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Hrnjic, Mahir; Brankovic, Azra
Article
Endogenous Growth Model: Evidence from East
European Countries
Economic Review: Journal of Economics and Business
Provided in Cooperation with:
Faculty of Economics, University of Tuzla
Suggested Citation: Hrnjic, Mahir; Brankovic, Azra (2017) : Endogenous Growth Model:
Evidence from East European Countries, Economic Review: Journal of Economics and
Business, ISSN 1512-8962, University of Tuzla, Faculty of Economics, Tuzla, Vol. 15, Iss. 1, pp.
33-46
This Version is available at:
http://hdl.handle.net/10419/193868
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Endogenous growth model: evidence from east european countries
ENDOGENOUS GROWTH MODEL: EVIDENCE FROM EAST EUROPEAN COUNTRIES
1 2
Mahir Hrnjić , Azra Branković
ABSTRACT The theoretical framework of endogenous
growth models incorporates the tax and
Fiscal policy is one of the key issues for every expenditure levels as determinants of long-run
government. In the endogenous growth model, growth. Barro (1990), Barro & Sala-i-Martin
fiscal policy is included as a key factor determining (1992), Mendoza, Milesi-Ferretti, and Asea
the growth of the economy. The focus in this study (1997) developed models that incorporated
is placed on eleven East European transitional fiscal policy as a determinant of the level of
countries for the period of 1995 to 2014. The output and long term growth. A significant
model includes both sides of government finance, number of studies have been performed
taxation and expenditures, with expenditures aimed at testing the theoretical models of
being grouped into homogeneous categories in endogenous growth, but the studies fail to
order to increase the structural efficiency. We produce conclusive evidence due to significant
find a positive impact on growth for certain difference in results between various studies.
government expenditures such as expenditures The endogenous growth models classify
aimed at improving human resources, property governmental fiscal policy instruments into
protection and social investment and a negative several categories. Taxation is grouped into
one for distortionary taxation. The results distortionary and non-distortionary taxation;
provide empirical evidence for the theoretical the first group reduces the incentives to
predictions of endogenous growth. invest and thereby reduces growth and the
second group has no effect on the investment
Keywords: East European countries, Fiscal incentive and therefore has no effect on
Policy, Public Expenditures, Taxation, Economic growth. The other side of government finance,
growth the expenditures, are classified into productive
expenditures, expenditures that positively
JEL: E620 impact the marginal product of privately owned
capital and thereby increase economic growth,
and unproductive expenditures, expenditures
1. INTRODUCTION that have no impact on marginal product of
privately owned capital and therefore do not
The endogenous growth models have made the affect growth.
fiscal policy a crucial field of study of economic
growth. According to Kongsamut, Rebelo, & The basic endogenous growth model has
Xie (2001) the theory of endogenous growth been extended upon in numerous studies.
is widely applied in macroeconomics as it is Studies such as Barro (1990) and Cashin
consistent with the fact expressed by Kaldor (1995) allowed for publicly-provided goods
(1960), that the per capita output rate, real to be productive. Devarajan, Swaroop, and Zou
interest rate, capital-output ratio, and the (1996), Sala-I-Martin (1997), Kaganovich and
labour capital ratio in national income are Zilcha (1999), and Zagler & Dürnecker (2003)
constant over time. allowed for different forms of expenditures to
be productive, while Ortigueira (1998) allowed
for various forms of taxation.
1
International University of Sarajevo, Faculty of Business and Administration, Department of International Business
and Finance, mahir.hrnjic@hotmail.com
2
International University of Sarajevo, Faculty of Business and Administration, Department of International Business
and Finance, abrankovic@ius.edu.ba,
Economic Review – Journal of Economics and Business, Vol. XV, Issue 1, May 2017 33
1. INTRODUCTION
The endogenous growth models have made the fiscal policy a crucial field of study of
economic growth. According to Kongsamut, Rebelo, & Xie (2001) the theory of endogenous
growth is widely applied in macroeconomics as it is consistent with the fact expressed by
Kaldor (1960), that the per capita output rate, real interest rate, capital-output ratio, and the
labour capital ratio in national income are constant over time.
The theoretical framework of endogenous growth models incorporates the tax and
expenditure levels as determinants of long-run growth. Barro (1990), Barro & Sala-i-Martin
(1992), Mendoza, Milesi-Ferretti, and Asea (1997) developed models that incorporated fiscal
policy as a determinant of the level of output and long term growth. A significant number of
studies have been performed aimed at testing the theoretical models of endogenous growth,
but the studies fail to produce conclusive evidence due to significant difference in results
between various studies. The endogenous growth models classify governmental fiscal policy
instruments into several categories. Taxation is grouped into distortionary and non-
distortionary taxation; the first group reduces the incentives to invest and thereby reduces
growth and the second group has no effect on the investment incentive and therefore has no
effect on growth. The other side of government finance, the expenditures, are classified into
productive expenditures, expenditures that positively impact the marginal product of
privately owned capital and thereby increase economic growth, and unproductive
expenditures, expenditures that have no impact on marginal product of privately owned
capital and therefore do not affect growth.
The basic endogenous growth model has been extended upon in numerous studies. Studies
such as Barro (1990) and Cashin (1995) allowed for publicly-provided goods to be
Hrnjić M., Branković A.
productive. Devarajan, Swaroop, and Zou (1996), Sala-I-Martin (1997), Kaganovich and
Zilcha (1999), and Zagler & Dürnecker (2003) allowed for different forms of expenditures to
be productive, while Ortigueira (1998) allowed for various forms of taxation.
Kneller et al. (1999) show that in empirical 2. EMPIRICAL LITERATURE REVIEW
Kneller et al. (1999) show that in empirical studies the impact of fiscal policy on growth
studies the impact of fiscal policy on growth is
is usually estimated by the fallowing equation:
usually estimated by the fallowing equation: A large number of studies have been performed
∑ ∑−1 in order to test the relationship between
= + + ( − ) + (1)
=1 =1 (1) the fiscal policy and economic growth. Early
studies adopted the neoclassical growth model
In equation (1) the represents the economic developed by Solow (1956) which estimated
In equation (1) the represents the economic growth achieved by the country i at time t.
growth achieved by the country i at time t. the long run growth as being determined by
represents the non-fiscal variable and is the fiscal variable. Furthermore is the constant
represents the non-fiscal variable and is the population growth and the rate of technological
term and is the coefficient of the non-fiscal variable i, furthermore the number of i
fiscal variable. Furthermore is the constant change. The model also estimated that changes
variables is equal to k. Additionally, represents the coefficient of the effect on growth for
term and is the coefficient of the non-fiscal to fiscal policy that affect the incentives to save
the variable. The number of such variables is equal to l-1. The represents the effect on
variable i, furthermore the number of i or invest also alter the capital-output ratio
growth for the lth fiscal variable. The lth is used to finance changes in one of the l-1 fiscal
variables is equal to k. Additionally, represents equilibrium and therefore impact only the
policy instruments.
the coefficient of the effect on growth for the output path but do not change the output slope.
variable. The number of such variables is equal Further studies such as Koopmans (1963) and
It is possible to observe, based on equation (1), that the empirical studies are usually
to l-1. The represents the effect on growth Cass (1965) expanded on the Solow model. The
conducted with the aim of testing the hypothesis that the variable has a coefficient equal
for the lth fiscal variable. The lth is used to studies estimated that a country’s per capita
to zero or alternatively to test whether − = 0. This is because the aim is to examine the
finance changes in one of the l-1 fiscal policy growth rate tended to be inversely related to its
effect of a change in fiscal category of interest, which is offset by a change in the lth fiscal
instruments. starting level of income per capita, with poorer
countries with similar structural parameters,
It is possible to observe, based on equation (1), preferences, and technology growing faster
that the empirical studies are usually conducted than richer countries due to having higher
with the aim of testing the hypothesis that marginal products of capital. Based on
the variable has a coefficient equal to zero or neoclassical growth models the studies such
alternatively to test whether . This is because as Landau’s (1983) which encompassed cross-
the aim is to examine the effect of a change sectional data for 104 countries and Barro’s
in fiscal category of interest, which is offset (1989), with a 98 country sample for the 1960-
by a change in the lth fiscal variable. The lth 1985 period, identified an inverse relationship
variable represents the omitted variable that is between the share of government consumption
used to implicitly finance variation in the fiscal as part of GDP and economic growth of per
category of interest. capita GDP.
One of the common issues that is present The studies by Romer (1986), Lucas (1988) and
in many studies that examine the impact of Rebelo (1991) departed from the neoclassical
fiscal policy on economic growth is the lack of growth models by adopting the possibility of
accounting for the effect on policy of transition economic growth without exogenous changes
onto steady-state. According to Benos (2005), in technology or population. Barro (1990)
this is important as the endogenous growth developed an endogenous growth model.
models differ from neoclassical models only in The model included government services
the prediction of the long term effects of fiscal funded through taxation which had an
policy. This is further supported by Bleaney, impact on production or utility with growth
Gemmell, and Kneller (2001) as they show that being negatively correlated with utility-type
taking data in five-year averages does not fully expenditures. Following the development
account for long term impact of fiscal policy. of theoretical framework of endogenous
growth models, studies started differentiating
This paper focuses on examining the impact between different types of public revenues
of fiscal policy on economic growth in 11 East and expenditures. Studies such as Easterly
European transitional countries that acceded to & Rebelo’s (1993) identified expenditure
the European Union (EU) and tries to determine on transport and communication as being
the effect of the fiscal policy instruments on consistently correlated with growth as well as a
growth. negative correlation between aggregate public
investment and per capita growth. Cashin
(1995) showed investment in public capital
34 Economic Review – Journal of Economics and Business, Vol. XV, Issue 1, May 2017
Endogenous growth model: evidence from east european countries
and transfer payments as having a positive having a negative impact on economic growth
impact on growth. Furthermore, Cashin (1995) and capital and corporate income taxes as
also identified distortionary taxes as having having an enhancing effect on economic growth.
a negative impact on growth. The study was Agénor (2008) established that infrastructure
performed using panel data for 23 developed had an impact on manufacturing and on supply
countries, with the observations taken for the of health services and therefore increased
period between 1971 and 1988.Using panel growth but at the same time identified
data for 43 countries for a period between 1970 evidence for uncertain long-run impact on
and 1990, Devarajan et al. (1996) identified a steady-state growth. Furthermore, this author
positive impact of higher level of current public identified that a revenue-neutral increase
expenditures on economic growth, while also in infrastructural investment can have a
showing that government capital spending contractionary effect on growth rate. Gemmell,
decreases per capita growth. Ortigueira (1998) Kneller, and Sanz (2013) identified a negative
extended an endogenous growth model by impact of distortionary taxes and a growth
including physical and human capital expansion enhancing impact of productive expenditures
as to test the impact of tax policies. The results on the long run economic growth in case of
provide evidence that taxes on capital income OECD countries.
have a key function along the convergence to
the balanced growth path. Kneller, Bleaney, This paper is based on endogenous growth
and Gemmell (1999) focused on the structure models developed by Barro (1990) and
of taxation and of expenditures on panel of 22 Mendoza et al. (1997). The applied criteria
OECD countries for a period between 1970 and is the one proposed by their models as well
1995. They identified distortionary taxation as as Benos (2009) in order to group fiscal data
having a negative impact on economic growth, into groups and test the growth impact of
while also establishing that non-distortionary each of them. Furthermore this paper includes
taxation has no effect on economic growth. government budget constraint in accordance
Furthermore, they identified productive with Kocherlakota and Yi (1997).
government expenditures as having a positive
impact on growth, whilst non-productive
expenditure does not. Furthermore they 3. DATA AND ECONOMETRIC
established that any studies must include both METHODOLOGY
taxation and expenditure in order to avoid
significant biases of the estimation coefficients. The study was carried out on an unbalanced
Zagler & Dürnecker (2003) grouped panel data set covering 11 East European
expenditures into productive and unproductive countries. The countries in question are
and found evidence that expenditures on Estonia, Latvia, Lithuania, Poland, Slovakia,
education and infrastructure contribute to Hungary, the Czech Republic, Bulgaria, Romania,
increased economic growth. Furthermore they Slovenia, and Croatia. The selected countries
found evidence that certain taxes, such as taxes are transitional countries that are members of
on savings as well as taxes on intermediate the EU. The observations are annual, taken for
goods and taxes on research and development the period of 1995 to 2014 and obtained from
spending, impact the distribution of labour Eurostat.
among the manufacturing and research and
development sectors and therefore can increase As previously mentioned, endogenous
innovation and thereby enhance growth. growth models estimate a basic classification
Angelopoulos, Economides, and Kammas of revenues as distortionary and non-
(2007) used data of 23 OECD countries during distortionary. Furthermore, expenditures are
1970–2000 and found evidence in support classified as productive or non-productive.
of endogenous growth theory. They showed However, when it comes to classifying public
that increased government expenditure on expenditures into productive/unproductive,
productive activities increases growth, as well there is a lack of theoretical literature as well
as evidence of different impact on growth of as empirical evidence. For example, the studies
different tax rates, with labour income taxes such as Castles & Dowrick (1990), Cashin (1995)
Economic Review – Journal of Economics and Business, Vol. XV, Issue 1, May 2017 35
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