6 Income Distribution, Fiscal Policy and Growth

In the models of income distribution and growth surveyed in Chapter 4, fiscal policy plays a crucial role in both the political mechanism and the economic mechanism. 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 redistribution 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

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