Public Spending and Long-Run Growth in Practice: Concepts, Tools, and Evidence
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The theoretical effects of public spending composition on growth were explored subsequently by Devarajan, Swaroop, and Zou (1996). They consider several productive public inputs and show that the composition of public spending also affects the growth rate of the economy. Other papers extend the Barro (1990) framework in other ways, generally showing that the prediction that fiscal policy affects growth holds under a variety of different assumptions with respect to the characteristics of the economy and to the indirect effects of fiscal policy. Increasing empirical evidence suggests that in both developed and developing countries fiscal policy affects long-run growth, which broadly confirms the predictions of endogenous growth models with public finance. This literature provides some information for policy makers. Although most of this existing evidence is confined to cross-country growth studies that have been somewhat challenged by various papers,4 more recent studies that have resolved a number of econometric issues appear to be more robust, and few papers use subnational fiscal policy data from one country. Studies of this kind consider fiscal policy parameters as explanatory variables, in contrast to the large body of literature on the impact of the stock of public infrastructure on economic performance, which has been reviewed in detail by Romp and de Haan (2007) and Straub (2008) and which considers the stock of public capital as the central explanatory variable. From a policy perspective, it is essential to understand the level and composition of public expenditure that are conducive to growth or, alternatively, the type of public expenditure reforms that enhance growth. Despite the wealth of empirical evidence, however, it is often difficult to derive well-founded policy implications for policy makers. Fiscal policy is subject to inherent trade-offs as a result of the government budget constraint, which are difficult to evaluate in practice (as discussed further in the section later in this chapter on conceptual issues in estimating the growth effects of public expenditure reform). Finally, fiscal policy may be used to pursue several policy objectives simultaneously. In addition to long-run growth, these objectives include equity by redistributing income and stabilization (to smooth output along the business cycle) and inevitably lead to trade-offs. Following the discussion of conceptual issues, we review evidence from mostly aggregate-level cross-country and panel growth regressions. Whether a given parameter estimate is useful for predicting the effects of expenditure reforms from the point of view of a policy maker depends on several factors. First, it must be clear which fiscal change—including