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Robert Solow's Economic Growth Model

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The roots of economic growth theory can be traced back to Nobel Prize winning Robert Solow through his development of the basic neoclassical model of economic growth (Polsser, 1993, p. 57). The neoclassical growth model captures the concept of an aggregate production function that contains labour and capital factors to influence economic growth.

Becsi (1996, p. 24) identifies theoretical effect of taxes on growth as that taxes raise costs and lower the returns to a tax activity. Therefore, taxes give opportunities for individuals and businesses to undertake out activities that diminish their tax payment, substituting away from activities taxed at a higher rate to those taxes at lower rates. In encouraging this substitution, taxes distort …show more content…

418) note that growth models share specific features that link certain taxes to growth rate. Thus they suggest that it is possible to draw the growth effect of tax and to simulate the impact of changes in tax policy in the context of Solow model. Moreover, Easterly el al. (1993, p. 420) state that the model provides for an argument that fiscal policy can only affect growth during transition to steady state. For instance according to Polsser (1993, pp. 65-66) state that “King and Rebelo (1991) have simulated the quantitative impact of income tax changes through the Solow model. They calibrate the model by selecting the conventional value of a=2/3 for labour’s share, a depreciation rate of 10 percent (6=1) and a growth rate of technology of 2 percent. Because of technological progress, this economy grows at 2 percent per year in a steady state. The tax experiment explored by King and Rebelo is an increase in the average income tax rate from 20 percent to 30 …show more content…

Assumption developed is that these taxes affect growth rate by reducing private rate of return on accumulation. The cross-country evidence in Mendoza, Razin and Tesar (1994, p. 3) shows that countries with higher capital income taxes are likely to encounter lower savings and investment rates. But, not all taxes are bad for growth. For example in Easterly et al. (1993, p. 420) an equation with exogenous labour supply, growth rate is resilient to the level of consumption taxes. Accoding to Easterly et al. (1993) cosumption taxes do not distort the relative price to accumulate

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