How Government Spending Slows Growth

Summary of working paper 7207
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...the labor market is the main channel linking these effects of fiscal policy on growth. Higher wages cut into profits, reducing investment, and as a result, economic growth.

Fiscal expansions sometimes have contractionary effects on the economy, and fiscal contractions may result in economic expansion. To understand why, we need to investigate the effect of fiscal policy on business investment. According to NBER Research Associate Alberto Alesina, Silvia Ardagana, Roberto Perotti, and Fabio Schiantarelli, increases in public spending can hit company profits and thus lead to a reduction in private investment and economic growth. Cuts in public spending, on the other hand, can lead to more private investment, and faster growth.

In the standard textbook case, fiscal expansion boosts aggregate demand and leads to an economic expansion; a fiscal squeeze leads to a slowdown. In Fiscal Policy, Profits, and Investment (NBER Working Paper No. 7207) Alesina and his coauthors push deeper, though, analyzing the experience of a number of OECD countries to explain why these standard predictions do not always hold. Most research into the effect of large fiscal swings on the economy has concentrated on the impact on private consumption. But fiscal expansions and contractions, the researchers say, have a much larger impact on private investment - and this accounts for the larger part of the response in terms of economic growth.

During the last 20 years, there have been radical shifts in the fiscal stance in many OECD countries. In the 1970s and early 1980s, these were largely the result of fiscal profligacy leading to the accumulation of large fiscal deficits. Since the mid-1980s, several large OECD economies have implemented major fiscal adjustments to slow the growth of public debt. Alesina and his coauthors use panel data over this period for 18 OECD countries, including the United States, Canada, Japan, the United Kingdom, Germany, France, and Italy. They focus on the role of profits in determining current and expected investment.

Changes in public spending and taxation affect corporate profits, and thus private investment, the researchers find. Changes in public spending have a bigger impact than tax changes do. Particularly important are changes in the public wage bill and in government transfers. This is because the labor market is the main channel linking these effects of fiscal policy on growth. Higher wages cut into profits, reducing investment, and as a result, economic growth.

Increases in public wages also can push up wage demands in the private sector, both in unionized and non-unionized labor markets. Increases in the number of public sector jobs lead to tighter labor market conditions and increased wage pressure. More generous government transfers to those who are out of work can also bid up private sector wages. The opposite holds for cuts in public wages and public employment.

The magnitude of these effects, the researchers find, is substantial. A reduction by 1 percentage point in the ratio of primary spending to GDP in the sample OECD countries leads to an immediate increase in the investment/GDP ratio by 0.16 percentage points. It leads to a cumulative increase by 0.5 percentage points after two years and by 0.8 percentage points after five years. This effect is particularly pronounced when the spending cut is achieved through lower government wages. A cut in the public wage bill of 1 percent of GDP leads to an immediate increase in the investment/GDP ratio by 0.51 percentage points, by 1.83 percentage points after two years, and by 2.77 percentage points after five years.

Increases in taxes also reduce profits and investment, but the magnitude of these tax effects is smaller than those on the expenditure side. As with spending, it is the change of fiscal policy with regard to labor markets that has the strongest effect. On the tax side, workers in the private sector may react to tax hikes by demanding higher pre-tax wages or by working less. This puts pressure on profits and investment (with cuts in labor taxes having the opposite effect). An increase in labor costs equal to 1 percent of GDP leads to a reduction in the investment/GDP ratio of 0.17 percentage points on impact. After five years there is a cumulative reduction of 0.7 percentage points.

The difference in the size of these expenditure and taxation effects suggests that the composition of any large swings in the fiscal stance is crucial. Fiscal expansions tend to be implemented largely through spending, particularly on public sector wages government and transfers, with larger effects. Contractionary adjustments, on the other hand, are characterized mostly by tax increases, where the effect is likely to be smaller.

The magnitude of these coefficients suggests that there is nothing special about the behavior of investment at times of large fiscal adjustments - and so there is need for special theories to explain the effects of large fiscal adjustments. The estimated effect of spending and taxes on investment imply that the different composition of the stabilization package can account for the observed differences in investment and growth rates, and for the surge in private investment that accompanies large public spending cuts.

-- Andrew Balls