Does the Composition of Government Expenditure Matter for Long‐Run GDP Levels?

DOIhttp://doi.org/10.1111/obes.12121
Published date01 August 2016
Date01 August 2016
522
©2015 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 78, 4 (2016) 0305–9049
doi: 10.1111/obes.12121
Does the Composition of Government Expenditure
Matter for Long-Run GDP Levels?
Norman Gemmell, Richard Kneller‡ and Ismael Sanz§
Victoria Business School, Victoria University of Wellington, Wellington, New Zealand
(e-mail: norman.gemmell@vuw.ac.nz)
School of Economics, University of Nottingham, Nottingham, UK
(e-mail: richard.kneller@nottingham.ac.uk)
§Universidad Rey Juan Carlos, Madrid, Spain (e-mail: ismael.sanz@urjc.es)
Abstract
We examine the long-run GDP impacts of changes in total government expenditure and
in the shares of different spending categories for a sample of OECD countries since the
1970s, taking account of methods of financing expenditure changes and possible endo-
genous relationships. We provide more systematic empirical evidence than available hith-
erto for OECD countries, obtaining strong evidence that reallocating total spending towards
infrastructure and education is positive for long-run output levels. Reallocating spending
towards social welfare (and away from all other expenditure categories pro-rata) may be
associated with modest negative effects on output in the long run.
I. Introduction
The fiscal stimulus packages enacted in many countries from 2009 onwards to combat the
global economic crisis typically included changes in various public expenditure programs.
Much debate surrounded the merits of these fiscal packages, not least with respect to the
wisdom of governments’ attempts, and ability, to stimulate the economy via expenditure
injections. The specific public spending choices in these short-term fiscal packages were
motivated in part by a desire to be consistent with long-term growth objectives, such as
expanding infrastructure spending perceived as benefiting long-run GDP levels or growth
rates. The austerity programs that havebeen used since then to deal with the resulting high
levels of public debt haveled to the same debates but from the opposite side; which types of
expenditure should be cut and what are the longer term growth effects from doing so.This
brings to the fore the twin questions: how strong is the evidencethat long-r un income levels
or growth rates respond to public expenditure changes, and which expenditure categories
have greatest impact?
JEL Classification numbers: H50; O40
Public expenditure and GDP growth 523
This paper focuses on these two questions. We first briefly review the relevant theory.
This builds on Barro (1990) and Devarajan, Swaroop and Zou (1996) who proposed that
some ‘productive’public expenditures can influence long-run growth rates via public sector
inputs in private production functions. Following a brief discussion of the existing evidence
on long-run public expenditure-output relationships, we providemore systematic empirical
evidence than available hitherto for OECD countries.1
In addition to the above political economymotivations, there are a number of academic
reasons to re-examine this issue. Firstly, most empirical studies focus on a subset of indi-
vidual expenditure categories, such as defence, education or transport and communication
expenditures. These have produced a mixed set of findings and do not typically allow the
trade-offs between different forms of public expenditure to be identified explicitly. Our
approach provides evidence on these trade-offs.
Secondly, a number of recent papers have used alternative methodologies to examine
long-run impacts of tax policy on GDP levels or growth rates (seeAdam and Bevan, 2005;
Lee and Gordon, 2005; Romero-Avila and Strauch, 2008;Arnold et al., 2011; Gemmell,
Kneller and Sanz, 2011, 2015). However, public expenditure is rarely the primary focus of
attention in these studies, or it is tested as an aggregate ‘productive’ spending category. In
this paper, we limit attention to potential effects of public expenditures on long-run GDP
levels, focusing both on total public expenditure (suitably financed via the government
budget constraint) and specific functional spending categories.
Thirdly, dealing with endogeneity associated with estimates of fiscal impacts on GDP
has proved difficult in previous studies. While we do not claim to have resolved these
concerns in this paper, we do carefully address potential endogeneity problems. Our fiscal
variables would appear to be at least ‘weakly exogenous’ (based on standard econometric
definitions, see Johansen, 1992, and Boswijk, 1995) with respect to their estimated effects
on GDP.
Fourthly, use of panel data methods has increased the reliability of recent studies.
However, these generally use fixedeffects estimators which impose parameter homogeneity
across countries. Furthermore, as Haque’s (2004) re-examination of the Devarajan et al.
(1996) results shows, how the time-series properties of the data are handled can be crucial
for estimated output effects of fiscal variables.
In this paper, access to an extended panel dataset with a longer time dimension than
previous studies has permitted application of the more flexible Pooled Mean Group (PMG)
estimator proposed by Pesaran, Shin and Smith (1999). This enables us to explore both
short-run dynamics and long-run equilibrium relationships among the variables of inter-
est, and account for heterogeneity across countries in their short-run dynamic relation-
ships. We compare these results with those obtained using more restrictive dynamic fixed
effects (DFE) methods, and the more flexible, but data-intensive, Mean Group (MG)
approach.
These improvementsprovide more robust evidence on the potential long-run association
and causation between public spending and GDP. This supports some traditional views,
such as that a spending reallocation towards infrastructure and education spending (and
1Weabstract from the question of whether there are short-r un benefits from stimulus packages, analysisof which
requires quite different empirical methodologies.
©2015 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd

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