Public Policy for Economic Growth: Theory and Empirics

This paper responds to the development policy debate involving the World Bank and the IMF on the use of fiscal policy not only for economic stabilization but also to promote growth and the increase of per capita income. A key issue in this debate relates to the effect of the composition of public expenditure, and its financing, on economic growth. The current paper lays out a research strategy to explore the effects of fiscal policy, including the composition of public expenditure, on economic growth, using a time series approach. Based on the modeling strategy by Greiner, Semmler and Gong (2005) we suggest a general model that includes (a) recurrent expenditure on education and health (which influences human capital), as well as expenditure on (b) public infrastructure investment, (c) transfers and consumption of public goods, and (d) public administration. The model can be used to explore the impact of expenditure composition on long run per capita income. Debt and external aid financing are also possible in the general model. A simplified model is proposed, numerically solved and the out of steady state dynamics studied. The model is then calibrated and the impact of the composition of public expenditure on the long run per capita income explored for low, lowermiddle and upper-middle income countries. Policy implications are spelled out, the extension to an estimable model indicated and a debt sustainability test proposed. ∗We want to thank Lars Gruene for extensive help in the numerical part of the paper and the audience at the World Bank Workshop on ”Growth and Fiscal Policy”, June 2006, for useful comments. †Schwartz Center for Economic Policy Analysis, New School, New York and CEM, Bielefeld ‡Dept. of Economics and CEM, Bielefeld University §Schwartz Center for Economic Policy Analysis, New School, New York ¶Schwartz Center for Economic Policy Analysis, New School, New York ‖World Bank, Washington, D.C