogenous growth mechanisms and suggest that the relationship between output and the tax rate is best described by the neoclassical growth model. (JEL E62, 041)