Taxes, Government Expenditures, and State Economic Growth: The Role of Nonlinearities

v1.5 Barro’s (1990) model of endogenous growth implies that economic growth will initially rise with an increase in taxes directed toward “productive ” expenditures (e.g., education, highways, and streets), but will subsequently decline. Previous tests of the model, including Barro (1989, 1990) and recently Bleaney et al (2001), focus on whether the linear incremental effect of taxes is positive, negative, or zero, with substantial evidence for all three conclusions. In this study, we test for nonlinearity directly by incorporating nonlinear effects for taxes, and based on U.S. states find that the incremental effect of taxes directed toward productive government expenditures is initially positive, but eventually declines. U.S. states on average appear to under invest in expenditures on productive government activities. 1. Introduction. Do taxes and government expenditures enhance or impede economic growth? This question lies at the heart of public finance and taxation policy, both at the nationa