bela balassa prices, incentives, and economic growth...bela balassa prices, incentives, and economic...

World Bank Reprint Series: Number 339 REP-339

Bela Balassa

Prices, Incentives,and Economic Growth

Reprinted with permission from WellwirtschafUliches Archiv, vol. 120, no. 4 (1984), pp. 611-30; toappear in the Proceedings of the Conference on Economic Incentives published by The MacmillanPress Limited.

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Prices, Incentives, and Economic Growth

By

Bela Balassa

Contents: 1. The Role of Relative Prices. - IL Policy-Imposed Distortions inProduct Markets. - 111. Policy-Imposed Distortions in Labor Markets. - IV. Policy-lmposed Distortions in Capital Markets. - V. Policy-Imposed Distortions in theRelative Prices of Labor and Capital. - VI. Taxes and Economic Growth. - VII.Conclusions.

I. The Role of Relative PricesR elative prices were at the center of economics during the one-and-a-half centuries following the publication of the Wealth of Nations.Classical economists never doubted that economic activities respond

to price incentives, generating economic growth in the process. The choicebetween work and leisure was seen to be affected by the relative prices ofgoods and labor; the choice between present and future consumption by therate of interest; and the choice among goods by their relative prices. Theinteractions of these choices, in turn, were seen to determine the allocation ofresources among industries and the pace of economic growth, with fullemployment being maintained over time.

There were few dissenting voices. The existence of a reserve army of laborkeeping wages at the subsistence level and periodic overproduction resultingfrom lack of effective demand underlied Marx's theory of capitalist crises, buthe and his disciples remained outside the mainstrearm of economics. And,while Marshall recognized the existence of market failures in the form ofexternal economies and diseconomies, these were considered rather unimpor-tant exceptions.

The classical consensus was shattered with the emergence of effectivedemand as the principal factor affecting the level of employment in theGeneral Theoiy. This was followed by the Hafrod-Ddmar model, in whicheconomic growth was determined by technical relationships, leading to aknife-edge situation that was not remedied by changes in relative prices. Priceswere also banished from structuralist explanations of economic developmentand the reserve army of labor re-emerged in theories of unlimited laborsupply.

Remark: The author is greatly indebted to participants at the Conference on Economic Incentives,held at the Institute for World Economics at the University of Kiel in June 1984 for helpful comments.At the same time, the paper reflects the author's views alone and should not be interpreted to expressthose of the World Bank. Research assistance by Eric Manes is gratefully acknowledged.

Weltwiatschaftliches Archiv Bd. CXX. I

612 Bela Balassa

There further came a fasciiiation with central planning. In an earlierperiod, Lange and Lerner attempted to reproduce the workings of a privatemarket model in the framework of a decentralized socialist system. After theSecond World War, Soviet-type central planning, eschewing the role of pricesin resource allocation, attracted the interest of economists particularly indeveloping, but also in developed, countries.

Mathematical economists established the conditions under which thecentralization of economic decisions was superior to decentralization. Whileexplicit or implicit use was made of prices in these models, economic agentswere assumed to respond to orders from above rather than to economicincentives. Furthermore, general equilibrium theorists gave increasing empha-sis to market failures that would not permit reaching Paretian competitiveequilibrium, thus legitimizing public inierventions in market processes. At thesame time, estimates were put forward purporting to show that the economiccosts of governmental actions, creating distortions in resource allocation,were rather small.

These developments did not fail to influence economic policy-making. Indeveloped countries, Keynesian policies held sway, with little attention givento their possible adverse consequences for the longer term. In severalWestern European countries, attempts were made to introduce some form ofplanning. Also, social legislation proliferated, neglecting its effects on econom-ic incentives.

In the newly-established socialist countries after World War 11, the Sovietsystem of central planning was copied, notwithstanding differences in econom-ic conditions in the countries concerned. In particular, attempts were madeto reach self-sufficiency in industrial products in the framework of smallnational markets that lacked the balanced natural resource endowment of theSoviet Union. At the same time, agriculture was neglected and the lack ofscarcity prices obstructed rationality in foreign trade.

The neglect of agriculture was also characteristic of developing countriesthat followed a pattern of inward-oriented industrialization. The governmentsof these countries failed to consider the adverse effects on agricultural outputof the disincentives inherent in high industrial protection. Also, they largelydisregarded the rising cost of import substitution as the imports of capital-intensive manufactured goods subject to economies of scale came to bereplaced by domestic production.

While this thumbnail sketch can do no more than indicate some generaltendencies without any pretension to accuracy, the main features of the storyare reasonably clear. Policy-makers followed economists in de-emphasizingprices and incentives, with government directives and interventions distortingthe price mechanism in developed and, in particular, in developing countriesand supplanting it in socialist countries.

Prices, Incentives, and Economic Growth 613

The importance of prices and incentives has re-emerged in the morerecent period. In the developed countries, the efficacy of Keynesian remedieshas come to be questioned; planning has fallen into disuse; and the adverseeconomic consequences of social legislation have been given attention. Intum, economic decision-making has been decentralized in Hungary; at-tempts at decentralization have been made in some other socialist contries;and a reform effort is under way in China. Finally, the example of Far Easterneconomies has been followed by several developing countries in adopting anoutward-oriented strategy and giving an increased role to the market me-chanism.

This paper will examine the economic effects of government directives andinterventions in developed, developing, and socialist countries that createdistortions in the system of incentives. In Bhagwati's terminology [1971], thediscussion will concem policy-imposed distortions rather than endogenousdistortions, which find their origin in market imperfections; also governmentmeasures designed to correct market imperfections fall outside the purview ofthe paper.

In the course of the discussion, consideration will be given to policy-imposed distortions in product and in factor markets, and the effects of thesedistortions on the efficiency of resource allocation and economic growth thathave been often neglected in the past. In so doing, use will be made ofempirical evidence that has accumulated in recent years'.

II. Policy-Imposed Distortions in Product Markets

In developed countries, distortions in product markets may result fromgovernment interventions in the form of price control and limitations oncompetition. In the case of non-traded goods, governments may set the priceof the particular service and/or restrict entry by new firms; in the case oftraded goods, protection is an important device limiting competition, therebyraising costs to the user and to the national economy as a whole.

Among services, one may single out transportation that is subject toregulations in most developed countries. In turn, while conclusive results arenot yet available, deregulation in the United States appears to have impor-tantly reduced the cost of air and surface transportation. This has occurred ascompetition has led to the streamlining of operations and to reductions infeatherbedding practices.

Estimates of the cost of protection in developed countries are generallylow, hardly reaching one percent of the gross national product. Theseestimates, however, fail to consider the losses involved in foregoing theexploitation of economies of scale in protected markets. Taking account of

I The paper builds on, and complements, the author's writings on policy-imposed distortionsin developing [19821 and in developed [1984b] countries.

1*

614 Bela Balassa

economies of scale, it has recently been estimated that protection has reducedpotential output by about 10 percent in Canada [Harris, Cox, 1983, p. 1151.

Protection rates are much higher, and vary to a considerable extent amongindustries, in inward-oriented developing economies. Partial equilibriumestimates show the cost of protection to range between 4 and 10 percent ofGNP in these countries even without adjusting for economies of scale[Balassa et aL, 1971, p. 82]. At the same time, the estimates understate the costof protection by excluding substitution among products (traded and non-traded) and factors that is taken into account in a general equilibriumframework. In fact, higher cost estimates have been obtained in a generalequilibrium model for Colombia, even though Colombia has lower levels ofprotection than the countries referred to above [de Melo, 1978, p. 217].

All these estimates concem the static effects of protection on the efficiencyof resource allocation. Economic growth will nevertheless be affected as theefficiency of investment declines and the loss of incomes reduces theavailability of domestic savings. Furthermore, as Johnson [1967] first showed,under certain conditions capital accumulation may lead to a decline in GNPif the protected sector is capital-intensive. Finally, protection may foster a"live and let live" attitude while technological change is stimulated by thecarrot and the stick of foreign competition.

Evidence on the effects of protection on economic growth in the develop-ing countries is provided by the experience of the 1973-1979 period ofexternal shocks. During this period, outward-oriented economies that givesimilar incentives to sales in domestic and in foreign markets have reachedbigher rates of economic growth than inward-oriented economies, eventhough they suffered larger external shocks owing to their greater exposure tointernational trade. While this result was originally obtained for newly-industrializing developing economies, it has subsequently been shown toapply to less developed economies and even to the low-income countries ofWestern Africa [Balassa, 1981; 1984b; 1984c]. The latter conclusion is ofspecial interest, given the often expressed view that price incentives havelimited effects in low-income countries.

Data for the three groups of countries have been combined in aneconometric study of 43 developing economies, in which initial trade orienta-tion and policy responses to external shocks have been separately introduced.The extent of outward-orientation has been estimated as deviations of actualfrom hypothetical values of per capita exports, the latter having been derivedin a regression equation that includes per capita incomes, population, and theratio of mineral exports to the gross national product as explanatory variables.In turn, alternative policy responses have been represented by relating thebalance-of-payments effects of export promotion, import substitution, andadditional net external financing to the balance-of-payments effects of exter-nal shocks [Balassa, 1985a].


Including further the extent of external shocks, per capita incomes, andthe share of manufactured exports in total exports among the explanatoryvariables, it has been shown that initial trade orientation as well as thecharacter of policy responses to external shocks importantly affected rates ofeconomic growth in the 1973-1979 period. GNP growth rates differ by 1.0percentage point between countries in the upper and the lower quartiles ofthe distribution in terms of trade orientation in 1973; also, there is a differenceof 1.2 percentage points in growth rates between countries in the upper andthe lower quartiles of the distribution in terms of export orientation.

The results are cumulative, indicating that initial trade orientation andreliance on export promotion in response to external shocks explain much ofthe intercountry variation in GNP growth rates that were 6.5 and 3.3 percent,respectively, for countries in the upper and the lower quartiles of thedistribution. The results are not materially affected if data on increases incapital and labor are introduced in the estimation.

Among socialist countries, the importance of foreign trade for its economypoor in natural resources was an important factor contributing to theintroduction of the 1968 economic reform in Hungary. The reform aimed atreplacing plan directives by market relations among firms; limiting the scope ofcentral price determination; linking the domestic prices of exports and importsto prices in the world market; and decentralizing a major part of investmentdecisions.

The reform was intended to reverse the decline in the rate of economicgrowth that occurred in the first half of the sixties, when it became increas-ingly difficult to make production decisions centrally in an economy thatbecame more sophisticated and to ensure that foreign trade conforms to theinterests of the national economy without reliance on scarcity prices. In fact,economic growth accelerated after 1968 as Hungary gained export marketshares in capitalist as well as in socialist countries.

A reversal occurred after 1973, when economic decision-making waspartially recentralized and prices were increasingly divorced from worldmarket price relations in an effort to isolate Hungary from the peripeties of theworld economy. But, as the adverse effects of these actions on economicgrowth came to be recognized, reform measures were again taken from 1980onwards. The break-up of monopolistic firms, the increased role given to the"second economy", and the actions envisaged for the 1985-1988 period toliberalize prices and wages go well beyond the original 1968 reforms.

III. Policy-Imposed Distortions in Labor Markets

Distortions in labor markets due to governmental actions may take avariety of forms. Some of these distortions affect the supply of labor, others thedemand for labor. Among government interventions affecting the supply of

616 Bela Balassa

labor, unemployment compensation and regulations aimed at ensuring jobsecurity tend to increase the rate of unemployment while the provision ofcertain social benefits and the taxation of labor incomes lower labor forceparticipation rates. In turn, the demand for labor is affected by minimum wagelegislation and by social security schemes. Apart from their effect on employ-ment, these regulations also influence the efficiency of resource allocationand economic growth.

Unemployment compensation is provided in developed but generally notin socialist or in developing countries. The rate of compensation and itsduration was increased to a considerable extent after 1973, with the value ofunemployment benefits reaching 75 percent of after-tax incomes in the majorEuropean countries. While some reductions have occurred since, there isevidence that the high rate and the long period of unemployment compensa-tion have raised the level of unemployment and lengthened its duration'.

In Western Europe, dismissing workers "for cause" is a difficult andtime-consuming process as is reducing the firm's labor force for economicreasons. And, in cases when labor can be discharged for economic reasons,those with seniority have to be retained and often high payments have to bemade to those who have become redundant.

While these regulations aim at limiting unemployment, their impactappears to have been the opposite as firms are reluctant to hire labor that hasbecome a quasi-fixed cost. Also, the mobility of labor is hindered and firmsthat have to retain labor turn to the govermment for compensation, therebyperpetuating the life of inefficient establishments. Finally, there is less incentiveon the part of workers to improve productivity, and absenteeism tends to rise.The liberal treatment of sickness leave has further contributed to absenteeism.

Regulations limiting the dismissal of labor and high redundancy paymentsfor those discharged have also been introduced in some developing countries,with consequences similar to those observed in Western Europe. The dismissalof labor was prohibited for several years in Turkey and redundancy paymentsmay amount to one year's salary in Latin America.

Labor regulations have rather pronounced effects in the socialist coun-tries. For one. thing, the existing regulations have given rise to overmanning insome factories while other firms cannot obtain the necessary labor. Foranother thing, the development of a "second economy" in several of these,countries has occurred in part at the expense of production in state-ownedfirms as workers reorient their efforts.

In Western Europe, attempts have been made to lower unemploymentthrough reductions in working hours. Such measures will have the desired

I A detailed discussion of regulations affecting the supply of labor in developed countries isprovided in Balassa [1984b], where it is indicated that the measures applied in Westem Europe findmuch less scope in the United States.


effect in the short run, provided that there are no compensating wageincreases. However, in reducing the workweek from 40 to 39 hours in January1982, the French Government decided on full compensation, and the Germanmetal %vorkers' union made such demands to accompany a cut in theworkweek from 40 to 35 hours in early 1984. While the demands of the unionhave been only partially met, the conclusion remains that compensatedreductions in the workweek lessen international competitiveness and reduceprofit margins on traded goods, with adverse effects on economic growth and,ultimately, on employment. But, even in the absence of compensation,potential output, and hence the demand for labor, will be lower in the longrun as a result of reductiorns in working hours.

Similar considerations apply to early retirement schemes that are in voguein Western Europe. And while profit margins decline to a lesser extent if thecost of the scheme is paid partly by the government, this alternative raisesquestions of financing. In any case, early retirement reduces labor forceparticipation rates and the rate of return on human capital. It may also lead tothe loss of valuable skills; this appears to have been the case in the Frenchautomobile industry after 1981 when foremen and production supervisorsretired in considerable numbers without equivalent replacements.

The retirement age is 60 years for men and 55 years for women in mostsocialist countries. It varies between 50 and 60 years in developing countries,with the most generous system applying in Uruguay where men can retire after30 years and women after 25 years of work and receive a pension equal to 100percent of average earnings in the last five years once they reach the age of 50.Finally, early retirement aside, the retirement age is generally between 60 and65 years in the developed countries.

Conversely, working hours are longer in the socialist countries (generallybetween 42 and 45 hours per week) than in the developed countries (usually40 hours). The workweek is even longer in the developing countries; it isbetween 45 and 50 hours in Latin America and between 50 and 55 hours inmuch of Africa and Asia.

The next question concerns the effects of taxation on the supply of labor.While it is customary to distinguish between substitution and income effects,with the former reducing and the latter increasing the supply of labor, thereare also income effects associated with the provision of goods and servicesfinanced by taxation that may offset the positive income effects of highertaxes. And, regardless of income effects, the taxation of labor involves awelfare. loss that rises with the progressivity of the tax system.

There is considerable information on the progressivity of the tax system indeveloped countries, an extreme case being Sweden where the combinedeffects of all taxes may exceed 100 percent on the margin for some highincome recipients. It is generally not recognized, however, that marginal taxrates are above 80 percent on relatively low labor incomes in several

618 Bela Balassa

developing countries, much exeeding the highest tax rate of 50 percent in theUnited States.

As Lindbeck [1982) has observed, high marginal tax rates have a variety ofadverse effects. Apart from distorting the income-leisure choice, they affectdecisions on the choice of the job and the intensity at which work isper*ormed. They further encourage the pursuit of do-it-yourself work, produc-tion for barter, the search for tax loopholes, and outright tax evasion whilediscouraging investment in human capital and risk taking by the entrepreneur.

The resulting distortions interfere with the efficiency of resource alloca-tion in the countries concerned. This will be so even in the case when taxloopholes are sought, owing to the diversion of labor from productiveactivities. The deterioration of efficiency, together with the decline in humaninvestment, then, lowers the rate of economic growth.

In turn, minimum wage legislation will reduce the demand for labor. Areview of available estimates pertaining to the United States has shown that aten-percent increase in the minimum wage lowers teenage employment byone to three percent and employment in low-wage manufacturing by one tofour percent [Brown et al., 1982, pp. 512-522]. Furthermore, there areemployment losses in the subminimum population (i.e. those with an uncon-strained wage less than the minimum) both at the extensive (the probability ofworking), and at the intensive (annual hours worked), margin [Linnemann,1982, p. 468]. Finally, estimates for Canada show that the minimum wagesignificantly reduces employment in five out of six age-sex groups, with theeffects being the largest for male teenagers. It further increases unemploymentrates in all groups, with a one-percent increase in the minimum wage beingassociated with an approximately one-percent. increase in the average rate ofunemployment [Schaafsma, Walsh, 1983].

Estimates for the United States relate to the postwar period of rapidincreases in minimum wages. This period has since come to an end and theminimum wage has not been raised since January 1981. In turn, minimumwages have been increased to a considerable extent in Western Europe and, inparticular, in France. As a result, the minimum wage reached one-half of theaverage wage in manufacturing in France while it hardly exceeds one-third ofthe manufacturing wage in the United States.

In developing countries, as in developed countries, the original purpose ofminimum wage legislation was to improve the conditions of low incomegroups. In practice, however, it benefits workers in the formal sector withoutaffecting wages in the informal urban sector and in rural areas. Correspond-ingly, distortions are created in these segmented labor markets'.

Empirical estimates of the welfare cost of minimum wage legislationpertain to its effects on lowering employment. For the United States, it has

FDr a detailed discussion, see Balassa [1985b].


been shown that if the elasticity of demand for low-wage labor is as low as 0.2,the reduction in national income is as large as the entire gain to the lower halfof the income distribution when marginal taxation effects are ignored and it istwice as large when marginal taxation effects are included [ohnson, Brow-ning, 1983, p. 211]. At the same time, decreases in wage differentials associatedwith a rise in minimum wages will reduce the rate of return on human capital.

By lowering the marginal productivity of capital, the substitution of capitalfor labor in response to the setting of minimum wages will also reduce therate of economic growth and, in extreme cases, it may lead to an absolutedecline in national income [Drabicki, Takiyama, 1982, p. 232]. As the resultshave been obtained by assuming labor to be homogeneous, they can beinterpreted as indicating the economic effects of exogenous increases in laborcosts. This, in turn, leads to the question of social security regulations.

Social security schemes have assumed particular importance in theEuropean Common Market, where the ratio of employer and employeecontributions to wages varies between 37 percent in Belgium and 55 percentin the Netherlands, compared with 23 percent in Japan and 18 percent in theUnited States. Among developing countries, social security contributionsexceed 20 percent in India and in several Latin American countries [UnitedStates Department of Health and Human Services, 1982].

In an early discussion of economic integration, the author examined theconditions under which the financing of social security schemes fromemployer and employee contributions would not create distortions in labormarkets. He concluded that "under perfect price and wage mobility, anyincrease in social charges would be shifted to the wage earners if theyregarded the corresponding social benefits as part of their earnings" [Balassa,1961, pp. 218-219].

Over a decade ago, Brittain [1972, Ch. III] found support for the proposi-tion that social security contributions are borne by the wage earnier, irrespec-tive of whether they are paid by the employer or the employee. More recently,an elasticity of substitution of 7.7 was estimated between wages and employer-financed fringe benefits, although the estimated elasticity is only 1.6 betweenwages and health and life insurance alone [Woodbury, 1983, p. 179].

However, the study includes only voluntary contributions by employers toretirement, health insurance, and life insurance plans, all of which are subjectto negotiations with the labor unions that cover wages as well as fringebenefits. It does not follow that wage-earners would consider the social benefitsreceived through governmental institutions as part of their income. Also, theymay not perceive a direct link between social security contributions, whethermade by the employer or the employee, and their social benefits. Yet, in theUnited States, these schemes are nearly three times as important as the fringebenefits financed by the voluntary contributions of employers.

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The moral hazard problem is of particular importance in Western Europe,where governmental programs of social security predominate. At the sametime, increases in social programs do not appear to have induced unions tomoderate their wage demands. It has been noted, for example, that in theUnited Kindom "workers did not acquiesce in the increased taxation that wasneeded to finance the extra-rapid growth of the non-market sector, and theytherefore made every effort to increase their private consumption at ratesalmost as fast as public consumption was growing. [As a result,j the share ofwages rose markedly at the expense of the share of profits" [Eltis, 1979, p.127-1281.

These conclusions are supported by empirical evidence derived fromcountry models of the growth of nominal wages, incorporating direct taxes andsocial security contributions, productivity growth, and the rate of unemploy-ment as explanatory variables. The results show full forward shifting of directtaxes and social security contributions in the Netherlands and considerableshifting, with a regression coefficient of 0.7, for Germany, the coefficientbeing 0.4 for the United States. The estimates pertain to the 1960-1980 periodand are statistically significant at the 5 percent level [Knoester, 1983, Table1] '.There is further evidence that social charges raise the cost of labor to thefirm in the developing countries [Balassa, 1985b].

It appears, then, that social security schemes create distortions in labormarkets by raising the cost of labor to the firm without the wage-earnersconsidering the benefits financed by these contributions as a full addition totheir incomes. At the same time, taxes and social charges establish a wedgebetween the cost of labor to the firm and after-tax labor incomes.

According to calculations made at the Institut der deutschen Wirtschaft,the cost of social charges and fringe benefits is 80 percent of the wage inGermany. With marginal tax rates, including the social security contributionsof employees, of 48 percent for unskilled labor and 61 percent for skilledlabor2, the ratio of labor costs to after-tax income in the two categories is 2.7and 2.9, respectively. Similar results for Sweden have led Lindbeck [1983,p. 2451 to conclude: "Market price distortions due to monopoly, monopsony,monopolistic competition, oligopoly, etc. - which have worried economictheorists so much for such a long time - are usually insignificant as comparedto these policy-implemented factor price distortions. Whereas the formeroften seem to create a wedge between price and marginal costs of some 5 or

The corresponding results for the United Kingdom are not reported on the grounds that withthe inclusion of this parameter, "the coefficients for prices and productivity would take on too highvalues" [Knoester, 1983, p. 5641.

2 The calculations pertain to a single worker with monthly pre-tax earnings of DM 2000 in thefirst case and DM 3000 in the second. Practically the same result is reached for a family of four, withtwo breadwinners each having the stated earnings [Boss et aL, 1982].


10 percent, the marginal wedges between wage costs for firms and the returnsto the individual are, as we have seen, often about 200 percent andoccasionally more than 500 percent".

Distortions in labor markets will reduce the efficiency of resource alloca-tion and depress the rate of economic growth. A further question, muchdebated in the literature, is whether pay-as-you-go social security schemeslower private savings. The flavor of the debate may be indicated by twoquotations: "In my opinion, the existing research indicates that social securitydoes substantially depress private saving and therefore national saving in theUnited States. Each dollar of social security wealth appears to reduce privatewealth accumulation by somewhat less than a dollar but more than 50 cents"[Feldstein, 1981, p. 18-19]. "It is not clear whether a pay-as-you-go systemreduces saving and the capital accumulation (measured against a relevantreference situation) below a defined level or not" Uanssen, 1984, p. 24].

Having surveyed the relevant literature, Janssen [1984, p. 17] adds that "thestatistical results showing a negative effect of Social Security on saving aresomewhat more convincing in the case of cross-section data than in timeseries analysis; nevertheless, the evidence does not seem to be conclusive andreliable". According to a recent study not covered by Janssen's survey,however, "the empirical work of Feldstein and his critics has been flawed by aspecification error. When this is corrected, the results - although still far fromconclusive - appear to favor the existence of a depressing effect of socialsecurity wealth on household saving" [Evans, 1983a, p. 611]. Furthermore,''government transfer programs in the United States may have loweredhousehold saving by redistributing income to those with higher than averagepropensities to consume - the poor, the liquidity constrained and the old. Insupport of this approach, the tests that were conducted found a propensity toconsume out of transfer payments that was close to unity" [ibid., p. 611].

IV. Policy-Imposed Distortions in Capital Markets

Policy-imposed distortions in capital markets may originate in creditpolicy, tax policy, and protection policy. To begin with, interest rates may bekept at below equilibrium levels, differential interest rates charged to differentborrowers, and credit rationed among users. In turn, the system of taxationapplied will affect the after-tax rate of return on capital. Finally, policies ofprotection will bear on the cost of capital goods.

In the United States, interest rate ceilings on personal saving were applieduntil recently and tax deductibility provisions continue to reduce after-taxinterest rates on loans. In other developed countries, interest rate ceilingshave often been combined with credit allocation among competing users.

In developing countries, in particular in Latin America, there has been atendancy to keep interest rates artificially low, giving rise to negative real

622 Bela Balassa

interest rates. As the resulting excess demand for credit has necessitatedrationing, governments have intervened in the allocation of credit. Also, avariety of credit preference schemes have been in effect, providing betterterms to favored users.

In socialist countries, interest rates have been kept low for savers as well asfor users. Although under central planning the government allocates credit, itscost nevertheless enters into the calculations of the firm. In turn, in Hungary,real interest rates are positive and play a role in the allocation of credit.

Negative, or below equilibrium, real interest rates encourage capital-intensive activities and provide incentives for "self-investment", includinginventory building, at rates lower than those obtainable in the rest of theeconomy. Also, credit preferences and credit rationing create distortionsamong the uses to which capital is put, thereby reducing the efficiency ofinvestment.

A further question concerns the effects of interest rates on savings. Whileearlier contributions suggested that the outcome is indeterminate, owing toconflicting income and substitution effects, in a structural estimation of theU.S. aggregate consumption function by the use of instrumental variables,Boskin [1978] obtained an interest elasticity of savings of 0.4. Utilizing alife-cycle growth model that incorporates the effect of interest rates on wealth,Summers [1981, p. 536] subsequently derived elasticities of 1.9 to 3.4 in whathe calls "the plausible logarithmic case"; the lower value corresponds toBoskin's estimate if wealth effects are excluded. These results were subse-quently challenged by Evans [1983b, Table 4] who obtained elasticities rangingbetween 0.1 and 1.9 for alternative parameter values. In turn, according toSummers [1984, p. 250], "empirical evidence casts doubts on the relevance ofparameter values underlying Evans' low elasticity cases". Summers alsosuggests that introducing the bequest motive would raise rather than reducethe interest elasticity of savings as Evans claimed.

A review of available evidence for the developing countries by theInternational Monetary Fund has also led to the conclusion that "therepression of interest rates produces lower rates of saving"[IMF, 1983, p. 191.It has further been observed that low interest rates contribute to the outflowof capital in search of higher returns abroad.

It would appear, then, that below-equilibrium interest rates reduce savingsand investment while the attendant rationing of credit depresses the efficiencyof investment. Correspondingly, the rate of economic growth will be lowerthan it would be in the absence of such distortions'.

Estimates of the interest elasticitiy of household savings are not availablefor the socialist countries. However, the recent experience of Hungary

I It shauld be added, however, that excessively high real interest rates, resulting from theapplication of strongly restrictive monetary policies, will also have adverse effects by discouragingsocially profitable investment and creating disturbances in capital markets.


suggests that savers strongly react to higher interest rates. At the same time,the use of low interest rates in calculations made by firms in the socialistcountries encourages the choice of capital-intensive activities.

Harberger [1966] estimated the loss due to the misallocation of capitalbetween the corporate and the noncorporate sectors in the United States,associated with the imposition of the corporate income tax, at 0.5 percent ofnational income. Subsequently, Feldstein [1978, p. 547] estimated the welfarecost of capital taxation, exclusive of the misallocation between corporate andnoncorporate business, to be of approximately the same magnitude if thealternative involves taxing consumption.

These estimates do not include the effects of corporate taxation on privatesavings. The latter is incorporated in Summers' estimates [1981, p. 541],according to which steady-state consumption would rise by 17 percent if thecorporate income tax were replaced by consumption taxation. In turn, a widerange of possible results is shown by Evans' calculations [1983b, p. 407]:steady-state consumption would increase by 67 percent if the intertemporalelasticity of substitution was assumed to be 1.0 and there were no bequests andit would be practically nil if the elasticity was 0.2 and there were intergenera-tional transfers. However, the latter estimate rests on the unrealistic assump-tion that the interest elasticity of savings was negative.

In the King-Fullerton study of the taxation of income from capital, theeffective marginal tax rate on U.S. corporate income, derived from newinvestments, was estimated at 48 percent in 1960, 47 percent in 1970, and 37percent in 1980, under the assumption of a 10 percent pre-tax rate of returnand actual rates of inflation. Following the 1981 tax reform, the marginal taxrate declined to 26 percent, rising to 32 percent in 1982 when some taxbenefits were again reduced. The comparable figures for 1980 are 4 percentfor the United Kingdom, 36 percent for Sweden, and 48 percent for Germany[King, Fullerton, 1984, Tables 6.20, 6.27-28, 6.31-32, 7.1].

At the same time, there are considerable differences in tax rates amongassets, among industries, as well as according to sources of finance andownership. In the United Kingdom, for example, machinery receives a 37percent subsidy, thereby substantially reducing the overall average. Theeffective tax rate on machinery is also low in Sweden and in the UnitedStates while it is 45 percent in Germany [ibid., Tables 6.28, 7.1].

Available evidence indicates that, owing to tax holidays and accelerateddepreciation provisions, effective tax rates on business income are low in thedeveloping countries. The overvaluation of the exchange rate associated withhigh protection, together with low tariffs on machinery, further reduces thecost of capital goods in these countries. In turn, taxes generally represent afixed percentage of profits in socialist countries while there appears to be atendency to underprice machinery in these countries.

624 Bela Balassa

V. Policy-Imposed Distortions in the Relative Prices of Labor and Capital

The impact of policy-imposed distortions in labor and capital markets onfactor intensity will depend on the relative magnitudes of these distortions.Such calculations have been made for several developing countries in acomparative study directed by Anne Krueger. According to the estimates,policy-imposed distortions raised the wage-rental ratio by 316 percent inPakistan, 87 percent in Tunisia, 45 percent in the Ivory Coast, 38 percent inArgentina, 31 percent in Brazil, 11 percent in Korea, and nil in Hong Kong[Krueger, 1983, p. 150]. The high ratios obtained in most of these countriesindicate the effects of social charges on the cost of labor and the effects of lowinterest rates, tax incentives, and low machinery tariffs on the cost of capital.

Combining the cited estimate of the wedge between the cost of labor to thefirm and labor's after-tax-income with the King-Fullerton estimate of theeffective marginal tax rate on capital income, it is apparent that the measuresapplied raise the relative price of labor to a considerable extent in Germany.Distortions in factor markets may be even greater in some other Europeancountries, such as France and Italy, where social security charges and fringebenefits account for a larger proportion of labor costs than in Germany. Theoutcome is less certain in the United States, where labor market distortionsare much less prevalent than in Western Europe [Balassa, 1984b].

These conclusions are supported by calculations in which employers'contributions to public and private social security schemes are related towages and revenue derived from the corporate income tax and from taxeslevied on land and buildings. The results obtained for 1980 show effective taxrates on labor and on capital of 40 and 10 percent in France, 23 and 10percent in Germany, 35 and 10 percent in Italy, 17 and 10 percent in theUnited Kingdom, and 19 and 18 percent in the United States; the cor-responding figures are 13 and 18 percent in Japan [Kay, Sen, 1983, Table 5].The overall results are not materially affected if one follows The Economist ofDecember 10, 1983, in adding employees' contributions, and deductingemployers' private pension contributions, from taxes on labor and adjustingprofit taxes for inflation.

VI. Taxes and Economic Growth

In recent years increased attention has been given to the adverse effects oftaxation on economic growth. This contention is far from new; Keynes is saidto have expressed the view that Colin Clark's "figure of 25 percent as themaximum tolerable proportion of taxation may be exceedingly near to thetruth".' Any such argument must rest on the inefficiencies introduced by thewedges between the demand price and the supply price of particular factors,

I Keynes ih a personal letter to Clark [Clark,. 1970, p. 211.


and on the responsiveness of the supply of factors - labor and entrepreneur-ship as well as savings - to the after-tax rate of return.

There have been several recent empirical studies on the relationshipbetween taxes and economic growth. In regressing rates of economic growthon the ratio of taxes to GNP in a time-series analysis of 27 developedcountries and in a cross-section analysis of the same countries, Petersen[1981, Tables 1, 21 obtained negative coefficients in practically all cases butfew of the results were statistically significant; most of the regressioncoefficients were significant, however, at the 5 percent level, when the ratio ofdirect taxes to GNP was used as the explanatory variable.

In turn, Marsden [1983, Tables 3, 4] found the regression coefficient of thetax/GDP variable to be statistically significant at the 1 percent level inexplaining intercountry differences in GDP growth rates in a twenty-countrysample as well as in low-income and high-income subsamples of equal size.And while significance levels declined when the rate of growth of domesticinvestment and that of the labor force were introduced as additional explana-tory variables, these two variables were shown to be negatively correlatedwith the ratio of taxes to GDP.

Finally, in a model that combines equations determining increases innominal wages, the rate of inflation, the growth of private employment, andthe ratio of net investment to GDP, Knoester [1983, p. 567] found thatsimultaneous and equal increases in income taxes and social security contribu-tions and in budgetary expenditures would have a negative long-run multipliereffect of 1.5 to 3.0 in the Netherlands, Germany, the United Kingdom, and theUnited States. This effect is obtained because the forward-sh'ifting of incometaxes and social security contributions reduces profits that, in turn, lowers therate of investment.

VII. Conclusions

Certain broad conclusions emerge from the analysis of the effects ofgovernment directives and interventions in product and factor markets on theefficiency of resource allocation and economic growth in developed, develop-ing and socialist countries. These conclusions, in turn, have implications forfuture policies.

The cost of protection is especially high in developing countries. Apartfrom its adverse effects on the efficiency of resource allocation, the resultingdecline in investment efficiency and savings, together with the lack ofadequate stimulation of technological change, protection tends to lower therate of economic growth. Levels of protection are lower in developedcountries but its cost has been generally underestimated by neglectingeconomies of scale and the effects of foreign competition on technologicalchange. Finally, in socialist countries, the adverse effects of import protection

626 Bela Balassa

are aggravated by the lack of scarcity prices for use in the evaluation of foreigntrade alternatives.

Among developed countries, social legislation has raised the cost of laborto a considerable extent in Western Europe and has contributed to unemploy-ment by reducing both the demand for and the supply of labor. With someexceptions, labor market distortions have been less prevalent in developingcountries; however, credit, tax, and protection measures substantially lowerthe cost of capital in many of these countries.

In raising the relative price of labor, the measures applied have encour-aged the expansion of capital-intensive activities in the countries concerned.In socialist countries, such activities are encouraged by the low rate of interestand by rigidities that impede the efficient allocation of labor. The lack ofscarcity prices further interferes with the efficient allocation of investmentfunds in socialist countries, lowering rates of economic growth, notwithstand-ing high savings ratios in these countries.

The conclusion emerges that improving the system of incentives throughreductions in distortions in product and in factor markets would permitreaching higher levels of efficiency and raising the rate of economic growth indeveloped and in developing countries. Also, on the example of Hungary,the decentralization of decision-making, combined with the introduction ofscarcity prices, would favor the efficiency of resource allocation and econom-ic growth in socialist countries.

It has been objected, however, that in a world of the second best, removinga particular distortion may be welfare-reducing in the presence of otherdistortions. But, infant industry cases apart, free trade will contribute toefficient resource allocation in a small country that cannot affect worldmarket prices and reducing distortions in the relative prices of labor andcapital will also unambiguously improve welfare.

It has also been suggested that, in making policy recommendations, oneshould take account of non-economic, in particular social, objectives. Thispaper has had a more modest aim: to appraise the economic cost ofdistortions that may or may not find their origin in the pursuit of non-economic objectives. At the same time, it should be recognized that economicand non-economic objectives are not necessarily in conflict. In developingcountries, for example, reducing distortions in products and in factor priceswould promote equity by increasing demand for labor.

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"The Newly-Industrializing Developing Countries after the Oil Crisis". Weltwirtschaftli-ches Archiv, Vol. 117, 1981, pp. 142-194.


Balassa, Bela, 'Disequilibrium Analysis in Developing Economies: An Overview". WorldDevelopment Vol. 10, 1982, pp. 1027-1038.

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- [1985bJ, Public Finance and Social Policy - Explanations of Their Trends and Develop-ments: The Case of Developing Countries. Paper presented at the 39th Congress of theInternational Institute of Public Finance held in Budapest in August 1983, forthcoming.

- et aL, The Structure of Protection in Developing Countries. Baltimore 1971.

Bhagwati, jagdish N., 'The Generalized Theory of Distortions and Welfare". In: Jagdish N.Bhagwati, Ronald W. Jones, Robert A Mundell, and Jaroslav Vanek (Eds.), ltade, Balanceof Payments and Growth - Papers in International Economics in Honor of Charles P.Kindleberger. Amsterdam 1971, pp. 69-90.

Boslin, Michael J., 'Taxation, Saving, and the Rate of Interest". Journal of Political Economty,Vol. 86, 1978, No. 2, Pt.2, pp. 3-27.

Boss, Alfred, Gunter Flemig, Peter Trapp, and Norlbert Walter, "Bundesrepublik Deutsch-land: Trotz Krise noch kein Umdenken". Die Wettwirtschaft, 1982, No. 2, pp. 22-47.

Brtain, John A., The PayroU Tax for Social Security. The Brookings Institution, Studies ofGovemment Finance, Washington 1972.

Brown, Charles, Curtis Gilroy, and Andrew Kohen, "The Effect of the Minimum Wage onEmployment and Unemployment". Journal of Economic Literature, Vol. 20, 1982, pp.487-528.

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Drabicki, John Z, and Akira Takiyama, "Minimum Wage Regulation and EconomicGrowth". Joumal of Economics and Business, Vol. 34, 1982, pp. 231-240.

Eltis, Walter, "How Rapid Public Sector Growth Can Undermine the Growth of the NationalProduct". In: Wilfred Beckerman (Ed.), Slow Growth in Britian: Causes and Consequences.Oxford 1979, pp. 118-139.

Evans, Owen J. [1983a], "Social Security and Household Saving in the United States: ARe-Examination". IMF Staff Papers, Vol. 30, 1983, pp. 601-618.

- [1983b], "Tax Policy, the Interest Elasticity of Saving, and Capital Accumulation:Numerical Analysis of Theoretical Models". The American Economic Reziew, Vol. 73,1983,pp. 398-410.

Ieldstein, Martin, "The Welfare Cost of Capital Income Taxation". Journal of PoliticalEconomy, Vol. 86, 1978, pp. 529-551.

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Janssen, Martin, Social Insurance: Incentives and Disincentives to Save and to Work. Paperpresented to the International Symposium on Economic Incentives, held at the Institute ofWorld Economics, Kiel, June 18-22, 1984. Forthcoming in the Conference Proceedings, tobe published by Macmillan, London.

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Johnson, William R., and Edgar K. Browning, "The Distributional and Efficiency Effects ofIncreasing the Minimum Wage: A Simulation". The American Economic Review, Vol. 73,1983, pp. 204-211.

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King, Mervyn A., and Don Fullerton, The Taxation of Income from Capital: A ComparativeStudy of the US., the U.K., Sweden, and West Germany. Chicago 1984.

Knoester, Anthonie, "Stagnation and the Inverted Haavelmo Effect: Some InternationalEvidence". De Economist, Vol. 131, 1983, pp. 548-584.

Krueger, Anne O., Trade and Employment in Developing Countries, VoL 3: Synthesis andConclusions. Chicago 1983.

lindbeck, Assar, 'Work Disincentives in the Welfare State". In: Austrian Economic Associa-tion, NOG, Lectures 79-80: Douglass C. North, Assar Lindbeck. Vienna 1982.

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Linneman, Peter, "The Economic Impacts of Minimum Wage Laws: A New Look at an OldQuestion". Joumal of Political Economy, Vol. 90, 1982, pp. 443-469.

Marsden, Keith, Links between Taxes and Economic Growth: Some Empirical Evidence.World Bank Staff Working Papers, No. 605, Washington 1983.

Melo, Jaime A.P. de, "Estimating the Costs of Protection: A General Equilibrium Approach".The Quarterly Journal of Bconomics, Vol. 92, 1978, pp. 209-226.

Petersen, Hans-Georg, "Taxes, Tax Systems and Economic Growth". In: Herbert Giersch(Ed.), Towards an Explanation of Economic Growth. Symposium 1980, lTbingen 1981, pp.313-347.

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Summers, Lawrence H., "Capital Taxation and Accumulation in a Life Cycle Growth Model".The American Economic Review, Vol. 71, 1981, pp. 533-542.

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Zusammenfassung: Preise, Anreize und wirtschaffliches Wachstum. - In dem Artikelwird untersucht, wie sich politikbedingte Verzerrungen auf die Effizienz der Ressourcenalloka-tion und das wirtschaftliche Wachstum in entwickelten, unterentwickelten und sozialistischenLandern auswirken. Eingriffe in die Giitermirkte konnen in Form der Importprotektion,Preiskontrollen und Wettbewerbsbeschrankungen erfolgen. Auf den Arbeitsmarkten verzerrendie Arbeitslosenunterstiitzung, die Kuindigungsschutzabkommen, die Sozialversicherungslei-stungen und die Lohnsteuer das Arbeitsangebot, wihrend Mindestlohngesetze und Sozialver-sicherungsbeitrige auf die Nachfrage nach Arbeit einwirken. Schliefflich sind Zinssatzverord-nungen, Korperschaftssteuern und Einfuhrbeschrankungen die hauptsachlichen Eingriffe indie Kapitalmarkte. Nach der Betrachtung der wirtschaftlichen Wirkungen dieser Interventio-nen werden Vorschlage gemacht, wie die Verzerrungen beseitigt oder gemildert werdenkonnen.

Resume: Prix, incitations et croissance economique. - Cet article examine les effets desdistorsions imposees par la politique sur 1' efficacite de l'allocation des ressources et sur lacroissance economique dans les pays developpes, developpants et socialistes. Les interventionssur les march6s de biens peuvent consister de la protection d'importation, des controles desprix et des freins a la concurrence. Parmi les distorsions sur les marches du travail, l'allocationde chomage, la protection contre le licenciement, les prestations de securite sociale et lesimp6ts sur les salaires affectent l'offre du travail pendant que le salaire minimum et descotisations d'assurance sociale chargent la demande du travail. Finalement, les regulations destaux d'interet, les impots sur les societes, et la protection d'importation sont les interventionsprincipales sur les marches des capitaux. Apres une revue des effets economiques de cesinterventions, l'auteur donne des recommandations a eliminer ou relacher les distorsions.

Resumen: Precios, incentivos y crecimiento econ6mico. - Este trabajo trata los efectosque tienen las distorsiones creadas por la politica econ6mica sobre la eficiencia de laasignaci6n de recursos y el crecimiento econ6mico en los paises desarrollados, en vias dedesarrallo y socialistas. Las intervenciones en los mercados de bienes pueden manifestarsecomo restricciones a las importaciones, controles de precios y limites a la competencia. Entrelas distorsiones de los mercados laborales, la compensaci6n por desempleo, la reglamentaci6nsobre la seguridad de las plazas de trabajo, los beneficios de la previsi6n social y los impuestosa los salarios afectan la oferta de trabajo, mientras que la reglamentaci6n del salario minimo y

2-

630 Bela BalassaPrices, Incentives, and Economic Growth

los descuentos para la previsi6n social inciden en la demanda de trabajo. Finalmente, laregulaci6n de la tasa de interes, los impuestos a las empresas y la restricci6n a lasimportaciones constituyen las principales formas de intervencion en los mercados de capital.Despues de pasar revista a las consecuencias econ6micas de dichas intervenciones, estetrabajo presenta recomendaciones para corregir o aliviar las distorsiones resultantes.

No. 319. David M. Newbery, "Commodity Price Stabilization in Imperfect or CartelizedMarkets," Econometrica

No. 320. George Psacharopoulos, 'The Contribution of Education to Economic Growth:Intemational Comparisons," with a Conmment by Theodore W. Schultz, InternationalComparisons of Productivity and Causes of the Slowdown

No. 321. Bela Balassa, "Trade between Developed and Developing Countries: the DecadeAhead," OECD Economic Studies

No. 322. Nicholas Prescott and Jeremy Warford, "Economic Appraisal in the Health Sector,"7he Economics of Health in Developing Countries

No. 323. William I. Jones, "Agriculture's Changing Role in International Trade and Aid: Tastesand Techniques," Annales d'Etudes Internationales

! No. 324. Ricardo Martin and Marcelo Selowsky, "Energy Prices, Substitution, and OptimalBorrowing in the Short Run: An Analysis of Adjustment in Oil-Importing DevelopingCountries," Journal of Development Economics

No. 325. A. Drud, W. Grais, and G. Pyatt, "The Transaction Value Approach: A SystematicMethod of Defining Economywide Models Based on Social Accounting Matrices,"Dynamic Modelling and Control of National Economies 1983

No. 326. Avishay Braverman and J. Luis Guasch, "Capital Requirements, Screening, andInterlinked Sharecropping and Credit Contrads," Journal of Development Economics

No. 327. Sang-Chuel Choe and Byung-Nak Song, "An Evaluation of Industrial Location Policiesfor Urban Deconcentration in Seoul Region," Journal of Environmental Studies

No. 328. Mohan Munasinghe, "Energy Strategies for Oil-Importing Developing Countries,"Natural Resources Journal

No. 329. Abdun Noor, "Shared Control of Education: Theory, Practice, and Impressions fromEducation Projects Assisted by the World Bank," Managing International Development

No. 330. Larry E. Westphal and Yung W. Rhee, "Choices of Technology in Industry,"International Journal of Development Banking

No. 331. George Psacharopoulos, "Assessing Training Priorities in Developing Countries:Current Practice and Possible Alternatives," International Labour Review

No. 332. Abdun Noor, "Proposing Another Dimension in International Adult Education:Availability of Basic Education," Graduate Studies Journal

No. 333. Sweder van Wijnbergen, "Inflation, Employment, and the Dutch Disease in Oil-Exporting Countries," Quarterly Journal of Economics

No. 334. Gerald T. O'Mara and John H. Duloy, "Modeling Efficient Water Allocation in aConjunctive Use Regime: The Indus Basin of Pakistan," Water Resources Research

No. 335. Stephen P. Heyneman, Dean T. Jamison, and Xenia Montenegro, "Textbooks in thePhilippines: Evaluation of the Pedagogical Impact of a Nationwide Investment,"Educational Evaluation and Policy Analysis

No. 336. Mieko Nishimizu and Sherman Robinson, "Trade Policies and Productivity Change inSemi-Industrialized Countries," Journal of Development Economics

No. 337. Gershon Feder and Roger Slade, "The Acquisition of Information and the Adoptionof New Technology," American Journal of Agricultural Economics

No. 338. Sweder van Wijnbergen, "Can an Oil Discovery Lead to a Recession? A Commnenton Eastwood and Venables," The Economic Journal

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