Academy of Economic Studies Doctoral School of Finance and Banking Economic Growth, Fiscal Size and Volatility: A Panel Assessment for EU Developing Economies MSc Student: Dan Matei Supervisor: PhD Professor Moisa Altar

Dissertation paper outline  Introduction  Literature review  Methodology  Empirical Analysis - Data - Results and Discussion - Robustness Analysis  Conclusions  Bibliography

Introduction  In the EU area, the gradual loss of monetary policy as an instrument to offset country-specific disturbances naturally places the onus on fiscal policy. European countries would thus be facing a difficult trade-off between maintaining large governments to ensure sufficient automatic fiscal stabilization and leaner ones to ensure efficiency and growth (there could be a tension between the ‘Maastricht’ and the ‘Lisbon’ goals).  Debate between the need to ensure adequate macroeconomic stabilization and the reduction in the size of governments that often accompanied efforts to boost market efficiency and promote long-term growth  The importance of high-quality fiscal policies for economic growth, a firm control and, where appropriate, reduction in public spending have been brought to the forefront by a number of developments over the past decades  With a view to understand how to limit government size and restrict fiscal policy volatility, it is quite relevant to assess which components of general government spending and revenue (both in terms of size and volatility) have a negative effect on growth. Although the effect of government expenditure volatility has been widely analyzed, the effect of volatility in the components of public spending and revenue has not so far been widely addressed in the literature  By regressing economic growth on budgetary items and on a set of other relevant variables we evaluate whether the allocation of taxes and public expenditures has been useful to promote growth in a panel of European countries for the period The outcome of the paper suggests that for several components of general government revenue and spending both size and volatility measures have a negative effect on growth, and that restrictions on these variables should be pursued.

Literature review  Wagner’s Law- the long-run tendency for government spending as a share of some national income aggregate such as GDP to grow in the course of economic development has become more or less a stylized fact in public finance  Keynesian perspective- public expenditure should act as a stabilizing force and move in a countercyclical direction  Barro (1990) constitutes one of the first attempts at endogenizing the relationship between growth and fiscal policies, distinguishing four categories of public finances: productive vs. non-productive expenditures and distortionary vs. non-distortionary taxation  Levine-Renelt (1992) found that most results from earlier studies on the relationship between long- run growth and fiscal policy indicators are fragile to small changes in the conditioning set  Easterly-Rebello (1993) public transportation, communication and educational investment are positively correlated with growth per capita and aggregate public investment is negatively correlated with growth per capita  Poot (1999) in a survey of published articles in did not find conclusive evidence for the relationship between government consumption and growth, still found empirical support for the negative effect of taxes on growth and reported definitive results on the positive link between growth and education spending  Afonso and Tanzi (2005) finds that a well-defined institutional framework and ‘high quality’ public finances are important to support the long-run growth. Studying the efficiency of the public sectors of 23 industrialized OECD countries, they noted that countries with large public sectors show more equal income distribution, while countries with small public sectors report significantly higher indicators than countries with medium-sized or big public sectors.

Literature review (contd.)  Fiscal volatility - There is little consensus on the sign of the effects of government expenditure volatility on growth, restrictions on government expenditure volatility may have both positive and negative effects on long-run growth. A crucial variable to determine the sign of these effects is business-cycle volatility  Ramey and Ramey (1995) find a negative relation between the business-cycle volatility and growth in cross-country data and this relation is robust to various controls  Aghion (2005) find that the effect of volatility on growth survives when one controls for the level of financial development, leaving open the possibility that volatility has a causal effect on growth (the negative relation between volatility on growth tends to be stronger in countries with lower financial development )  On the mechanism through which fiscal policy can affect business cycles, Lane (2003) shows that restrictions on government expenditure, and thus lower government expenditure volatility, result in a slower adjustment of the economy to unexpected shocks  In contrast, Fatas and Mihov (2003) present evidence that aggressive use of discretionary fiscal policy generates undesirable output volatility and leads to lower growth. Not only discretionary changes but also transitory (and cyclical) changes in fiscal policy may increase output volatility and thereby reduce output growth  Ayagari, Christiano and Eichenbaum (1992) temporary changes in fiscal policy may have a significant impact on interest rate volatility and this, in turn, will reduce long-run growth. Furceri (2007b) analyzing a panel of 99 countries from , shows that a 1 percent increase in government expenditure business cycle volatility determines a decrease of 0.78 percentage points in the long-run rate of growth  The survey of different empirical studies shows that an objective and unambiguous overall catalogue of “high quality”-expenditure items is not feasible. There is no cookbook for growth. Economics gives an idea of the major ingredients, but it does not clearly tell the recipe.

Methodology  The inclusion of particular control variables in a growth regression can wipe out the negative bivariate relationship between growth and the measure of government size (Easterly and Rebelo, 1993)  Levine and Renelt (1992) found that robust cross-country growth correlates to the average investment share of GDP, the initial log of GDP per capita, initial human capital and the average growth rate of the population  Initial income is often used to test the convergence hypothesis  Opening to trade is beneficial to economic growth on average, allows the dissemination of knowledge and technological progress, still the aftermath of trade openness varies considerably across countries and depends on a variety of conditions related to the structure of the economy and its institutions  Output volatility: tends to have negative effects on long-term economic growth, welfare, and income inequality, particularly in developing countries. As main justifications for short-run “stabilization” policies (policies aimed at reducing volatility, The World Bank and the IMF routinely advise governments to reduce fluctuations to achieve higher growth rates

Methodology (contd.)  Time span- cross-country growth regressions make use of large time spans ( years) and consider the average value of growth determinants over this time period. As argued by Afonso and Furceri (2008), this could raise problems such as endogeneity and significant simultaneity. Cross-section analysis over long time spans may fail to capture growth causality effects of taxation  The analysis is focused on combined cross-section time-series regressions using three four-year periods from 1996 to 2007, and we use pooled country and fixed effects  The model- two growth equations respectively for general government revenue and expenditure: g i,t = α 1 + β 1 R i,t +γ 1 R 2 i,t +δ 1 σ R i,t +φ 1 X i,t +ε i,t (1) g i,t = α 2 + β 2 E i,t +γ 2 E 2 i,t +δ 2 σ E i,t +φ 2 Xi,t +ε i,t (2) where the index i (i=1, …, 10) denotes the country, the index t (t= , , ) indicates the period, α1 and α2 stand for the individual effects to be estimated for each country i. g is the growth rate of real GDP per capita, R is the vector of general government revenue variables as percentage of GDP, E is the vector of general government expenditure variables as percentage of GDP, σR is the vector of revenue volatility variables, and σE is the vector of expenditure volatility variables, X is a vector of control variables (initial level of output per capita, output volatility, investment share, population growth and openness). Both regressions also include square terms for R and E with a view to test the possible effect on economic growth of different government sizes.

Empirical analysis- Data  Sources of data are European Commission AMECO (Annual Macro- Economic Data), supplemented by EUROSTAT database, covering the period  The panel consists in 10 EU members and emerging economies: Bulgaria, Czech Rep, Estonia, Hungary, Lithuania, Latvia, Poland, Romania, Slovenia and Slovak Rep

Empirical analysis- Data (contd.)  Advantages  homogeneity - all 10 EU countries are emerging market economies  data quality and cross-country comparability are likely to be of a good standard for the EU members (fiscal variable in ESA 95)  Drawbacks  fiscal data availability for the studied economies is rather limited  only 3 observations per country for each variable, employing 4 year growth periods  Two measures for both government revenues and expenditures (the aggregates and components): the relative share of each variable as a percentage of GDP and the volatility of the cyclical component for each fiscal variable  For volatility measures, all fiscal variables are converted into constant prices using the GDP deflator. To compute the cyclical component for each fiscal variable, Hodrick and Prescott Filter was set with the smoothness parameter (λ) equal to to In this way, as pointed out by Ravn and Uhlig (2002), the Hodrick-Prescott filter produces cyclical components comparable to those obtained by the Band-Pass filter.  The analysis excludes those fiscal variables that have a residual importance on the public budget or whose interpretation is not clear

Empirical analysis- Data (contd.)

Results and Discussion

Likelihood Ratio Test (LR) Total general gov revenue and Growth Total general gov expenditure and Growth

Likelihood Ratio Test (LR) Government revenue composition and Growth Government expenditure composition and Growth

Likelihood Ratio Test (LR) Total general revenue Size and Growth Total general expenditure Size and Growth

Robustness analysis  The inclusion of country specific effects has the advantage of controlling for unobserved country heterogeneity, it could lead to misleading conclusion in the analysis of the results  Re-estimating the growth equations excluding country dummies, the results remain robust to the change  To control for a possible endogeneity problem in the regression, the equations were re- estimated using the initial level of government spending and revenue-to- GDP ratios

Likelihood Ratio Test (LR) Total general gov revenue and Growth Total general gov expenditure and Growth including only period dummies including only period dummies

Likelihood Ratio Test (LR) Total general gov revenue and Growth Total general gov expenditure and Growth initial share initial share

Conclusion  The overall results suggest that both fiscal size and volatility tend to hamper growth in EU developing economies  A percentage point increase in the share of total revenue (expenditure) would reduce output growth by 0.25 and 0.21 percentage points respectively, for the EU developing countries  Among total revenue the variables that are most detrimental to growth, both in terms of size and volatility, are direct taxes and social contributions  Among government outlays, subsidies and government consumption have a significantly negative impact on growth, government investment and transfers does not significantly affect growth  In terms of volatility, the government transfers and public subsidies volatility have the largest negative effect on growth in the sample, in addition the investment volatility have a negative and statistically significant effect on growth in the EU developing countries

Conclusion (contd.)  Restrain in government consumption and subsidies enhances economic growth, on the revenue-side, contributions to social security and direct taxation seem to be an obstacle for higher growth  The result of this analysis should be taken with some prudence and the estimated elasticities have to be analyzed with concern  Insightful results for policy makers when deciding which components of public finances to adjust  The national policies appear to be a complex package and future researchers may wish to focus on interactions and synergies among fiscal policies as opposed to the influence of any particular variable  The analysis can be improved in several ways:  the channels through which the composition of the public budget affects economic growth may be addressed in a specific context;  one could investigate the optimal size and the nature of the relationship between the role of the various components of government spending and revenue and growth;  the decomposition of public expenditure may be extended to include transfers between the different levels of government and transfers from supranational levels of government (European Commission)

References  Afonso, A. and D. Furceri (2008), “Government size, composition, volatility and economic growth”, European Central Bank Working Paper no  Afonso, A., L. Schuknecht, and V. Tanzi (2005), “Public Sector Efficiency: An International Comparison”, Public Choice, 123 (3-4),  Afonso, A., W. Ebert, L. Schuknecht, and M. Thöne (2005), “Quality of public finances and growth,” European Central Bank Working Paper n  Aghion, P., G. Angeletos, A. Banerjee, and K. Manova (2005), “Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment”, NBER Working Papers,  Aghion, P. and I. Marinescu (2007), “Cyclical budgetary policy and economic growth: What do we learn from OECD panel data?”.  Ayagari, S., L. Christiano, and M. Eichenbaum (1992), “The Output, Employment, and Interest Rate of Government Consumption”, Journal of Monetary Economics, 30,  Barro, R. and X. Sala-i-Martin (1995), Economic Growth. McGraw-Hill, New York.  Bird, R. (1971), “‘Wagner’s law: a pooled time-series, cross section comparisons,” National Tax Journal, 38,  Bose, N., M. Haque, and D. Osborn (2003), "Public Expenditure and Economic Growth: A Disaggregated Analysis for Developing Countries", Centre for Growth and Business Cycle Research Discussion Paper Series (University of Manchester), No. 30.  Cavallo, A. (2007), “Output volatility and openness to trade: A reassessment”, Inter-American Development Bank, Working paper n.604.  de Ávila, D. and R. Strauch (2003), “Public finances and long-term growth in Europe evidence from panel data analysis” ECB Working Paper N  Easterly, W. and S. Rebelo (1993), “Fiscal Policy and Economic Growth: An Empirical Investigation,” Journal of Monetary Economics 32 (3),  Fatás, A. (2002), “The Effects of Business Cycles on Growth” in Loayza, N. and R. Soto, (eds.) Economic Growth: Sources, Trends and Cycles, Central Bank of Chile.  Fatás, A. and I. Mihov (2003), “The Case for Restricting Fiscal Policy Discretion”, Quarterly Journal of Economics, 118,

References (contd.)  Fölster, S. and M. Henrekson (2002), “Growth effects of government expenditures and taxation in rich countries”, European Economic Review 45 (8),  Furceri, D. (2007b), “Is Government Expenditure Volatility Harmful for Growth? A Cross-Country Analysis,” Fiscal Studies 28 (1),  Hemming, R., M. Kell, and S. Mahfouz (2002), “The Effectiveness of Fiscal Policy in Stimulating Economic Activity - A Review of the Literature,” IMF Working Paper No.02/208.  Hodrick, R. and E. Prescott, (1997), “Postwar U.S. Business Cycles: An Empirical Investigations”, Journal of Money, Credit and Banking, 29(1),  Kneller, R., M. Bleaney, and N. Gemmell (1999), "Fiscal policy and growth: evidence from OECD countries", Journal of Public Economics 74,  Lane, P. (2003), “The Cyclical Behavior of Fiscal Policy: Evidence from the OECD”, Journal of Public Economics, 87,  Levine, R. and D. Renelt (1991), “Cross-Country Studies of Growth and Policy”, Macroeconomic Adjustment and Growth Division, Country Economics Department World Bank Working Paper no  Levine, R. and D. Renelt (1992), “A Sensitivity Analysis of Cross-Country Growth Regressions”, American Economic Review, 82,  Poot, J. 1999, "A meta-analytic study of the role of government in long-run economic growth," ERSA conference papers, European Regional Science AssociationA meta-analytic study of the role of government in long-run economic growthERSA conference papers  Ramey, G. and V. Ramey (1995), “Cross-country evidence on the link-between volatility and growth”, American Economic Review, 85,  Ravn, M. and H. Uhlig (2002), “On Adjusting the Hodrick-Prescott Filter for the Frequency of Observations”, Review of Economics and Statistics, 84,  Rodriguez, F. and D. Rodrick (1998), “Trade policy and economic growth: A skeptics guide to the cross-national evidence”, Journal of Political Economy, 106(5),  Sala-i-Martin, X. (1997), “I Just Ran Two Million Regressions”, AEA Papers and Proceedings 87,  Scarpetta, S., A. Bassanini (2001), “Economic growth in the OECD area: Recent trends at the aggregate and sectoral level”, OECD Working Papers no. 248.