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Economic growth and development-policy issues

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Which is the increase in value of the goods and services produced by an economy?

As an area of study, economic growth is generally distinguished from economic development which is growth in GDP accompanied by social and institutional changes by which growth can be sustained. The former being largely the study of how the developed world can advance their economies, while the latter is essentially how developing countries can catch up with the developed ones.{{more}} Economists draw a distinction between short term economic stabilization and long term economic growth, because the topic of economic growth is primarily concerned with the long run. Almost all countries experience periodical recessions, and stabilization policies are generally implemented to bring the economy back on course.

Traditionally, economists believe that economic growth could be managed by the judicious use of monetary and fiscal policies. Monetary policy involves the raising or lowering of rates of interest as appropriate, and expansion or contraction in the money supply. Fiscal policy on the other hand refers to the degree to which governments can run budgets surpluses or deficits. By raising interest rates or suppressing the money supply and raising taxes or cutting spending, periods of boom or excessive demand could be moderated. Likewise, lowering interest rates an expanding money supply, coupled with tax cuts or spending increases could pull the economy out of a recession. These traditional levers of Monetary and Fiscal policy were intended to affect the demand for or consumption of goods and services as well as the decisions of businesses to make investments in plant or equipment.

In the 1970’s, however, a new challenge emerged as the economies of many developed countries suffered, at one and the same time, high inflation which is usually a symptom of rapid economic growth; and high unemployment, usually a symptom of recession or very tardy growth. Economists, therefore, searched for answers. One school of Economist referred to as supply-siders believed that while monetary and fiscal policies could create plenty of demand, those policies were not sufficient in themselves to induce businesses to produce goods and services to meet that demand. This new school of thought argued that deregulation of industries allowing more potential businesses to enter markets, reduce power of unions to allow for more flexibility and lower labour costs; and reduced taxes, to create greater after tax returns on work and investment was the answer. These measures seemed to have worked well in the U.S., although the tax cut did result in the widening of the fiscal deficit.

The role of confidence in economic policy making may, however, be more important than is generally recognized. Whether we are implementing fiscal or monetary policies, or supply side incentives, investors who do not believe that the future economy will be strong, will not make long term high risk investment, and this is the type of investment that leads to innovation or high risk productivity and will contribute to a rapidly growing standard of living. Even small investors can now invest their funds anywhere in the world. Moreover, global investors cannot really predict the problems that will occur in particular countries in five or ten year’s time when they are counting on their investment paying off. Therefore, they must choose ventures to fund, based on their confidence that whatever problems exist in the host nation, its political system will find a solution and their investments will not be vulnerable. In the final analysis, economic growth depends on how tax rates, regulations and inflation affect investment, entrepreneurship and work effort.

It is important that taxation is not pitched at such a high level as to defeat its objective of raising increased revenues and that, given sufficient time to gather its fruits, a reduction in taxation could stand a better chance than an increase in balancing the budget. The basic ideas between tax rates and tax revenues is that changes in tax rates have two effects on revenues, the arithmetic effect and he economic effect. (1) The Arithmetic Effect: If tax rates are lowered by the amount of the decrease in the rate. (2) The Economic Effect: This recognizes the positive impact that lower tax rates have on work, output and employment (and hence the eventual tax base) by providing incentives to increase these activities. The Arithmetic Effect always works in the opposite direction to the Economic effect. Therefore, when the arithmetic and economic effects of tax-rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.

Economic development in our small countries is possible, provided real GDP grows at a fast pace over a long period to permit the social and institutional changes by which growth can be sustained. The engine of growth is investment in capital formation. But herein lies the challenge for our countries deficient in capital due to the low level of savings and one of the reasons for low savings is the low level of incomes. It would, therefore, seem necessary to augment savings with foreign savings in order to achieve our developmental objectives.