Education, Growth, and Redistribution in the Presence of Capital Flight

The conventional wisdom in the literature on capital controls and growth argues that capital controls increase the ability of a government to tax capitalists which proves detrimental for growth. To address this issue, we construct an OLG model to study the effect of capital controls on human capital investments and the incidence of redistributive taxation in a growing economy. We argue to the contrary: i.e., the conventional wisdowm linking higher capital controls to lower growth is reproduced only when an economy is sufficiently developed. For under-developed countries, higher capital controls can induce balanced growth, and the wisdom does not apply. When the model is augmented with a subsistence sector, we show that if workers are sufficiently poor, then workers do not invest in human capital. Hence, a modern sector does not exist. Higher capital controls however makes it feasible for a modern sector to exist by lowering the threshold income level required by workers to invest in human capital. Our results are consistent with recent evidence which show that, while financial liberalizations are associated with significant increases in growth, the effect is larger for countries with high education levels. Our results are also consistent with empirical evidence that argues that liberalizing the capital account positively affects growth only after a country has achieved a certain degree of economic development.