Income Distribution
In the former government expenditure and the tax rate depend on the distribution of income through the voting process. In the latter government expenditure and the associated tax rate affect the incentives to invest and therefore the rate of growth. We estimate these two mechanisms in this section: thus, we go beyond the results presented before by decomposing the reduced form regression into its two main components.
The difficulty in pursuing this analysis is that the policy instruments used to achieve re-distribution may vary across countries and time periods. In some cases redistribution may be achieved by a very progressive labour income taxation, in other cases by a certain composition of government spending, in others still by trade policy. It may be hopelessly restrictive to focus on one specific policy tool to test these models of income distribution and growth.
Nevertheless, it is instructive to make an attempt at going into the 'transmission mechanism' from income distribution to growth, while keeping in mind that all the results we present will have to be evaluated with the above important caveats. We concentrate on the case of purely redistributive government transfers for at least two reasons. First, transfers are the main component of virtually all government budgets in the countries in our sample of democracies.
Second, when public investment or investment subsidies are involved one should be careful about what type of taxation finances them. For instance, in the Alesina and Rodrik model results are likely to be reversed if public expenditure on infrastructure is financed by proportional taxes on labour income. On the other hand, they would continue to hold with sufficiently progressive taxation on total income.
In addition to this theoretical complication, the existing breakdown in the tax data does not easily allow a satisfactory use of tax data in these regressions. The idea that redistributional transfers reduce the incentives to invest seems fairly robust. By their very nature, transfers are associated with a redistribution of income from the high income agents to low income agents, and are financed by distortionary taxes. High income agents also tend to own a disproportionate share of the capital stock and to make most of the investment in physical capital. Therefore, re-distribution tends to hurt the agents with the highest propensity to invest.
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