The Empirical Economics Letters, 9(4): (April 2010) ISSN 1681 8997 Fiscal Policy and Growth Nexus: Scenario of Developing Economies Ihtsham Ul Haq Padda ♣ and Naeem Akram ♥ FSES, FUUAST Islamabad, Pakistan Abstract: Tax based fiscal policies have been regarded as less effective policy tool to overcome the fiscal deficit in developing countries. Tax revenue may be a possible source to correct fiscal deficit which reduces economic growth and social welfare. The empirical analysis shows that changes in tax rate may have permanent effects on output, but will have only temporary effects on its growth rate. The study implies that an increase in the tax rate will permanently reduce the level of output per-capita, but will have no permanent effect on growth rate. These findings suggest that neoclassical growth model best describes the relationship between tax and output growth. Keywords: Tax; Growth; Fiscal Policy; Tax Smoothing JEL Classification Number: H10, E62, O40 1. Introduction Changes in tax rates have different implications in neoclassical and endogenous growth models. Most of the exogenous models predict that permanent changes in government policies do not have permanent effect on the per-capita growth of output. The neoclassical growth models imply that changes in a country’s tax structure should have no impact on its long-run growth. Such changes allow a country to move towards a higher or lower level of economic activity, but the new long-run growth path converges to the old long-run path. It is only during the transition from the old path to the new path that the rate of growth of a country’s real output raises or declines. This study investigates whether tax policies adopted by selected developing countries have transitory or permanent impact on their growth. Rest of the paper deals the theoretical and empirical background, estimation, discussion and policy implications of the results. 2. Theoretical and Empirical Background An important research issue arising from Barro’s (1979) tax-smoothing hypothesis (TSH) insights is: whether, the tax policies adopted by a government effects its output growth permanently or transitorily. A prominent feature of the endogenous growth theories is--- ♣ Email: ihtsham91@yahoo.com ♥ PhD Scholar, at the FSES, Email: naeem378@yahoo.com Acknowledgement: The authors are highly indebted to Syed Nawab Haider Naqvi for his encouragement and guidance.