ing growth are often also seen as measures to improve public finances, cf e.g.
ECOFIN Council (2005). This type of reasoning is based on the fact that budget
positions are very sensitive to the underlying business cycle situation. Despite
this, the relationship between growth and public finance in the medium to long
run may differ.
As seen from table 1, increasing the growth rate for productivity growth
by 0.5 percentage points the sustainable tax increase is 12.8 percentage points
rather than 8.7 percentage points in the base case, i.e. the sustainability problem
is worse when the growth rate is higher.
This result may at first seem counterintuitive but it arises from some very
basic mechanisms, cf also appendix. To see this start with the following basic
effects of growth for public finances. If productivity increases in the private
sector and wages and income increase, it will have a direct effect on public rev-
enues. However, expenditures will also be affected. There are basically two
types of public expenditures, namely wage expenditures and income transfers.
The former will over the medium to long-run have to follow wage developments
in the private sector21. The latter will also, under the political distributional
constraint that all groups should share the gains in material well-being (or equiv-
alently the distribution of income is not to change), follow wage developments
in the private sector. Hence to a first approximation public expenditures will
grow in parallel to the growth rate for given welfare arrangements.
Actually, there are mechanisms implying that increasing growth may deteri-
orate public finances. First, since some tax bases are defined on past income (say
the taxation of withdrawals from pension funds) it follows that revenue is not
following the growth rate22 . Second, increasing growth may lead to increases in
the demand for leisure (non taxed) but also increasing demand to standards in
services provided by the public sector (expenditure increase) implying a further
deterioration of public finances.
For the sustainable tax rate there is a further effect at stake. Even under
assumptions ensuring that the PAYG-tax is independent of the growth rate. The
reason is the trend increase in the dependency rate. The increasing dependency
ratio implies a tendency towards systematic deterioration of public finances.
The sustainable tax requires that all - current and future generations - pay the
same tax rate, such that the intertemporal budget constraint holds. This implies
that current generations with lower income than future generations are going
to contribute to the financing of future expenditures. The larger the growth
rate, the larger the tax rate would have to be to ensure that current generations
contribute sufficiently to the financing of expenditure drifts caused by a trend
increase in the dependency ratio.
The basic budget implications of changes in productivity growth under both
PAYG-taxes and the sustainable tax rate are worked out in a simple two-period
overlapping generations model presented in the appendix. The mechanisms
through which growth affects either indicator are shown to demonstrate why
21 Transfers are indexed to wages,cf the so-called "satsreguleringslov".
22A similar effect is found for N orway in Heide et. al (2005).
22