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Does Fiscal Policy Stimulate Growth? The case of Zambia a Small Open developingCountry.Spyton PhiriAdvisor: Prof.Takashi FukushimaMEF07103SummaryIs government involvement vital for economic growth? This question hassurprisingly dominated both theoretical and empirical debate amongst economistsfor a long time.In the theoretical literature, some schools of thought believe that governmentinvolvement in economic activity is essential for growth, whereas those of anopposing thought retains that government operations are inherently bureaucraticand inefficient and therefore holds back rather than stimulate growth. In theempirical literature, equally mixed results abound.The objective of this paper henceforth is not to reach a decision on theremarkable debate but to add to the fiscal policy-growth knowledge of works byexamining the case of Zambia, a small open developing country.Time series techniques were used to investigate the relationship between variousmeasures of fiscal and non-fiscal policy on growth on annual data for the period1964 – 2007. Classifying total government expenditure into productive andunproductive expenditures, it was found that unproductive expenditure was neutralto growth as predicted by economic theory. Further it was found that productivegovernment expenditure and private investment have a strong beneficial effect ongrowth in the long run.Hence these results should prove useful to policy formulators in Zambia indevising expenditure policies to make certain that unproductive expenditures arecut short and productive expenditures are enhanced while at the same time boostingprivate investment by putting in an enabling environment.1.00 IntroductionAdvocates of government interference in economic activity maintain that suchinterference can result into long term growth.They quote government’s role in ensuring efficiency in resource allocation,stabilization of the economy and general regulation of markets as some of themethods in which government could expedite economic growth.On the other hand, antagonists hold the opinion that government operations areinherently bureaucratic and inefficient and consequently hold back rather thanstimulate growth. It therefore then appears like whether government’s fiscalpolicy stimulates or holds back growth still remains a big empirical question tobe resolved. Nonetheless, the current empirical literature is mixed, with someresearchers finding the relationship between fiscal policy and growth as beingpositive meaning that fiscal policy stimulates growth, others as negative meaningthat fiscal policy does not stimulate growth and still others with results as, notprecisely determined.The objective of this paper henceforth is not to reach a decision on theremarkable debate but to add to the literature by examining the effects of fiscalpolicy on growth in a small developing economy, Zambia.Barro (1990) and Kneller et al (1999) as cited by M’Amanja and Morrissey providea theoretical ground for, as well as empirical evidence of the beneficial effectof productive government expenditure and the harmful effect of taxation. In thispaper, total government expenditure has been classified into productive andunproductive expenditures.

Time series techniques with incorporation of two time lags on annual time seriesdata covering the period 1964 – 2007 was used to carry out this analysis for thecase of Zambia. Zambia has had a mixed economic performance since independence andtherefore it would be interesting to know the role of fiscal and related variablesover the period in question.When Zambia became independent in 1964, its rich endowment of copper seemed toguarantee a bright future. However, state dominated economic policies coupled withfalling copper revenues, led to plummeting standards of living. By the early1990’s, Zambia was among the most heavily indebted and poorest countries inAfrica. Following elections in 1991, the new government embarked upon a farreaching economic reform program. Despite substantial achievements inliberalization and establishing a market based economy, sustained growth hasremained elusive. Positive growth rates in 1996 and 1997 were followed by a 2%decline in GDP in 1998.The big question to Zambian policy makers and indeed many other observers of theeconomy is what has been going wrong? And what could be the answer for Zambia’seconomy if any?It will therefore be attempted in this paper to explain some of the causalfactors.2.00 Theoretical issues and empirical evidence2.10 Theoretical issues According to literature available on endogenous growth theory, fiscal policycarried out by the government can affect both the level and growth rate of percapita output. An illustration in much details of the mechanism through whichfiscal policy impacts on growth can be found in, among others, Barro (1990),Aghion and Durlauf (2005) and Barro and Sala-i-Martin (1995). These authors employa Cobb-Douglas type production function with government provided goods andservices (g) as an input to show the positive effect of productive spending andthe adverse effects associated with distortionary taxes. The production function,in per capita terms can be given as follows,y=Ak1-g

α α

(1)Where y is the per capita output, k is per capita private capital and A is aproductivity factor. If its assumed that the government runs a balanced budgetduring each period by raising a proportional tax on output at rate () and lump

sum taxes (L), the government budget constraint then can be expressed as,Ng+C=L+ny

(2)where n is the number of the producers in that economy and C is the governmentconsumption which is assumed to be unproductive. Theoretically, it has been foundthat a proportional tax on output affects the private incentives to invest, but alump sum tax does not. Therefore, subject to a specified utility function, Barro(1990) and Barro and Sala-i-Martin (1995) derive the long run growth rate () in

the model as below,= (1-) (1-) A1/(1-) (g/y)/(1-) –

γ λ τ α α α α μ

(3)where and stand for parameters in the assumed utility function. From equation

λ μ

(3), it can be seen that the growth rate is a decreasing function of thedistortionary tax rate () and an increasing function of the productive government

expenditure (g). It can also be seen that the growth rate is not affected by boththe non-distortionary taxes (L) and the unproductive government expenditure (C).This specification above assumes that the government balances its budget in eachperiod. The empirical model to be adopted therefore follows Kneller et al (1999)and Bleaney et al (2000) as cited in M’Amanja and Morrisey (2005) in which a morepractical view is taken by assuming a non-balancing government budget constraint

in some periods. Equation (3) can therefore be re-written when this fact has beentaken into account to hence obtain the following below expression,ng+C+b=L+ny

(4)where b is the budget deficit or surplus in a given period. Since “g” is taken tobe productive, its predicted sign will therefore be positive, but is negative

because it distorts incentives of the private agents. But both C and L arehypothesized to have zero effects on growth. In the same manner, the effect of bis expected to be zero so long as Ricardian equivalence holds, but may be non-zero otherwise (Bleaney et al, 2000) as cited in M’Amanja and Morrisey (2005). Thegrowth equation to be adopted in this paper is specified in the spirit of Knelleret al (1999) as cited in M’Amanja and Morrisey (2005) by considering both fiscalvariables (Xit) and non-fiscal (Zit) variables so that the growth equationbecomes,yt = + iZit + jXjt +it

α β γ ε

(5)where yt is the growth rate of output, X is the vector of fiscal variables, Z isthe vector of non-fiscal variables, and it are the white noise error terms. Its

interesting to note that, if the budget constraint is fully specified, then jXjt

= 0 because expenditures must balance the revenues. For this to be avoided thereis need to omit at least one element of X (say Xm) to avoid perfect collinearity(Kneller et al, 1999 as cited in M’Amanja and Morrisey, (2005)). But obviously,the omitted element must be that which theory suggests has neutral effect ongrowth, for if any other is selected will result in the introduction ofsubstantial bias in the parameter estimates.Hence, equation (5) can be re-written as follows,yt = + iZit + jXjt +mXmt +it

α β γ γ ε

(6)From equation (6), Xmt can then be omitted to obtain the final growth equationgiven as below,yit = + iZit + (j-m)Xjt + it

α β γ γ ε

(7)Equation (7) therefore, as specified in Kneller et al (1999) as cited in M’Amanjaand Morrisey (2005), constitutes the main idea of the model to be estimated. Whenspecified in this manner, the interpretation of the coefficients of the fiscalvariables should be seen in terms of implied financing. This therefore means that,the null hypothesis to be tested is (j-m) =0 instead of the conventional null

γ γ

that j = 0. Thus accordingly, the interpretation of the coefficient of the fiscal

variables is the “Effect of a unit change in the relevant variable offset by aunit change in the element omitted from the regression” (Kneller et al (1999) ascited in M’Amanja and Morrisey (2005). If it happens that the null is rejected,then more parameter estimates can be obtained if the neutral elements areeliminated from the model.According to literature that is available currently, there is no growth model thatis generally accepted with regard to what factors are to be included in the growthequation. Therefore, those fiscal variables that are found to have neutral effecton growth as stated above are to be dropped. In the formulation of the variants ofthe growth equation (7), a model is estimated in which all the fiscal variables(except budget deficit because it’s an identity and is assumed to have no longterm growth effect but is likely to have adverse short run effects) are included.Next, unproductive government expenditure is dropped from the equation (7) whileretaining all the other expenditure and revenue items.To follow in line, is the dropping of the tax revenue item, but retaining all theother variables including unproductive expenditure and test for zero coefficientof the other neutral element (i.e. unproductive expenditure). Theoretically, theneutral elements of fiscal policy should be insignificant in the model andtherefore in the final specification that is to be carried out, are to be dropped.This is because the expectation, based on literature and theory, is that, these