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CHAPTER 1

INTRODUCTION

1.1 STATEMENT OF THE PROBLEM

The relationship between government expenditure and economic growth

is an important subject of analysis and debate. As a fiscal policy instrument,

government expenditure can have great influence on economic growth

depending on how it is utilized and managed by the government.

Government mainly performs two functions, namely, protection and

provision of certain public goods- the enforcement of property rights and the

creation of rule of law reflect the protective functions of government and, the

provision of public goods for collective consumption includes defense, roads,

education, health, power etc. These functions can improve economic efficiency

and promote economic growth. Increase in government expenditure on socio-

economic infrastructure lead to positive externalities and encourages economic

growth. For example, government expenditure on education and health leads to

increase in productivity and efficiency and promotes economic growth.

Similarly, government expenditure on infrastructure such as roads,

communication, power etc. reduces the cost of production, increases private

investment and enhances economic growth.

However, the financing of government expenditure through increase in

taxes or borrowing or both can retard growth. Increase in taxes to finance rising

government expenditure result in disincentive impact on the private sector.

Further, increase in borrowing by the government, especially from banks, will

compete away the private sector leading to reduction of private investment.

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Over the past, a substantial volume of empirical research has been

directed towards identifying the elements of government expenditure that bear

significant association with economic growth. There are certain revenue

expenditures by the government for example on education, health,

transportation, which are quite productive and contributory but the capital

expenditure if not exploited properly may be quite unproductive.

There has been a phenomenal increase in the level of government

expenditure in relation to state income in Assam in the past few years.

Although central funds are available for state economic development spending,

a significant portion of economic development spending is funded with state

taxes. There have been persistent attempts by all the governments including the

Centre to contain revenue expenditures and thereby to bridge the revenue

deficits in the budgets as set out in the Fiscal Responsibility and Budget

Management Bill legislated by the Centre in the parliament and mandated in

the budget.

Against this background, it is found imperative to examine whether

revenue expenditure has adversely affected the economic growth, or has helped

the economy to grow, along with examining the growth effects of total

government expenditure, capital expenditure and public expenditure by sector.

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1.2 THEORETICAL BACKGROUND

THE CLASSICAL VIEW:

The classical economists (Smith 1776, Ricardo 1821) viewed that

countries with higher government expenditure would experience lower

economic growth. Adam Smith (1776) confined the subject of public

expenditure mainly to defense, the administration of justice (i.e. law and order)

and certain public works and hence advocated limited role of government.

Adam Smith propagated that governmental activity was strictly limited to the

three duties of sovereign. The classical economists Smith (1776), Ricardo

(1821) advocated the policy of laissez-faire in economic affairs. According to

the classical economists, it is the ‘invisible hand’ – the automatic equilibrating

mechanism of the perfectly competitive market, which maximizes the national

income. The classical economists viewed that the state activities should be

confined to the bare minimum, because interference with the free economy by

the government would hinder economic progress.

According to the classical economists increase in government

expenditure requiring imposition of increasing amount of taxes, result in

disincentive impact on the private sector to work and invest. Further they view

that increase in government expenditure financed through increase in

government borrowing (especially from banks) will compete (crowd out) away

the private sector, thus reducing private investment.

Thus, according to the Classical view, countries with higher government

expenditure would experience lower economic growth and hence the classical

economists favour for lower level of government expenditure for promoting

economic growth.

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THE KEYNESIAN VIEW:

John Maynard Keynes (1936) supported higher government expenditure

in order to promote economic growth. The tendency of continuous increase in

government expenditure was observed throughout the world particularly since

late nineteenth century. However it was clearly stated by Keynes in the

twentieth century. Keynes reacted to the incidence of world depression of

1930s by suggesting that even government expenditure in the form of ‘digging

the holes and filling them up’ could generate employment and additional

income in the economy. Keynes viewed that increasing the government

expenditure promotes economic growth by driving up aggregate demand. A

theoretical basis for recent development in government expenditure program is

provided by Keynes’ General Theory of Employment, Interest and Money

(1936).

According to Keynes, government expenditure, once initiated, continues

to increase generation of income in the economy through the multiplier

process. In Keynesian economics, increased government expenditure is thought

to raise aggregate demand and increase consumption, which in turn leads to

increased production.

According to the Keynesian view, government expenditure as a tool of

fiscal policy is useful for achieving short term stability and higher long run

growth rate. In the Keynesian model, increase in government expenditure leads

to higher economic growth and hence the Keynesians support higher

government expenditure in order to promote economic growth.

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NEO-CLASSICAL VIEW:

Contrary to the Keynesian view, the neo-classical growth models

argued that fiscal policies cannot bring about changes in long-run growth of

output. Solow (1956) in his neo-classical/exogenous growth model viewed

that there is no long run impact of government expenditures on the economic

growth rate; the long run growth rate being driven by population growth (i.e.

rate of labour force growth) and the rate of technological progress which is

determined exogenously. The neo-classical growth model predicts that income

per capita of countries will converge on the basis of the assumption of

diminishing marginal productivity of capital. Solow viewed that government

policy cannot affect growth rates, except temporarily during the transition of

economies to their steady state.

MYRDAL’S VIEW:

Karl Gunnar Myrdal was a dissenter from mainstream neo-classical

analysis. Myrdal in his Economic Theory and Under-Developed Regions,

(1957) argued against the belief by the neoclassical mainstream that economic

processes generally tend to develop towards an equilibrium outcome. Myrdal

asserted that most economic processes exhibit characteristics of ‘circular and

cumulative causation’, so that a small initial change amplifies over time to

become a substantial change (Myrdal 1957). Myrdal believed that government

executed development plan can set in motion a process in which circular forces

cumulate in an upward spiral of development, by reducing the backwash effects

and strengthening the spread effects in the underdeveloped countries.

Backwash effects are the result of interregional flows of goods and factors i.e.

migration, capital movements and trade. Spread effects refer to certain

centrifugal ‘spread effects’ of expansionary momentum from the centers of

economic expansion to other regions.

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Myrdal advocated planned investment in different industries and

emphasized the need for simultaneous engagement by the state in areas such as

infrastructure, health and education. According to Myrdal (1957), “Breaking

social chains and creating a psychological, ideological, social and political

situation propitious to economic development becomes the paramount duty of

the state in underdeveloped countries. The sphere of state action is very vast. It

includes maintaining public services, influencing the use of resources,

influencing the distribution of income, controlling the quantity of money,

controlling fluctuations, ensuring full employment and influencing the level of

investment”.

NEOCLASSICAL COUNTER-REVOLUTION VIEW:

The neoclassical counter-revolution school of the 1980s viewed that

state intervention in economic activity slows the pace of economic growth. In

the 1980s, the dominant political control of conservative governments in the

United States, Canada, Britain, and West Germany gave rise to a neoclassical

counter-revolution in economic theory and policy. The main argument of the

neoclassical counter-revolution is that underdevelopment is the result of poor

resource allocation due to incorrect pricing policies and too much state

intervention by over-active developing-nation governments. Some of the

leading writers of the counter-revolution school are Lord Peter Bauer, Deepak

Lal and Ian Little. The neoliberals of the neoclassical counter-revolution are of

the view that economic efficiency and economic growth will be stimulated by

privatizing state-owned enterprises, eliminating excessive government

regulations and price distortions in factor, product, and financial markets,

permitting competitive free markets to flourish and promoting free trade and

export expansion.

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THE MARKET FRIENDLY APPROACH:

The most recent variant on the neoclassical counter-revolution is the

market-friendly approach which is associated mainly with the writings of the

World Bank and its economists. The market friendly approach views that less

developed countries’ product and factor markets have many imperfections and

governments do have a key role to play in facilitating the operation of markets

through market friendly interventions- for example, by investing in social and

economic infrastructure and by providing a suitable climate for private

enterprise.

ENDOGENOUS GROWTH THEORY:

Models of endogenous growth developed by Romer (1986), Lucas

(1988), Barro (1990) and Rebelo (1991), view that the government plays an

active or key role in the growth process. The work of Barro (1990) has given a

new direction to the investigation of the impact of fiscal policy (government

expenditure) on economic growth. According to the endogenous growth

models with fiscal policy, higher taxation reduces output, but such losses may

be offset, by using the proceeds for productive expenditure items (Barro 1990,

Turnovsky 2000). Endogenous growth models of Barro (1990) and King and

Rebelo (1990) view that taxation which produces distortion and productive

expenditures will affect the long run growth rate.

Robert Barro (1990), points out that government expenditure on

investment and productive activities or services should contribute towards

growth whereas government consumption expenditure which he identifies as

non-productive government expenditure is growth retarding. According to

Barro (1990), an increase in the share of non-productive government

consumption expenditure lowers the growth rate. This is because a higher share

of government consumption expenditure has no direct effect on private-sector

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productivity, but leads to a higher income-tax rate. Thus as pointed out by

Barro, as individuals retain a smaller fraction of their returns from investment,

they have less incentive to invest, and the economy tends to grow at a lower

rate.

The introduction of endogenous growth models incorporating the

government sector has led to the conclusion that fiscal policies can affect the

long run growth rate of an economy (Barro and Sala-i-Martin 1992).

Endogenous growth theory provides a theoretical framework for

analyzing endogenous growth i.e. persistent GNP growth that is determined by

the system governing the production process rather than by forces outside that

system. Endogenous growth theory assumes that public and private investments

in human capital generate external economies and productivity improvements

that offset the natural tendency for diminishing returns, thus leading to

sustained long-term growth. Therefore, endogenous growth theory seeks to

explain the existence of increasing returns to scale and the divergent long-term

growth patterns among countries. According to the endogenous growth theory,

governments may improve the efficiency of resource allocation by providing

public goods (infrastructure) or encouraging private investment in knowledge-

intensive industries where human capital can be accumulated and subsequent

increasing returns to scale generated.

Thus, in contrast to the neoclassical counter-revolution theories, models

of endogenous growth suggest an active role for public policy in promoting

economic development through direct and indirect investments in human

capital formation (education), infrastructure and research and development.

Thus, given the contrasting arguments, the conclusion can be drawn out

that while Classical economists favour for lower level of government

expenditure for promoting economic growth, Keynesians support higher

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government expenditure in order to promote economic growth. Proponents of

endogenous growth models suggest an active role for public policy in

promoting economic development through investments in productive activities

or services such as human capital (education), infrastructure.

1.3 REVIEW OF LITERATURE

Many researchers have attempted to examine the impact of government

expenditure on economic growth. On the basis of the arguments as regard to

the positive and negative effects of government expenditure, some economists

(Daniel J. Mitchell, James S. Guseh and others) theoretically argue for a low

level of government expenditure for promoting economic growth, while some

other economists (D. Dillard, A. P. Lerner and others) favour for higher level

of government expenditure in order to boost economic growth. Advocates of

higher government expenditure argue that increase in government expenditure

on socio-economic infrastructure encourages economic growth as these

expenditures are believed to have significant positive externalities. The

proponents of lower government expenditure argue that higher government

expenditure undermines economic growth by reducing the resource availability

for the productive private sectors since the resources are transferred from the

productive private sectors to the government.

Contrast to the standard presumption that government expenditure

supports the growth objective, evidences show that it may have positive as well

as negative effects on the economy. As stated by Philip J. Grossman (1990),

“Economic theory suggests that government contributes to total economic

growth in two ways: positively, through the provision of Pigovian public

goods and services; and negatively through the inefficient provision of such

goods and services and the distortionary effects attendant with their provision.”

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Gwartney et al. (1998) in their study found a strong and persistent

negative relationship between government expenditures and economic growth

both for the developed economies of the OECD and for a larger set of 60

nations around the world. According to Gwartney et al. (1998) government

expenditure on core functions contributes positively to economic growth. They

further hold that expansion of government much beyond those core activities

will exert a negative impact on the economy.1

Studying the linkage between government size and economic growth for a

group of 115 countries during the period 1960-1980, Ram (1986) found that the

overall impact of government size on growth is positive in almost all cases.

Examining the relationship between government expenditure and economic

growth in New Zealand, Erkin (1988) found that higher government

expenditure does not hurt consumption, but instead raises private investment

that in turn accelerates economic growth. Al-Yousif (2000) found that

government expenditure has a positive relationship with economic growth in

Saudi Arabia.

Some studies show that total government expenditure or a large

government sector has a negative effect on growth (Romer 1990, Alexander

1990, Folster and Henrekson 1999, Engen and Skinner 1992, Hansson and

Henrekson 1994, Folster and Henrekson 2001, Taban 2010). Dar and Amir

Khalkhali (2002) showed that countries with a large government size have

lower productivity of the capital input resulting in lower economic growth.

Hence, the advantage of a small government sector is that it results in greater

efficiencies due to fewer policy induced distortions, lower tax burden and

absence of crowding out effects. Mitchell (2005) argued that the American

1 Gwartney et al. (1998) view that the core functions comprise of two general

categories (1) activities that protect persons and their property from plunder, and (2)

provision of a limited set of goods that for various reasons markets may find it

difficult to provide.

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government expenditure has grown too much in the last couple of years and has

contributed to the negative growth. The author suggested that government

should cut its spending, particularly on projects/programs that generate least

benefits or impose highest costs.

Examining the relationship between government expenditure and

economic growth in OECD countries, Folster and Henerekson (2001) found

that the relationship between the two is negative. However, Agell, et al. (1999)

examined the relationship between government expenditure and economic

growth in OECD countries and found that the relationship between the two is

insignificant.

In the literature it is usually stressed that the impact of government

expenditure on economic growth depends on the type of expenditure that the

government incurs, whether government expenditure is directed more towards

current or capital heads. Government expenditure on capital head is likely to

directly increase capital formation and foster economic growth. However

current expenditure is argued to be less productive than capital expenditure.

In most of the studies, the main conclusion is that government

consumption expenditure has a negative influence on growth (Landau 1983,

Grier and Tullock 1989, Barro 1991, Easterly and Rebelo 1993, Slemrod et al.

1995, Sala-i-Martin et al. 2004) while public investment has a positive effect

on economic growth (Aschauer 1989, Knight et al. 1993) or has little relation

(insignificant relationship) with growth (Barro 1991). Easterly and Rebelo

(1993) found that although public enterprise investment have no effect on

growth but the general government investment including the infrastructural

investments on transportation and communication has a positive relation with

growth.

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Examining the growth effects of government expenditure of a panel of

30 developing countries over the decades of the 1970s and 1980s, Bose et al.

(2003) found that

1) The share of government capital expenditure in GDP is positively and

significantly correlated with economic growth but current expenditure is

insignificant. 2) At the sectoral level, government investment and total

expenditures in education are the only outlays that are significantly

associated with growth once the budget constraint and omitted variables

are taken into consideration. Therefore, they concluded that education is

the key to growth for developing countries.

Assessing the effects of government expenditure on economic growth

for a sample of 39 low-income countries during 1990s, Gupta et al. (2005)

showed that countries where government expenditure is more on wages tend to

have lower growth, while those countries that allocate higher share to capital

and non-wage goods and services by cutting their current expenditures register

faster growth.

Using data from 43 developing countries over 20 years, Devarajan et al.

(1996), found that an increase in the share of current expenditure has positive

and statistically significant growth effects but the relationship between capital

expenditure and per capita growth is negative. Thus seemingly productive

expenditures, when used in excess could become unproductive. According to

Devarajan et al. (1996) the results of their study imply that developing-country

governments have been misallocating public expenditures in favour of capital

expenditure at the expense of current expenditure. Kweka and Morrissey

(2000) observed similar result for Tanzania. Gregoriou and Ghosh (2009) in

their study of 15 developing countries have also found similar results.

There are different relationships between different government

expenditures and growth. Kneller et al. (1999) categorized government

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expenditure into: productive and non-productive expenditure. These are

distinguished from each other on the basis of whether they are included in the

private production function or not. Kneller et al. (1999) viewed that the

productive government expenditures consists of general public services,

defense, educational, health, housing, and transport and communication

expenditures whereas the non-productive government expenditures consists of

social security and welfare expenditure, expenditure on recreation and

economic services. Using a panel data of 22 OECD countries over the period

1970-95, they found that productive government expenditure enhances growth,

while non-productive expenditure does not.

However, there are disagreements regarding which government

expenditures should be productive or unproductive (Summers and Heston,

1988, Grier and Tullock 1989, Barro and Sala-i-Martin 1995, Devarajan et al.

1996). But the productive government expenditures may not be positive in

growth regressions. Musgrave (1997) pointed out that if a so called

‘productive’ category of public spending is not used effectively, it can have a

negative impact on growth. Therefore, he argued that what matters most for

public spending is how effective it is.

From the empirical analysis, it is found that the capital component of

expenditure is more productive if used properly or efficiently. However, there

is a debate regarding which component is more influencing. There are certain

revenue expenditures by the government, for example on education, health,

transport and communication which are quite productive and contributory but

the capital expenditure if it is not used properly may be quite unproductive.

Hence revenue expenditure can also contribute positively to economic growth,

which may not be the case with capital expenditure.

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Some Time Series Evidence from India

Examining the relationship between public sector spending and economic

growth in India, Khundrakpam (2001) employed the ARDL model and found

that although public expenditure has a positive influence on economic growth

over the long run but trade off between the two occurs in the short run.

Studying the relationship between government expenditure and economic

growth in India, Dash and Sharma (2008) found that government expenditure

has a positive impact on economic growth. Applying cointegration and error

correction model in Indian context, Tulsidharan (2006) found that in nominal

terms higher economic growth invariably is accompanied by an increase in

government final consumption expenditure.

Examining the impact of aggregate government expenditure and its two

broader components such as revenue expenditure and capital expenditure on

the growth rate of output, Mallick (2008) employed the structural vector

autoregression methodology and found that neither aggregate expenditure nor

the capital expenditure does have significant influence on the growth rate of the

Indian economy. Rather, it is the revenue expenditure, which to some extent,

explains the variation in growth rate and it is again in the positive direction.

Studies relating to Public Expenditure in Assam

Choudhury (2002) in her study of budgetary expenditures in Assam has

shown that public expenditure has increased over time. As the growth rate of

Assam economy was still dismal, the study states that public expenditure has a

poor effect on the state’s economy.

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1.4 OBJECTIVES OF THE STUDY

The objective of the study is to examine the impact of government

expenditure on economic growth in Assam over the period 1981-82 to

2006-07.

The following are the specific objectives:

1. To study the trend and pattern of government expenditure in Assam over

the study period.

2. To investigate the existence of a long run equilibrium relationship between

government expenditure including gross fixed public capital formation and

economic growth.

3. To estimate the significance of the selected variables both in the long run

and short run.

4. Based on the investigation, to prescribe policy measures.

1.5 HYPOTHESIS:

• Revenue expenditure and gross fixed public capital formation is

conducive to economic growth of the state.

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1.6 DATA, CONCEPTS AND METHODOLOGY

DATA

The study uses the annual time series data of the growth rate of real GSDP

denoted by Y (at 1999-2000 constant prices), the growth rate of real per capita

GSDP denoted by YPC (at 1999-2000 constant prices), the share of total

government expenditure in GSDP denoted by GE, the share of revenue

expenditure in GSDP denoted by RE, the share of capital expenditure in GSDP

denoted by CE, the share of ‘other expenditures’ in GSDP denoted by OE, the

share of gross fixed public capital formation in GSDP denoted by GFPCF, the

share of revenue expenditure under general services, social and community

services, economic services, grants-in-aid and contribution in GSDP, denoted

by RGS, RSCS, RES, RGR respectively, the share of capital expenditure under

general services, social and community services, economic services, repayment

of loans to centre, discharge of internal debt, loans and advances in GSDP,

denoted by CGS, CSCS, CES, RLC, DID, LAD respectively, the share of

revenue expenditure under agriculture and allied services in GSDP, denoted by

RAG and the share of capital expenditure under agriculture and allied services,

water and power development, transport and communication in GSDP, denoted

by CAG, CWP, CTRC respectively for Assam from 1981-82 to 2006-2007.

Economic growth is measured by the growth rate of real Gross State Domestic

Product and the growth rate of real per capita Gross State Domestic Product.

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CONCEPTS

Total government expenditure is the sum of expenditures of-

I. Consolidated Fund- Revenue Account and Capital Account.

The terms ‘Revenue expenditure’ and ‘Capital expenditure’ are used in lieu of

expenditure from the Revenue Account and Capital Account respectively.

Revenue expenditure of the government is broadly classified as consumption

expenditure (i.e. public or government purchase of current goods and services

e.g. consumables, labour etc) and transfer payments. Within the broad

classification of revenue expenditure include salary and wages, election,

interest payment, pension, subsidies, grants to local bodies etc. Capital

expenditure consists of capital outlay on economic overheads like roads and

railways, electricity generation, schools and hospital buildings and facilities

and other investment projects, lending (disbursements of loans and advances)

and repayment of loans.

II. OTHER EXPENDITURES

Government expenditures under Contingency Fund Account and Public

Account are consolidated and classified as ‘Other Expenditures’.

Disbursement from the Contingency Fund includes advances from

Contingency Fund, repayment to the Consolidated Fund and Closing balance.

The heads of disbursement under Public Account Fund are

(a) Small Savings, Provident Funds, etc.

(b) Reserve Funds.

(c) Account with Other Countries.

(d) Suspense and Miscellaneous.

(e) Remittances.

(f) Inter-government adjustment.

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Revenue expenditure is divided under the following four heads as given

below:

1. General Services

(a) Organs of State

(b) Fiscal Services

(c) Interest Payments and Servicing of Debt

(d) Administrative Services

(e) Pension and Miscellaneous Services

2. Social and Community Services

(a) Education, Art and Culture

(b) Medical, Family Planning, Public Health and Sanitation

(c) Others

3. Economic Services

(a) General Economic Services

(b) Agriculture and Allied Services

(c) Industry and Mineral

(d) Water and Power Development

(e) Transport and Communication

(f) Other Economic Services

4. Grants-in-aid & Contribution

Capital Expenditure is divided under the following heads as given below:

1. General Services

2. Social and Community Services

(a) Education, Art and Culture

(b) Medical, Family Planning, Public Health and Sanitation

(c) Others

3. Economic Services

(a) General Economic Services

(b) Agriculture and Allied Services

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(c) Industry and Mineral

(d) Water and Power Development

(e) Transport and Communication

4. Repayment of Loans to the Centre

5. Discharge of Internal Debt

6. Loans and Advances issued by the state government

GROSS FIXED PUBLIC CAPITAL FORMATION

Gross fixed capital formation refers to the gross additions to fixed assets (i.e.

fixed capital formation) during the accounting period. Fixed assets comprise

construction (including buildings, roads & bridges and other construction) and

machinery and equipment (including plant & machinery and transport

equipment).

Gross fixed public capital formation is composed of the gross fixed capital

formation of the State and Central Government under

(1) Administrative department

(2) Departmental Commercial Undertakings

(3) Non-Departmental Commercial Undertakings and

(4) Local Bodies.

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DATA SOURCE AND METHODOLOGY

The study is primarily based on secondary data and the sources are:

(a) Directorate of Economics and Statistics, Government of Assam, for

collecting statistics regarding state income and government expenditure in

Assam.

(b) Assam Government Budgets for statistics regarding government

expenditure in Assam.

(c) Finance (Budget) Department, Government of Assam, Assam Secretariat,

Dispur, Guwahati, for data regarding government expenditure in Assam.

In order to convert the nominal expenditure into real, the

expenditure variables are deflated with respect to GSDP at factor cost

deflator and expressed as percentage of GSDP. The real expenditure values

at constant (1999-2000) prices removes the influence of price changes over the

study period.

The study examines the impact of government expenditure on economic

growth with the help of models by employing the Autoregressive Distributed

Lag (ARDL) bounds testing approach to cointegration, proposed by

Pesaran et al. (2001).

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