Fiscal policy can also affect growth through its effects on the incentives faced by individuals and firms. Business taxes can affect firms’ decisions regarding how much to invest and in what kind of assets; taxes on labor can affect the level of employment and decisions on the acquisition of education and job training; stumpage fees can discourage tree cutting (or encourage illegal logging); taxes on capital income can affect incentives to save; the absence of emissions charges can lead to excessive pollution; the availability of special tax breaks and subsidies for those with political connections (rent-seeking) can reduce incentives to engage in productive activity; and excessively generous social programs can reduce incentives to work and save. Incentive effects are not limited to the private sector; they play just as important a role within the public sector. Pay and disciplinary policies, for instance, shape the extent of corruption in the civil service and the productivity of public sector employees.
Incentive effects can constrain the effectiveness of fiscal policies. An increase in the corporate tax rate intended to increase revenues will fail to do so, for instance, insofar as this leads businesses to invest instead in other countries or to shift their profits to jurisdictions offering low tax rates.18 High benefit levels in social programs may discourage recipients from seeking employment and gaining job skills, miring individuals in a “poverty trap.” These problems have implications for policy design. For example, poverty relief may be more cost-effective if linked to work participation or to children’s school attendance.
Tax and expenditure policies should, in general, be designed to minimize adverse incentive effects. In choosing tax policy measures to raise revenues, for example, there should be preference for those that least distort labor supply, consumption, saving, and other decisions. When the aim of a policy is to help the poor, little is gained by discouraging them from raising their own living standards. In some important cases, however, notably in relation to the environment and natural resources, tax and spending policies have a role in correcting what would otherwise be inappropriate incentives for overconsumption. For example, the price of energy determined by the private market is too low if the true social cost of energy consumption (which includes the cost of pollution and traffic congestion)
is not incorporated into the private sector price. The role of incentives in designing fiscal policies to support sustainable development is a central consideration in many of the issues addressed in this pamphlet.
Fiscal Dimensions of Sustainable Development Prepared for World Summit on Sustainable Development Johannesburg, August 26–September 4, 2002
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