Government spending decomposition: priorities toward anchoring higher growth

Abstract

This paper uses vector autoregressive models to investigate which government spending category has been more beneficial for private economic growth in the short and long run. To that end, the analysis considers a longtime horizon to detect contemporaneous and lagged cyclical effects of government spending and underlying components on the economy as well as common trends over time. Moreover, the paper demonstrates how the Egyptian government managed to frequently increase the current expenditure ratios in the state budget, and the economic consequences of such increases on private activity. More specifically, the paper explores the extent to which government spending categories played a role in enhancing private investment and hence contributed indirectly to private economic growth. The paper arrives at the following conclusions. First, the effect of the various government expenditure ratios on economic growth is generally weak. In contrast, the effect of private investment on growth is dominant. Second, while the magnitude of the relationship between fiscal policy variables and private investment is generally small, the accumulated effect of higher government purchases of goods and services on private investment is relatively high. Third, the paper confirms the observation that the government frequently reduced the government investment ratio to accommodate the increases in the current expenditure ratios which negatively affected economic growth. Priorities for fiscal policies should aim at reducing the deficit and restructuring the budget to create better space for targeted spending in support of inclusive economic growth.

Keywords:

• wage bill
• government investment
• government spending decomposition
• private investment
• economic growth
• VAR

Notes

1. Nonetheless, Cashin (1995) found a positive effect of welfare spending on growth.

2. See also Lindauer and Velenchik (1992).

3. Subsidies include transfer payments.

4. The Public Services Sector includes spending on wages associated with these services, while the Social Protection Sector includes spending on subsidies and transfer payments. The sectoral decomposition aims to illustrate the various functions associated with spending. The analysis in Section 3 follows the standard classification of public finances into current and capital spending and the underlying components.

5. The sample period is based on availability from the sources, Egyptian Ministry of Planning and Ministry of Finance. More recently, there has been a change in the methodology of public finance data that preclude combining more recent observations with the earlier data using a different methodology.

6. The government has been explicitly incorporating fuel subsidies into the state budget only since the fiscal year 2004/2005.

7. We exclude fuel subsidies as the amount has increased out of proportion over the years, reflecting fluctuations in the international price and continued commitment by the Government of Egypt to maintain subsidized prices. To illustrate, fuel subsidies registered LE 1 billion in 1996 and has exceeded LE 120 billion in the last fiscal year, 2012/2013. Fuel subsidies were not recorded in the budget over the period under investigation. While energy subsidies may have determined economic activity, the bulk of the subsidies have been subsidizing inefficient consumption, which is likely to be detrimental to growth as it crowds out available resources for public investment and increases the deficit and the need to finance government operations.

8. The second subperiod witnessed the economic reform program with the International Monetary Fund. The program aimed to increase the competitiveness of the economy, and bring fiscal and current account deficits under control.

9. The data for real private GDP are from the Ministry of Economic development; the fiscal data are from the Ministry of Finance.

10. See Stock and Watson (2001).

11. For example, Bernanke (1986) argues that the Choleski decomposition is equivalent to assuming that the structural model for the residuals is of a particular form, strictly recursive, which is usually not motivated by the relevant economic theory. Related to this issue, see also Christiano, Eichenbaum, and Evans (1998).

12. Public investment was reduced in the 1990s to attain the target of lower fiscal deficit in the context of the IMF program. However, privatization of many public enterprises, coupled with the suspension of guaranteed employment in the public sector in the early 1990s, has created the space to reduce public wages and expand public investment. Nonetheless, high-inflationary pressures have forced the government to grow wages and pensions at the rate of inflation rates, in addition to supplementary incentives that were instituted to maintain populist support.

13. Balassone and Franco (2000) showed that there has been a close relationship between fiscal consolidation and cuts in capital spending in Europe during the 1980s and 1990s, and the strong constraints on public finances imposed by the Maastricht and Amsterdam treaties have certainly played a role in this consolidation.