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Fiscal Policy, Incentives, and Growth

Written by: International Monetary Fund

Article Overview: Fiscal policy can also affect growth through its effects on the incentives faced by individuals and firms.

Fiscal Policy, Incentives, and Growth

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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  5.1 Fiscal space is critical for diversification: Economic Report on Africa 2007
  Economic Growth, Sustainable Development, and the Millennium Development Goals (MDGs)
  6.1 Macroeconomic policies for diversification: Economic Report on Africa 2007

Article Tags: benefit levels, civil service, disciplinary policies, excessive pollution, expenditure policies, fiscal policies, fiscal policy, illegal logging, incentive effects, policy measures, political connections, poverty relief, poverty trap, productive activity, public sector employees, school attendance, seeking employment, stumpage, tax breaks, tax rates



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