Research

We study the volatility of growth rates and find that it differs systematically across countries. Our empirical investigation reveals that disparity in polity across countries is significant in explaining the difference in volatility, rather than initial income, inequality or instability of regimes, which are the commonly cited reasons in the literature. We find that less democratic countries are more volatile. To explain this observation we use a stochastic dynamic model in which democracy is parameterized by the fraction of people who benefit from being in power. The government in this model maximizes the utility of the group in power using uniform income taxes but transfers to the favored group only. When there is a bad shock in this economy, the marginal utility of agents in power is high. So, when the transfer is divided among a few, gains from increased transfer outweigh distortionary costs of higher tax. Thus, the optimal tax policy in non-democratic countries, in contrast to that in democratic countries, is such that tax rates are high when there is a bad shock and low when there is a good shock (i.e., procyclical). Further, we show that procyclical tax rates will lead to higher volatility of growth rates than under alternative tax policies. Thus, our model is successful in explaining why tax policies are pro-cyclical in some countries, a commonly observed phenomenon, in addition to providing reasons for differences in volatility of growth rates across countries.

The empirical relationship between average growth rate and volatility of growth rates, both over time and across countries, has important policy implications, which depend critically on the sign of the relationship. Following Ramey and Ramey (1995) a wide consensus has been building that, in the post WWII data, the correlation is negative. We replicate their result and then find that it is not robust to either the definition of growth rate, or the composition of the sample. We show that the use of log difference as growth rates, as in Ramey and Ramey, creates a strong bias towards finding a negative relationship. Further, we exhaustively investigate this relationship, for various growth rates, across time, countries, within groups of countries and states in the Unites States. We use different methods and control variables for this inquiry. Our analysis suggests that there is no significant relationship between the two variables in question. However, we observe that the volatility of growth rates differs widely across countries, particularly between democratic and non-democratic countries. The latter finding is quite robust to a variety of controls, definitions of growth rates and time periods. We claim it is an important fact that existing political-economic models cannot explain.

Chatterjee and Shukayev's response to "Ramey & Ramey Response to Chatterjee-Shukayev "Are Average Growth Rate and Volatility Related?""