The importance of public spending

The existence of long-term growth effects from public spending is hardly contested in policy discussions.

Growth literature that has emerged over the last 20 years supports the belief that public spending affects long-term growth.

First, standard growth models explaining total output level as a function of factor inputs (capital and labour), as well as the productivity through which these inputs are combined, have been extended by incorporating various elements of fiscal policy.

In particular, growth models assume that governments can raise taxes to finance various types of public expenditures that raise the marginal product of factor inputs in the output production process. This may, for instance, be motivated by the fact that private equipment, such as machinery and vehicles, can be employed more productively when public infrastructure is in place.

Other models embody additional transmission channels through which public spending affects aggregate private investment.

In neo-classical models, there are effects on growth only for a transitional period, as the economy moves to its new level of output — though the length of this transition remains subject to debate and may last a long time.

In addition, empirical evidence increasingly suggests that, in both developed and developing countries, fiscal policy affects long-term growth.

Finally, there is strand of the growth literature that identifies more fundamental determinants of growth.

This literature has identified three deep determinants of growth. These include trade, institutions and geography.

Here, anecdotal evidence also suggests that many of these factors and their effects are influenced by public expenditure. Poor geography may at least partially be overcome through, for example, public spending on better infrastructure links, public-health programs and agricultural research.

The quality of institutions also depends on public services such as the judiciary and public administration, which are both, at least partially, financed through public spending.

Further, trade costs are influenced by the level and quality of publicly financed services, partially or totally, such as customs, trade logistics and transport links.

From a policy perspective, it is essential to understand what types of public spending allocations promote long-run growth in a particular country setting.

However, this is easier said than done.

Given that fiscal policy is subject to inherent trade-offs that arise in part due to government budget constraints, which are difficult to evaluate.

The fundamental property of government budget constraint is that, like any other identity, it requires every fiscal change to be offset by a compensating change. Increases in a certain category of public spending must be financed by increases in tax revenue, in the deficit, or in the level of grants.

Otherwise, other types of spending would have to be lowered, or the off-setting mechanism could be a combination of some or all those elements. The net effects of any fiscal change on growth therefore depend on the way it is off-set.

The direct and indirect growth effects of the off-setting element may have similar or opposite signs. In addition, the growth effects of alternative offsetting changes are likely to differ in magnitude and time horizon.

Since not all types of public spending have the same level of importance, increasing certain public-spending types at the expense of others, affects long-term growth.

Therefore, the relative productivity of different public expenditure categories is critical for policy makers to determine the composition of public spending. To this end, policy analysis sometimes distinguishes between capital and current government spending to predict the growth effects of public spending.

Underlying this categorisation is the belief that capital spending leads to the accumulation of public capital and therefore to higher economic growth, whereas current or consumptive spending affects, at best, welfare, while being growth neutral, or in a more pessimistic scenario, is growth inhibiting and may not even affect welfare.

However, this approach is being increasingly questioned by economic research.

In models of growth and public finance, the growth effects of public spending depend on whether the particular types of public spending affect the productivity of labour and private capital, and on the magnitude of these effects.

In other words, whether public spending results in the accumulation of public capital is less relevant. Rather, through affecting private productivity, certain types of public spending potentially raise the returns to investment and thereby the rate of total (private and public) capital accumulation.

It is the latter transmission channel that is essential to understand the effects of public spending on growth. Further, alternative approaches emphasise that it is essential to consider capital and current expenditures together, given the fact that they usually have a joint effect on growth and that their distinction is often mechanical and artificial in practice.

Given the government budget constraint, the effects of increasing the overall level of public spending on growth are ambiguous.

During economic downturns, governments may increase public spending as a means of stabilising aggregate demand.

Ideally, stimulus packages meet both the objectives of short-run output stabilisation and long-run growth promotion, but, in practice, numerous trade-offs arise.

The objective of short-run stabilisation often dictates that any public investment projects financed be labour intensive and able to be quickly implemented.

By contrast, large and complex investment projects (such as major roads, railways or electricity generation facilities), which are often required to remove bottlenecks for growth, are more likely to be subject to long implementation lags and may be less labour intensive, and therefore less attractive as stimulus plans.