8.3 Policies to Promote Growth


So far we have used the Solow model to uncover the relationships among the different sources of economic growth and we have discussed some of the empirical work that describes actual growth experiences. We can now use the theory to help guide our thinking about economic policy.

Evaluating the Rate of Saving

According to the Solow growth model, how much a nation saves and invests is a key determinant of its citizens’ standard of living. So let’s begin our policy discussion with a natural question: Is the rate of saving in the Canadian economy too low, too high, or about right?

As we have seen, the saving rate determines the steady-state levels of capital and output. One particular saving rate produces the Golden Rule steady state, which maximizes consumption per worker and thus economic well-being. The Golden Rule provides the benchmark against which we can compare the Canadian economy.

To decide whether the Canadian economy is at, above, or below the Golden Rule steady state, we need to compare the marginal product of capital net of depreciation (MPK – δ) with the growth rate of total output (n + g). As we established in Section 8.1, at the Golden Rule steady state, MPKδ = n + g. If the economy is operating with less capital than in the Golden Rule steady state, then diminishing marginal product tells us that MPK – δ > n + g. In this case, increasing the rate of saving will increase capital accumulation and economic growth, and eventually lead to a steady state with higher consumption (although consumption will be lower for part of the transition to the new steady state). On the other hand, if the economy is operating with too much capital, then MPK – δ < n + g. In this case, capital accumulation is excessive: reducing the rate of saving would lead to higher consumption, both immediately and in the long run.

To make this comparison for a real economy, such as the Canadian economy, we need an estimate of the growth rate (n + g) and an estimate of the net marginal product of capital (MPK – δ). Real GDP in Canada has grown at just under 4 percent per year since 1950, so n + g = 0.04. We can estimate the net marginal product of capital from the following three facts:

  1. The capital stock is about 3 times one year’s GDP.

  2. Depreciation of capital is about 10 percent of GDP.

  3. Capital income is about 33 percent of GDP.

Using the notation of our model (and the result from Chapter 3 that capital owners earn income of MPK for each unit of capital), we can write these facts as

  1. k = 3y.

  2. δk = 0.1y.

  3. MPK × k = 0.33y.


We solve for the rate of depreciation δ by dividing equation 2 by equation 1:


δ = 0.033.

And we solve for the marginal product of capital MPK by dividing equation 3 by equation 1:


MPK = 0.11.

Thus, about 3.33 percent of the capital stock depreciates each year, and the marginal product of capital is about 11 percent per year. The net marginal product of capital, MPK – δ, is 7.67 percent per year.

We can now see that the return to capital (MPK – δ = 7.67 percent per year) is well in excess of the economy’s average growth rate (n + g = 4 percent per year). This fact, together with our previous analysis, indicates that the capital stock in the Canadian economy is well below the Golden Rule level. In other words, if Canada saved and invested a higher fraction of its income, it would grow more rapidly and eventually reach a steady state with higher consumption. This finding suggests that policymakers should want to increase the rate of saving and investment. In fact, for many years, increasing capital formation has been a high priority of economic policy.

This conclusion is not unique to the Canadian economy. When calculations similar to preceding ones are done for other economies, the results are similar. The possibility of excessive saving and capital accumulation beyond the Golden Rule level is intriguing as a matter of theory, but it appears not to be a problem that actual economies face. In practice, economists are more often concerned with insufficient saving. This kind of calculation provides the intellectual foundation for this concern.5

Changing the Rate of Saving

The preceding calculations show that to move the Canadian economy toward the Golden Rule steady state, policymakers should increase national saving. But how can they do that? We saw in Chapter 3 that, as a matter of sheer accounting, higher national saving means higher public saving, higher private saving, or some combination of the two. Much of the debate over policies to increase growth centers on which of these is likely to be most effective.


The most direct way in which the government affects national saving is through public saving—the difference between what the government receives in tax revenue and what it spends. When the government’s spending exceeds its revenue, the government runs a budget deficit, which represents negative public saving. As we saw in Chapter 3, a budget deficit raises interest rates and crowds out investment; the resulting reduction in the capital stock is part of the burden of the national debt on future generations. Conversely, if the government spends less than it raises in revenue, it runs a budget surplus. It can then retire some of the national debt and stimulate investment. This influence of government budget policy on capital accumulation explains why our federal government made reducing the budget deficit an important priority during the 1990s, and why there is much public concern about the federal government’s record annual budget deficit of $50 billion in 2009. As this book goes to press, the government is running this deficit for short-run cyclical reasons—to help stimulate the level of economic activity during a recession. It is encountering a trade-off between its short-run and its long-run objectives—deficits help to end the recession in the short run, but they are undesirable in the long run because they limit capital formation.

The government also affects national saving by influencing private saving—the saving done by households and firms. In particular, how much people decide to save depends on the incentives they face, and these incentives are altered by a variety of public policies. Many economists argue that high tax rates on capital income—including the corporate income tax and the personal income tax—discourage private saving by reducing the rate of return that savers earn. On the other hand, tax-exempt savings plans, such as RRSPs for retirement planning and the recently introduced tax-free savings accounts, are designed to encourage private saving by giving preferential treatment to income that is saved. Some economists have proposed increasing the incentive to save by replacing the current system of income taxation with a system of consumption taxation.

Many disagreements among economists over public policy are rooted in different views about how much private saving responds to incentives. For example, suppose that the government were to expand the amount that people can put into RRSPs. Would people respond to the increased incentive to save by saving more? Or would people merely transfer saving done in other forms into this form—reducing tax revenue and thus public saving without any stimulus to private saving? Clearly, the desirability of the policy depends on the answers to these questions. Unfortunately, despite much research on this issue, no consensus has emerged.


Tax Incentives for Saving and Investment

The Canadian government has long believed that Canada’s capital/labour ratio is below the Golden Rule value. This has been the motivation behind a series of policies that were designed to raise domestic saving and to make investment more profitable for firms.


On the saving side, we have had tax-free savings accounts, RRSPs, the goods and services tax (GST), and the capital gains exemption from income taxes. All savings that are deposited within an RRSP involve two tax breaks. First, the amount contributed can be deducted from taxable income (so individuals in a 50 percent tax bracket are effectively earning interest on twice the funds that they would have without an RRSP). Second, all interest earned within the plan is tax deferred. Eventually, when the RRSP is closed out, the individuals must pay taxes on all funds withdrawn. But this does not remove the tax advantage. For one thing, the tax rate is often lower during one’s retirement. For another thing, even when this is not the case, people prefer to pay taxes later. By allowing people to defer taxes, RRSPs involve the government in extending an interest-free loan to individuals (for many years). The government has been willing to give up all the associated revenue in an attempt to increase national saving.

The GST was introduced in 1988. One rationale for this tax is that sales taxes stimulate saving (compared to income taxes). With an income tax, individuals pay taxes whether they spend their income on consumption or saving. With a sales tax, people can avoid the tax by saving, since the tax is only levied when people spend.

The tax exemption on capital gains income was removed in the 1994 federal budget. With the government budget deficit running out of control, the government felt it had no option but to end this tax incentive. But its original intent was the same as with RRSPs. Prior to the 1994 budget, all individuals were exempt from tax on the first $100,000 of capital gains they had received on their saving. It is still the case that dividend and capital-gain income is taxed at lower rates than wage income.

Although many government policies are designed to encourage saving, one important policy is often thought to reduce saving: the public pension system. These transfers to the elderly are financed with a payroll tax on the working-age population. This system is thought to reduce private saving because it reduces individuals’ need to provide for their own retirement.

To counteract the reduction in national saving attributed to public pensions, some economists have proposed reforms. The system is now largely pay-as-you-go: most of the current tax receipts are paid out to the current elderly population. One suggestion is that the system should be fully funded. Under this plan, the government would put aside in a trust fund the payments a generation makes when it is young and working; the government would then pay out the principal and accumulated interest to this same generation when it is older and retired. Under a fully funded pension system, an increase in public saving would offset the reduction in private saving.

A closely related proposal is privatisation, which means turning this government program for the elderly into a system of mandatory private savings accounts, much like private pension plans. In principle, the issues of funding and privatisation are distinct. A fully funded system could be either public (in which case the government holds the funds) or private (in which case private financial institutions hold the funds). In practice, however, the issues are often linked. Some economists have argued that a fully funded public system is problematic. They note that such a system would end up holding a large share of the nation’s wealth, which would increase the role of the government in allocating capital. In addition, they fear that a large publicly controlled fund would tempt politicians to cut taxes or increase spending, which could deplete the fund and cause the system to revert to pay-as-you-go status.


These issues rose to prominence in the late 1990s, as policymakers became aware that the current public pension system was not sustainable. That is, the amount of revenue being raised by the payroll tax appeared insufficient to pay all the benefits being promised. According to most projections, this problem was to become acute as the large baby-boom generation retired during the early decades of the twenty-first century. Various solutions were proposed. One possibility was to maintain the current system with some combination of smaller benefits and higher taxes. Other possibilities included movements toward a fully funded system, perhaps also including private accounts. The federal government opted for higher payroll taxes.

In addition to its attempts to stimulate private saving, the government also tries to raise investment by giving interest-free loans directly to firms, in the form of “accelerated depreciation allowances.” Again, the purpose is to increase capital accumulation in the economy. When firms fill out their corporate tax forms, they deduct expenses from gross sales to calculate their tax base (profits). One aspect of these calculations is particularly arbitrary—how the expenses of the firm’s machines and equipment are treated. Firms would like to claim (for tax purposes) that equipment fully wears out (depreciates) during the purchase year. Firms can then claim the entire cost of the equipment immediately. This makes recorded profits low, and so keeps initial tax payments low. In fact, equipment wears out over a period of years. By having no equipment-purchase expenses left to claim in those later years, firms have bigger tax obligations later on. But, as with households, firms like paying taxes later, since by doing so they have received an interest-free loan from the government.

Vast amounts of tax revenue are forgone because of these tax incentives, so it should not be surprising to learn that some have been controversial. One class of policies that is particularly “expensive” is the set of corporate tax breaks that are available to all firms operating in Canada, whether or not they are branch plants of multinational companies. International tax agreements make our tax initiatives useless for these firms. Multinationals are allowed a tax credit for taxes already paid in other countries when they calcuate their corporate tax obligations in the country where the parent company is based. For example, a company based in the United States is allowed to deduct the taxes its affiliate has already paid in Canada from what taxes it would otherwise owe to the U.S. government. Thus, a tax break offered by the Canadian government makes the tax credit in the United States precisely that much smaller. The Canadian government is simply transferring revenue to the U.S. government. Since these firms are no better off as a result of the Canadian government’s generosity, we cannot expect the policy to stimulate investment spending on the part of these firms.

This is not the place to evaluate more fully the Canadian attempts to raise saving and investment. However successful these schemes have been, the main point to be appreciated is why these initiatives were taken. The purpose has been to move Canada closer to the Golden Rule outcome. image

Allocating the Economy’s Investment


The Solow model makes the simplifying assumption that there is only one type of capital. In the world, of course, there are many types. Private businesses invest in traditional types of capital, such as bulldozers and steel plants, and newer types of capital, such as computers and robots. The government invests in various forms of public capital, called infrastructure, such as roads, bridges, and sewer systems.

In addition, there is human capital—the knowledge and skills that workers acquire through education, from early childhood programs to on-the-job training for adults in the labour force. Although the captial variable in the Solow model is usually interpreted as including only physical capital, in many ways human capital is analogous to physical capital. Like physical capital, human capital raises our ability to produce goods and services. Raising the level of human capital requires investment in the form of teachers, libraries, and student time. Recent research on economic growth has emphasized that human capital is at least as important as physical capital in explaining international differences in standards of living. One way of modeling this fact is to give the variable we call “capital” a broader definition that includes both human and physical capital.6

Policymakers trying to stimulate economic growth must confront the issue of what kinds of capital the economy needs most. In other words, what kinds of capital yield the highest marginal products? To a large extent, policymakers can rely on the marketplace to allocate the pool of saving to alternative types of investment. Those industries with the highest marginal products of capital will naturally be most willing to borrow at market interest rates to finance new investment. Many economists advocate that the government should merely create a “level playing field” for different types of capital—for example, by ensuring that the tax system treats all forms of capital equally. The government can then rely on the market to allocate capital efficiently.

Other economists have suggested that the government should actively encourage particular forms of capital. Suppose, for instance, that technological advance occurs as a by-product of certain economic activities. This would happen if new and improved production processes are devised during the process of building capital (a phenomenon called learning by doing) and if these ideas become part of society’s pool of knowledge. Such a by-product is called a technological externality (or a knowledge spillover). In the presence of such externalities, the social returns to capital exceed the private returns, and the benefits of increased capital accumulation to society are greater than the Solow model suggests.7 Moreover, some types of capital accumulation may yield greater externalities than others. If, for example, installing robots yields greater technological externalities than building a new steel mill, then perhaps the government should use the tax laws to encourage investment in robots. The success of such an industrial policy, as it is sometimes called, requires that the government be able to measure accurately the externalities of different economic activities so it can give the correct incentive to each activity.


Most economists are skeptical about industrial policies, for two reasons. First, measuring the externalities from different sectors is so difficult as to be virtually impossible. If policy is based on poor measurements, its effects might be close to random and, thus, worse than no policy at all. Second, the political process is far from perfect. Once the government gets in the business of rewarding specific industries with subsidies and tax breaks, the rewards are as likely to be based on political clout as the magnitude of externalties.

One type of capital that necessarily involves the government is public capital. Municipal, provincial, and federal governments are always deciding if and when they should borrow to finance new roads, bridges, and transit systems. In 2009, one of U.S. President Barack Obama’s first economic proposals was to increase spending on such infrastructure. This policy was motivated partly by a desire to increase short-run aggregate demand (a goal we will examine later in this book) and partly by a desire to provide public capital and enhance long-run economic growth. Many politicians have argued that here in Canada we have been investing too little in infrastructure as well. They claim that a higher level of infrastructure investment would make the economy substantially more productive. Among economists, this claim has had both defenders and critics. Yet all of them agree that measuring the marginal product of public capital is difficult. Private capital generates an easily measured rate of profit for the firm owning the capital, whereas the benefits of public capital are more diffuse. Moreover, while private capital investment is made by investors spending their own money, the allocation of resources for public capital involves the political process and taxpayer funding. It is all too common to see essentially useless projects being built simply because the local member of parliament has the political muscle to get funds approved.

Establishing the Right Institutions

As discussed earlier, economists who study international differences in the standard of living attribute some of these differences to the inputs of physical and human capital and some to the productivity with which these inputs are used. One reason that nations may have different levels of production efficiency is that they have different institutions that guide the allocation of scarce resources. Creating the right institutions is important for ensuring that resources are allocated to their best use.


A nation’s legal tradition is an example of such an institution. Some countries, such as Canada, the United States, Australia, India, and Singapore, are former colonies of the United Kingdom and therefore have English-style common law systems. Other nations, such as Italy, Spain, and most of Latin America, have legal traditions that evolved from the French Napoleonic Codes. Studies have found that legal protections for shareholders and creditors are stronger in the English-style legal systems than in the French-style systems. As a result, the English-style countries have better developed capital markets. Nations with more developed capital markets, in turn, experience more rapid growth because it is easier for small and start-up companies to finance investment projects, leading to a more efficient allocation of the nation’s capital.8

Another important institutional difference across countries is the quality of government itself. Ideally, governments should provide a “helping hand” to the market system, protecting property rights, enforcing contracts, promoting competition, prosecuting fraud, and so on. Yet governments sometimes diverge from this ideal and act more like a “grabbing hand,” using the authority of the state to enrich a few powerful individuals at the expense of the broader community. Empirical studies have shown that the extent of corruption in a nation is indeed a significant determinant of economic growth.9

Adam Smith, the great eighteenth-century economist, was well aware of the role of institutions in economic growth. He once wrote, “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.” Sadly, many nations do not enjoy these three simple advantages.


The Colonial Origins of Modern Institutions

International data show a remarkable correlation between latitude and economic prosperity: nations closer to the equator typically have lower levels of income per person than nations farther from the equator. This fact is true in both the northern and southern hemispheres.

What explains the correlation? Some economists have suggested that the tropical climates near the equator have a direct negative impact on productivity. In the heat of the tropics, agriculture is more difficult, and disease is more prevalent. This makes the production of goods and services more difficult.

Although the direct impact of geography is one reason tropical nations tend to be poor, it is not the whole story. Recent research by Daron Acemoglu, Simon Johnson, and James Robinson has suggested an indirect mechanism—the impact of geography on institutions. Here is their explanation, presented in several steps:


  1. In the seventeenth, eighteenth, and nineteenth centuries, tropical climates presented European settlers with an increased risk of disease, especially from malaria and yellow fever. As a result, when Europeans were colonizing much of the rest of the world, they avoided settling in tropical areas, such as most of Africa and Central America. The European settlers preferred areas with more moderate climates and better health conditions, such as the regions that are now Canada, the United States, and New Zealand.

  2. In areas where Europeans settled in large numbers, the settlers established European-like institutions that protected individual property rights and limited the power of government. By contrast, in tropical climates, the colonial powers often set up “extractive” institutions, including authoritarian governments, so that they could take advantage of the area’s natural resources. These institutions enriched the colonizers, but they did little to foster economic growth.

  3. Although the era of colonial rule is now over, the early institutions that the European colonizers established are strongly correlated with the modern institutions in the former colonies. In tropical nations, where the colonial powers set up extractive institutions, there is typically less protection of property rights even today. When the colonizers left, the extractive institutions remained and were simply taken over by new ruling elites.

  4. The quality of institutions is a key determinant of economic performance. Where property rights are well protected, people have more incentive to make the investments that lead to economic growth. Where property rights are less respected, as is typically the case in tropical nations, investment and growth tend to lag behind.

This research suggests that much of the international variation in living standards we observe today is a result of the long reach of history.10 image

Encouraging Technological Progress

The Solow model shows that sustained growth in income per worker must come from technological progress. The Solow model, however, takes technological progress as exogenous; it does not explain it. Unfortunately, the determinants of technological progress are not well understood.

Despite this limited understanding, many public policies are designed to stimulate technological progress. Most of these policies encourage the private sector to devote resources to technological innovation. For example, the patent system gives a temporary monopoly to inventors of new products; the tax code offers tax breaks for firms engaging in research and development; and government funding agencies directly subsidize basic research. In addition, as discussed above, proponents of industrial policy argue that the government should take a more active role in promoting specific industries that are key for rapid technological advance. In recent years, the encouragement of technological progress has taken on an international dimension. Many of the companies that engage in research to advance technology are located in the United States and other developed nations. Developing nations such as China have an incentive to “free ride” on this research by not strictly enforcing intellectual property rights. That is, Chinese companies often use the ideas developed abroad without compensating the patent holders. The United States has strenuously objected to this practice, and China has promised to step up enforcement. If intellectual property rights were better enforced around the world, firms would have more incentive to engage in research, and this would promote worldwide technological progress.



The Worldwide Slowdown in Economic Growth: 1972–1995

Beginning in the early 1970s and lasting until the mid-1990s, world policymakers faced a perplexing problem: a global slowdown in economic growth. Table 8-2 presents data on the growth in real GDP per person for seven major world economies. Growth in Canada fell from 2.9 percent before 1972 to 1.8 percent from 1972 to 1995. Other countries experienced similar or more severe declines. Accumulated over many years, even a small change in the rate of growth has a large effect on economic well-being. Indeed, real income in Canada in 2008 was 28 percent lower than it would have been had growth remained at its previous level. (Incidently, it is worth emphasizing that Table 8-2 focuses on growth in GDP per person. Since Canada’s population grew more rapidly than our real GDP during these periods, these reported growth rates are lower than the 4 percent output growth mentioned earlier in this chapter.)

TABLE 8-2 Growth Around the World
Country 1948–1972 1972–1995 1995–2010
Canada 2.9 1.8 1.6
France 4.3 1.6 1.1
West Germany 5.7 2.0
Germany 1.3
Italy 4.9 2.3 0.6
Japan 8.2 2.6 0.6
United Kingdom 2.4 1.8 1.7
United States 2.2 1.5 1.5

Source: Angus Maddison, Phases of Capitalist Development (Oxford: Oxford University Press, 1982); OECD National Accounts; and World Bank: World Development Indicators.


Why did the productivity growth slowdown occur? Studies have shown that the slowdown in growth is attributable to a slowdown in the rate at which the production function is improving over time. The appendix to this chapter explains how economists measure changes in the production function with a variable called total factor productivity, which is closely related to the efficiency of labour in the Solow model. Our understanding of why the growth in total factor productivity slowed is still quite incomplete. This is frustrating since, as just noted, accumulated over many years, even a small change in productivity growth has a large effect on economic welfare.

Many economists have attempted to explain this adverse change. Let’s consider some of their explanations.

Measurement Problems One possibility is that the productivity slowdown did not really occur and that it shows up in the data simply because the data are flawed. As you may recall from Chapter 2, one problem in measuring inflation is correcting for changes in the quality of goods and services. The same issue arises when measuring output and productivity. For instance, if technological advance leads to more computers being built, then the increase in output and productivity is easy to measure. But if technological advance leads to faster computers being built, then output and productivity have in effect increased, but that increase is more subtle and harder to measure. Government statisticians try to correct for changes in quality, but despite their best efforts, the resulting data are far from perfect.

Unmeasured quality improvements mean that our standard of living is rising more rapidly than the official data indicate. This issue should make us suspicious of the data, but by itself it cannot explain the productivity slowdown. To explain a slowdown in growth, one must argue that the measurement problems have gotten worse. There is some indication that this might be so. Over time, fewer people are working in industries with tangible and easily measured output, such as agriculture, and more people are working in industries with intangible and less easily measured output, such as medical services. Yet few economists believe that measurement problems are the full story.

Oil Prices When the productivity slowdown began around 1973, the obvious hypothesis to explain it was the large increase in oil prices caused by the actions of the OPEC oil cartel. The primary piece of evidence was the timing: productivity growth slowed at almost exactly the same time that oil prices skyrocketed. Over time, however, this explanation has appeared less likely. One reason is that the accumulated shortfall in productivity seems too large to be explained by an increase in oil prices—petroleum-based products are not that large a fraction of a typical firm’s costs. In addition, if this explanation were right, productivity should have sped up when political turmoil in OPEC caused oil prices to plummet in 1986. Unfortunately, that did not happen.

Worker Quality Some economists have suggested that the productivity slowdown might be attributable to changes in the labour force. In the early 1970s, the large baby-boom generation started leaving school and taking jobs. At the same time, changing social norms encouraged many women to leave full-time housework and enter the labour force. Both of these developments lowered the average level of experience among workers, which in turn lowered average productivity.


Other economists point to changes in worker quality due to human capital. Although the educational attainment of the labour force is now as high as it has ever been, educational attainment is not increasing as rapidly as it has in the past. In addition, declining performance on some standardized tests suggests that the quality of education has been declining over time. If so, this could explain slowing productivity growth.

The Depletion of Ideas Still other economists have suggested that the world has started to run out of new ideas about how to produce and, as a result, we have entered an age of slower technological progress. These economists often argue that the anomaly is not the period since 1970 but the two decades before that. In the late 1940s, the economy had a large backlog of ideas that had not been fully implemented because of the Great Depression of the 1930s and World War II in the first half of 1940s. After the economy used up this backlog, the argument goes, a slowdown in productivity growth was inevitable. Indeed, while recent growth rates are disappointing compared to those of the 1950s and 1960s, they are not any lower than average growth rates from 1870 to 1950. Perhaps lower productivity growth is something we just have to get used to.

As any good doctor will tell you, sometimes a patient’s illness goes away on its own, even if the doctor has failed to come up with an accurate diagnosis and an effective remedy. This situation seems—at least partially—to be the outcome of the productivity slowdown. In the mid-1990s, economic growth rebounded, at least in some English-speaking countries and in particular in the United States. As with the slowdown in economic growth in the 1970s, the acceleration in the 1990s is hard to explain definitively. But at least part of the credit goes to advances in computer and information technology, including the Internet.11 And, in any event, with the financial crisis and the ensuing recession, productivity growth rates have fallen again.

You might wonder why it would take so long for computers to seem to contribute to rising productivity. In this regard, it is useful to recall that similar lags have been common throughout history. For example, the electric light bulb was invented in 1879, but it took several decades for electricity to have a big economic impact. For businesses to reap large productivity gains, they had to do more than just replace steam engines with electric motors; they had to rethink the entire organization of factories. Similarly, replacing the typewriters on desks with computers and word processing programs, as was common in the 1980s, may have had small productivity effects. Only later, when the Internet and other advanced applications were invented, did the computers yield large economic gains.12 image