Introduction to Public Finance Lecture 5 Public sector

Introduction to Public Finance Lecture 5: Public sector and economic growth. The impact of public sector on economy. Welfare state, savings and economic growth. 1

The impact of public sector on economy Public expenditure plays four main roles (from the previous lecture): 1. it contributes to current effective demand; 2. it expresses a coordinated impulse on the economy, which can be used for stabilization, business cycle inversion, and growth purposes; 3. it increases the public endowment of goods for everybody; 4. it gives rise to positive externalities to economy and society, the more so through its capital component. The question is how does it influence economics? 2

The impact of public sector on economy Forms of governmental intervention: 1. Public production - Distribution, - Supply with prices below the production costs, - Supply with prices equal to costs. 2. Private production - Public subsidies for/taxes on producers, - Public subsidies for/taxes on consumers, - Direct distribution by the public sector, - Regulations. 3

The impact of public sector on economy Negative effects: • Government expenditure often involves unforeseen costs. • Government spending often distorts allocation of resources. • Government expenditures require taxes and/ or borrowing that burdens the economy. • Government expenditures lack key elements of entrepreneurship that contribute to economic growth. • Growth in government expenditures to noncore activities often involves redistribution of income or protectionism. 4

The impact of public sector on economy Positive effects: • Government can help in solving the problem of negative externalities. • Government provides goods, which would not be otherwise supplied. • Government protects the institutional framework of the society and punishes deviations. • Government lowers the risk of economic activities. • Government keeps poor people alive. 5

The impact of public sector on economy Ambiguous effects: • Crowding-out of private actions. • Government’s actions lead to substitution and income effects (the substitution effect is usually the source of inefficiency of these actions). • Capitalization of benefits of a public action – possible shift in the allocation of benefits. • Intertemporal distribution of effects. • Changes in the political mechanism. 6

Public expenditure and economic growth Robert Barro found that “the ratio of real government consumption expenditure to real GDP had a negative association with growth and investment. ” Gwartney, Holcombe, and Lawson examined the three instances of substantially reduced government expenditures among the OECD countries between 1960 - 1996: • Ireland from 1986 -1996, • New Zealand from 1992 - 1996, • United Kingdom from 1982 - 1989. In each case, the reduction in government expenditures led to periods of substantially improved 7 growth.

Public expenditure and economic growth Milton Friedman observed that “Government has an essential role to play in a free and open society. Its average contribution is positive; but I believe that the marginal contribution of going from 15% of the national income to 50% has been negative. ” Georgios Karras 1996 noted that “the optimal government size is 23 percent for the average country but ranges from 14 percent for the average OECD country to 33 percent in South America; and the marginal productivity of government services is negatively related to government size. ” 8

Public expenditure and economic growth Vito Tanzi and Ludger Schuknecht (1997) undermine the arguments of those who use social improvements to justify increased government expenditure. They found that: • „Higher spending on social programs has not improved critical social indicators such as life expectancy, infant mortality, or school enrollment, suggesting that increases in public spending are not necessarily productive beyond a certain level…” • „…Government spending needs to be no higher than 30 percent of GDP to achieve socially desirable goals. . . ” 9

Public expenditure and economic growth Two general principles on the size of government expenditure and its impact on economic growth. First, some level of government spending is necessary to ensure that the basic structures of society function smoothly enough to facilitate economic activity. Second, excessive government spending shifts resources from the private sector and impedes economic growth. 10

Public expenditure and economic growth Different government programs may affect growth in many ways (examples): 1. Education – increases individual endowment, raises productivity and leads to technological progress effects on growth in the long run. 2. Infrastructure – facilitates development, improves transition of goods, services and technologies. 3. Health care – increases productivity, extends working careers. 4. Public safety and legal system – creates the institutional framework in which economy is operating, reduces uncertainty. However, the effects of these programs on growth are not 11 always positive.

Welfare state, savings and economic growth There is a positive statistical correlation between economic performance indicators and the size of the welfare state. Problems with causality: 1. Higher welfare spending may lead to higher national income. 2. Richer countries can afford a more generous social security system. or 3. The relation is not direct and both phenomena may be connected through a third mechanism, like e. g. industrialization. 12

Welfare state, savings and economic growth Levels hypothesis: There is a relation between the size of the welfare state and the level of GDP. Growth rate hypothesis: There is a relation between the size of the welfare state and the rate of growth of GDP. However, we cannot say with certainty which hypothesis is true. There are many processes which can influence economic performance and it is very difficult to control for all of them. 13

Welfare state, savings and economic growth Simple growth model (Solow): Y = A KβL 1 -β where Y is GDP, K – capital, L – labor and A is the level of productivity. Then growth rate of GDP = β*growth rate of capital + (1β)*growth rate of labor + rate of technological progress. The sources for growth in the Solow model are: - capital accumulation, - population growth, - technological progress. 14

Welfare state, savings and economic growth Even in such a simple model we can see that the existence of the welfare state can: • Reduce savings (savings trap), • Decrease employment, • Lower economic activity in the society, • Lower the population growth, • … In these ways the welfare state can influence the growth rate in the economy. Since in most circumstances these are all negative changes, it would suggest negative impact on growth. 15

Welfare state, savings and economic growth It would suggest that reducing the welfare state can increase the growth rate in the economy. However, we do not know if: • these changes affect growth rate, • the reduction in welfare state increases the growth rate, • possible positive effect of reducing the welfare state is temporary or permanent, • the new institutions, which replace the welfare state, affect the growth rate positively. However, we must also remember that the impact of the welfare state on growth can be in some cases 16 positive.

Bibliography 1. Atkinson A. B. (1999), The Economic Consequences of Rolling Back the Welfare State, The MIT Press, chapters 2 and 6 2. Musgrave P. , Musgrave R. , Part 3, Expenditure structure and policy chapter 3. Stiglitz J. (2000), Economics of public sector, chapter 10 and 28 4. Vermeend, W. , R. van der Ploeg, J. W. Timmer (2008), Taxes and the economy, Edward Elgar 5. António Afonso, Hans Peter Grüner and Christina Kolerus, Fiscal Policy and Growth. Do Financial Crises Make a Difference? , ECB Working Paper Series NO 1217 / June 2010 6. Balázs Égert, Tomasz Kozluk, Douglas Sutherland, Infrastructure and Growth, OECD 2009 17