Fiscal policy and long-term growth

Fiscal policy can play a significant role in economic growth. In the short term, counter-cyclical fiscal expansion can help support aggregate demand and growth during cyclical downturns. Conversely, fiscal contraction can cool down an economy that is growing at an unsustainable pace and thus faces the risk of overheating. Advanced economies in particular have a long history of using taxes and government spending to smooth the business cycle. At the same time, fiscal policy can also have a major impact on medium- and long-term economic growth. This is especially true in developing economies where the private sector is relatively weak and underdeveloped. Public spending on physical infrastructure, such as roads, ports, and power plants, affects the productivity of all firms and industries, and the entire economy. Likewise, public spending on education fosters human capital, a vital ingredient to long-term growth. Taxes can harm growth because they distort economic incentives and behavior; for example, corporate income taxes have a negative impact on investment. But generally, different taxes vary in the extent of their distortionary impacts.

Endogenous growth theory provides the analytical framework for studying the effects of fiscal policy on long-run growth. In contrast to neoclassical growth theory, in which policy can only have a transitory effect on growth since long-term growth is driven by exogenous and policy-invariant factors, endogenous growth theory provides a framework to analyze how government policy can affect long-term growth

The analysis performed within the paper is based on a dynamic model with discrete variables, on an infinite horizon. The optimality conditions are derived by applying Pontryagin’s Maximum Principle, adapted for discrete systems. On the basis of the optimality conditions, we highlight the existence of a solution for an optimal policy and a growing equilibrium path.

Using statistical data for Romania and other Central and Eastern European countries, our paper investigates the relationship between the composition of public expenditure and economic growth. Using the model, we derive conditions under which a change in the mix of public spending could lead to a higher steady-state growth rate for the economy. The conditions depend not just on the physical productivity of different components of public spending, but also on the shares of government expenditure allocated to them. Based on the model, our empirical results suggest that expenditures, which are normally considered productive, could become unproductive if there is an excessive amount of them.