Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

Public Debt, Public Spending & Economic Growth

Public Spending and Growth by Patrick Minford and Jiang Wang

L’endettement de l’Etat: stratégie de croissance ou myopie insouciante ? - Pierre Garello, Vesselina Spassova (french and english versions available)

Public Spending and Growth by Patrick Minford and Jiang Wang

Abstract: There is by now a huge and rapidly expanding- literature on ’endogenous growth’. In this literature certain ingredients ’enter the production function’- that is contribute to the generation of output- which are themselves enhanced in their effects by the extra output. Hence growth may enter a ’self-feeding’ phase when these elements are present or increased beyond a certain threshold. Such elements are said to include education or personal knowledge (’human capital’), public infrastructure and research and development. This view is often found to be associated with the advocacy of policies to increase public spending in ways that add to these elements. It seems fairly obvious after all that public spending can directly finance education, infrastructure and R&D.

If so, it is natural to argue that this will add to the stock of these desirable elements and so promote growth. On this view, to pay for this spending the tax rate will need to rise somewhat but the extra growth will itself raise revenue. The higher tax rates will not affect growth. We will call this the ’activist theory of development’. An alternative policy approach would not necessarily dispute the importance of the elements identified in the endogenous growth literature as mechanisms of growth transmission. Rather it would question whether these elements would have their effect in the absence of strong incentives for people to engage in entrepreneurial activity. Thus it is people who invest in their own (or their children’s) education and knowledge, who make use of infrastructure to produce goods and services, and who use research and development to innovate. It follows that the level of taxation- which is the main ingredient effecting personal incentives- will be the key determinant of growth. When it is high, however much is spent on education etc, it will not fructify in enterprise and growth; when it is low, moderate public spending on these elements can have a strong effect on growth. In this approach, it is not denied that basic public sector provision of ’public goods’ is necessary, rather that it should be restrained efficiently to enable the tax rate to remain low. Our later empirical work will review empirically just what this relationship looks like: we expect a rather nonlinear relation ship is expected, with growth little affected by rising tax rates at low levels but farmore heavily affected as the tax rate rises beyond these. We will call this policy approach ’the incentivist theory of development’.How might one test these two policy approaches to growth? The key idea that separates them is the effect of incentives on ’dynamic activity’- that is, on entrepreneurial decisions to invest and innovate. In the activist approach this effect is absent; taxation has incentive effects on allocation (the standard welfare effects on productive efficiency and consumer choice) but not on dynamism and not therefore on the production function or its contributing elements (beyond these allocation effects, eg on labour supply). In the incentivist approach, the dynamic effect is all-important (beyond a certain low threshold of taxation below which government barely functions); with it growth occurs, without it is does not- regardless of how much public spending is directed at education, infrastructure and R&D.

L’endettement de l’Etat: stratégie de croissance ou myopie insouciante ? - Pierre Garello, Vesselina Spassova

Abstract: Few will debate the proposition that the rate at which an economy grows has an impact on its debt and that, inversely, public debt impacts growth. Opinions among economists however start to diverge when dealing with the magnitude and direction of such impacts. To decide these questions macroeconomic modelling and econometrics have been often relied upon. Here, however, another path has been taken to approach study of the interactions between national debt and economic growth. Drawing a parallel with the case of a household economy, we believe—admittedly without great originality—that public debt can lead to greater or lesser public wealth depending on how the borrowed capital is used. For this reason we have decided to look first at the structure of public spending: What are the respective shares of consumption and investment expenditure? We will see that, in a country such as France, most public money is spent on consumption and little on investment, so that sound reasons exist for concern about an increasing public debt.

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