Fiscal Policy for Growth and Social Welfare
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is widely believed that productive spending on health reduces sickness, morbidity, and mortality, thereby increasing the labor supply with beneficial effects for growth. Good health also improves the ability of workers to acquire new skills and better education, with an additional potential beneficial effect on growth. Finally, infrastructure public spending is expected to affect growth positively through traditional and nontraditional channels by means of its positive impact on both health and education (Agénor and Moreno-Dodson 2006). On the revenue side of the general government constraint, taxation produces the resources needed to finance public spending, and it is generally considered to be a less distortionary alternative to other forms of financing such as inflation or debt (González-Páramo and MorenoDodson 2003), although its effect on growth depends on the composition of the tax system.21 To the extent that taxation interferes with private decisions to save and invest, it is expected to have an impact on the input accumulation process, which is one important determinant of economic growth. A high effective tax rate on corporate and individual income or on capital gains along with low depreciation allowances could dampen the rate of private investment. Furthermore, taxation can affect the marginal productivity of capital by distorting the allocation of investment between the sectors of the economy that are heavily taxed and those that are lightly taxed or not taxed at all. Moreover, it can distort asset diversification and the choice of organizational form. One would also expect special tax preferences to be detrimental to efficiency because capital may be allocated to low-return projects. The impact of a tax on labor depends on the effect of such a tax on labor force participation, occupational choice, labor supply, and the acquisition of education and training. Zagler and Dürnecker (2003) explain that taxation on earnings can have a negative impact on the quality of labor input. This impact stems from the fact that the acquisition of new knowledge and skills is driven by the expectation of higher future earnings. Optimality of schooling decisions implies that marginal benefits (in terms of higher future earnings) are equal to marginal costs. If tuition costs are kept constant, then a tax on labor income will induce individuals to cut back on their efforts to obtain schooling, thereby reducing the average quality of the workforce, with a detrimental effect on growth. The net effect of public spending and taxation on growth ultimately depends on their levels and composition. Although a combination of productive spending and less distortionary taxes is expected to affect