The Effects of Government Expenditures on Economic

Growth

Manal Sharif Bajwa S2016060003

School of Business & Economics

University of Management & Technology

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Chapter 1

Introduction

This study is conducted to find out the relationship between government spending and economic

growth in Pakistan. We need to find out whether the expenditures of government cause an increase

in economic growth and vice versa. Increasing economic growth is the main objective of the

government, they might look into different channels to increase but the public expenditure remains

on top of the list.

The highest impact on our living standards, employment levels and state benefits is measured by

economic performance. So which factors increase or decrease our economic growth is critical.

Starting with government expenditure as it is the most significant determinant of economic growth.

The larger the government is, the more economic growth suffers. Why? Because the taxes that are

required to assist the government expenditures destroy the incentives to invest money in and to

work for it, that would have been used by the private sector to generate more profitable outcomes.

This normally minimizes the efficient resource allocation which ultimately results in reduction of

level of output.

In Pakistan, The government operations are organized and implemented in a poor manner and not

to mention the regulatory processes put a huge load and increased costs on our economic system.

The increased government expenditure leads to lower economic growth.

Nowadays, the major challenge for policy makers is the constant long term economic growth and

there are very mixed opinions on whether government spending increases or decreases economic
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growth. To find out the effect of government spending on economic growth we look at two

different thoughts:

1. Keynesian

2. Wagnars Law

According to Keynesian economics, the increased government expenditure ultimately increases

economic growth. Therefore, government spending is an external force that changes economic

growth (Loizides & Vamvoukas, 2005). Governments have a very powerful tool i.e. fiscal policy

to trigger economic growth, suggests Keynesian economics (Shahuda, 2015). If the government

expenditures are increased and taxes are decreased, this will decrease economic growth. So for

this purpose fiscal policy plays an important role in reducing the effects on output and employment

level in short run ((Zagler & Durnecker, 2003). Keynesians thought is also off the view that the

government expenditures, even if they are repeated have a positive impact on the economic growth.

Fiscal policy can show its impact if the government expenditures crowd out private spending, in

this case aggregate demand can be stabilized (Kandil, 2006).

According to Solow (1956) economic growth is not affected by government expenditures in the

long run and also fiscal policy cannot have a long term effect on output. The Neo-classical

economists are off the view that there are other various exogenous factors that affect economic

growth including growth in population, labor force growth and technological progress growth rate.

Looking at the endogenous growth model, Barro (1989) discusses that government consumption

expenditure has a negative impact on economic growth of a country. Positive investments and

growth are also negatively affected and government expenditures cause problems and destructions.

He was also off the view that government expenditures being spent on investment has a positive
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impact on economic growth and government consumption expenditure has a negative effect on

economic growth.

Many economists have different views regarding to the relationship between government spending

and economic growth. The conclusion has not been yet drawn in order to know whether there

exists a positive relationship or negative relationship. According to Barro and Sala-i-Martin (1995)

government spending should be either categorized as productive or un productive by examining

the growth theory.

Talking about the Pakistan’s economy, Government spending and economic growths relationship

is not defined properly. The Pakistani economy is quite unstable due to many obvious factors like,

no proper governance in the country, High rate of corruption, law and order situation is also not

up to the mark. Other factors that also contribute to the instability include high rate of inflation,

increasing energy crisis and most importantly the spread of terrorism across the whole country. If
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we look back at the performance of growth sector in the 1980’s or so we see instability among

social and agricultural sector. Pakistan’s growth performance sector was doing quite well before

1990’s where the economy went towards downfall due to poor macroeconomic conditions. The

economic growth rate also declined during this time period immensely.

According to Kemal (2003) Pakistan’s economy was going through positive and negative changes

from the year 1961 to 2003. The economic growth rate was 5 percent (average), but from the year

2006 until five years the economy was growing at a very low rate due to factors that are mentioned

above (No proper governance and poor political situation in the country). In the past ten years the

economic growth rate has changed from 5 percent per year to 6 percent (average).

Investment % of GDP 1980-1990 – 18.7% , 1990-2000 18.3%

Health Expenditure % of GDP 1980’s > 1%

Education Expenditure % of GDP 1980-till now 2%

This study is going to help the economy of Pakistan is acquiring more economic growth, as the

economy is going the downfall. The law and order situation in the country is getting worse day by

day and so are energy crisis. The rate of inflation is also increasing at a very high rate. The country

is drowned in loans and terrorism is at it’s peak. Pakistan is suffering at a national and international

level. The influence of donor countries is also increasing day by day putting a huge amount of

intimidation on the Pakistani economy to put a restriction on non development expenditures.

Pakistan is wrapped around political, economic and social problems and we need to find out a

strategy and formulate policies that are going to help us achieve all of our goals and rescue our

economy.
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The Objective of Research

This study aims to find out the relationship between government spending in social sectors on

economic growth in the Pakistani economy.

Research Question

Does government spending has a long term relationship with economic growth?

Novelty of the study

This research paper is going to identify the areas where government spending is required to reach

optimal level of economic growth in Pakistan. This study is also going to help the policy makers

in formulating strategies and policies to increase economic growth by increasing the government

spending in social sectors.

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Chapter 2

Literature Review

Government Spending can have a positive or negative impact on the economic growth of a country.

Various studies have been carried out to find the relationship between them in order to accelerate

economic growth of a country.

According to Ghura (1995) he used pooled time series and cross section data, The data was used

for more than thirty countries in Africa. Time line was from the year 1970 to the year 1990. The

study indicated that there exists a negative relationship between government spending and the

economy of a country.

According to Komendi and Meguire (1985) there exists a negative relationship between

government spending and Real GDP growth rate. He used the data of 47 countries.

According to Barro (1990) there are various policies that can be implemented in order to generate

favorable results. If the expenditures are increased for the development activities then it raises the

saving rate upto a certain level. If the government spending is increased for unproductive activities

than it can decline the economic growth of a country.

According to a study by Shenggen Fan, if the government spending is used in productive activities

then the reduction in poverty takes place at an increasing rate and it also increases the productivity

rate.
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Yasin (2000) did an analysis on 26 African countries and used a time line from the year 1987 to

the year 1997 and used different techniques (Fixed and Random Effect) and came to the conclusion

that government spending has a positive relationship with economic growth of a country. He also

gave policy makers a great suggestion to increase the government spending on capital formation,

this will generate a more stable economy.

In this paper inclusive growth is used as a dependent variable, it is a growth with equal opportunity

which puts a huge emphasis on forming of and distributing equal access to all. Inclusive growth

also puts an emphasis that the unequal opportunities are started due to social prohibition from the

market and policy collapses. A strategy that is presented on inclusive growth comprises of

strategies for sustainable growth to formulate new economic related opportunities and also equal

access to all the opportunities. This will end poverty, increase economic growth and also keep

rising inequality issues at bay. For all this inclusive growth strategy should be adopted.

According to Ali (2007) Inclusive growths importance has been realized when it is identified that

in Asia (Developing) there is a major issue that when the economic growth is booming the benefits

of it are no enjoyed equally.

According to Roemer (2006) growth based on equal opportunity differs the inequality which are

caused due to individuals from those due to efforts and not circumstances.

According to Yasin (2000), Alexiou (2009) they analyzed the impact of government spending in

social sectors on economic growth in 7 European countries from the time period of 1995 to the
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year 2005 and found out that the effect of population growth on economic growth was negative

and the remaining variables had a positive effect on economic growth which included trade

openness (proxy), capital formation, development assistance and private investment. So he was

off the view that the variables that are showing positive and significant results on the economic

growth, policy formations should be according to that so that economic growth is increased.

According to Alshahrani & Alsadiq (2014) The country the analysis was done on is Saudia Arabia

and they used the vecm model to have a look at the both long and short run results. They used the

data from the year 1969 to the year 2010. The results show that trade openness and housing sector

spending boom in the short run. In the long run private domestic and public investments and the

expenditures of health care boom in the long run.

According to Knoop (1999) He saw the effects in the US of government spending on economic

growth. The method he used was OLS and the model was endogenous growth, he found out that

if the government spending is decreased then it will prevent the economic growth to boom.

On the other hand Gused (1997) was working on the same technique and model as Knoop and

used the data from the year 1960 to the year 1985, the used the data of developing countries (59)

and he came to the conclusion that increasing the government spending will decrease economic

growth.

According to Wahab (2011) he saw the effect of both aggregate and disaggregate government

expenditures on the economy on developing or developed countries. The aggregate government

spending on economic growth shows that it increases the economic growth.

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According to Tang (2001) The analysis was done for Malaysia, he found out that there exists no

co integration between government spending and NI and the conclusion of this study supports

Wagner’s law.

According to Tang (2009) this paper suggested that the there exists co integration between

government spending (Edu, Def) with NI. Government expenditures on health is not co integrated

with National Income. The conclusion of this paper also supports Wagner’s law.
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Chapter 3

Methodology

This research is carried out to find the relationship between government spending and economic

growth. For this purpose we have extracted the data from WDI. The dependent variable is Poverty+

GINI= Inclusive growth and dependent variables include labor force, gross fixed capital formation,

Polity 2 and various expenditures including water, population planning, education, health, low cost

housing, rural development, subsidies, agriculture and social security and welfare. The time period

of the data is from 1980-2016.

Definition of Variables

Inclusive growth

It basically means growth with equal opportunities. Inclusive growth therefore focuses on both

creating opportunities and making the opportunities accessible to all. Growth is inclusive when it

allows all members of a society to participate in and contribute to the growth process on an equal

basis regardless of their individual circumstances. (Plagiarized).

Dependent variable

Abbreviation Variable Name Variable definition Source Time period

LINC Natural log of Poverty + GINI = WDI 1980 to 2016

Poverty and GINI Inclusive Growth

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List of Independent variables

Abbreviation Variable Name Variable definition Source Time period

LLF Natural log Labor Force Labor Force, total WDI 1980 to 2016

LGFCF Natural log of Gross Fixed Gross Fixed Capital WDI 1980 to 2016

Capital Formation Formation, % of GDP

LPOL Natural log of Polity 2 WDI 1980 to 2016

LWAT Natural log of Water Water (% of GDP) WDI 1980 to 2016

LPOPP Natural log of Population Population Planning (% of WDI 1980 to 2016

Planning GDP)

LHTH Natural log of Health Health (% of GDP) WDI 1980 to 2016

LEDU Natural log of Education Education (% of GDP) WDI 1980 to 2016

LAGR Natural log of Agriculture Agriculture (% of GDP) WDI 1980 to 2016

LSUB Natural log of Subsidies (% of Subsidies (% of GDP) WDI 1980 to 2016

GDP)
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LSSW Natural log of Social Security Social Security and Welfare WDI 1980 to 2016

and Welfare (% of GDP)

LRD Natural log of Rural Rural Development (% of WDI 1980 to 2016

Development GDP)

LLCH Natural log of Low Cost Low Cost Housing (% of WDI 1980 to 2016

Housing GDP)

Models

Equation #1:

LINC=ßo+ß1LLF+ß2LGFCF+ß3 LPOPP +ß4 LWAT +et

Equation #2:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LPOPP +et

Equation #3:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LHTH +et

Equation #4:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LEDU +et

Equation #5:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LAGR +et

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Equation #6:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LSUB +et

Equation #7:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LSSW +et

Equation #8:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LRD +et

Equation #9:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LLCH +et

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Chapter 4

Estimation

Our aim is to find out if there exists any problem in our models and testing to find out the problems

of autocorrelation, Heteroskedasticity, multicollinearity and non-linearity, to find out whether our

data is reliable.

Equation #1:

LINC=ßo+ß1LLF+ß2LGFCF+ß3 LPOPP +ß4 LWAT +et

Equation #2:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LPOPP +et

Equation #3:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LHTH +et

Equation #4:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LEDU +et

Equation #5:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LAGR +et

Equation #6:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LSUB +et

Equation #7:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LSSW +et

Equation #8:
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LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LRD +et

Equation #9:

LINC =ßo+ß1LLF+ß2 LGFCF +ß3 LPOPP +ß4 LLCH +et

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References

Smeeding, T., & Moon, M. (1980). Valuing government expenditures: The case of medical care

transfers and poverty. Review of Income and Wealth, 26(3), 305-323.

Fan, S., Hazell, P., & Thorat, S. (2000). Government spending, growth and poverty in rural

India. American journal of agricultural economics, 82(4), 1038-1051.

Ali, I., & Zhuang, J. (2007). Inclusive growth toward a prosperous Asia: Policy implications (No.

97). ERD Working Paper Series.

Lahirushan, K. P. K. S., & Gunasekara, W. G. V. (2015). The impact of government expenditure

on economic growth: A study of Asian countries. International Journal of Social, Behavioural,

Educational, Economic, Business and Industrial Engineering, 9(9), 2995-3003.

Asghar, N., Azim, P., & ur Rehman, H. (2011). Impact of government spending in social sectors

on economic growth: A case study of Pakistan. Journal of Business & Economics, 3(2), 214.

Hasnul, A. G. (2015). The effects of government expenditure on economic growth: the case of

Malaysia.
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Tang, T. C. (2010). Wagner's Law Versus Keynesian Hypothesis in Malaysia: An Impressionistic

View. International Journal of Business and Society, 11(2), 87.