Fiscal consolidation with a view on economic growth
Crisis-ridden European countries such as Spain or Italy are struggling to redress their public budgets. This has sparked a debate whether fiscal consolidation should be purely ‘thrift-based’ or also be ‘growth-based’. This present paper contributes to this debate by estimating the impact of the composition of public expenditure on economic growth in 25 OECD countries. In order to reduce their public-debt-to-GDP ratio governments are inclined to cut expenditure across the board. However, this may prove detrimental as some government expenditure can raise the productivity. For example, Alesina and Perotti (1997)[1] show that cutting expenditure on public capital may bring about a permanent adverse affect on growth. This present paper aims at highlighting the relevance of the composition of government expenditure to economic growth and shows how a reduction of productive public expenditure would affect economic growth and the unemployment rate in the long run. By doing so, this paper fills a gap in the recent literature as most of the debate revolves around the issue whether restrictive fiscal policies have an expansionary effect even in the short term. In contrast, it is a commonly shared view that fiscal consolidation should prove beneficial in the long run if it is of a structural nature (IMF, 2010)[2]. According to this view, expenditure cuts are more likely to promote economic growth than tax increases due to the distortionary effects of taxes. However, this position neglects that productive public expenditure may exert a beneficial impact on the growth potential of an economy. Moreover, in the field of macroeconomics only nonhigh-quality are usually available, which can cause the widely used least square estimators (LSE) to become biased and inefficient. Therefore, Zaman et al. (2001)[3] recommend applying robust statistical methods. This paper follows their proposal by introducing a robust pseudo-within estimator to estimating the impact of public expenditure on economic performance.
Data/ Methods
We carry out regressions with panel data from 25 OECD countries for the period from 1990 to 2010 and apply a fixed-effects model with a robust pseudo-within estimator. The database originates from the OECD National Accounts.
Conclusions
It is expected to show that cuts in productive public expenditure prove detrimental in terms of economic growth. Therefore, governments of crisis-ridden countries should take stock of this in their effort to reduce the public-debt-to-GDP ratio in the medium to long run. Rather than reducing public expenditure across the board, governments should seek to make the composition of government expenditure growth-friendly. Moreover, we expect to demonstrate that the view according to which tax hikes are less beneficial than reducing public expenditure in the long run cannot be upheld with respect to productive public expenditure.
[1] Alesina, A. and Perotti, R. (1997) Fiscal Adjustments in OECD countries: composition and macroeconomic effects, International Monetary Fund Stuff Papers, 44(2), pp. 210-28.
[2] IMF World Economic Outlook, October 2010, chapter 3.
[3] Zaman, A., Roouseeuw, P.J. and Orhan, M. (2001) Econometric applications of high-breakdown robust regression techniques, Economic Letters, 71, 1-8.