Discussion Paper No. 107 of 2010 on Are Prior Restrictions on Factor Shares Appropriate in Economic Growth Accounting Estimations?

Abstract

Several studies make different prior assumptions on the magnitude of factor shares and scale of production when accounting for economic growth. The initial Solow estimations, for instance, assumed a capital share of 0.3 and constant returns to scale. Most authors have subsequently used the same restrictions just because they were used in previous studies, even when production in the countries under study may not necessarily be taking place under constant returns to scale, and capital share may be a value not any close to 0.3. This is likely to distort growth accounting estimation results. This study investigates whether these prior restrictions on factor shares and scale of production as commonly used in the literature are appropriate. The paper also examines whether there is any change in the explanatory power of the model when the Solow Model is augmented with human capital accumulation. An improvement in the explanatory power of the model after augmentation may be indicative of misspecification of the classical Solow model. Policy advice from a mispecified model results may, therefore, be misleading. Using Kenyan data and structural vector autoregressions, the main observations from the results are: first, in all cases of the unrestricted estimations, the share of physical capital is less than 0.1, which is less than the commonly used 0.3. An estimation that imposes 0.3 as the share of physical capital in this case would therefore not be in line with the data generating process, leading to biased results. Secondly, in all cases, the explanatory power of the model decreases when restrictions on factor shares are imposed. The findings also show that augmenting the Solow model with human capital accumulation improves the explanatory power of the model. In addition, the results show that restrictions on factor shares grossly underestimate the contribution of the factors to economic growth, while exaggerating the contribution of own shocks.