While the empirical literature on the direction and magnitude of the impact of public spending on growth is mixed, there is growing evidence that, at the macroeconomic and microeconomic levels, public expenditure can impact development. Public investment focused on areas where there are market failures and public good externalities have a highly positive rate of return and yield benefits that substantially outweigh the costs. In contrast, poorly-implemented efforts in activities that are better suited to private activities can be counter-productive.
In the literature on growth, several empirical studies have focused on both the traditional and new channels through which different types of public spending can affect growth.2 A direct effect relates to an increase in the economy’s capital stock (physical or human) reflecting higher flows of public funds, especially when they are complementary to those privately financed. Public investment can also contribute to growth indirectly by increasing the marginal productivity of both publicly and privately supplied production factors. For example, public expenditure on agriculture research and development (R&D) can promote higher productivity by improving the interaction between physical and human capital production inputs. Other components of public spending, related for instance to the enforcement of land property rights, can also exert a positive indirect effect on growth by contributing to better use of existing assets. There is also growing evidence suggesting that, in developing countries, externalities associated with infrastructure public spending may be more important than commonly thought by having a sizable impact on human capital as well.
There are limits to the positive impact that public spending may have on growth. Regarding the total level of public spending, an implicit common result in recent empirical studies seems to support an inverse U-shaped relationship theory, according to which public spending may affect growth positively (after controlling for the negative effects associated with its financing) up to a certain point, above which additional spending may lead to negative growth as the needs for additional (and likely distortionary) financing increase. This caveat on the limits to government intervention should inform policy analysis regarding the likely impact of public spending on growth, as increasing the size of the budget beyond a certain threshold may be associated with efficiency losses.
Both the composition as well as the level of spending matter for growth. Regarding the composition of public spending, some items can trigger a complementary effect by either stimulating private spending or providing additional counterpart funding for growing private sector investments, such as safe roads, and reliable communications and energy supply. On the contrary, some other budget items can crowd out private spending, either by reducing incentives for private investors entering in a particular market or sector, or by triggering higher public deficits and accumulated public debt in need of financing, which reduces the credit available for the private sector and, in the long run, leads to higher interest rates.
Several empirical studies find that, whilst controlling formally for the government budget constraint, under certain fiscal policy conditions (for example, fiscal stability and a relatively small government budget size), at least some categories of public expenditures do exhibit positive growth effects.7 In particular some authors (Gemmel, 2007; Moreno-Dodson, 2008), provide empirical support for the view that in a developing country context, “productive” public expenditure triggers a growth-enhancing effect.
World Bank.Author: Armas,Enrique Blanco; Osorio, Camilo Gomez; Moreno-Dodson, Blanca; Abriningrum, Dwi Endah. Document Date: 2012/02/01. Document Type: Policy Research Working Paper.Report Number: WPS5977