The impact of productive and non-productive government expenditure.

 

The impact of productive and non-productive government expenditure.

Abstract

This paper examines the relationship between the compositions of government expenditure and economic growth. It develops an endogenous growth framework drawing on variables from existing models, and separates government expenditure into productive and non-productive forms. Using panel data from 37 high-income and 22 low- to middle-income countries covering 1993–2012, our findings are based on OLS fixed effects and GMM techniques. We challenge much of the existing empirical literature in relation to developing economies by showing that a shift in government expenditure away from non-productive government expenditure and towards productive forms of expenditure are associated with higher levels of growth in both high-income and low- to middle-income economies. Moreover, we identify the differing components of government expenditure that are most associated with increased long-run output levels in both high-income and low- to middle-income economies.

Introduction

Recent studies on determining economic growth have been dominated by endogenous growth models (Cyrenne and Pandey 2015; Ghosh and Gregoriou 2008; Petrakos et al. 2007). In these models it is assumed that any policy encouraging factor input accumulation results in enhanced economic growth, thereby offering governments a broad range of effective growth policies. Beginning with Barro (1990) and King and Rebelo (1990), a number of papers have helped develop the analysis of public spending and growth, highlighting the effect of the compositions of government spending has on growth (Afonso and González Alegre 2011; Agénor and Neanidis 2011; Ghosh and Roy 2004; Fuente 1997; Monteiro and Turnovsky 2008). Researchers have differentiated between productive and non-productive government expenditure and have shown how a country can increase its economic growth by changing the mix between these alternative forms of expenditure. Kneller et al. (1999) underlined that productive government spending influences private sector productivity and hence has a direct impact on growth, while non-productive expenditure, which normally has an effect on citizens’ welfare, is likely to have a zero or negative growth impact. Devarajan et al. (1996) was one of the first to introduce a model that expresses the difference between productive and non-productive expenditures by how a change in the proportion of total expenditure dedicated to either one impacts on long-run economic growth. They stated that a country’s desire to reach a more optimal growth rate can be achieved by increasing the proportion of total government expenditure dedicated to productive areas.

If the theory linking various components of government expenditure to economic growth appears reasonably clear, the results from related empirical research are not, especially when distinguishing between the effects of changes in the absolute level of government expenditure and changes in relative amount of productive and non-productive expenditures. In term of absolute levels of expenditure compositions (as a share in GDP), empirical results have consistently reported a positive relationship between productive government expenditure and economic growth, and either a negative or no-impact relationship between non-productive expenditure and economic growth for high-income economies (Afonso and González Alegre 2011; Bleaney et al. 2001; Kneller et al. 1999). However, findings on the relationship between the level of public spending and economic growth in low- to middle-income economies are mixed. Gupta et al. (2005) used a panel of 39 low-income countries and found that productive government spending enhances growth, while non-productive expenditure fails to do so. Christie (2012) revealed an inverse relationship between productive government spending and real GDP per capita for developing economies. Regarding the relative division of total expenditure between productive and non-productive uses, Devarajan et al. (1996) found that diverting expenditure from productive to non-productive can promote economic growth by using 43 developing countries. They subsequently re-tested their regressions with a sample of 21 developed countries for the same period and found that the results are reversed. Ghosh and Gregoriou (2008) also found similar results with Devarajan et al. (1996) in 15 developing countries, where a greater proportion of current (non-productive) spending was found to have a positive effect on the growth rate. Given these inconsistencies in empirical findings, it is surprising that relatively little attention has been given to comparing and contrasting the impact of government expenditure composition on economic growth in countries at different stages of development.