How can fiscal policy help the economy grow: Evidence from OECD countries

Peripheral European countries have been struggling to redress their budget balances. Although some countries such as Spain see a sluggish recovery from the crisis mode, most of the crisis countries such as Spain and Portugal still breach the Stability and Growth Pact by surpassing the Maastricht deficit limit of 3% of GDP. In addition, the output of the peripheral European Union (EU) countries still remains considerably below its potential output. As a consequence, restoring economic growth has become a paramount issue for EU governments. This present paper shows that the composition of government expenditures is key to fostering economic growth in the long run. This paper fills a gap in the recent literature as most of the relevant literature focuses on short-term fiscal multipliers and does not take account of the functional decomposition of government expenditure. We decompose government expenditure by function and carry out an estimation for a panel dataset of 20 OECD countries for the time span from 1995 to 2013. So far crisis-ridden EU member states have adopted an austerity-driven fiscal policy in order to achieve sustainable public finances. This is based on the view that an expenditure-based fiscal policy can be expansionary even in the short run as it may restore confidence of investors and consumers in the sustainability of public finances. However, this present paper provides evidence that a purely expenditure-based fiscal consolidation fails to reignite economic growth. Moreover, in the field of macroeconomics only less than high quality data are usually available, which can cause the widely used least square estimators (LSE) to become biased and inefficient. Therefore, Zaman et al. (2001) recommend applying robust statistical methods. This paper follows their proposal by introducing a robust pseudo-within estimator to estimation of the impact of public expenditure on economic performance. We carry out regressions with panel data from 20 OECD countries for the period from 1995 to 2015 and apply a fixed-effects model with a robust pseudo-within estimator. The database originates from the OECD National Accounts. It is expected to show that austerity-driven fiscal policy proves 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.