Relationship between public expenditures and economic growth in budget constraint

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Relationship between public expenditures
and economic growth in budget constraint
TRAN TRUNG KIEN
University of Economics HCMC –

Abstract
This paper investigates relationship between public expenditures and economic growth in
budget constraint. Public expenditures are divided into productive expenditure and unproductive
expenditure. The budget constraint is conditional on public debt and fiscal balance. Based on the
panel data of 66 developing countries in the period of 1998 -2106, the study find that fiscal surplus
enhances the growth effects of public unproductive expenditure and public productive expenditure,
while the growth effect of public debt is only significant in the case unproductive expenditure when
it exceeds 17.025% GDP.
Keywords: economic growth; public expenditure; budget constraint.

1. Introduction
Many theories explain the impact of public expenditure on economic growth. Wagner
law focuses on the causal link between public expenditure and growth (Al-Faris, 2002;
Bagdigen & Cetintas, 2003). As Keynesians say, public expenditure is a component of
growth equation (Keynes, 1937). Endogenous models consider public expenditure by the
extension of AK model (Barro, 1990; Devarajan, Swaroop, & Zou, 1996; Mankiw, Romer,
& Weil, 1992).
Empirical evidence has been still ambiguous. When some papers indicate the positive
effect of public expenditure on growth (Grier & Tullock, 1989; Holmes & Hutton, 1990;
Lin, 1994; Ram, 1995), others imply the opposite one (Easterly & Rebelo, 1993; Fölster &
Henrekson, 2001; Landau, 1985; Marlow, 1988; Tanninen, 1999). Meanwhile, some recent
studies conclude the nonlinear growth effects of public expenditure (Chen & Lee, 2005;

Abounoori & Nademi, 2010; Herath, 2012; Altunc & Aydin, 2013).
Explaining the heterogeneity of the empirical results, some scholars point out the
rationale of this one is the difference in public expenditure composition across the
countries (Bayraktar & Moreno-Dodson, 2015; Gemmell, Misch, & Moreno-Dodson, 2012;


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Martins & Veiga, 2014). A general increase in the scale of public expenditure leads to the
apprehensiveness that increasing public spending would hurt the economy, causing
negative externalities such as crowding-out effects, inefficient distribution. However, the
provision of public goods and public services like education, infrastructure and healthcare
system are necessary for economic growth (Martins & Veiga, 2014). Some studies
examining the growth effect of public expenditure with general measure often ignore
trade-offs effects of specific public expenditure components. If the budget constraint is
constant, an increase in a component of public expenditure must be offset by the decrease
in other public expenditure components (Gemmell et al., 2012; Martins & Veiga, 2014).
Besides the disparity of public expenditure composition, the state of budget constraint
is also a rationale of the difference in growth effect of public expenditure. As Gemmell et
al. (2012) explain, budget constraint plays an important role in examining the impact of
public expenditure on economic growth empirically because an increase in public
spending generally requires funding, usually from tax increases. However, the
government can not forever raise taxes. With limited resources, public expenditure
financing comes not only from tax increases but also from debt financing, so public debt
also plays an important role in the relationship between public expenditure and growth (
Zagler & Dürnecker, 2003).
In this study, we explore the role of public expenditure composition and budget
constraint in public expenditure and economic growth nexus in the case of developing
countries, both in linear and non-linear context. Following Martins and Veiga (2014),

there is a large difference between developed and developing countries, so we concentrate
on developing countries. As far as we’re concerned, there are few of studies examining
simultaneously the role of public expenditure components, fiscal balance and public debt
in public expenditure and economic growth nexus in developing countries, especially in
non-linear context.
This paper is designed as follows. Section 2 summarises the literature review on public
expenditure and growth nexus. The empirical models are presented in Sect. 3 and the
results are displayed and analysed in Sect.4. Finally, Sect.5 is the conclusion.
2. Literature review
Empirical studies researching on the relationship between public expenditure and
growth are developed in many ways. In general, based on research objectives, these
studies are able to be classified into three groups:


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Firstly, based on Wagner's Law, many studies aimed at exploring the causal
relationship between public expenditure and economic growth in different cases (Akitoby,
Clements, Gupta, & Inchauste, 2006; Bagdigen & Cetintas, 2003; Chang, Huang, & Yang,
2011; Devlin & Hansen, 2001; Erdil & Yetkiner, 2009; Ghorbani & Zarea, 2009; Huang,
2006; Islam, 2001; Lamartina & Zaghini, 2011; Magazzino, 2012; Wu, Tang, & Lin, 2010).
In particular, the most commonly used method is the Granger causality test for time series
and panel data. However, focusing on the causal link between public expenditure and
economic growth, the role of other growth factors as well as the interactions between
public expenditure and others have not been yet analysed thoroughly.
Secondly, some studies focus on analysing the short-term impact of public expenditure
on economic growth. These studies have also been developed in various ways, such as
analysing the impact of a shock of public expenditure on macroeconomic factors (Beetsma
& Giuliodori, 2011; Beetsma, Giuliodori, & Klaassen, 2008; Burriel et al., 2010; Ramey,

2011) or exploring the public expenditure multiplier in each case (Auerbach &
Gorodnichenko, 2014; Caldara & Kamps, 2008; Ramey & Zubairy, 2014). The empirical
methods used commonly in these studies are VAR methods for time series and panel data.
As usual, they use the Keynesian models to examine demand-side effects resulting from
price rigidities and credit-constrained consumers and analyse investment and
consumption responses explicitly (Gemmell et al., 2012). However, as Gemmell et al.
(2012) discussed, these studies don’t have a tendency to separate productive and
unproductive public expenditure: public expenditure isn't analysed as a component of the
production of private sector output, so one does not have an effect on the productivity of
private sector inputs. Consequently, its effect predicted by these models is determined
mainly from other transmission channels that make it difficult to explore the effect of
public expenditure components.
Thirdly, based on endogenous growth theory, many studies are concerned with the
effect of public expenditure on economic growth in the long-term. In the early period,
some studies explore this effect with general public expenditure measure (Agell, Lindh, &
Ohlsson, 1997; Bairam, 1990; Fölster & Henrekson, 1999; Ghali, 1999; P. Hansen, 1994;
Landau, 1985; Sattar, 1993; Sheehey, 1993). They usually ignore the difference in public
expenditure composition and the budget constraint so the empirical results are
controversial. Therefore, several recent papers focus on the role of public expenditure
composition or budget constraint in this nexus (Benos, 2009; Bleaney, Gemmell, &
Kneller, 2001; Bose, Haque, & Osborn, 2007; Fan, Yu, & Saurkar, 2008; Romero-Avila &


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Strauch, 2008; Teles & Mussolini, 2011). However, these empirical studies are mainly
implemented in the linear context.
3. Empirical model
As analysed, the empirical model of this study is based on Barro framework. In

extension, we categorise public expenditure into productive expenditure and
unproductive expenditure (Devarajan et al., 1996; Kneller, Bleaney, & Gemmell, 1999)
and analyse the role fiscal balance and public debt (Gemmell et al., 2012; Teles &
Mussolini, 2011) in the empirical model. In particular, productive expenditure is public
expenditure components used for education, health care, transport and communication
(Devarajan et al., 1996; Kneller, Bleaney, & Gemmell, 1999) and unproductive expenditure
is extant public expenditure components. Following Barro (1990), Mankiw et al. (1992)
Devarajan et al. (1996) and Cooray (2009), the basic empirical model like that:
d"#$%& = α)* + β. "#y)*0. + β1 "#k )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
η) + ε)*
(1)
ηi ~ i.i.d (0, ση ) ; εit ~ i.i.d (0, σε ) ; E(ηiεit ) = 0.
GPP per capita growth rate(dlny)* = lny)* − lny)*0. ) = The first difference of log of
GDP per capita in each country.
Private investment (lnkit) = Log of private investment to GDP in each
country.
Human capital (lnhit) = Log of human capital indicator
Productive expenditure (lng1) = Log of productive public expenditure components
(education, health care, transport and communication) to GDP.
Unproductive expenditure (lng2) = Log of other public expenditure components
(except for productive public expenditure components) to GDP.
Zit is a collective of control variables, such as public debt (dit) and trade openness
(tradeit). All of them are in logarithm. The choice of control variables is based on previous
papers (Aizenman, Pinto, & Radziwill, 2007; Baldwin, 2004; Checherita-Westphal &
Rother, 2012; Dowrick & Golley, 2004; Elmendorf & Mankiw, 1999; Grossman &
Helpman, 1992; Harrison, 1996; Jin, 2000; Rodríguez, 2006; Saint-Paul, 1992)
Similar to Teles and Mussolini (2011), we use interaction variables to examine the role
of fiscal balance (surplusit) and public debt (dit). Moreover, we include interaction

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variables not only between productive expenditure with fiscal balance and public debt but
also unproductive expenditure with ones:
d"#$%& = α)* + β. "#y)*0. + β1 "#k )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
β@ g.)* ∗ d)* + η) + ε)*
(2)
dln$%& = α)* + β. lny)*0. + β1 lnk )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
βB g.)* ∗ surplus)* + η) + ε)*
(3)
dln$%& = α)* + β. lny)*0. + β1 lnk )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
β@ g.)* ∗ d)* + βB g.)* ∗ surplus)* + η) + ε)*
(4)
d"#$%& = α)* + β. "#y)*0. + β1 lnk )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
βG g 1)* ∗ d)* + η) + ε)*
(5)
dln$%& = α)* + β. lny)*0. + β1 lnk )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
β.H g 1)* ∗ surplus)* + η) + ε)*
(6)
dln$%& = α)* + β. lny)*0. + β1 lnk )* + β3 "#h)* + β5 "#g.)* + β7 "#g 1)* + β8 Z)* +
βG g 1)* ∗ d)* + β.H g 1)* ∗ surplus)* + η) + ε)*
(7)
To estimate the proposed models, we use a panel data with the cross-section
dimension of up to 66 developing countries and the time dimension covering the period
1998-2016. The majority of data are collected from International Monetary Fund (IMF),
except for public expenditure components and human capital indicator. Public
expenditure components are gathered from Statistics on Public Expenditures for
Economic Development (SPEED) của International Food Policy Research Institute (IFPRI)
and human capital is from Penn World Table 9.0 (PWT 9.0) of Groningen Growth and

Development Centre- Groningen University.
Table 1
Descriptive statistics
Variable

Mean

Std. Dev

Min

Max

5151.858

7088.306

111.531

54484.3

22.972

7.277

1.729

51.335

2.311

0.546

1.140

3.390

Public debt (d)

52.793

59.989

2.69

789.333

Trade openess (trade)

78.483

40.753

0.167

321.632

Productive expenditure (g1)

6.609

3.621

0.181

20.681

GDP per capita (y)
Private investment (k)
Human capital (h)

Unproductive expenditure (g2)
Source: IMF (2017); PWT 9.0, IFPRI.

21.413

8.063

3.730

58.144


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We employ generalised method of moments (GMM) approach to estimate these
models in the case of 66 developing countries 1998-2016. Following Arellano and Bond
(1991), this approach may be useful to estimate a dynamic model from a panel data
consistently and efficiently. However, GMM approach requires careful consideration in

the selection of instruments and regressors in each equation. An equation may be overidentified, exactly identified or under-identified, depending on the numbers of
instruments. There is no instruction to decide how many instruments are suitable
(Roodman 2009). Roodman (2009) suggests a rule of thumb that instruments should
not be larger than the number of cross-sections. Therefore, this study implements
Arellano-Bond difference GMM as the difference GMM needs fewer instruments than
system GMM.
In addition, we apply the Hansen’s threshold estimation to examine the non-linear
growth effects of public expenditure components and explore the threshold values of
these public expenditure components. Although this approach is based on fixed-effect
estimation, a bootstrap technique with 500 replications is employed that makes the
empirical results more efficient. In extension, we use fixed-effect estimation to analyse
the role of fiscal balance and public debt in the public expenditure and economic growth
nexus in each threshold regime1.
4. Result
4.1.

In linear context

The empirical results of the model (1), (2), (3), (4), (5), (6) and (7) are respectively
presented in Table 1. The results show that the effects of most variables are similar to the
theoretical expectation. The negative effect of lnyt-1 reflects the convergence theory, the
poor countries have faster growth rate to catch up with the rich countries. Private
investment and human capital have positive effects on economic growth that reflects the
endogenous growth theory.
Meanwhile, trade openness, although the significance of its effect is not clear, has a
negative impact on economic growth. This result is similar to Yanikkaya (2003), also in
the case of developing countries. Yanikkaya (2003) points out trade barriers have the
positive impact on economic growth in developing countries. Explaining this result,

1

The GMM approach is ineficient because of the small number of cross-sections in each sub-group.


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Yanikkaya (2003) implies that trade barriers such as tariffs would help protect young
industries in developing countries as well as implement strategic trade policies.
Similar to Presbitero (2012); Bal and Rath (2014); Zouhaier and Fatma (2014), the
empirical results indicate a significant negative impact of public debt on economic growth
in developing countries. Presbitero (2012) argues that developing countries borrow and
use loans inefficiently that enhances the negative impact of public debt on investment and
causes more policy fluctuations. Moreover, in developing countries, the cost of overborrowing outweighs the benefit of having more resources.
Like previous studies, in this case, the productive expenditure components (education,
health care, transport and communication) have positive effects on economic growth
while unproductive components have the opposite effects (Barro, 1990; Devarajan et al.,
1996; Fan et al., 2008; Kneller et al., 1999). Barro’s model implies that an increase in
resources used for unproductive government spending is associated with lower economic
growth while productive government spending boosts economic growth. As Fan et al.
(2008) argue, developing countries should scale down their public expenditure in
unproductive sectors such as military, and reduce exaggerated subsidies in irrigation,
fertiliser, pesticides and energy.
Meanwhile, the interactions between public expenditure components and fiscal
balance have positive significant effects on economic growth. According to Teles and
Mussolini (2011), an increase in the productive public expenditure has a positive effect on
economic growth. However, the marginal effect of this one depends on the state of fiscal
balance. As productive expenditure rises in the context of large fiscal deficits, the
government is forced to borrow. Debt expansion has a negative impact reducing the
positive effect of productive expenditure on economic growth. Therefore, when the fiscal

deficit is small, it makes less the negative effect on the growth effect of productive
expenditure. Similarly, the empirical results imply that the level of fiscal deficit
exacerbates the negative effect of unproductive expenditure on economic growth.
Consequently, regardless of whether an increase in public expenditure is productive or
unproductive expenditure, the smaller the fiscal deficit is, the less the negative impact on
growth effect of public expenditure is created.
The empirical results indicate significant negative effects of the interaction between
public expenditure components and public debt on economic growth. The marginal
effects of public expenditure components on economic growth are affected by the size of
public debt. An increase in public spending leads to higher interest rates, while


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government pay interest on loans (Teles & Mussolini, 2011). Large interest payments
overwhelm government spending, so governments with large public debt tend to cut
spending on public investment in order to interest payments (Lora & Olivera, 2007;
Sturm, 2001).


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Table 2
The role of public expenditure components and budget constraint in public expenditure and economic growth nexus in developing
countries (1998 – 2016)
Variable

(1)

(2)

(3)

(4)

(5)

(6)

(7)

Lnyit-1

-0.7002***

-0.6750***

-0.6910***

-0.6962***

-0.7185***

-0.6440***

-0.7249***

Private investment (lnkit)

0.3999***

0.2388***

0.3312***

0.3569***

0.2823***

0.4539***

0.1827***

Human capital (lnkit)

4.9215***

4.5301***

4.2237***

4.3465***

4.6553***

4.4537***

4.3709***

-0.017

-0.010

-0.0395*

-0.0397**

-0.0285**

-0.015

-0.013

-0.1938***

-0.1308***

-0.0589**

-0.0777**

-0.0627*

-0.0873***

-0.0791**

0.0742**

0.1032**

0.0753*

0.0969*

0.044

0.1279***

0.0982***

-0.3973***

-0.3106***

-0.3116***

-0.2759***

-0.3149***

-0.3403***

-0.1060***

Trade openness (lntradeit)
Public debt (lndit)
Productive expenditure (lng1it)

Unproductive expenditure (lng2it)
Productive expenditure * Public debt

-0.0002*

Productive expenditure * fiscal balance

-0.0002***
0.0008***

0.0009***

Unproductive expenditure * Public debt

-0.0000**

Unproductive expenditure * fiscal balance

-0.0000**
0.0003***

0.0003***

Hansen test

0.122

0.200

0.121

0.174

0.185

0.124

0.179

Sargan test

0.348

0.572

0.521

0.490

0.401

0.494

0.837

AR(2) test

0.900

0.485

0.925

0.698

0.949

0.576

0.695

43

50

50

51

50

50

57

Number of instruments

*, **, and *** show the statistical significance at 1, 5, 10 % levels respectively.

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4.2.

In non-linear context

We examine the growth effects of public expenditure components in non-linear
context. The productive expenditure and unproductive expenditure are respectively
found at 2.838% GDP and 17.025% GDP. The empirical results are presented in Table 2.
Table 3
The effect of public expenditure on economic growth in developing countries in nonlinear context (1998-2016)
Variable

(1)

(2)

g1 ≤
2.838%
GDP

g1 > 2.838%
GDP

g2 ≤ 17.025%
GDP

g2 > 17.025%
GDP

Lnyit-1

-0.147***

-0.184***

-0.176***

-0.158***

Private investment (lnkit)

0.134***

0.097***

0.024

0.177***

Human capital (lnkit)

0.605***

1.066***

1.106***

0.969***

Trade openness (lntradeit)

-0.039***

-0.016

-0.019

0.004

Public debt (lndit)

-0.057***

-0.104***

-0.091***

-0.095***

Productive expenditure (lng1it)

-0.006**

0.042*

0.001

0.006

-0.057

-0.073***

0.040

-0.170***

Unproductive expenditure (lng2it)

*, **, and *** show the statistical significance at 1, 5, 10 % levels respectively.

In general, productive expenditure has a positive impact on economic growth.
However, if its scale is extremely small (g1 ≤ 2.838% GDP), productive expenditure is too
weak to support economic growth. Until it passes the threshold value (g1 > 2.838% GDP),
productive expenditure is large enough to have the positive effect on economic growth.
Meanwhile, unproductive is typically detrimental to economic growth. Nonetheless, its
negative effect is only significant when it is larger than the threshold value (g2 > 17.025%
GDP).
In addition, we explore the role of public expenditure components and budget
constraint in each threshold regime by adding suitable interaction variables. The results
are displayed in Table 3.






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Table 4
The role of public expenditure components and budget constraint in each threshold
regime (1998-2016)
Variable

(1)

(2)

g1 ≤ 2.838%
GDP

g1 > 2.838%
GDP

g2 ≤ 17.025%
GDP

g2 > 17.025%
GDP

-0.294***

-0.175***

-0.224***

-0.190***

0.089

0.101***

0.015

0.177***

Human capital (lnkit)

2.085***

1.028***

1.195***

1.335***

Trade openness (lntradeit)

-0.033**

-0.028

-0.112***

-0.008

Public debt (lndit)

-0.077**

-0.099***

-0.145***

-0.058***

Productive expenditure (lng1it)

-0.066

0.053**

0.000

0.025

Unproductive expenditure
(lng2it)

0.003

-0.041

0.083*

-0.080*

Productive expenditure * Public
debt

0.000

0.000

Productive expenditure * fiscal
balance

0.007***

0.001***

Unproductive expenditure *
Public debt

0.000

-0.000*

Unproductive expenditure *
fiscal balance

0.0005***

0.0002***

Lnyit-1
Private investment (lnkit)

*, **, and *** show the statistical significance at 1, 5, 10 % levels respectively.

The empirical results indicate the positive impact of fiscal balance on the adjustment
of the effect of public expenditure components on economic growth in developing
countries, regardless of the scale of these public expenditure components. Meanwhile, the
negative impact of public debt on the growth of public expenditure components is only
clear in the case unproductive expenditure exceeds 17.025% GDP.
5. Conclusions
Public expenditure composition and budget constraint play a significant role in
explaining the growth effect of public expenditure in developing countries. Public
expenditure components have other effects on economic growth. In particular, productive
expenditure generally supports economic growth while unproductive expenditure has the
opposite impact. Moreover, the growth effects of these public expenditure components


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depend on the state of fiscal balance and public debt. The smaller fiscal deficit and public
debt are, the less negative effects they affect on growth effects of these public expenditure
components.
Additionally, the public expenditure and economic growth nexus is analysed in nonlinear context. The threshold values of productive and unproductive expenditure are
respectively 2.838% GDP and 17.025% GDP. In extension, we explore the role of public
expenditure components and budget constraint in each threshold regime. Interestingly,
the empirical results show that the fiscal balance affects positively on growth effects of
public expenditure components regardless of the scale of these ones. Meanwhile, public
debt only has significant negative effect on the growth effect of public expenditure
components in the case unproductive expenditure exceeds 17.025% GDP.

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