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The Effect Of Government Expenditure Economics Essay

1656 words (7 pages) Essay in Economics

5/12/16 Economics Reference this

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Pakistan stood categorized in the sixties by high rates of growth and it was widely believed that this exclusive preoccupation with growth had resulted in concentration of income in a few rich families. It has been argued that the manufacturing sector received favorable treatment at the hands of government policy thereby redistributing income from agriculture to industrial sector through over-valued exchange rate for industrial Sector, provision of cheap credit, liberal import of capital goods at below equilibrium cost of capital. The relationship between government expenditure and economic growth has continued to generate series of debate among scholars. Government performs two functions- protection (and security) and provisions of certain public goods Protection function consist of the creation of rule of law and enforcement of property rights. This helps to minimize risks of criminality, protect life and property, and the nation from external aggression. Under the provisions of public goods are defense, roads, education, health, and power, to mention few. Some scholars argue that increase in government expenditure on socio-economic and physical infrastructures encourages economic growth. For example, government expenditure on health and education raises the productivity of labor and increase the growth of national output. Similarly, expenditure on infrastructure such as roads, communications, power, etc, reduces production costs, increases private sector investment and profitability of firms, thus fostering economic growth.

However, some scholars did not support the claim that increasing government expenditure promotes economic growth, instead they assert that higher government expenditure may slowdown overall performance of the economy. For instance, in an attempt to finance rising expenditure, government may increase taxes and/or borrowing. Higher income tax discourages individual from working for long hours or even searching for jobs. This in turn reduces income and aggregate demand. In the same vein, higher profit tax tends to increase production costs and reduce investment expenditure as well as profitability of firms. Moreover, if government increases borrowing (especially from the banks) in order to finance its expenditure, it will compete (crowds-out) away the private sector, thus reducing private investment.

Furthermore, in a bid to score cheap popularity and ensure that they continue to remain in power, politicians and governments officials sometimes increase expenditure and investment in unproductive projects or in goods that the private sector can produce more efficiently. Thus, government activity sometimes produces misallocation of resources and impedes the growth of national economy.

Public Finance is to provide information to all arms of government in other to provide useful data as done for the developed nations that transferred Pubic Finance technology to developing countries. However, the public finance technological transfer has not been used in developing countries to develop their economies. One of the assumptions might have been due to culture mingled with public finance information made available to policy makers. The realities have been x-rayed by public finance and practices. Thus, ID omen citied the following:

Economic growth represents the expansion of a country’s potential GDP or output.


1. Short run relationship between government expenditure and economic growth of Pakistan.

2. Long run relationship between government expenditure and economic growth of Pakistan.


Ranjan KD, Sharma C

Examined the effect of government development expenditure on economic growth during the period 1950-2007. The authors discovered a significant positive impact of government expenditure on economic growth. They also reported the existence of co integration among the variables.

Easterly and Rebelo (2009)

find that public investment in transport and communications in developing countries leads to higher economic growth.

Abdullah HA, 2000 analyzed the relationship between government expenditure and economic growth. The author reported that the size of government is very important in the performance of economy. He advised that government should increase its spending on

Infrastructure, social and economic activities. In addition, government should encourage and support the private sector to accelerate economic growth.

Ogiogio GO

Revealed a long-term relationship between government expenditure and economic growth. Moreover, the author’s findings showed that recurrent expenditure exerts more influence than capital expenditure on growth.

On empirical research using panel data, one can cite (among others) the papers by

Devarajan et al. (1996) – henceforth DSZ – and Gupta et al. (2005)

On the composition of government expenditure and growth for a sample of developing

countries. DSZ found a negative (positive) and significant relationship between the

capital (current) component of public expenditure and per capita real GDP growth for

43 countries over the period 1970-1990, while Gupta et al. (2005) found quite the

reverse for 39 countries between 1990 and 2000.

Lee et al. (2009), commenting on Islam (2009),

observe that slope heterogeneity, even when random, causes major difficulties for estimation in dynamic panels. They contend that potential heterogeneity in growth rates of different countries renders the standard fixed effects panel estimator to be biased.

Given the importance of slope heterogeneity as an econometric issue (see, among others,

Baltagi (1995), and Pesaran and Smith (1995),

we extend the methodology implemented by DSZ by explicitly modelling the potential cross-country heterogeneity in capital and current expenditure. The fixed effects panel estimator

used in DSZ assumes that all the slope coefficients, adjustment dynamics and error

variances are invariant across all countries. However, these assumptions are unlikely

to hold, because countries are not unanimous in their views on the role of government

expenditure in fostering growth, and this largely depends on the political stance of the

party in power. The importance assigned to capital and current expenditures, i.e., the

1 commitment to spend on viable long-term capital projects vis-a-vis the spending on

recurrent types of expenditure like wages and salaries, subsidies and pension arrangements, also vary across countries. The potential cross-country variations in the parameters of the level and composition of public expenditure are consequently modelled as a linear function of country-specific levels of current and capital spending in this paper.

Wagner says, (1999:46)

That there is a positive relationship between the per capital income of the citizens in a country with government spending such that the income elasticity of government expenditure is always greater than one. However, other researchers have discovered that the relationship is not always certain because there are periods when government expenditure in relations to the national income will decline when the elasticity of income to government expenditure is less than one.

Ram Rati (1986) concluded that overall impact of government size and government expenditures on growth is positive.

Rostow –

Musgrave model (1999:46) carried out a research on growth of public expenditure and concluded that, at the early stages of economic development, the rate of growth of public expenditure will be very high because government provides the basic infrastructural facilities (social overheads) and most of these projects are capital intensive, therefore, the spending of the government will

increase steadily. The investment in education, health, roads, electricity, water supply are necessities that can launch the economy from the practitioner stage to the take off stage of economic development, making government to spend and increasing amount with time in order to develop an egalitarian society. To illustrate, models with varieties of capital goods is related to technological process corresponds to an expansion of the number of capital goods, the production function

Barro’s (1979)

Tax-smoothing hypothesis says that, if the marginal cost of raising tax revenue is increasing the optimal tax rate is a martingale. This implies that changes in the tax rate will be permanent and, given their different effects on growth, under the two types of growth models, very useful in empirically distinguishing between the exogenous and endogenous models.


According to the Keynesian there is increase in government expenditure, the country will grow, holding other things constant.

Y = C + I + G+ (X-M )



I= Investment

(X-M)=Net exports


Data is collected on annual basis from the year 1972 to 2008 from various issues of economic survey of Pakistan and IFS (International Financial statistics) for GDP and government expenditure. That is converted into growth form.

Oxmatrics software is used for estimation.


Y=f (GE)

Where GE=Government expenditures

The model is specified as

Y=α+ β (GE) + µ


GE=Government expenditures

µ=error term

Y = GDP growth

5.Estimation technique:

Unit root Test:

Both series GDP and GE are unit root. AS ADF greater than critical value so we can further proceed for co integration.

Regression model:

After regression disequilibrium saved the residuals , further test the residuals for stationary , so the residual is stationary it means co integration is exist between GDP and government expenditures.

Unit root for disequilibrium:

As ADF is less than critical value so the series is stationary and co integration exists.


Now check the long run relationship between government expenditures and GDP growth by ECM.

This is error correction model

Dgdp = + 0.9029*DLgov – 0.8551*deq_1

So the value of dis equilibrium is negative and lies between 0 to 1 there exists long run relationship between two variables.

6. Policy implications:

The results suggest that the economic growth can be achieved by increasing government expenditures.

As we know that increase in government expenditures has also other implications for the economy and this study is limited in scope. So we suggest that government expenditures hike will increase GDP keeping other things constant.

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