AMERICAN JOURNAL OF SOCIAL AND MANAGEMENT SCIENCES

ISSN Print: 2156-1540, ISSN Online: 2151-1559, doi:10.5251/ajsms.2016.7.2.33.41

© 2016, ScienceHuβ, http://www.scihub.org/AJSMS

Public Expenditures and Economic Growth: A Case study of Pakistan

Nadia Farooq

Research Economist

ABSTRACT

The impact of government expenditures in economic growth is well understood and recognized.
However, most of theoretical and empirical research on determining this role has focused on the
impact of public investments, implicitly assuming that recurrent expenditure of the government is
more or less irrelevant from the perspective of economic growth. Using Pakistani data, this study
not only reiterates the positive impact of public expenditure on economic activity, but also
highlights that primary recurrent expenditure is about as much important as public investment in
enhancing economic activity. This is perhaps because in Pakistan government’s development
expenditure has more inherent inefficiencies than recurrent expenditures, as prolonged fiscal
adversity has stripped that latter to “bare bones” to contain large inefficiencies. However, this also
implies that simply creating structures and infrastructure is not enough to accelerate economic
growth. Each structure has to be adequately financed for its operation and maintenance to give
optimum results, which is done from recurrent spending. As such, this study points to a rethink on
the role of public expenditure and its impact on growth, especially the composition of expenditure.

Keywords: Current expenditures, Development expenditures, Economic Growth

INTRODUCTION conditions and depends critically on the mode, and

therefore the cost, of financing this additional
There is unanimity among the present day
government spending, and the magnitudes of impact
economists that the government can, and should,
the spending has on economic activity.
influence the pace of economic activity in a country or
region. This influence can be exerted through public Role of Government and Public Spending: There
policies, which can facilitate economic growth by has been a long standing consensus among the
minimizing the non-pecuniary production costs, development community that the role of government
reducing the ill-effects of negative externalities or in managing the economy is very important, at least
promoting the favorable effect of positive ones. for developing countries, where market structure and
Government’s taxation policy is an effective tool to institutions are not yet developed to self-regulate the
achieve these objectives. More importantly, however, private sector. In past literature we found that the role
the government can incur expenditure in areas which of government is positive in developing countries
directly or indirectly support investment and growth. while it is negative in the developed countries. This
Public expenditure not only has a direct effect on statement can be justified with the help of Rahn curve
economic activity through raising aggregate demand (Mitchell 2010), where in start the economic benefits
(the Keynesian effect), but also a more profound and become larger with the initial government intervention
long-lasting impact by creating public infrastructure and at maximum level the excessive government
and delivering key economic or social services which intervention negatively affects the economic
can crowd-in private investments, which, in turn, performance and then the curve becomes downward
accelerate economic growth. sloped.
In this paper we hypothesize that public expenditure It is therefore no surprise that public spending and its
has a positive impact on economic growth. If true, impact on economic growth is thoroughly discussed
this also implies that higher level of economic activity in economic literature.
is likely to have a positive impact of government’s th
In the18 century the Classical economists have
revenue, which can enhance public expenditure –
limited the government’s role in the country while in
thus creating a multiplier effect on economic activity. th
the19 century the Wegner had developed his law in
However, the debt sustainability literature tells us that
favor of state’s intervention in the form of public
the above indicated virtuous cycle is not
expenditures then Keynesians presented their
automatically guaranteed, it requires certain
 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

hypothesis about the state’s role and economic growth but he did not find a significant impact of
expansions. Well, most of the endogenous growth educational expenditures in the short run in case of
models show that public expenditures have either Ghana.
productive or consumptive effects. Now the need is to
Katraklidis and Tsiliki (2009) have found supporting
find out why some governments spend more and
results with the Wagner’s law and Keynesian
some less and also some spend on productive
hypothesis in case of Greece. They even found two
manners while others on only the consumptive way.
way causation between public expenditures and
Many articles concluded that the size of public
economic growth from 1958 till 2004.Kelly (1997)
consumption is negatively related with the economic
found a positive impact of public expenditures;
growth. So the size of government is also very
especially social expenditures on the enhancement of
important to be considered. Freeman (1975)
economic growth.
extracted that the larger the size of government the
higher the inefficiencies. Faris (2010) has estimated the Wagner’s law and
Keynesians’ hypothesis on the GCC countries and he
There are many classifications about public
found the positive impact while he found two way
expenditures like A.C Piguo, a British economist has
causation in case of Bahrain. Ahmed and Qayyum
defined them into transfer and non-transfer
(2007) analyzed the positive linkage between
expenditures while modern economists have divided
government’s development expenditures and private
them into development and non-developmental public
fixed investment. They and Landea (2005) also found
expenditures. Development expenditures are those
that higher or large government size has negative
who occurred by the state bank, local or federal
impact on the private sector’s betterment, which
governments; on infrastructural development,
ultimately effects the economic growth
irrigation and agriculture, human development and
etc are those who are stepping stones toward Research and Development is very essential for
economic activity and growth. While non- finding out the margin for higher economic growth.
development expenditures are those who do not Sylwester (2001) found a positive linkage between
directly pay back like expenses on law and order, industrial R&D and economic growth in G-7
defense spending, pensions etc Gaurav Akran, 2011. countries. Abbot et al (2015) and Tellier (2005) have
discussed about cyclical public expenditures.
Many economists have showed the crowding out
According to Tellier the public spending use to
effect of public expenditures. According to them as
increase before elections and decreased afterwards.
government increases its expenditures then people
foresee about the increment of taxes in future so they According to Chao and Gruble (1998) there is always
decrease their consumption which actually affect the diminishing returns to scale exists so after a certain
aggregate demand in the negative way. Or if time the economic growth starts decreasing with the
Government borrows so it causes the crowding out increase in the public spending. We can see this
effect. Ricardian Equilance is also about the same effect by this diagram:
effect by saying that people are rational and they
8.0 A
start saving for paying off the future increase in taxes.
Friedman (1972-78) said that raising taxes will
Grwoth Rate (percent)

definitely leads towards more or higher taxes. 6.0

Landau (2005) has estimated that the slower income
countries grow faster than the high income countries. 4.0
Balducci (2005) has critically analyzed the Barro’s
model and found that productive expenditures have
positive impact on the economic growth and it 2.0
includes the expenditures in the public investments
etc. 0.0 Government Expenditure to GDP Ratio
According to Bryn (1990) the police and fire
Source: Author’s own formulation based on Chao and
expenditures have the direct and positive linkage with
Gruble’s argument.
growth while welfare expenditures cause the
economic stagnation. Amponsah (2009) found a Fig.1: Government Expenditures and its impact on
positive effect of public expenditures on economic Economic Growth

34
 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

Figure 1, shows that after a certain point (A) the increase in Such a strong consensus in favor of government’s
Government expenditures (as a percent of GDP) the development spending is surprising when there is no
diminishing returns become so large that it causes conclusive evidence in favor of such a hypothesis in the
economic growth to decline. public finance literature. For example, some studies have
found a negative relationship between public investment
According to Bose et all. (2007) aggregate current and economic growth, especially in developing countries.
expenditures have no effect on economic growth while Some recent work on Pakistan suggests the absence of
aggregate capital expenditures have positive impact on
any positive impact of public investment on growth.
economic growth in case of developing countries.
Whereas others concluded that public investment
Delina and Magazzino (2012) found a “tax and spend” have positive impact on the labor productivity,
strategy in case of Italy in the liberal period while there was profitability and the private investment. In general,
“spend and tax” strategy in the war period. Mohsen(1989) public investment is found to be necessary, but not
has analyzed about the developed countries that property
sufficient for sustaining economic growth as other
taxes are much better than consumption taxes. Because
consumption taxes directly affect the economic growth and factors are also important: (i) the enabling
it further enhances the deficit. environment which enhances the productivity of
investment, both public and private; (ii) the mode by
Public Expenditure and Growth – Evidence from which public investment is increased, as the objective
Pakistani Data: There is a remarkable consensus in
of crowding-in private investment may get defeated if
Pakistan among the policy-makers, politicians and a large
segment of general public that public investment is crucial public investment is enhanced by running high fiscal
for economic growth, as it helps to provide for physical and deficits; and (iii) effective use of capital stocks
social infrastructure and other public services which created through investment.
enhance the productivity of private investment and
Looking at the trends in (real) government
generate growth. According to this view, there is direct link
between public investment and economic growth through expenditure and (real) GDP in Pakistan (Figure 2)
increased aggregate demand. However, more important is one could be tempted to conclude that there is some
the indirect link, by which public investments helps provide co-linearity between the two trends. This however
for education, health, municipal services, scientific does not in any sense indicate that there is any
research, and physical infrastructure which generate causal relationship between the two. And even if
positive spillovers in the economy and crowd-in private there is some causality between GDP and public
investment by increasing its productivity, thereby expenditure, the direction of causality is not
stimulating economic growth. This belief has given rise to immediately obvious.
the perception that government’s development spending is
“high quality” spending, especially in comparison with the
recurrent spending, which is generally considered as a
“waste”.

12000 2500
Total Real Expenditure (Rs Billion)
10000 2000
Real GDP (Rs Billion)

8000
1500
6000
1000
4000
2000 500

0 0

GDPFCR TEXPR

Fig. 2: Trends in Real GDP and Real Public Expenditure

35
 AMERICAN JOURNAL OF SOCIAL AND MANAGEMENT SCIENCES
ISSN Print: 2156-1540, ISSN Online: 2151-1559, doi:10.5251/ajsms.2016.7.2.33.41
© 2016, ScienceHuβ, http://www.scihub.org/AJSMS

Determining causality between GDP and public national/regional output/income and public
expenditure: As a first step towards determining the expenditure. The results of the test are reproduced
quantitative impact of public spending on economic in Table 1.
activity we undertook a Granger Causality Test to
determine if there is any causal relationship between
Table 1: Granger Pairwise Causality Test
F-
Null Hypothesis: Obs Prob.
Statistic

EMPN does not Granger Cause

GDPFCR 43 1.08331 0.3487
GDPFCR does not Granger Cause
EMPN 43 6.54747 0.0036 **

KAPR does not Granger Cause

GDPFCR 43 4.66486 0.0154 **
GDPFCR does not Granger Cause 4.00E-
KAPR 43 17.7569 06 ***

TEXPR does not Granger Cause

GDPFCR 41 5.27079 0.0098 ***
GDPFCR does not Granger Cause
TEXPR 6.12245 0.0051 ***

DEXPR does not Granger Cause

GDPFCR 41 2.8611 0.0703 *
GDPFCR does not Granger Cause
DEXPR 41 2.14139 0.1322
* Null Hypothesis rejected at 90 percent level of significance
** Null Hypothesis rejected at 95 percent level of significance
*** Null Hypothesis rejected at 99 percent level of significance
Where: Model and Estimation:
EMPN = Level of employment.
The output/income equation:
GDPFCR = GDP at constant factor cost.
KAPR = Private Capital stock (in constant LOG(GDPFCR) = β0 + β1LOG(EMPN) +
prices). β2LOG(KAPR) + β3LOG(TEXPR) (1)
TEXPR = Real total expenditure of the government.
The equation specified is a standard production
The only surprising element in these results is that function where output (GDP) is determined by level of
they indicate that employment level does not have employment, the stock of private capital and real
any effect on GDP, whereas GDP does impact level expenditure of the government.
of employment (i.e. demand for labor increases with
The labor demand equation
increased GDP). On the other hand, private capital
impacts, and is impacted by, GDP. Similarly, the total LOG(EMPN) = δ0 + δ1LOG(GDPFCR) +
expenditure of the government has a clear two-way δ2LOG(EMPN(-1)) (2)
causality with GDP.
Labor demand depends on the level of real GDP and
Having determined a causal relationship between labor demand in the last year. The real wage rate is
public expenditure and GDP, we adopted a simple excluded as it depicted little variation, i.e. wage rate
log-linear multi-equation model to estimate the and output price moved more or less in a similar
coefficients of these causal relationships. trend. The lagged value of labor demand indicate the
stickiness of labor demand due to inherent difficulties
in hiring and firing of labor in Pakistan.
 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

Capital demand equation LOG(GDPFCR) = -2.5682 + -0.2292 *LOG(EMPN) +

0.9079 *LOG(KAPR) + 0.2519 LOG(TEXPR)
LOG(KAPR) = θ0 + θ1LOG(GDPFCR) +
θ2LOG(KAPR(-1)) (3) - (5.1689)* (2.5668)***
(16.1228)*** (6.0524)***
Adjusted R-squared = 0.997773
Like labor demand, private capital demand is
specified to depend on GDP and lagged value of Durbin-Watson stat = 1.097592
private capital stock.
LOG(TEXPC) = 0.4750 + 0.4757 *LOG(TREVC) +
Nominal expenditure equation 0.5051 *LOG(TEXPC(-1))
LOG(TEXPC) = γ0 + γ1LOG(TREVC) + (5.1100)*** (3.9010)***
γ2LOG(TEXPC(-1)) (4) (4.1186)***
For this model we postulate that fiscal decisions are Adjusted R-squared = 0.997773
primarily nominal. In other words, revenue targets
Durbin-Watson stat = 1.097592
and expenditure allocations are made in nominal
values. For this reason, we specified that nominal LOG(TREVC) = -1.0404 + 0.5853 *LOG(GDPFCC) +
total expenditure of the government depends on 0.4126 *LOG(TREVC(-1))
nominal level of revenue and the lagged value of
expenditure. The latter variable indicates that despite (-3.6530)*** (4.8051)***
(3.4349)***
significant improvements, budgetary allocations are
determined primarily on incremental basis, i.e. last Adjusted R-squared = 0.998228
year’s allocation plus an add-on (depending on
revenue collection). Durbin-Watson stat = 1.7298

Real expenditure identity LOG(EMPN) = -0.2690 + 0.0354 *LOG(GDPFCR) +

0.9301 *LOG(EMPN(-1)
TEXPR = TEXPC/PGDP
(5) (-0.9338)*** (1.0900)
(15.3106)***
As total expenditure is being used as the main fiscal
variable, GDP deflator is used to deflate nominal Adjusted R-squared =0.995408
expenditure. Durbin-Watson stat = 2.083718
Nominal GDP identity LOG(KAPR) = 0.3663 + 0.1164 *LOG(GDPFCR) +
GDPFCC = GDPFCR*PGDP 0.8744 *LOG(KAPR(-1))
(6) (12.9897)*** (8.3661) ***
Similarly, nominal GDP is a product of real GDP and (61.4947)***
GDP deflator. Adjusted R-squared = 0.999966
Total revenue equation -Watson stat = 0.880809
LOG(TREVC) = α0 + α1LOG(GDPFCC) + DISCUSSION OF RESULTS:
α2LOG(TREVC(-1)) (7)
The results show that “government intervention”
Total revenue of the government is assumed to through public expenditure has a strong positive
depend of nominal GDP (α1 being the buoyancy impact on GDP. Public expenditure elasticity of GDP
coefficient), and the lagged value of revenue. The of 0.25 indicates that a 10 percent increase in real
latter indicates rigidities in revenue collection due to expenditure of the government will lead to an almost
weaknesses of revenue agencies and the manner in 2.5 percent GDP growth. On the other hand, labor
which revenue targets are set (which are mainly on (employment) elasticity came out to be negative.
the basis of last year’s collection). This implies a negative marginal product of labor, and
This simple seven-equation system is estimated could very well be due to strong collinearity between
using Three-Stage Least Squares Method (3-SLS). employment and capital stock. This is also indicated
The results are presented below:

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 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

by very level of adjusted R-squared as well very high As a first step in this direction the public expenditures
elasticity of capital stock variable. are bifurcated on the basis of government’s own
classification of non-development (current) and
The expenditure equation indicates that a 10 percent
development expenditures. The general impression is
increase in (nominal) revenue cause only a 5 percent
that non-development would have much smaller (if
increase in expenditure. This also indicates that at
any) impact on GDP compared to development
every one percent increase in revenue, half goes for
expenditure. We therefore modified the model as
increasing expenditure while remaining 5 percent
follows:
goes towards reducing fiscal deficit, ceteris paribus.
Given the past history of government’s fiscal The modified output/income equation
management, this result appears somewhat counter
LOG(GDPFCR) = β0 + β1LOG(EMPN) + G(KAPR) +
intuitive.
β3LOG(CEXPR) + β4LOG(DEXPR)
However, it has to be kept in view that present level
of government expenditure is also influenced by its Where:
level in the previous year but also the results show
CEXPR = Government’s real current expenditure.
that if previous year’s public spending was higher
(than what it was years before) it leads to Rs 5 DEXPR = Government’s real development
increase in spending in the present year. In other expenditure.
words, there are strong rigidities in public spending.
This rigid component of spending remains unaffected Nominal expenditure equations
by revenue. LOG(CEXPC) = γ0 + γ1LOG(TREVC) +
The revenue equation highlights two important facts. γ2LOG(CEXPC(-1)) (4’)
First, in Pakistan, revenue buoyancy (at 0.59) is very LOG(DEXPC) = µ0 + µ1LOG(TREVC) +
low. A 10 percent increase in nominal GDP leads to µ2LOG(DEXPC(-1)) (4”)
only 5.9 percent increase in revenue. This not only
highlights the fundamental weakness of taxation The estimation results of the modified model are
system, but also points to the fact that, at least in given below:
part, faster growing sectors of the economy (e.g. LOG(GDPFCR) = -3.6393 -0.2338 *LOG(EMPN) +
services sector) is much lightly taxed than slow 0.9805 *LOG(KAPR) + 0.1314 *LOG(CEXPR) +
growing sectors (e.g. manufacturing). The results 0.1255 *LOG(DEXPR)
also show that past level of revenue has a positive
impact on the present level. This may imply that -3.3689 -(1.9296)
revenue targets are set on the basis of last year’s (10.8047) (2.4676)
level of collection. (4.024685)

Estimated labor and capital demand functions show

positive elasticities with respect to real GDP as well Adjusted R-squared = 0.998057
as lagged dependent variables. Both functions show Durbin-Watson stat = 1.102641
a very high elasticity of lagged value of dependent
variable, implying a very high long-run GDP LOG(CEXPC) = -0.1003 + 0.4454
elasticities. *LOG(TREVC) + 0.5706 *LOG(CEXPC(-1))

Expanding the model – recurrent and (-0.7935) (3.8916) (5.3165)

development expenditures: Although in the Adjusted R-squared = 0.998392
previous section we have conclusively established
that public expenditure does have a positive impact Durbin-Watson stat = 1.144614
on GDP (and in turn is also impacted by GDP), it is LOG(DEXPC) = 0.9403 + 0.2883
important to deepen this investigation to determine if *LOG(TREVC) + 0.6068 *LOG(DEXPC(-1))
every expenditure that government made impacts
GDP and in the same way as the other, or whether (5.8889) (3.4650) (5.8889)
some types of expenditure impact GDP more than Adjusted R-squared = 0.981719
the other.
Durbin-Watson stat = 1.681344

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 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

LOG(TREVC)= -1.0520 + 0.5908 *LOG(GDPFCC) + responsibility and of public expenditure into

0.4071 *LOG(TREVC(-1)) development and non-development components do
not make much difference.
(-3.7293) (4.9085)
(3.4290) Further expansion of the model – “productive”
and “non-productive” expenditures: Argument
Adjusted R-squared = 0.998224
could also be made that not all spending of the
Durbin-Watson stat = 1.72128 government is “productive” in terms of impacting
GDP. For example, interest payments can impact
LOG(EMPN) = -0.3957 + 0.0499 *LOG(GDPFCR) +
GDP only through enhancement of aggregate
0.9031 *LOG(EMPN(-1) demand; that too if the payments are made within
(-1.3900) (1.5559) Pakistan. As such, these expenditures are not likely
(15.0552) to increase productive capacity of the economy either
through creation or operation and maintenance of
Adjusted R-squared = 0.995399 infrastructure or delivery of social and economic
Durbin-Watson stat = 2.027747 services.
LOG(KAPR) = 0.3712 + 0.1192 *LOG(GDPFCR) + Hence, the basic model is further modified to net out
0.8716 *LOG(KAPR(-1)) the “non-productive” expenditure from the output
equation (1’).
(13.5231) (8.8759) (63.4897)
Hence the new output equation is written as:
Adjusted R-squared = 0.999965
LOG(GDPFCR) = β0 + β1LOG(EMPN) + β2LOG(KAP)
Durbin-Watson stat = 0.875459
β3LOG(CEXPR –EXPINTR) + β4LOG(DEXPR)
The results are not very dissimilar to those of the
original model. They highlight two important features Where:
of government intervention in the economy. First, the EXINTR = Real expenditure in interest payments.
estimated coefficients indicate that public
expenditures, both non-development and We define the “productive” recurrent expenditure,
development do impact GDP. The coefficients of the CECPR1 = CEXPR-EXINR
two types of expenditures are not statistically
The estimation results of the new model are present
different, implying that non-development expenditure below:
and development expenditure impact GDP more or
less by same magnitude. This also implies that our LOG(GDPFCR) = -4.2355 + -0.3793 *LOG(EMPN) +
formulation of output equation (equation (1)) was not 1.0557 *LOG(KAPR) + 0.1565 *LOG(CEXPR1) +
incorrect. Moreover, this conclusively negates the 0.090024 *LOG(DEXPR)
prevailing perception of “wastefulness” of recurrent
(-4.6423) (-3.6710) (14.7263) (3.7769) (2.454224)
expenditure from the view of economic growth.
Adjusted R-squared = 0.998157
Second, while the impact of public expenditure is the
same irrespective of the type of expenditure, the Durbin-Watson stat = 1.061362
impact of revenue (and consequently of GDP) on
LOG(CEXPC) = -0.0983 + 0.4426 *LOG(TREVC) +
expenditure vary by type of expenditure. The impact
0.5733 *LOG(CEXPC(-1))
of revenue on non-development expenditure is much
higher than that on development expenditure. These (-0.7819) (3.9036) (5.3908)
results indicate that recurrent expenditure has a
much bigger claim on additional revenue compared Adjusted R-squared = 0.998394
to development expenditure. This may have some Durbin-Watson stat = 1.147482
political economy consequences, especially the role
of Finance Ministry, which is responsible for LOG(DEXPC) = 0.6214 + 1.1086 *LOG(TREVC) +
preparation and execution of recurrent budget; vis-à- 0.6159 *LOG(DEXPC(-1))
vis the role of Planning Commission, which prepares (5.9667) (3.9088) (5.0851)
and executes Public Sector Development Program
(PSDP). However, from the perspective of economic Adjusted R-squared = 0.981702
growth, it is already shown that the bifurcation of

39
 Am. J. Soc. Mgmt. Sci., 2016, 7(2): 33-41

Durbin-Watson stat = 1.707482 the “productive” recurrent spending, not only lead to
creation of human capital but also finance the
LOG(TREVC) -1.1086 + 0.6159 *LOG(GDPFCC) +
operation and maintenance (O&M) of the
0.3825 *LOG(TREVC(-1))
infrastructure created through development budget.
(-3.9088) (5.0851) (3.2019) In addition, it is this component of public spending
which finances creation and functioning of public
Adjusted R-squared = 0.998203
institutions, which are as much important for
Durbin-Watson stat = 1.683034 economic growth as is the creation of physical
infrastructure.
LOG(EMPN) = -0.4105 + 0.0516 *LOG(GDPFCR) +
0.8997 *LOG(EMPN(-1) There is therefore a need for a rethink not only the
level but also the composition of public spending.
(-1.4451) (1.6137) (15.0393) Improved tax, and better debt management can help
Adjusted R-squared = 0.995395 the government to create additional fiscal space to
enhance the level of public spending. In addition, in
Durbin-Watson stat = 2.019813 light of the above discussion, a better balance needs
LOG(KAPR) = 0.3780 + 0.1230 *LOG(GDPFCR) + to be established between development and
0.8676 *LOG(KAPR(-1)) recurrent expenditures to get the optimal growth
outcome from public spending.
(13.1828) (8.6768) (59.8562)
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