Does government expenditure have a positive or negative effect on economic growth? A priori, we do not know. Arguments can be made in both directions. To the extent that the well-known effects of the existence of collective goods, externalities and natural monopolies are important impediments to growth, the types of government expenditure that rectify these problems can be expected to have growth-enhancing effects.
Following Barro we may label this ‘productive’ government spending. Another problem is that the valuation of government output may lead to an overestimation of measured growth. In the different accounts, government goods and services are valued at their cost of production. This procedure gives rise to a number of difficulties which bias the researcher to find that increased government spending results in increased economic growth. This is due to the implicit assumption that government output is produced with a constant returns to scale technology, that all government production can be classified as final output rather than intermediate inputs lowering private sector production costs, and that the market value of government output is equal to the cost of production Government expenditure is also part of GDP. Since both government consumption and investment are part of GDP when measured from the expenditure side, explaining GDP growth by changes in government spending involves explaining something partly by itself.
In particular during periods when the government spending share has been increasing, this problem lends an upward bias to the estimated effect. Kaldor claimed that a high rate of utilization has a beneficial effect on long-run productivity growth. In so far as an expansion of the public sector results in a higher utilization rate, here ought to be a positive effect on economic growth through the workings of Verdoorn's Law. Furthermore, Myrdal stressed that a greater government involvement in the economy can foster growth because the greater involvement can be used partly to reduce social inequality, which is seen as detrimental to growth because it restricts the opportunities for low-income individuals to exploit their talent.
Here we may also note Alesina and Perrotti's (this volume) finding that social conflict can be abated by increased government involvement. As regards the growth-retarding effects of government expenditure, the most important of these effects deal with the distortionary effect on economic decisions that arise when spending has to be financed through taxation. Almost invariably, taxation inserts a wedge between the private and the social rate of return; taxation leads to an excess burden. In recent endogenous growth models such as Barro and King and Rebelo, taxes create a wedge between the gross and net returns on saving, which leads to a lower rate of capital accumulation and hence a lower rate of economic growth. Lindbeck, among others, has instead stressed the disincentive effects of large tax wedges on labour income in high-tax societies.
Hansson assesses that the cost of increasing public revenue at the margin may be extremely high in a country like Sweden with a large public sector. It is also important to stress that there are many other important aspects of labour supply additional to the number of hours worked: degree of effort, worker morale, willingness to assume more responsibility in the work place, investment in human capital, transfer of labour to the informal economy etc. These empirically less tractable aspects may potentially be of great importance for the growth rate. Other researchers have emphasized the fact that government activity may crowd out private production and private capital formation. Koskela and Virén have analysed how increased government demand for labour will put an upward pressure on real wages and hence crowd out private sector employment.
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