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Review Of Theories On Government Expenditure Economics Essay

The role of a government to economic growth is mostly depicted on through their choice of monetary and fiscal policies. Policies might not be always economic ones as in a multiracial country like Mauritius, socio-political stability is imperative for economic progress. The government should ensure that the populace stands “unity in diversity [1] ”. Our main focus will be on the government expenditure to find whether it contributes to economic growth. Little literature on public expenditure was present until the post-era 1929-30 Great Depression where economies underwent rising public expenditure. Subsequently, the post-war economic reconstruction and public welfare programmes grasp many economists’ interest on the study of public expenditure. A judicious theoretical approach on public expenditure was requisite. Adolf Wagner (1883, 1893), Alan T. Peacock and Jack Wiseman (1961), Robert Solow (1956), William G. Bowen (1965), Professor Arthur Cecil Pigou (1928) and Hough Dalton (1965) as well as the classical and Keynesian economists poured light on the nexus of government spending and national income. These theories’ outlook will be elucidated here, supplemented by several empirical research done by Meltzer and Richard (1981) and Persson and Tabellini (1990), Barro (1989a, b), Demirbas (1999), Henrekson (1993), James and Bradley (1996), Hondroyiannis and Papapetrou (1995), Bohl (1996), Payne and Ewing (1996), Lin (1995), Rati Ram (1986), Beck (1985), Mahmood and Sohrad (1992), Daniel Landau (1983) and Saunders (1988) .

2.2 Theories on government expenditure

2.2.1 Wagner’s Law

Wagner’s Law is named after the German political economist Adolph Wagner (1835-1917), who developed a “law of increasing state activity” after empirical analysis on Western Europe at the end of the 19th century. He argued that government growth is a function of increased industrialization and economic development. Wagner stated that during the industrialization process, as the real income per capita of a nation increases, the share of public expenditures in total expenditures increases. The law cited that “The advent of modern industrial society will result in increasing political pressure for social progress and increased allowance for social consideration by industry.”

Wagner (1893) designed three focal bases for the increased in state expenditure. Firstly, during industrialization process, public sector activity will replace private sector activity. State functions like administrative and protective functions will increase. Secondly, governments needed to provide cultural and welfare services like education, public health, old age pension or retirement insurance, food subsidy, natural disaster aid, environmental protection programs and other welfare functions. Thirdly, increased industrialization will bring out technological change and large firms that tend to monopolize. Governments will have to offset these effects by providing social and merit goods through budgetary means.

In his Finanzwissenschaft (1883) and Grundlegung der politischen Wissenschaft (1893), Adolf Wagner pointed out that public spending is an endogenous factor, which is determined by the growth of national income. Hence, it is national income that causes public expenditure. The Wagner’s Law tends to be a long-run phenomenon: the longer the time-series, the better the economic interpretations and statistical inferences. It was noted that these trends were to be realized after fifty to hundred years of modern industrial society [2] .

2.2.2 Peacock and Wiseman Theory of public expenditure

In 1961, Peacock and Wiseman elicited salient shaft of light about the nature of increase in public expenditure based on their study of public expenditure in England. Peacock and Wiseman (1967) suggested that the growth in public expenditure does not occur in the same way that Wagner theorized. Peacock and Wiseman choose the political propositions instead of the organic state where it is deemed that government like to spend money, people do not like increasing taxation and the population voting for ever-increasing social services.

There may be divergence of ideas about desirable public spending and limits of taxation but these can be narrowed by large-scale disturbances, such as major wars. According to Peacock and Wiseman, these disturbances will cause displacement effect, shifting public revenue and public expenditure to new levels. Government will fall short of revenue and there will be an upward revision of taxation. Initially, citizens will engender displeasure but later on, will accept the verdict in times of crisis. There will be a new level of “tax tolerance”. Individuals will now accept new taxation levels, previously thought to be intolerable. Furthermore, the public expect the state to heal up the economy and adjust to the new social ideas, or otherwise, there will be the inspection effect.

Peacock and Wiseman viewed the period of displacement as reducing barriers that protect local autonomy and increasing the concentration power over public expenditure to the Central government. During the process of public expenditure centralization, the role of state activities tend to grew larger and larger. This can be referred to the concentration process of increasing public sector activities.

Nowadays, the growth in public expenditure has become a compulsion and thus, the disturbance situations matter little.

2.2.3 The Classical v/s the Keynesian approach of public expenditure

The classical economists believe that the government intervention brings more harm than good to an economy and that the private sector should carry out most of the activities. In his Welfare of Nations, Adam Smith (1776) advocated much on the “laissez-faire” economy where the profit motive was to be the main cause of economic developments. According to the classical dichotomy, an increase in the total amount of money leads to a proportionate increase in all money prices, with no change in the allocation of resources or the level of real GDP, which is known as money neutrality. The classical economists assumed that the economy was perfect: it is always at full employment level, wage rate and rate of interest is self-adjusting and as a matter of fact, the budget should always balance as savings is always equal to investment. Since they believe that the economy was always at its full employment level, their objective was certainly not growth.

Following the 1929-30 Great Depression, the classical economists that opposed government interventions, argued that strong trade unions prevented wage flexibility which resulted in high unemployment. The Keynesians, on the other hand, favored government intervention to correct market failures. In 1936, John Maynard Keynes’ (1883-1946) “General Theory of Employment, Interest and Money”, criticized the classical economists to put too much emphasis on the long run. According to Keynes, “we are all dead in the long run”. Keynes believed depression needed government intervention as a short term cure. Increasing saving will not help but spending. Government will increase public spending giving individuals, purchasing power and producers will produce more, creating more employment. This is the multiplier effect that shows causality from public expenditure to national income.

Keynes categorized public expenditure as an exogenous variable that can generate economic growth instead of an endogenous phenomenon. Hereby, Keynes believed the role of the government to be crucial as it can avoid depression by increasing aggregate demand and thus, switching on the economy again by the multiplier effect. It is a tool that bring stability in the short run but this need to be done cautiously as too much of public expenditure lead to inflationary situations while too little of it leads to unemployment.

These can be demonstrated in figure 2.1 and figure 2.2. Keynes (1936) assumed in his model that nominal wages are rigid downwards and there is a time-lag in the market.

Price

AS

Price

AS

P’

AD’

AD’

AD

P

AD

Y’

Y

Output level

Y*

Y*

Output level

Figure 2.1 Figure 2.2

In figure 2.1, an increase in government expenditure will shift the aggregate demand curve from AD to AD’. However, this will only increase the price level from P to P’ (money neutrality) as the economy is already at the full employment level, Y*, as claimed by the classical economists. On the other side, the Keynesians model is depicted in figure 2.2 where an increase in public spending (AD to AD’) will make the employment level to increase (Y to Y’), moving towards full employment level (Y*). This theory of Keynes is rationale though it is only a short term solution.

2.2.4 Maximum Social Advantage

The politics of public expenditure have gained new dimensions, namely welfare maximization. The principle of maximum social advantage is derived from the principle of equi-marginal utility. The law states that a rationale individual will distribute his given money income on two or more goods in such a way, that the marginal utility of the last money spent on either good, is the same. This law is based on ceteris paribus conditions. This can be explained in figure 2.3 and figure 2.4 below:

Marginal Utility of Expenditure

Marginal Utility of Expenditure

A

E

F

B

0’

PE

G

H

C

D

0

PE

Figure 2.3 Figure 2.4

Figure 2.3 represents public spending on social goods like public parks, infrastructure and road lightening while figure 2.4 shows the government spending on merit goods like education and public health. Expenditure (PE) is on the horizontal axis and marginal utility on the vertical one. Initial amount of resources allocated to public parks is 0D while that of education is 0G. Then, transfer of resources from public parks to education (CD=GH) will increase aggregate utility because the area EFHG is larger than area ABCD. This is how equality in marginal utility from public expenditure in all direction will maximize social advantage.

Dalton’s Condition

According to Dalton, “public expenditure in every direction must be carried just so far that the advantage to the community of a further small increase in any direction is just balance by the disadvantage of a corresponding small increase in taxation and in receipts from any other source of public income. This gives the ideal of both public expenditure and public income”. Hereby, there will be a cycle where money collected from the public, directly or indirectly, will go back to them in the form of pubic expenditure programmes. During this process, taxpayers suffer those benefitting from these social welfare programmes gain. For the population to benefit from these continuous transfers of funds, sacrifice must be less than benefit. This is depicted in figure 2.5.

MSS

MSB

Marginal utility of Expenditure

E

Taxes and Expenditure

M

0

Figure 2.5

Herein figure 2.5, MSB represents the Marginal Social Benefit of government expenditure while MSS is the Marginal Social Sacrifice of the citizens in the form of taxation. At point E with a level of M taxation and government expenditure, there is maximum social advantage where MSB=MSS.

However, the practical significance of this doctrine depends upon how social welfare is to be measured. Dalton laid down the increase in production, equitable distribution of wealth, political and economic stability, full employment and sustainability of resources as standards of measurement for social welfare. This theory has some limitations. Measurement of variables like MSB and MSS are very difficult, public is not future-oriented due to present sacrifice and it is difficult to estimate burden of taxation.

Pigou’s Condition

In his Economics of Welfare, Professor A. C. Pigou (1932) divided welfare economics into two parts, namely, the production and the distribution. The pigou tax rate is used to internalize negative externalities and taxes are used as subsidy for positive externalities. According to Professor Pigou (1928), the condition of maximum social advantage is that situation in which, “Expenditure should be pushed in a direction to the point at which satisfaction obtained from the last shilling spent is equal to the satisfaction lost in respect of the last shilling paid as taxes to the government.”

Social cost- Social benefit

MSB-MSSThe theory is based upon two assumptions: rational consumers and the principle of equality between marginal social sacrifice and marginal social benefit. Pigou’s condition should lead the Net Social Benefit which is the difference between marginal social sacrifice (MSS) and marginal social benefit (MSB). These are diagrammatically shown below:

G

B1

C

NN

C1

F

D

Taxes and public expenditure

0

Net Social Benefit

MSS

MSB

E

Taxes and Expenditure

M

0

B

A

Figure 2.6 Figure 2.7

From figure 2.6, point E is the maximum point of net social benefit and M is the amount of government spending and taxes collected where MSB=MSC. This is as well depicted in figure 2.7 where the difference between curve B1 and C1 (CF) is the net social benefit, being the excess of marginal social benefit over marginal social cost. The difference is basically the curve N. It is noted that when output 0D is taxed and spent by the government, MSB=MSC. The government should stop operation at point 0D because beyond point D, the loss is greater than the gain since area 0DG represents the maximum social advantage.

Musgrave’s Condition

Dr. R. A. Musgrave has explained the maximum social advantage differently on diagrams. He believed that the situation of maximum social advantage can be achieved where net social benefit equals zero. In other words, the net social benefit is at maximum when MSB minus MSC equals zero. The Musgrave’s condition can be explained in figure 2.8 below:

MSB-MSC

M

MSB curve

E

Tax and public expenditure

N

NSB curve

MSS curve

0

Figure 2.8

Here, in figure 2.8, it can be noted down that the optimum point where the maximum social benefit lies is at point E where MSB=MSC and NM measures the net social benefit.

2.2.5 Bowen’s model of public expenditure

Figure 2.9

Unit PriceAn interesting point by Howard R. Bowen (1943) is that social goods are not equally available to all voters. According to him, since social goods are consumed by all individuals in a community, each of them needs to contribute for the social goods. But as Bowen rightly says, we must in the case of public goods add different individuals’ curves vertically. This is so because the capacity to enjoy the social goods is different for different individuals. Since each of them has different valuation of the social goods, we expect them to contribute different amounts. Hereby, the government will produce an amount of social goods equal to the marginal cost of supplying that good, to be equal to the marginal utilities received by the community. This can be explained in figure 2.9:

S

Unit of social goods

A

B

E

T

0

R

N

Q

Demand curve A and B is the demand schedule for individual A and B respectively while the curve T is the aggregate demand for both individuals and S is the supply curve of the social goods. T can also be taken for the demand curve of the whole community.

Equilibrium level of output is 0Q where the marginal social cost (S) equals the marginal social benefit (T) at point E. At 0Q, the marginal cost of producing social good X equals the revenue generated from individual A and B, which can be demonstrated by point QR and QN. The addition of these two should, therefore, be equal to the addition of marginal utility obtained from individual A and B by consuming social good X. Hence, this is the amount of social good that the public authority should produce which is 0Q.

2.2.6 Solow growth model

In his classic 1956 article, Robert Solow proposed the study of economic growth basing itself from a standard neoclassical production function. Neoclassical growth theory focuses mainly on capital accumulation and saving-related topics. Assuming there is no technological progress, this would imply that the economy has reached the steady-state equilibrium, where per capita income and capital are constant.

Solow found that the critical elements of GDP growth are technical progress, increased labor supply and capital accumulation. More profound research showed other factors as well to increase GDP growth: availability of natural resources and human capital. As a matter of fact, the income share of human capital is large in industrialized countries. Moreover, the result of high investment ratio (large physical capital stock) might as well increase the GDP growth. On the other hand, Solow residual is the change in total factor productivity which is technical progress. In other words, it means the amount by which output would increase as a result of improvements in methods of production, with all inputs unchanged.

2.3 Empirical Review

The role of government involves public spending in order to maximize social welfare and various attempts have been done to test whether these government expenditure contribute to the economic growth rate. Since the Wagner’s law suggests that economic growth should rise with increasing public spending, tests for Wagner’s law is also relevant.

Meltzer and Richard (1981) and Persson and Tabellini (1990) consider public choice to make the government distribute the social benefits. They explained the growth of government in the 18th and 19th century which increased the number of low income voters who push for more redistributive expenditures. In their model, they explained how the government embarked on satisfying the median voters which generate a relationship between economic growth and public spending if the position of the decisive voter shifts towards the lower end. When incomes of skilled labor increases, redistribution is needed.

Barro (1989a, b) based on the Summers-Heston data (1988) to have found from a sample of 98 countries for the period of 1960-85 that the growth in GDP per capita is positively related to initial human capital and to investment and negatively related to GDP per capita, political instability and price distortions. Barro (1990) in another distinguished paper states that the role of the fiscal policy (Government expenditure and taxes) along with the rate of economic growth has been part of the literature on endogenous growth that government spending directly affects the private production functions.

Demirbas (1999) investigated on the presence of the Wagner’s law using data for Turkey over the period of 1950-1996. His research focuses on the existence of a long-run relationship between public expenditure and the GNP. As a result, there was no link between these two variables. On the other hand, Anwar et al. (1996) examined the causality between economic growth and general government expenditures for 88 countries over the period of 1960-92 using unit root and cointegration techniques. They found unidirectional causality for 23 countries, bidirectional causality for 8 countries while only 23 countries attested that economic growth causes an increase in the role of the government to make it grow larger in size.

Henrekson (1993) carried out time-series analysis for Sweden using data for the period of 1861-1990 and he concluded that “we cannot find any long-run relationship between GDP and government expenditure and we judge it to be probable that this finding carries over to other countries as well”. Henrekson has tested the Wagner’s law using two-stage cointegration (Engle and Granger, 1987) and has found no support for it in the case of Sweden. Furthermore, in a very alluring paper, Henrekson (1993) questioned the validity of previous findings. He argued that before testing for causality between public spending and economic growth, one must make sure that the data for these variables are stationary. Otherwise, non-stationary variables will lead to spurious results.

James and Bradley (1996) extend the Henrekson’s methodology by using error-correction models to examine the Granger-Causality between government expenditure and economic growth. He found only 6 positive relationships between the two variables from a list of 22 countries. From the remaining countries, only one pointed out unidirectional causality and bi-directional causality.

Hondroyiannis and Papapetrou (1995) used the Johansen (1988) cointegration technique to test the long-run relationship between government spending and national income for Greece. As a result, no remarks were found to support the Wagner’s law, that is, the causality between government expenditure and rate of economic growth.

Bohl (1996) tested for evidence for Wagner’s law on G-7 countries using primarily post-World War II data. The data was integrated of order one. Except for Canada and UK, the other countries provided no evidence on any relationship between these two variables. When Granger causality was applied in these two countries, it was found that real per capita income Granger caused government size, thus, supporting the Wagner’s hypothesis.

Error-correction model was used by Payne and Ewing (1996) to test for Wagner’s law on a sample of 22 randomly selected countries. Evidence of Wagner’s Law is found only for Australia, Colombia, Germany, Malaysia, Pakistan and the Philippines. Bi-directional causality is found for India, Peru, Sweden, Switzerland, UK, U.S., and Venezuela, and Granger causality is absent in Chile, Finland, Greece, Honduras, Italy and Japan.

Lin (1995) reinvestigated Murthy (1993) and used data from Mexico for the period of 1950-80 and 1950-90. There was a mixed evidence to support Wagner’s law in the 1950-80 period and to reject it on the other period.

Ram (1987) reported that while some time-series studies support the Wagner’s hypothesis, cross-sectional studies lack such support. Nonetheless, Ram (1986) in a cross-sectional investigation found that government size has positive effect on economic performance and growth and this does apply to a vast number of countries. In another paper, Ram (1986) tested the Wagner’s law for 63 countries from time period of 1950 to 1980. It concluded as a multiplicity of results for different countries. In one of the countries analyzed, Mauritius was one of them and it was noted that Wagner’s law does not hold for Mauritius.

Beck (1985) measured government expenditure in real terms for the US to separate the price effect from the total government expenditure. It showed that nominal value of government expenditure might be misleading as it does not show the growth in government expenditure in volume. Beck (1981) noted that a more than proportional increase in government spending relative to GDP growth rates is generally a post-1945 phenomenon.

Mahmood and Sohrad (1992) study and tried to explain the rise in government expenditure at state level in the United States. Since, it is advocated by Wagner’s law that the income elasticity of demand for public goods is greater than one, that is, public goods and services are luxuries, it is postulated that the use of time series data and middle-income groups will be more consistent. This was done by proper regional representation and as a result it was proclaimed the income elasticity of demand for public goods is greater than unity.

Daniel Landau (1983) examines the relationship between the share of government consumption expenditure in GDP and the rate of growth of real per capita GDP by using data during the period of 1961-76 for a sample of 96 countries. The result of the study suggests a negative relationship between the two variables above mentioned. The negative link was because of the full sample of countries, unweighted or weighted by population, for all six periods examined.

Saunders (1988) in a very appealing paper set the factors behind the size and growth of public expenditure in OECD countries between 1960 and 1980. The framework of the model revealed that the growth in public expenditure is a function of economic, social and political interactions. Five variables were identified and found to be statistically significant to explain the growth of government spending. Following several additions and removal of variables, it was found that the growth of public expenditure is partly the cause of evolving demographic and economic nature. Moreover, social, historical and political influences’ on public spending is debatable.

2.4 Conclusion

Succeeding all the above theories, one can choose how to spend the government revenues optimally in order to maximize economic welfare and/or social welfare. The theoretical approach to public spending is likely to be based on the Wagner’s law. This theory was developed by Adolf Wagner and it gained significant importance so as several empirical researches is being performed on the Wagner’s law.

Now, we will move to the history of Mauritius, keeping in mind the theories of public expenditure.

Chapter Three

History of Mauritius

3.1 Introduction

Going back to the history of Mauritius provides us insights of how each internal and external factor contributed to its development. The island was visited by Swahili, Malay, Arabs (7th to 9th century) and Portuguese sailors [3] (early 16th century) [4] who did not stay long. When the Dutch arrived in 1598, they established the Dutch East India Company in 1638 and introduced the sugar cane in 1639. They extracted the ebony trees and famously made the dodo birds extinct before decamping for Cape Colony in 1710 leaving nothing useful but its name to the island. Eleven years later, the French Bertrand Mahe de Labourdonnais came into action, developing the island with sugar plantation and a port in Port-Louis [5] . The escalating sugar industry depended much on slavery [6] for the workforce. In 1814 the British took over the island [7] to use it only as a way station on the route of India and the Far East, leaving the Franco-Mauritians as the land-owning elite. Mauritius gained independence on the 12th March of 1968 and became a republic on the 12th March of 1992 [8] .

However, the Napoleonic code is still maintained in the Mauritian legal system, French [9] is still the dominant language, cars still drive on the left, the island’s Supreme Court is the Britain’s Privy Council and it can be noted down that the three languages that appear in the Mauritian money are English, Hindu and Tamil. These were the bequests that the Portuguese, French and British left to Mauritius.

3.2 Political History of Mauritius

Subsequent to the abolition of slavery in Mauritius in 1835, there was a lack of labor [10] and then, the “Great Experiment” was executed that proved to be successful. More than a half million indentured Indian laborers passed through the immigration depot at the dock called Aaprivasi Ghat [11] . In due course, the political rights were to equally spread among its citizens. Under the 1886 Constitution, a Creole elite was allowed to join the Franco-Mauritians to elect the national representatives while the extended one in 1948, allowed all adults who could write the franchise. Hereby, the Indian-dominated Labour Party won a majority of seats in the Legislative Council which was feared by the minority’s ethnic groups that there will be “Hindu hegemony.” The Mauritian Social Democratic Party (PMSD) composed of Creoles and Franco-Mauritians, lost election to the Hindu-dominated Labour Party in 1967. Since only about 55% voted for independence manifesto, tensions grew intense among ethnic groups such that there were riots and the Labour Party had to call for British troops to restore order in January 1968.

Mauritius gained independence in 12th March 1968, where the Mauritian Labour Party (MLP) nominated Sir Seewoosagur Ramgoolam (SSR) as Prime Minister who served for 14 years. From 1976 to 1982, the MLP was weakened by flaws of its new coalition partner, the PMSD. Afterwards, the country was taken over by Sir Anerood Jugnauth [12] (SAJ), leader of Mouvement Militant Mauricien (MMM) with an alliance to Harish Boodhoo’s Parti Socialiste Mauricien (PSM) in 1982. SAJ created its own political party, the Militant Socialist Movement (MSM) in 1983 after conflicts within MMM’s members to again win elections. SAJ continued serving as Prime Minister until 1995 where the son of the founding premier, Navin Ramgoolam (now leader of the Mauritian Labour Party-MLP) took over. SAJ returned to the office in 2000 with a coalition to MMM. In 2003, a Franco-Mauritian, Paul Bérenger, leader of MMM, became the fourth Prime minister following the resignation of SAJ who sworn to presidency where he is still serving. In 2005, the MLP won again and Navin Ramgoolam became Prime minister once again where he is still serving.

3.2 Economical History of Mauritius

As a matter of fact, the economy of Mauritius is well-credited to the Dutch who introduced the sugar cane to the island and the French who expanded the industry. Since then till the independence of Mauritius, the island remained a low-income agricultural-based economy, much dependent on sugar industry. It is quite interesting to examine how each of these political leaders coped with the internal and external world to make Mauritius what it is today, to be termed as the Mauritian Growth Miracle.

This was so termed as scope of progress was glum in the island due to its cynical traits. Tow Nobel Prize winners, James Meade (1961) and V.S. Naipaul (1972), prophesized pessimistic future for Mauritius.

It is going to be a great achievement if Mauritius can find productive employment for its population without a serious reduction in the existing standard living. Heavy population pressure must inevitably reduce real income per head below what it might otherwise be. That surely is bad enough in a community that is full of political conflict. But if in addition, in the absence of other remedies, it must lead either to unemployment (exacerbating the scramble for jobs between Indians and Creoles) or to even greater inequalities (stocking up still more the envy felt by the Indian and Creole underdog for the Franco-Mauritian top dog), the outlook for peaceful development is poor.

(Meade 1961)

The barracoon is overcrowded; the escape routes are closed. The people are disaffected and have no sense of danger.

(Naipaul 1972)


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