Government Consumption, Government Debt and Economic Growth
One sentence summary: The negative effects of government consumption on growth are relatively higher than those of government debt.
The corresponding paper by Shahrzad Ghourchian and Hakan Yilmazkuday has been accepted for publication at Review of Development Economics.
The working paper version is available here.
Abstract
This paper compares the effects of government consumption and government debt on economic growth by using data from 83 countries, including both developed and developing markets, over the period between 1960 and 2014. Linear regressions reveal that the negative effects of government consumption are relatively higher than the negative effects of government debt. A nonlinear investigation further suggests that the restrictions on government expenditure to prevent negative growth are shown to be more important for countries with lower trade openness, lower inflation, or higher financial depth, whereas the restrictions on government debt are shown to be more important for countries with higher trade openness, lower inflation or higher financial depth.
Non-technical Summary
The Great Recession of 2007-2009 has resulted in many governments bailing out their financial institutions and even providing finance for the real sector using government resources. Combined with the necessity of an expansionary fiscal policy due to the restricted monetary policy at the zero lower bound, many governments around the world started having problems regarding their budgets, and they eventually employed austerity measures, potentially at the cost of their economic growth. Influential studies have ignited the debate based on such budget problems and their impact on growth from a policy perspective by showing a negative correlation between government debt and growth for countries with debt above 90% (of GDP) for the post--World War II era.
Within this picture, though, the effects of government consumption/expenditure on growth have not been investigated and compared enough with those of government debt. While the latter may be effective on growth through the reductions in public saving, the former may affect growth through factor accumulation or influences on technical progress such as public research and development, the reductions in company profits and private investment, or organized interest groups attempting to gain benefits for themselves in the form of legislation or transfers. Such a comparison between government consumption and government debt is also important from the policy perspective; e.g., according to, Carlo Cottarelli, former Director of the Fiscal Affairs Department, IMF:
"Government debt remains very high in many advanced economies, and fiscal adjustment to bring debt down over the medium term is essential. Nearly all advanced economies plan to reduce their deficits this year. But if growth slows more than expected, some may feel inclined to preserve their short-term plans through additional tightening, even if hurts growth more. My bottom line for them: unless you have to, you shouldn't."
where he also emphasizes the importance of country-specific fiscal policies due to the economic characteristics of the countries. Accordingly, the debate is not only about the government debt itself but also about the short- and medium-term adjustments of fiscal policies, which we can be measured by government consumption/expenditure and/or tax revenues.
Based on the discussion so far, in this paper, we compare the effects of government consumption versus government debt on growth by using data from 83 countries over the period between 1960 and 2014, including both developed and developing markets. In order to connect our results to the existing studies, we first consider linear regressions that are supported by statistical tests regarding the potential issue of endogeneity. Such a linear investigation results in government consumption having a bigger reducing impact on growth compared to the negative effects of government debt. When the significant effects are compared, one standard deviation of an increase in government consumption (% of GDP) results in about 0.52% of a reduction in growth, whereas one standard deviation of an increase in government debt (% of GDP) results in about 0.33% of a reduction in growth.
We further investigate this contradiction by considering
nonlinear/threshold effects of government fiscal policies on growth.
Such nonlinear analyses show that the effects of both government
consumption and government debt on growth are highly affected by the
economic characteristics of the countries investigated. It is implied
that certain countries should pay more attention to their government
expenditure, while certain others should pay more attention to their
government debt, if they would like to prevent having negative economic
growth.
In terms of policy suggestions, it is implied that restrictions on government expenditure, rather than government debt, are relatively more important for faster growth. Based on nonlinear analyses, the restrictions on government expenditure (to prevent negative growth) are shown to be more important for countries with lower trade openness, lower inflation, or higher financial depth, whereas the restrictions on government debt are shown to be more important for countries with higher trade openness, lower inflation or higher financial depth. Therefore, certain countries should pay more attention to their government expenditure, while certain others should pay more attention to their government debt, if they would like to prevent having negative economic growth.
Overall, this paper contributes to the literature by (i) comparing the effects of government expenditure versus government debt, (ii) using a rich data set with much more countries and time coverage compared to the existing studies, (iii) considering nonlinearities in the relationship between growth and government expenditure/debt that are essential in the determination of country-specific policies.
In terms of policy suggestions, it is implied that restrictions on government expenditure, rather than government debt, are relatively more important for faster growth. Based on nonlinear analyses, the restrictions on government expenditure (to prevent negative growth) are shown to be more important for countries with lower trade openness, lower inflation, or higher financial depth, whereas the restrictions on government debt are shown to be more important for countries with higher trade openness, lower inflation or higher financial depth. Therefore, certain countries should pay more attention to their government expenditure, while certain others should pay more attention to their government debt, if they would like to prevent having negative economic growth.
Overall, this paper contributes to the literature by (i) comparing the effects of government expenditure versus government debt, (ii) using a rich data set with much more countries and time coverage compared to the existing studies, (iii) considering nonlinearities in the relationship between growth and government expenditure/debt that are essential in the determination of country-specific policies.