Explaining why some countries are rich and why some
are poor can be explained through two theories:
equation theory and institutional theory. Equation
allows us to algebraically look at how we manipulate the
different inputs to maximize output while institution
focuses on the practices within a country and its effect
on the economy.
The main point of focus here is how the rental rate on
capital, less depreciation and capital income taxes,
affects the rate of return on capital. By looking at the
equation, we must set an equilibrium. Households
demand a certain after-tax and after-depreciation return
on capital (as denoted in the equation by 1 less tax rate
and capital less depreciation). That figure leftover is
equal to the rate of return on capital. Therefore, the tax
rate greatly affects the rate of return on capital as seen
in the equation.
Labor (income tax) and capital must go hand-in-hand.
High capital income tax rates will discourage
accumulation of capital which will then lead to lower
wages. Higher rates of taxation on capital income
actually tends to make workers worse off. So, when tax
rates on capital are relatively high, the levels of capital
output and wages are relatively low.
In a poorer countries, corrupt government entities
impose a higher capital income tax (i.e. bribes).
Therefore, because of this high tax, firms are unable to
accumulate capital. Thus they are unable to pay their
workers sufficient wages and therefore, the economy is
unable to flourish as they don’t have the income to then
put back into the economy. The opposite holds true for
wealthier, developed nations such as the US.
Institutional theory, on the other hand, is based on
concepts and policies within a country. Institution theory
looks at the policies that a particular country has in place
and how it affects the economy and real GDP.
Institutional theory is studied by looking at four
components: income level, growth, volatility, and
policies and how they are all correlated.
When looking at income, economic outcomes could be
substantially improved if developed countries
strengthen their institutions. The income gain is much
larger if institutional quality rises to the level of advanced
economies as we see in developed countries. Institutions
are also directly correlated to volatility. Therefore, the
better the institutions, the lower the volatility of growth.
Institutional improvements could have significant impact
on growth rates and as a result, institutions have a strong
and significant impact on GDP growth. When
institutional and policy variables are considered
together, institutions are found to be the dominant
influence on economic performance, with policies having
little independent influence. However, a country’s level
of financial development, which may be highly
influenced by policy, has a significant positive impact on
Institutions are very important as seen in developed
countries because lack of them can lead to corruption
and stagnant growth as seen in the developing countries.
Institutional theory is based on concepts. Equation
theory stipulates income tax and deprecation are driving
factors as seen through the equation. This theory depicts
institution theory by using numbers to algebraically show
how changes in taxes and depreciation affect real-GDP.
Both theories suggest growth and development be
allocated towards finding equilibrium with the rate of
return on capital and also having a solid foundation such
as institutions to ensure growth.
In summation, both concepts are looking to find an
equilibrium within the country to ensure a growing
increases/decreases in taxes or depreciation affect that
equilibrium while institution theory looks at social
factors and their effect on the equilibrium. Both theories
are vital for economic growth and development and both
illustrate the same concept but demonstrate them in
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