Government Spending Research Paper

Government Spending and Budget Deficits in the Industrial Economies

Nouriel Roubini, Jeffrey Sachs

NBER Working Paper No. 2919
Issued in April 1989
NBER Program(s):International Trade and Investment, International Finance and Macroeconomics

In this paper, we try to interpret several important trends in the size of governments and government deficits in the OECD economies : the rapid increase in the public spending to GDP ratio in the 1970s; the sharp rise in budget deficits and in debt-GNP ratios after 1973; and the early signs of a slowdown or reversal in the rise of the spending ratios in the 1980s. We show that the rise in size of the government was importantly associated with the slowdown in output growth after 1973, as well as with the gradual adjustment of spending ratios to long-run values. These long-run values appear to depend on the political and institutional characteristics of the various economies (the ideological orientation of the government, the degree of wage indexation, and the average number of parties in the governing coalitions). As for budget deficits, we argue that much can be explained by normal cyclical factors (the slowdown in growth and the rise in unemployment after 1973), but that in addition, the size of the budget deficits has been related to political as well as economic characteristics of the countries. Deficit reduction requires political consensus, at least among the parties belonging to the governing coalition. We note that such consensus is harder to achieve in multi-party coalition governments and that the failure to reach a consensus on budget cutting can help to explain why countries with multi-party coalition governments have experienced particularly large increases in the debt-GNP ratio.

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Document Object Identifier (DOI): 10.3386/w2919

Published: Economic Policy, No. 8, April 1989

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Economic growth is driven by new ideas, by discoveries that result in better products and more efficient production technologies.

Human capital is the engine of this process: a better educated labour force increases the return on research and development and ensures that discoveries are more readily absorbed in the productive structure of the economy. In the end, more education equals more economic growth.

Or so goes the theory.

In practice, researchers and policymakers have often questioned the effective aggregate return of spending on education.

Simply put, the question is: does government spending on education promote economic growth?

Some stylised facts

Using data available from The World Bank’s World Development Indicators (WDI) database, it is possible to estimate the bivariate relationship between government education expenditure and GDP across a large sample of countries.

The estimates show that for every dollar the government spends on education, GDP grows on average by $20.

When the estimate is run for Australia only, the multiplier is slightly higher: an extra $1 of education expenditure increases Australian GDP by $21.

While intuitively appealing, these results raise some questions. An obvious concern is that a country with a larger GDP must also spend more on education. This introduces the risk of reverse causality; that is, the model might pick the effect of GDP size on education expenditure and not vice-versa.

The graph below somewhat addresses this limitation.

In the chart, GDP is measured by its rate of annual growth between 2000 and 2010 and education expenditure is measured as a share of total GDP over the period 1990-99. This time lag reduces the risk of reverse causality.

The dots indicate combinations of education expenditure and GDP growth for each of 151 countries for which data are available from the WDI.

The red line provides the best statistical approximation of the bi-dimensional scatter plot. The positive slope indicates that countries that spent more on education as a proportion of GDP in 1990-99 experienced faster growth in the subsequent decade.

More precisely, an increase in education expenditure by 1 point of GDP (eg from 4.5% to 5.5%) increases GDP growth by 0.9 percentage points (eg from 4.5% to 5.4%).

What do academics have to say about this?

A lot of research has been devoted to the analysis of the effects of education on economic growth.

Academic research in this area is characterised by a certain degree of technical complexity and results often differ across studies depending on the methodology used, the sample considered, or how education is measured.

A survey of this vast literature identified 57 studies, many of which measure education in terms of outcomes (eg enrolment rates, literacy rates, years of schooling in the workforce) rather than expenditure.

But the studies that did look at educational expenditure as a proxy for education generally reported a positive effect of education on growth.

A recent a meta-analysis considered 29 papers that specifically look at the impact of government education expenditures on economic growth. Of these 29 studies, 14 report a positive and statistically significant effect of government expenditure on growth, 12 report a negative effect, and 3 report no statistically significant effect.

Averaging across all studies, the effect of educational expenditure on growth is positive - albeit modest - in the order of a 0.2-0.3% increase in growth for an increase in expenditure by 1% of GDP.

All these studies typically look at the direct effect of educational expenditure on growth. However, if education outcomes affect growth, and educational expenditure affects education outcomes, then expenditure also has an indirect effect on growth.

Recent estimates that use US data suggest that this indirect effect can be large: a 10% increase in per-pupil spending each year for 12 grades of public school was found to lead to 0.27 more completed years of education, 7.25% higher wages and 3.67 percentage point reduction in the annual incidence of adult poverty.

An important aspect that only recently has been addressed by some studies is the one of “quality” of education, as measured for instance by test scores.

One such study uses international student achievement tests to construct a measure of cognitive skills that ranges from 3 to 5.5. It reports that an increase in this measure by 0.6 is associated with a two percentage point higher average annual growth rate in GDP per capita across 40 years.

The question is then how to produce quality education. The authors of this study consider some of the drivers of test scores, but do not include education expenditure in their analysis. This represents an interesting avenue of future research.

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