China Economic Review: Chuanglian Chen, Shujie Yao, Peiwei Hu, Yuting Lin

China Economic Review 45 (2017) 257–278
Contents lists available at ScienceDirect
China Economic Review
Optimal government investment and public debt in an

economic growth model☆
Chuanglian Chen a, Shujie Yao b,c,⁎, Peiwei Hu d, Yuting Lin e
a
School of Economics and Management, International Financial Research Center, South China Normal University, China
b
Chongqing University, China
c
University of Nottingham, China
d
School of International Business, Jinan University, China
e
Department of Finance, Guangdong University of Finance, China
a r t i c l e i n f o a b s t r a c t
Article history: This paper establishes a nonlinear theoretical model and uses panel smoothing transitional re-
Received 20 January 2016 gression to study the optimal levels of government investment and public debt in a growth
Received in revised form 14 August 2016 model using a panel dataset of 65 developed and developing economies over the period
Accepted 14 August 2016
1991–2014. The empirical results show that the effect of government investment on economic
Available online 17 August 2016
growth is decreasing as the level of expenditure rises. When the government investment/GDP
ratio reaches a certain point (threshold), the effect of government investment could change
Keywords: from positive to negative. The effect of public debt on economic growth demonstrates a similar
Government investment
pattern. Our results suggest that there must exist an optimal level of government investment
Public debt
or public debt as far as economic growth is concerned, although the optimal level may vary
Economic growth
Panel smoothing transition regression in different economies. The government investment/GDP and public debt/GDP ratios of China
were respectively 15.66% and 41.14% in 2014. These levels did not reach their respective
thresholds and hence their effects on economic growth were still in the positive territory. De-
spite the expansion of government investment and public debt in China after the world finan-
cial crisis, their scales had not affected the country's economic growth during the data period.
© 2016 Published by Elsevier Inc.
1. Introduction
Since the US subprime crisis in 2008, many governments have launched a proactive fiscal policy to stabilize economic growth
and prevent the collapse of the whole financial system, leading to an expansion of government expenditure and public debt.
Although these policies have helped promote economic growth and smooth the economic cycle in the short run, the discretionary
loosening fiscal policies and banking industry bailouts have resulted in a sharp increase in public debt/GDP ratios in many
countries, such as Italy, Spain, Greece and the USA, which may hinder economic growth. Furthermore, government spending
is decomposed into government investment and government consumption, playing substantially different roles in economic
growth.
☆ This research is generously supported by the following grants in China: National Natural Science Foundation of China (71303081 & 71673033), Ministry of
Education (12YJC790006, 16YJA790058), National Social Science Foundation (12BJL057, 11CJY098).
⁎ Corresponding author at: School of Economics and Business Administration, Chongqing University, China.
E-mail addresses: chenchuanglian@aliyun.com (C. Chen), shujie.yao@nottingham.ac.uk (S. Yao), dannyhu.aiesec@gmail.com (P. Hu), linyuting2016@aliyun.com (Y. Lin).
http://dx.doi.org/10.1016/j.chieco.2016.08.005
1043-951X/© 2016 Published by Elsevier Inc.
258 C. Chen et al. / China Economic Review 45 (2017) 257–278
For the sample countries in this study, the average government expenditure as a proportion of GDP and the public debt/GDP
ratio respectively rose from 32% and 55% in 1991 to 35% and 61% in 2014. For the developed economies in particular, these two
ratios respectively rose from 41% and 49% to 43% and 78% over the same period. The average government investment/GDP and
government consumption/GDP ratios respectively rose from 16% and 16% in 1991 to 18% and 17% in 2014 for all the sample coun-
tries. However, it appears that there is a negative relationship between GDP growth and the level of public debt or government
investment. In particular, when the public debt/GDP ratio is higher than 90% or the government investment/GDP ratio exceeds
30% (see Appendix E), the average economic growth rate declines dramatically. This information suggests that there may exist
two non-linear relationships among the three concerned variables: one between GDP growth and public debt, and the other be-
tween GDP growth and government investment.
According to traditional Keynesian theory, as part of GDP, government investment should promote economic growth. Thus an
expansion of government investment would promote economic growth in the short run, through providing more infrastructure
and complementary public goods, whose positive external effects can effectively improve the investment environment for the pri-
vate sector. However, some recent theoretical and empirical studies show that excessive government investment could be
growth-retarding. This is because overcrowding of government investment and excessive government monopolistic activities
would distort resource allocation, jumble human resources and encourage rent-seeking, all of which could weaken the positive
externality of public investment. Furthermore, excessive government investment would increase financing demand, tax-
enhancing, high private burden and public debt, all of which are harmful to economic growth. Therefore, the negative effect of
rising government investment and public debt on economic growth strengthens the argument that there exists an Armey Curve
(named after Armey, 1995) effect of government investment on economic growth.
Therefore, it is important to consider the non-linear relationship when we study the effect of government investment and pub-
lic debt on economic growth. The main reasons are as follows.
Firstly, if the impact of government investment on economic growth would change from positive to negative as govern-
ment size expands, then the crowd-out effect would also reduce the economic growth effect of government investment. The
discretionary loosening fiscal policies should be paid more attention to, especially when the level of government investment
is close to the “yellow warning line”, which may shift the effect of government investment on economic growth from pro-
moting to hindering.
Secondly, the Chinese government has recently implemented an expansionary fiscal policy, raising government
investment as a proportion of GDP from 25% in 1990 to 28.75% in 2014. Whether this may result in government invest-
ment crowding out private investment and thus hindering economic growth is an important policy issue that needs to
be addressed. Therefore, estimating an optimal and nonlinear relationship between government investment, public debt
and economic growth from a global perspective is worthy of reference for China's proactive fiscal as well as fiscal deficit
policies.
Thirdly, recent literature has used a quadratic function or (panel) threshold model to investigate the optimal level of
government investment and public debts, while we use a panel smoothing transitional regression (PSTR) model. The
model can set parameters flexibly, reflecting the heterogeneity variations of the parameters across different countries
and over time.
This model allows us to derive the smoothing time path of the parameters associated with government investment and public
debts and economic growth as the levels of government investment and public debts rise. This makes it possible to estimate the
optimal levels of government investment and public debts as the macro-economic environment changes.
Finally, we identify the key factors that may affect the elasticities of government investment and public debt with respect to
output, which has not been studied in the existing literature. In addition, our study has provided a mechanism to testify whether
the optimal levels of government investment and public debt could be raised, and suggest how these levels may be raised without
adversely affecting economic growth.
Based on the above analysis, this paper firstly builds a theoretical model incorporating a government sector to analyze the op-
timal levels of government investment and public debt as well as their key determinants. It then employs a panel smoothing tran-
sitional regression approach (PSTR) to identify the optimal levels of government investment and public debts using a panel
dataset covering sixty-five advanced and developing economies during 1991–2014 from a dynamic perspective. The empirical re-
sults show that the effect of government investment on economic growth diminishes as government investment increases, espe-
cially when the government investment/GDP ratio is N20.04%. After this level, the original positive effect of government
investment on economic growth would become negative. Furthermore, the effect of public debt on economic growth also de-
creases as the level of debt rises. When the public debt/GDP ratio reaches 59.72%, the originally positive effect of debt on GDP
growth would become negative as more debt accumulate. These results support our hypothesis that there exists a non-
linear relationship between economic growth with either government investment or public debt. We also identify the
determinants of optimal government investment and public debt. Finally, it is found that the share of government invest-
ment in government expenditure has a negative effect on the elasticities of government investment and public debt with
respect to output, but the intraperiod elasticity of substitution between government and private consumptions does not
have any effect on the same elasticities. An increase in the elasticity of private capital to output would lead to a higher
optimal level of government investment but a lower optimal level of public debt, while an increase in the elasticity of
government investment to output would result in a lower optimal level of government expenditure but a higher optimal
level of public debts. Finally, some policy recommendations are put forward for the discretionary loosening fiscal policies
of the Chinese government.
C. Chen et al. / China Economic Review 45 (2017) 257–278 259
2. Literature
According to traditional theory, government investment would improve social infrastructure and increase the marginal pro-
ductivity of private investment to stimulate economic growth, but it may also crowd out private investment and hence restrain
economic growth at the same time. Secondly, increase in government consumption can stimulate economic growth, but it may
also crowd out private consumption and hence hamper economic growth at the same time. As government investment has
both crowd-in and crowd-out effects on the private sector, it may have a monotonic nonlinear relationship with economic growth.
The above inconsistency concerning the effect of government expenditure on economic growth could be due to a non-linear
rather than a linear relationship between government expenditure and economic growth (Abounoori & Nademi, 2010; Chen &
Lee, 2005a,b; Christie, 2014; Martins & Veiga, 2014; Shanaka, 2012; Thanh, 2015). Armey (1995) first implements the Laffer
curve to present this relationship. This is followed by a large number of empirical studies. Chen and Lee (2005a,b) suggest differ-
ent threshold values for different indicators of government expenditure in Taiwan. They show that the threshold values are re-
spectively 22.8%, 7.3% and 15% for total government expenditure share in GDP, government investment expenditure share in
GDP and government consumption expenditure share in GDP. This implies that there must exist an optimal level of government
expenditure as far as economic growth is concerned. Abounoori and Nademi (2010) also show a non-linear Armey Curve effect in
Iran, and the corresponding threshold effects to total government expenditure/GDP ratio, government consumption expenditure/
GDP ratio, and government investment expenditure/GDP ratio are respectively 34.7%, 23.6% and 8%. Shanaka (2012) confirms the
optimal level of government expenditure to be approximately 27% for Sri Lanka. Christie (2014) supports that when total govern-
ment spending exceeds 33% of GDP, there is a strong negative effect on growth. Thanh (2015) employs a nonlinear smooth tran-
sition autoregressive model to estimate and find that the optimal government consumption expenditure to GDP ratio is
respectively 15.2% for Japan and 19.4% for China. Martins and Veiga (2014) find that government size as a percentage of GDP
has a quadratic (inverted U-shaped) effect on the growth rate in a sample of 156 countries.
The crowding-out effect of government expenditure on economic growth may in part be due to the corresponding increase in
taxes and public debt (Baum et al., 2013; Égert, 2013; Reinhart & Rogoff, 2010). Telesa and Mussolinib (2014) propose an endog-
enous growth model to demonstrate that the public debt/GDP ratio should negatively impact the effect of fiscal policy on growth,
because government indebtedness extracts a portion of young people's savings to pay interest on debt. Many recent empirical
studies have sought to pin down and explain whether there exists a non-linear negative relationship between public debt and
economic growth. Reinhart and Rogoff (2010) use descriptive statistics to show that economic growth slows down rapidly
when public debt exceeds 90% of GDP. Their findings are also supported by Kumar and Woo (2010), Checherita and Rother
(2010) and Baum et al. (2013) for a mix of advanced and emerging market economies along with eurozone countries. However,
Herndon, Ash, and Pollin (2014) point out that the relationship between public debt and economic growth varies significantly in
different time periods and countries. For example, Caner, Grennes, and Koehler-Geib (2010), Cecchetti, Mohanty, and Zampolli
(2011) and Elmeskov and Sutherland (2012) suggest that the public debt/GDP ratio thresholds are 77% for a set of 77 countries,
86% for 18 OECD countries and 66% for a dozen of OECD countries, respectively. Furthermore, Égert (2013) shows that the neg-
ative nonlinear effect kicks in at much lower levels of public debt at 20–60% of GDP.
Furthermore, as shown in Gwartney, Lawson, and Holcombe (1998), Mueller (2004) et al., the expansion of government in-
vestment, and the subsequent increase in public debt, may crowd-out private investment. This, in turn, would weaken the positive
effect of government investment on economic growth, or even shift the positive effect to a negative one. It means that fiscal policy
which depends on the expansion of government investment to stimulate economic growth may not be persistent. More impor-
tantly, how to prevent the influence of government investment on economic growth from a promoting effect to a hindering effect
is a major concern of governments when a new fiscal policy is implemented. Therefore, when we study the push (positive) effect
of government investment on economic growth, we should also consider the potential pull (negative) effect of public debt on eco-
nomic growth due to the expansion of government investment. Government investment and public debt are two important fiscal
policy instruments affecting macroeconomic performance, and their links to economic growth is an important issue for research.
However, the above literature does not discuss why there exist two nonlinear relationships between economic growth, gov-
ernment investment and public debt in a theoretical model. This paper aims to fill this gap in the literature. Firstly, unlike
other studies, we construct a Keynesian effective demand function in a Cobb-Douglas framework to measure the substitution,
complementary or unrelated effects between government and private consumptions. Secondly, we introduce private capital, gov-
ernment investment and labor as three important factors of output in the production function, which provides an effective mea-
sure for the impact of government investment on economic growth. Thirdly, we use the optimization theory to derive the
nonlinear relationships between government investment, public debt and economic growth, and the optimal levels of government
investment and public debt. Fourthly, based on the above theoretical model, we use a panel smoothing transitional regression
model (PSTR) to identify the optimal levels of government investment and public debt for sixty-five developed and developing
economies from a dynamic perspective.
3. Theoretical model
The endogenous growth model emphasizes the effects of savings, population growth and technology on economic growth
(Carboni & Medda, 2007). While some recent studies indicate that productive public investment can be directly incorporated
into the production function as it may influence economic growth through changing the marginal productivities of capital and
labor. In addition, public consumption expenditure can be introduced into the utility function of households to improve their
welfare.
This paper incorporates a government sector and pays attention to analyzing the fiscal policy effects on economic growth.
Firstly, public investment would improve social infrastructure and increase the marginal productivity of private investment to
stimulate economic growth, but it may also crowd out private investment and hence restrain economic growth at the same
time. Secondly, the increase in government consumption can stimulate economic growth, but it may also crowd out private con-
sumption and hence hamper economic growth at the same time. As government expenditure has both crowd-in and crowd-out
effects on the private sector, it may have a monotonic nonlinear relationship with economic growth. Based on this intuition
and different to the traditional literature, this paper builds a nonlinear theoretical model to study the optimal size and composi-
tion of government expenditure (investment expenditure Gk = ϕG, consumption expenditureGc = (1− ϕ)G, 0 ≤ ϕ ≤ 1) and public
debt in an endogenous growth model.
3.1. The household sector
Ho (2001) and Neih and Ho (2006) assume that Keynesian effective demand can be constructed as a simple linear equation
C∗t = Ct + ϑGc,t of private consumption Ct and government consumption Gc,t, where ϑ can be positive or negative as it may respec-
tively denote the substitutionary or complementary relationship between private and government consumptions. Since utility is
an increasing function of effective demand C∗t , when ϑis negative, the total utility function U(C∗t ) is a decreasing function of gov-
ernment consumption Gc,t. When the relationship between government consumption and private consumption is complementary,
an increase in government consumption will still reduce consumer utility based on the above linear equation, which is contradic-
tory to the classical hypothesis. In order to address this problem, we construct a Keynesian effective demand function in a Cobb-
Douglas form of government consumption Gc,t and private consumption Ct:
θ 1−θ
C t ¼ C t Gc;t ð1Þ
where, θ is the elasticity of private consumption in the following consumption, indicating that there is some elastic effect relation-
ship between government consumption and private consumption. The dynamic optimization problem of a representative house-
hold at time zero in an infinite horizon economy is defined as follows:
Z∞ " 1−σ #
ðC t Þ −1 −ρt
U Ct ¼ e dt ð2Þ
1−σ
0
where, ρ is a subjective discount factor, σ is a curvature parameter, andC∗1−σ

t /(1− σ) = ln C∗t if and only if σ = 1. Assume Wt is the
real assets held by households at time t, Yt is the stochastic labor income at time t, and r stands for real interest rate, Dt is public
debt, we can derive the lifetime budget constraint of the agent representing all households as follows:
W tþ1 ¼ ð1 þ r ÞW t þ Y t þ rDt −C t −Gc;t ð3Þ
Using the Lagrangian approach to solve the above optimal problem by setting the marginal utility of government spending
equal to the marginal utility of private consumption, we can obtain Ct =θGc,t/(1− θ).
3.2. The productive sector
The production technology is Yt =AKαt Gβk,tL1−α−β, where Yt is output, Kt private capital stock, A technology and L labor force,
Gk,t government capital spending. α and β denote respectively the elasticities of private capital and government capital spending
with respect to output, such that 0 b α + βb 1. Following Greiner (2012), we assume that government capital spending is financed
by tax and public debt, so that the government's budget constraint can be derived as follows:
τðY t þ rDt Þ þ D_ t −rDt ¼ Gt ¼ Gc;t þ Gk;t ð4Þ
where, τ represents tax rate. Dt is public debt, D_ t is the growth rate of public debt, and r is the return rate of public debt. The
government capital accumulation function can be written as follows:
h i
G_ k;t ¼ ϕGt −δGk;t ¼ ϕ τY t þ D_ t −ð1−τ ÞrDt −δGk;t ð5Þ
where, δ is the capital depreciation rate. From Eq. (5), we note that government can increase its investment to stimulate economic
growth through increasing the tax rate or public debt. On the other hand, the increase in government capital investment would
raise private taxes, crowd out private investment and hence reduce economic growth. Therefore, if and only if the marginal pro-
ductivity of government investment is equal to the marginal productivity of private investment, the “net” effect of fiscal policy on
economic growth would be neutral. In addition, government capital accumulation is positively related to the share of government
investment in total government expenditure (ϕ).
Private capital accumulation depends on private savings and capital depreciation:
K_ t ¼ ð1−τÞðY t þ rDt Þ−C t −δK t ð6Þ
Incorporating Ct = θGc,t/(1 −θ) into the above equation yields:

θ
K_ t ¼ ð1−τÞð1 þ rdt Þ− ð1−ϕÞ½ηdt −ð1−τÞrdt þ τ Y t −δK t ð7Þ
1−θ
where, dt = Dt/Yt, η ¼ D_ t =Dt represents the public debt growth rate. From Eq. (7), we note that government can increase private
investment to stimulate economic growth through reducing the tax rate or public debts. The larger the intraperiod elasticity of
substitution between private and government consumptions (θ/(1− θ)), the smaller the effect of the change in tax rate or public
debt on private capital accumulation.
Eqs. (5) and (7) can be expressed as the following in per capita form:
g_ k;t ¼ ϕ½ηdt −ð1−τ Þrdt þ τyt −ðδ þ nÞg k;t ð8Þ

θ
k_ t ¼ ð1−τÞð1 þ rdt Þ− ð1−ϕÞ½ηdt −ð1−τÞrdt þ τ yt −ðδ þ nÞkt ð9Þ
1−θ
where lower case letters indicate variables divided by population (L). n is the labor force growth rate. Output per labor is:
α β
yt ¼ Akt g k;t ð10Þ
In the steady state equilibrium, the growth rates of capital and consumption are equal to zero, satisfying fg_ ¼ 0; k_ ¼ 0; g_ k ¼ 0g.
Using the dynamic optimal method, we can drive the equilibrium per capita output:
β αþβ
−
y ¼ A½ϕðηdt −ð1−τÞrdt þ τÞ1−α−β ðδ þ nÞ 1−α−β
α
θ 1−α−β ð11Þ
ð1−τ Þð1 þ rdt Þ− ð1−ϕÞ½ηd−ð1−τ Þrdt þ τ
1−θ
From Eq. (11), we can see that the steady state per capita output depends on endogenous and exogenous factors as well
as elasticity parameters. The exogenous variables include interest rate, depreciation rate, technology and population growth.
Endogenous variables include the composition of government expenditure, tax rate and public debt. The elasticity
parameters include the elasticities of output with respect to private capital and government capital expenditure, as well
as the elasticity of private consumption to effective demand. Eq. (11) shows that there is a nonlinear relationship between
per capita output and the following indicators: the growth rate of labor, public debt and government expenditure as well as
their composition.
3.3. Fiscal policy effects
In order to examine the optimal levels of government expenditure, government investment and public debt, we take a log-
linear function of Eq. (11) to derive the expression for the growth rate of per capita output. Using the optimisation theory, we
derive the following propositions.
α
Proposition 1. There exists an optimal composition of government investment on long term economic growth ðϕopt ¼ αþβ ½1− 1−θ 1
θ ϖ
ð1−τÞð1 þ rdÞÞ; and the optimal composition of government investment is positively related to the elasticity of private capital invest-
ment to output (α) divided by the total elasticity of social capital to output (α+ β), and to government expenditure size (ϖ) and tax
θ Þ.
rate (τ),but is negatively related to the intraperiod elasticity of substitution for both government and private consumptions ð1−θ
Proof. Take the derivative of the log-linear form of Eq. (11) with respect to ϕ, we can derive the optimal composition of govern-
ment investment as follows:

_ Þ
∂ðy=y α 1−θ 1
¼ 0⇒ϕopt ¼ 1− ð1−τÞð1 þ rdÞ ð12Þ
∂ϕ αþβ θ ϖ
2
_ Þ
∂2 ðy=y β 1 α ϖ
¼ − − ð13Þ
∂ϕ2 1−α−β ϕ2 1−α−β ð1−τÞð1 þ rdÞð1−θÞ=θ−ð1−ϕÞϖ
2
_
Substituting (12) to (13) yields ∂ ∂ϕ
ðy=yÞ
jϕ¼ α _
b0, according to the maximization principle and y=yis a concave func-
αþβ½1− θ ϖ ð1−τÞð1þrdÞ
2 1−θ 1
tion of ϕ, we can then prove that ϕoptis the optimal composition of government investment, where, ϖ =ηd − (1− τ)rdt + τ.
θ ðαþβÞτr−βðr−ηÞ
ðαþβÞð1−ϕÞτ þ½ ð1−τÞ
Proposition 2. There exists an optimal level of public debt on long term economic growth ðdopt ¼ ðαþβÞ½rð1−τÞþ 1−θ
θ
ð1−τÞr−η
ð1−ϕÞ½ð1−τÞr−η
Þ;1 the
1−θ
optimal level of public debt is positively related to the return rate of public debt (r), the elasticity of government capital investment to
output (β), the total elasticity of social capital to output (α + β), the intraperiod elasticity of substitution for both government and pri-
vate consumption ð1−θθ Þ, and the share of public investment in government investment (ϕ), but negatively related to the tax rate (τ),and
the growth rate of public debt (η).
Proof. Take the derivative of the log-linear form of Eq. (11) with respect to d, we can derive the optimal level of public debt as
follows.

θ ðα þ βÞτr−βðr−ηÞ
ðα þ βÞð1−ϕÞτ þ ð1−τÞ
_ Þ
∂ðy=y 1−θ ð1−τÞr−η
¼ 0⇒dopt ¼ ð14Þ
∂d θ
ðα þ βÞ r ð1−τÞ þ ð1−ϕÞ½ð1−τ Þr−η
1−θ
" #2
_ Þ θ
∂2 ðy=y β η−ð1−τ Þr 2 α ð1−τÞr− 1−θ ð1−ϕÞ½η−ð1−τÞr
¼ − − ð15Þ
∂d2 1−α−β ϖ θ
1−α−β ð1−τÞð1 þ rdÞ−ð1−ϕÞϖ 1−θ
2
_
Substituting Eqs. (14) to (15) yields ∂ ðy=yÞ
j ðαþβÞð1−ϕÞτ θ þ½
ðαþβÞτr−βðr−ηÞ _
b0, according to the maximization principle andy=yis a con-
∂d2 1−θ ð1−τÞr−η
ð1−τÞ
d¼
ðαþβÞ½rð1−τÞþ θ ð1−ϕÞ½ð1−τÞr−η
1−θ
cave function of d, we can prove that doptis the optimal level of public debt.
4. Empirical models and methodology
In order to verify Propositions 1 and 2 we use a panel smoothing transition regression (PSTR) approach to study the optimal
composition of government investment and public debt in an endogenous growth model. In a PSTR model, the estimated coeffi-
cients are time-varying and can take different values depending on the values of the cross-section observable variables. The PSTR
model also allows the estimated coefficients to be smoothing and regime-switching depending on the transitional variables. Tak-
ing logarithms of the production equation, and considering the nonlinear effects of public debt and government spending on eco-
nomic growth, we have:
Y_ it K_ L_ D_ _k
ð1Þ G
_k
ð2Þ G
¼ a0 þ a1 it þ a2 it þ a3 it þ a4 itk þ a4 itk f ðQ it ; γ; Q D Þ þ ε it ð16Þ
Y it K it Lit Dit Git Git
Y_ it K_ L_ G_ _ _
k
ð1Þ D ð2Þ D
¼ b0 þ b1 it þ b2 it þ b3 itk þ b4 it þ b4 it f ðQ it ; γ; Q D Þ þ ε it ð17Þ
Y it K it Lit Git D it D it
_
where Y=Y is economic growth rate, K=K_ _ is population growth rate, G_ k =Gk is government in-
is private capital growth rate, L=L it it
_
vestment capital growth rate, D=D is public debt growth rate. a and b are estimated coefficients. Smoothing regime-switching
function f(Q,γ, QG,D) follows the logistic process satisfying 0 ≤g ≤ 1 is defined by:
m
−1
f ðQ it ; γ; Q c Þ ¼ 1 þ exp −γ ∏ ðQ it −Q c Þ ; γ N0; Q 1 ≤…≤Q m ð18Þ
c¼1
where, Qc are the location parameters of the transitional function, γ is the smoothing parameter, and these parameters determine
the smoothing degree of the logistic function and regime-switching speed of different systems, we can use them to estimate the
optimal composition of government investment and public debt on economic growth.
1
In order to keep dopt N 0, iff ð1− αþβ
β τÞrbηbð1−τÞr, we noted that if and only if the growth rate of public debt keeps in a certain range, then the optimal public debt
would be positive.
According to Gonzulez, Terasvirta, and van Dijk (2005), in order to test the significance of regime-switching effects of the sys-
tem, we replace f(Qit,γ, Qc) by a first-order Taylor expansion around γ = 0, and derive an auxiliary regression as follows:
Y_ it K_ L_ D_ G_ G_ G_
k k k
m
¼ a0 þ a1 it þ a2 it þ a3 it þ φ0 itk þ φ1 itk Q þ … þ φm itk Q þ εG;it ð19Þ
Y it K it Lit Dit Git Git Git
Y_ it K_ L_ G_ D_ D_ D_
k
m
¼ b0 þ b1 it þ b2 it þ b3 itk þ δ0 it þ δ1 it Q þ … þ δm it Q þ εD;it ð20Þ
Y it K it Lit Git Dit Dit Dit
ε ¼ε þR φ G_ ε ¼ε þR0 δ D_
k
where G;it G;itGk m 1 it , D;it D;itD m 1 it , Rmand Rm′ are the remaining terms of the Taylor expansion. According to Gonzulez et al.
it
(2005), testing H0 : γ = 0in Eqs. (16) and (17) is equivalent to testing H∗0 : φ1 = ⋯ = φm = 0 and H∗0 : δ1 = ⋯ = δm = 0 in (19) and
it
(20). In order to test H∗0, two test statistics are computed as follows:
TNðSSR0 −SSR1 Þ 2
LM ¼ χ mk ð21Þ
SSR0
TN ðSSR0 −SSR1 Þ
F¼ F ðmk; TN−N−mkÞ ð22Þ
SSR0 =ðTN−N−1Þ
where, TN is the total observations, k is the number of explanatory variables, SSR0 is the residual sum of squares by imposing
H0 :γ = 0, while SSR1 is the residual sum of squares given H1 : γ≠ 0. After testing the hypothesis of parameter constancy, we test
the hypothesis of no remaining heterogeneity. Firstly, we assume the model only has one-regime switching as in Eqs. (16) and
(17). Secondly, we consider the model has two-regime switchings as in Eqs. (19) and (20), thus:
Y_ it K_ L_ D_ _k
ð1Þ G
_ k ð1Þ
ð2Þ G
_ k ð2Þ
ð3Þ G

¼ a0 þ a1 it þ a2 it þ a3 it þ a4 itk þ a4 itk f Q ; γ 1 ; Q G þ a4 itk f Q ; γ2 ; Q G þ εit ð23Þ
Y it K it Lit Dit Git Git Git
Y_ it K_ L_ G_
k _
ð1Þ D
_ ð1 Þ
ð2Þ D
_ ð2Þ
ð3Þ D

¼ b0 þ b1 it þ b2 it þ b3 itk þ b4 it þ b4 it f Q ; γ1 ; Q D þ b4 it f Q ; γ2 ; Q D þ εit ð24Þ
Y it K it Lit Git Dit Dit Dit
where, Q(1) = Q(2). Similar to the above testing method, to test whether there exist two regime-switchings, we assume that the
null hypothesis is H0 : γ2 = 0, and then replace f(Q(2), γ2, Qc)by a first-order Taylor expansion around γ2 = 0, and then use LM
and F statistics to test for the significant number of regime-switchings. Meanwhile, we have to test whether there exist three
or more regime-switchings in the regression model until we cannot reject H0. We then derive an optimal number of regime-
switchings and the location parameters as well as the smoothing parameter of the switching function.
5. Data
This paper uses annual data during 1990–2014 for sixty-five Asian, European, American, African and Oceanian countries and
regions, including the USA, China, Japan, UK, Germany, India and South Africa et al..2 The variables used in the model are derived
bellow.
_
Gross domestic product (GDP) growth rate ðY=YÞ, _
capital stock growth rate ðK=KÞ, _
labor growth rate ðL=LÞ, government invest-
ment capital growth rate ðG_ =Gk Þ and public debt growth rate ðD=DÞ
k
_ are derived from the World Development Indicators published
by the World Bank, IMF World Economic Outlook (WEO), International Financial Statistics and Government Financial Statistics (see
Table 1).
Private capital stock is constructed using a perpetual inventory method, Kt = Kt−1(1− δ) + It, where It is capital formation, δ is
the capital depreciation rate which is assumed to be 5% according to the previous literature. Specifically, the beginning initial cap-
ital stock is given by K1990 = I1990/(g + δ), where g is the 24-year growth rate capital formation (so that g = ln (I2014/I1990)/25).
Furthermore, gross capital formation price index (2005 = 100) is measured by gross capital formation (current US$) divided
by gross capital formation (constant 2005 US$),3 which is used to derive private capital stock Kt in constant 2005 prices. Govern-
ment investment (Gk) is estimated through government expenditure (G) minus government consumption (Gc), and government
investment capital (Gk) is estimated based on government investment. According to the estimated method of private capital stock,
government investment capital stock is Gkt = Gkt−1(1− δ) + Gk,t, and the beginning initial capital stock is given by Gk1990 =Gk,1990/
(gk + δ), where gkis the 24-year government investment growth rate capital formation (so that gk = ln (Gk,2014/Gk,1990)/25).
2
All of the countries and regions and their codes are in Appendix E.
3
Gross capital formation (current US$) and gross capital formation (constant 2005 US$) come from World Development Indicators, published by the World Bank.
Table 1
Variables defined and data sources.
Variables Denoted Sources

by
Gross domestic product (GDP) growth _

Y=Y World Development Indicators published by the World Bank, 1991–2013
rate
Private capital stock growth ratea _
K=K International Monetary Fund (IMF), World Economic Outlook (WEO) constructed by perpetual
inventory method
Labor growth rate _
L=L World Development Indicators published by the World Bank, 1991–2013
Government investment capitalb G_ =Gk
k International Monetary Fund (IMF), World Economic Outlook (WEO)
Public debt growth rate c
_
D=D International Monetary Fund (IMF), World Economic Outlook (WEO)
Government investment/GDP ratios ϕG/Y International Monetary Fund (IMF), World Economic Outlook (WEO)
Public debt/GDP ratios D/Y International Monetary Fund (IMF), World Economic Outlook (WEO)
a
Provided by Aqib Aslam, Samya Beidas-Strom, Daniel Leigh (team leader), Seok Gil Park, and Hui Tong, IMF World Economic Outlook, Chapter 4 Private Investment:
What's The Hold Up?.
b
Expressed as a ratio of total investment in current local currency and GDP in current local currency. Investment or gross capital formation is measured by the total
value of the gross fixed capital formation and changes in inventories and acquisitions less disposals of valuables for a unit or sector. [SNA 1993] General government
total expenditure (National currency) is defined by IMF. Total expenditure consists of total expenses and the net acquisition of nonfinancial assets. Note: Apart from
being on an accrual basis, total expenditure differs from the GFSM 1986 definition of total expenditure in the sense that it also takes the disposals of nonfinancial assets
into account.
c
General government gross debt (National currency) is defined by IMF. Gross debt consists of all liabilities that require payment or payments of interest and/or
principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of SDRs, currency and deposits, debt securities, loans,
insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the GFSM 2001 system are debt, except for equity and in-
vestment fund shares and financial derivatives and employee stock options. Debt can be valued at current market, nominal, or face values (Citation “GFSM 2001” has not
been found in the reference list. Please supply full details for this reference.GFSM 2001, paragraph 7.110).
Table 2
Summary statistics of the variables.
Variables Average Median Maximum Minimum Std. dev.

_
Y=Y 3.574% 3.678% 18.672% −13.127% 3.392
_
L=L 1.876% 1.874% 17.732% −4.687% 1.766
_
K=K 15.435% 4.820% 3840.369% −41.225% 135.705
G_ =Gk
k 8.475% 6.601% 246.023% −4.695% 10.871
_
D=D 15.986% 8.744% 2602.212% −69.543% 75.716
Gk/Y 16.487% 15.271% 40.902% 0.199% 8.989
D/Y 56.843% 51.564% 454.949% 1.583% 36.732
Notes: The definitions of all the variables are provided in Table 1.

Sources: World Bank; IMF, IFS and GFS for the period 1990–2014.
According to the theoretical model and existing literature, such as Chen and Lee (2005a,b), we use government investment/
GDP and public debt/GDP ratios to measure the composition of government investment and public debt. Table 2 gives the sum-
mary statistics of the variables used in this paper. Over the data period, the average GDP growth rate of the sample countries was
3.6%, the government investment capital growth rate 8.5%, the private capital stock growth rate nearly 15%, the public debt
growth rate nearly 16%, and the labor growth rate only 1.9%. The average public debts/GDP ratio was 59%, while the government
investment/GDP ratio was 16.5%.
6. Empirical results
To test whether there is a non-linear effect between government investment and public debts, we conduct the F and LM tests.
In the linearity tests, the null hypothesis and alterative hypothesis are respectively H0: γ = 0 and H1: γ = 1. Table 3 presents the F
Table 3
Tests for remaining nonlinearity.
Model statistics Public investment Public debt
F LM F LM
H0: γ = 0 VSH1: γ = 1 7.0893⁎⁎⁎ 14.6755⁎⁎⁎ 17.6918⁎⁎⁎ 36.1155⁎⁎⁎

(0.0009) (0.0007) (0.0000) (0.0000)
H0: γ = 1 VSH1: γ = 2 0.4093 1.7182 0.8341 3.6115
(0.8020) (0.7874) (0.5034) (0.4611)
Notes: LM and F statistics are calculated through Eqs. (21) and (22). Numbers in square brackets are p-values.
⁎⁎⁎ Significance at 1% level.
Table 4
Economic growth function parameter estimates for the PSTR models.
Model Public investment Model Public debt
Coefficient Std. error Coefficient Std. error
Smoothing parameters 0.25069⁎⁎⁎ 0.0416 Smoothing Parameters 0.2308⁎⁎ 0.1008

Location parameters 16.0346⁎⁎⁎ 1.0349 Location Parameters 51.7559⁎⁎⁎ 0.1115
a1 0.1417⁎⁎ 0.05904 b1 0.1648⁎⁎ 0.06454
a2 0.1755⁎⁎⁎ 0.0535 b2 0.1850⁎⁎⁎ 0.0531
a3 – – b3 0.0086⁎⁎⁎ 0.0020
a(1)
4 0.02917⁎⁎⁎ 0.0026 b(1)
4 0.0306⁎⁎⁎ 0.0046
a(1)
4 −0.0399⁎⁎⁎ 0.0074⁎ b(1)
4 −0.0355⁎⁎⁎ 0.0047
No. of transition function 1 No. of transition function 1
AIC 2.1191 AIC 2.1036
BIC 2.1396 BIC 2.1276
Notes: aiand bi (i=1,2,3,4) are coefficients in Eqs. (16) and (17), smoothing parameters and location parameters are respectively γ and Qc in Eq. (18).
⁎ Significant at 10%.
⁎⁎ Significant at 5%.
⁎⁎⁎ Significant at 1%.
and LM test statistics. When we use the optimal government investment as the regime-switching variable to analyze the nonlin-
ear effect of government investment on economic growth, the F and LM statistics both significantly reject the null hypothesis
H0: γ= 0, indicating that the effect of government investment on economic growth depends on the level of expenditure. Further-
more, setting the optimal public debt as the regime-switching variable to analyze the nonlinear effect of public debt on economic
growth, the F and LM statistics also both significantly reject the null hypothesis H0: γ= 0, indicating that the effect of public debt
on economic growth depends on the level of debts.
Secondly, in order to analyze the nonlinear characteristics of the model, we test the hypothesis of no remaining heterogeneity
to determine the optimal number of regime-switchings. We firstly assume that there is only one regime-switching (H0 : γ = 1),
and the alternative hypothesis is that there exist two-regime switchings (H1 : γ= 2). We replace f(Qi,t,γ2, Qc)by a first-order Taylor
expansion around γ2 = 0, and use LM and F tests to verify the hypothesis. As shown in Table 3, we can see that the null hypoth-
esis of one regime-switching (H0 : γ =1) cannot be rejected at the 1% critical level.
Based on the tests of linearity and no remaining heterogeneity, according to Gonzulez et al. (2005), we estimate the param-
eters of a PSTR model in two steps. Firstly, we eliminate the individual effect by removing individual specific means and then
apply a nonlinear least square (NLS) method to estimate the parameters. One important issue in estimating the PSTR model is
the selection of starting values. We use a grid search method to obtain the sensible starting values by minimizing the residual
sum of squares of the model, and let it be the starting values of the nonlinear optimization algorithm until the estimated param-
eters of the model are convergent. Table 4 presents the estimated results of the model.
Private capital stock and labor are found to have positive effects on economic growth, which is consistent with the classical
theory. The estimated results also show that the smoothing parameters are all less than unity, indicating that the regime-
switching function presents obvious smoothing features. Combining the estimated location parameters, and based on the transi-
tional functionf(Qi, t, γ2, Qc), we can respectively derive the logistic function for the transitional levels of government investment
and public debt in Fig. 1.
Fig. 1 shows a nonlinear regime-switching process in both models. Furthermore, since the coefficients of a(1) (1)
3 and b3 are neg-
ative, indicating that increased government investment and public debt can lead to a rise in the corresponding public tax rate,
Fig. 1. logistic function for different transitional variables Notes: Transitional function is calculated through Eq. (18) based on the parameters estimated in Table 4.
Fig. 2. Effects of government investment on economic growth based on PSRT Notes: Coefficient is calculated through Eq. (25) based on the parameters estimated
in Table 4. The elasticity denotes the average effect of government investment on economic growth.
which can potentially change the effects of government investment and public debt on economic growth from positive to
negative.
To present the nonlinear characteristics of the coefficients, we respectively estimate the average values of government invest-
ment and public debt from 2000 to 2014, and use them as the estimators of Q i;t in the PSTR model to calculate the following co-
efficients in Eqs. (25) and (26).

_
∂ Y=Y
a¼ ¼ að41Þ þ að42Þ f Q it ; γ; Q G ð25Þ
_
∂ G=G

_
∂ Y=Y
b¼ ¼ bð41Þ þ bð42Þ f Q it ; γ; Q D ð26Þ
_
∂ D=D
Based on the estimated parameters, we show respectively the nonlinear effects of government investment and public debts on
economic growth in Figs. 2 and 5, including China, the USA, Japan, Germany, India, Brazil, Russia and South Africa et.al.
Fig. 2 shows a positive relationship between government investment and economic growth in most developing and emerging
economies, such as Indonesia, Sudan, Peru, the Philippines, Mexico, Pakistan, Thailand, India, Malaysia, South Korea, Hong Kong
and China (41 countries). However, the same relationship is found to be negative for many developed countries, including
Denmark, Sweden, Finland, France, Belgium, Italy, Germany, Egypt, Turkey and Venezuela et al. (24 countries).
This is mainly because compared to the developed countries, the level of economic development and infrastructure are rela-
tively backward, and public goods and services are relatively scarce in the developing economies. As a result, the expansion of
government investment has relatively more scope to stimulate private investment and economic growth. Furthermore, the indi-
vidual estimated effects of government investment on economic growth is time-varying depending on the level of expenditure.
For instance, since government investment is relatively stable in Pakistan, India, China and South Korea, the consequent effects
upon economic growth remains stable. While for the UK, the USA and Iceland, with the expansion of government investment
after the 1990s and 2000s, the effects of government investment on economic growth changed from positive to negative. For
the same countries, this negative effect increased significantly after the subprime crisis in 2008. In addition, as the level of gov-
ernment investment was very high and private investment was suppressed, economic growth became sluggish in Italy, Spain,
Greece and Germany. (See Fig. 3.)
The estimated results also show that the positive effect of government investment on economic growth is diminishing as the
level of expenditure rises. Especially when the government investment/GDP ratio is higher than 20.04%, the effect would shift
from positive to negative, indicating that government investment must have an optimal level as far as economic growth is con-
cerned, supporting Proposition 1.4
This can be explained as follows. Firstly, when government investment is small, it would provide some public goods which are
complementary with private consumption, boosting domestic demand and stimulating economic growth. However, when govern-
ment investment rises, it would crowd out private consumption, reduce productive investments, and reduce the multiplier effect
of fiscal expansion. In addition, increased government investment may lead to waste or inefficient use of resources, and lower
production efficiency.
4
We also can use government consumption/GDP ratio as a threshold variable to test proposition 2, the estimated results are available on request.
Fig. 3. Government investment and economic growth for some individual economiesNotes: Coefficient is calculated through Eq. (25) based on the parameters estimated in Ta-
ble 4. The elasticity denotes the effect of government investment on economic growth for each country. Sources: World Bank; IMF, IFS and GFS for the period 1990–2014.
ϕ OCG
ϕ*
BGP
φ * φ
_ _ _ _
Fig. 4. Optimal level of government investment Notes: φ ¼ yy ¼ cc_ ¼ kk ¼ ggc ¼ ggI denotes the balanced growth rate, ϕ is the share of government investment in total
c I
government expenditure, BGP is short for balanced growth path, OCG is short for optimal condition for government. Please see Appendix C.
Secondly, according to Chen and Lee (2015), from the perspective of dynamic optimization (see Appendix B), the increase and
decline in government investment have two counteractive effects on economic growth. It can promote economic growth because
of the direct consumption effect, but it can also restrain economic growth because of its crowding out effect on private consump-
tion or investment. As a result, whether government investment will have a positive or a negative effect will depend on its spe-
cific level. This implies that there exists an optimal level of government investment on economic growth. This optimal level is
conditional on the equality of the marginal increase (decline) of government investment and the marginal decline (increase) of
private consumption.
As shown in Fig. 4, when the share of government investment is higher than its optimal level, due to the OCG (the optimiza-
tion of government behavior), the economic growth rate would decrease, resulting in government revenue and expenditure fall-
ing, then the share of government investment would decrease to the equilibrium value.
On the other hand, when the share of government investment is lower than its optimal level, due to the OCG, the economic
growth rate would increase, resulting in government revenue and expenditure rising, then the share of government investment
would increase to the equilibrium value.
We now analyze how public debts may affect economic growth. Fig. 5 shows that the positive effect of public debts on eco-
nomic growth are found in some economies, such as Chile, Botswana, Hong Kong, Australia, New Zealand, Dominican Republic,
Algeria, South Korea and China (44 economies). However, the same effect is found to be negative in some other countries, includ-
ing India, Singapore, Egypt, Greece, Italy, Belgium and Japan et.al (21 countries).
For instance, as shown in Fig. 6, since the public debts/GDP ratios are relatively stable in China, Italy, Korea, Australia, Mexico,
South Africa and Japan, the consequent effects upon economic growth remains stable. It also appears that public debt has a pos-
itive effect on economic growth in China, Korea, Australia et.al, but the same effect in other countries such as Germany, the USA,
the UK and France appear to be mixed or negative. The expansion of public debt after 2003 for the USA, 2008 for the UK and 1997
for Germany appears to have changed its impact on economic growth from positive to negative.
The estimated results also show that the consequent effects of public debts on economic growth is decreasing as the level of
debts rises. In particular, when the public debts/GDP ratio is higher than 59.72%, its effect on economic growth shifts from positive
to negative, indicating that as far as economic growth is concerned, public debts must have an optimal level, supporting
Proposition 2.
Why excessive public debts may hamper long-run economic growth may be explained as follows. Firstly, excessive public
debts crowd out private investment through reducing personal incomes, raising and amplifying the distortionary costs of taxation.
Secondly, expected soaring public debts would push up the long-term sovereign yields in a nonlinear manner. High long-term re-
turn rate will reduce productive government investment and crowd out private investment because of higher capital cost, leading
to lower economic growth. Thirdly, in order to dilute public debts, some governments issue more money, leading to higher infla-
tion, which is unfavorable for long-term sustainable economic growth.
7. Robust test
To check whether government investment and public debts may have different effects on economic growth in different econ-
omies, we divide the sample economies into ten classifications according to the World Bank, and calculate the average sizes of
government investment and public debts during 1991–2014. We mark the point based on the PSTR model in Figs. 7 and 8.
The estimated results show that there is a positive effect of government investment on economic growth for the heavily indebted
poor countries, lower middle income, middle income, upper middle income economies, high income: non-OECD and the world,
but a negative effect on high income countries, including high income, the high income OECD countries, OECD members and
the EU member states. Our finding is consistent with those of some previous studies.
Fig. 5. Public debt and economic growth based on PSRT Notes: Coefficient is calculated through Eq. (26) based on the parameters estimated in Table 4. The elas-
ticity denotes the average effect of public debt on economic growth.
However, there is a positive effect of government debts on economic growth for most upper middle income, high income:
non-OECD, middle income, the world, high-income countries and OECD members. In contrast, public debts have a negative effect
on economic growth for high income: OECD, European union, lower middle income and heavily indebted poor ones.
8. Influencing factors of the elasticity5
According to Propositions 1 in Section 3, we know that the effects of government investment on economic growth are influ-
enced by the elasticity of government investment capital to output (β) divided by the total elasticity of social capital to output
(α + β), the intraperiod elasticity of substitution for both government and private consumption ð1−θ θ Þ and the share of government
investment in total government expenditure (ϕ). While following Proposition 2 in Section 3, we also know that the effects of pub-
lic debt on economic growth are influenced by the elasticity of government capital investment to output (β), the total elasticity of
social capital to output (α+ β), and the intraperiod elasticity of substitution for both government and private consumptions ð1−θ θ Þ,
the share of government investment in government expenditure (ϕ) and also the growth rate of public debt (η).
Therefore, in this part we firstly use the stochastic frontier function approach (SFA) to estimate the elasticity of private capital
and government expenditure to output (α and β). And then, following the theoretical model constructed by Amano and Wirjanto
(1997), we use the panel data model with variable coefficients to define the intraperiod elasticity of substitution between govern-
θ
ment and private consumptions ð1−θ Þ. Finally, we use the panel data model with random-effects GLS regression to identify the
determinants of the government investment capital and public debts elasticities.
The estimated results in Table 5 show that the share of government investment in government expenditure (ϕ) is significantly
negative, whereas the intraperiod elasticity of substitution between government and private consumptions ð1−θ θ Þ are both insignif-
icant to the elasticity of government investment and public debt on economic growth. Furthermore, the elasticity of private capital
α
to output (α) divided by the total elasticity of social capital to output ðαþβ Þ is significantly positive to the effects of government
investment on economic growth, indicating that a rise in the contribution elasticity of private capital to output would lead to
higher effects of government investment on economic growth, and then improve the optimal level of government investment.
β
However, the elasticity of government investment to output (β) divided by the total elasticity of social capital to output ðαþβ Þ is
significantly negative to the effects of government investment on economic growth, indicating that a rise in the contribution elas-
ticity of government investment to output would lead to lower effects of government investment on economic growth, and then
reduce the optimal level of government investment, which is consistent with Proposition 1.
We also find that the growth rate of public debt (η) is insignificant to the effects of public debt on economic growth. The elas-
α
ticity of private capital to output (α) divided by the total elasticity of social capital to output ðαþβ Þ is significantly negative to the
effects of public debt on economic growth, indicating that a rise in the contribution elasticity of private capital to output would
lead to lower effects of public debt on economic growth, and then reduce the optimal level of public debt.
β
In addition, the elasticity of government investment to output (β) divided by the total elasticity of social capital to output ðαþβ Þ
are significantly positive to the effects of public debt on economic growth, implying that a rise in the contribution elasticity of
government investment to output would lead to higher effects of public debt on economic growth, and then improve the optimal
level of public debt. Furthermore, the share of government investment in government expenditure (ϕ) is significantly positive to
the effects of public debt on economic growth, which is consistent with Proposition 2.
5
This part thanks the opinions of the anonymous referees.
Fig. 7. Effects of government investment on economic growth for different regions Notes: Coefficient is calculated through Eq. (25) based on the parameters es-
timated in Table 4 and the average ratio of government investment/GDP for different regions in Eq. (25).
Sources: World Bank. International Monetary Fund (IMF) and World Economic Outlook (WEO) for the period 1990-2014.
9. Conclusions
Since the US subprime crisis in 2008, many governments have launched a proactive fiscal policy to stabilize economic growth.
Many studies have claimed that government investment expansion can be growth-enhancing. However, according to the recent
literature, excessive government investment can be detrimental to economic growth, caused by low investment efficiency and in-
dustrial distortion. Excessive government investment could also lead to high taxation on individuals and the private sector, reduc-
ing their ability for investment and consumption. It means that fiscal policy depending on the expansion of government
investment to stimulate economic growth cannot be sustained without causing damage to long term economic growth.
In this paper, we use the panel smoothing transitional regression model (PSTR) to identify the optimal levels of government
investment and public debt based on sixty-five advanced and developing economies during 1991–2014 from a dynamic
perspective.
The estimated results show that the positive effects of government investment on economic growth decreases as the level of
government investment rises, especially when the government investment/GDP ratio is higher than 20.04%, after which the pos-
itive effect would turn to be negative. Similarly, the effect of public debt on economic growth decreases if the size of public debt
rises, especially when the public debt/GDP ratio is higher than 59.72%, after which the positive effect would turn into a negative
effect. The empirical results support that there should exist an optimal level for either government investment or public debt as
far as economic growth is concerned.
In more detail, our results show that government investment has positive effects on economic growth in heavily indebted poor
countries, lower middle income, middle income, upper middle income economies, but a negative effect on high income countries,
including the OECD members and the EU member states. In contrast, public debt has a positive effect on economic growth for
most upper middle income, high income: non-OECD, middle income, and the world, but a negative effect on economic growth
for high income: OECD, EU member states, lower middle income and heavily indebted poor ones.
Although expansionary fiscal policies may promote economic growth, the subsequent increase in financing demand and tax-
ation can be growth-retarding. The empirical results show that the government investment/GDP ratio and public debt/GDP ratio
of China were respectively 15.66% and 41.14% in 2014, which were less than the thresholds, indicating that although the levels of
government investment and public debt in China were increasing, they may not have reached the levels that could lead to
restraining its long term economic growth.
However, we cannot be too optimistic about China's fiscal policy. Firstly, government investment in China is near the threshold
level estimated by the model. Any further expansion of government investment relative to GDP may start to have a negative im-
pact on economic growth. Secondly, although China's public debt/GDP ratio is far lower than the threshold level estimated by the
model, due to some accounting reasons, China's public debt financing has not been transparent. In other words, the real level of
China's public debt could be higher than the official statistics, leading to difficulty in judging the optimal level of public debt for
the country in relation to economic growth.
Finally, we find that the growth rate of public debt and the intraperiod elasticity of substitution between government and pri-
vate consumptions are insignificant to the effects of government investment and public debt on economic growth. The share of
government investment in total government expenditure is significantly negative to the effects of government investment and
public debt on economic growth, implying that a higher share of government investment in total government expenditure may
lower the optimal levels of government investment and public debt. An increase in the elasticity of private capital to output
would lead to a higher optimal level of government investment but a lower optimal level of public debt. While, an increase in
the elasticity of government investment to output would result in a lower optimal level of government investment but a higher
optimal level of public debt.
Fig. 6. Public debts and economic growth for selected economiesNotes: Coefficient is calculated through Eq. (26) based on the parameters estimated in Table 4.
The elasticity denotes the effect of public debt on economic growth for each country. Sources: World Bank; IMF, IFS and GFS for the period 1990–2014.
Fig. 8. Effects of public debts on economic growth for different economies Notes: Coefficient is calculated through Eq. (26) based on the parameters estimated in
Table 4 and the average ratio of public debt/GDP for different regions in Eq. (26).
Appendix A
A.1. Mathematical proof of the Edgeworth complements or substitutes between private consumption and government investment
The Edgeworth Complements (or Substitutes) between government consumption and private consumption can be concluded,
based on the second order cross derivative UCGC of a representative consumer utility function. The specific principle concluded fol-
lows: whenUCGC N 0, it means that an increase in government spending leads to an increase of the marginal utility of private con-
sumption, government spending and private consumption are Edgeworth complements; on the contrary, when UCGC b 0, it means
that government spending and private consumption are Edgeworth substitutes; when UCGC = 0, it means that government spend-
ing and private consumption are Edgeworth Independent.
As for the maximization problem of consumer utility in this paper, take derivation of Eq. (2) with respect to private consump-
tion (Ct) and government spending (Gc,t), we can derive:
∂U θ 1−θ −σ 1−θ θ−1 ∂U

θ 1−θ −σ θ −θ
¼ C Gc Gc θC and ¼ C Gc C ð1−θÞGc ð1AÞ
∂C t ∂Gc;t
Table 5
Determinants of government investment and public debt elasticities.
Effects of government investment on economic growth (a) Effects of public debt on economic growth (b)
Model(1) Model(2) Model(3) Model(4) Model(5) Model(6) Model(7) Model(8)
Constant 0.0301⁎⁎⁎ 0.0242⁎⁎⁎ 0.0294⁎⁎⁎ 0.0346⁎⁎⁎ 0.0196⁎⁎⁎ −0.0382⁎⁎⁎ 0.0229⁎⁎⁎ −0.0039

(0.0005) (0.0010) (0.0005) (0.0006) (0.0022) (0.0043) (0.0024) (0.0026)
ϕ −0.0013⁎⁎⁎ −0.0013⁎⁎⁎ −0.0013⁎⁎⁎ −0.0013⁎⁎⁎ −0.0002⁎⁎⁎ −0.0002⁎⁎⁎ −0.0002⁎⁎⁎ −0.0002⁎⁎⁎
(0.0000) (0.0000) (0.0000) (0.0000) (0.0001) (0.0001) (0.0001) (0.0001)
θ
1−θ
−0.0004 −0.0004⁎,⁎⁎ −0.0004 −0.0004 0.0003 −0.0003 −0.0003 −0.0003
(0.0008) (0.0008) (0.0008) (0.0008) (0.0034) (0.0034) (0.0034) (0.0034)
α 0.0218⁎⁎⁎ −0.0692⁎⁎⁎
(0.0025) (0.0116)
β −0.0802⁎⁎⁎ 0.2542⁎⁎⁎
(0.0093) (0.0425)
α
αþβ 0.0052⁎⁎⁎ −0.0191⁎⁎⁎
(0.0007) (0.0029)
β −0.0052⁎⁎⁎ 0.0191⁎⁎⁎
αþβ
(0.0007) (0.0029)
η 0.2390 0.2390 0.1960 0.1960
(0.8680) (0.8680) (0.8660) (0.8660)
Country 62 62 62 62 62 62 62 62
Obs. 1550 1550 1550 1550 1550 1550 1550 1550
θ
Notes: ϕ is the share of government investment in government expenditure (%), η is the growth rate of public debt (%), 1−θ denotes the intraperiod elasticity of
substitution between government and private consumptions (%), α and βrespectively denote the elasticity of private capital and government investment to output
α β
(%), αþβ and αþβ are respectively the elasticity of private capital and government investment to output divided by the total elasticity of social capital to output (%).
The coefficient and standard error both multiply 10−7. Numbers in square brackets are p-values.
Sources: See Appendices D and E. World Bank; IMF, IFS and GFS for the period 1990–2014 and Appendix Table E-1.
⁎ Significant at 10%.
⁎⁎ Significant at 5%.
⁎⁎⁎ Significant at 1%.
From Eq. (1a)we can derive:
∂ð∂U=∂C t Þ
θ 1−θ −σ −1 θ −θ 1−θ θ−1 θ 1−θ −σ −θ θ−1
¼ −σ C Gc C ð1−θÞGc θGc C þ C Gc ð1−θÞθGc C ð2AÞ
∂Gc;t
Due to Gc,t = (1− θ)Ct/θ, we can calculate and derive the elasticity of government spending on the marginal utility private con-
sumption as follows:
Gc;t ∂ð∂U=∂C t Þ
EI ¼ ¼ ð1−θÞð1−σ Þ ð3AÞ
∂U=∂C t ∂Gc;t
EI N 0 means that an increase in government spending leads to an increase of the marginal utility of private consumption,
government spending and private consumption are Edgeworth complements; on the contrary, EI b 0 means that government
spending and private consumption are Edgeworth substitutes; EI = 0 means that government spending and private consumption
are Edgeworth Independent. Meanwhile, the elasticity EI describes correlation between government spending and private
consumption.
Appendix B
Taking derivation of Eq. (11), we can derive the per capita of effective labor productivity growth rate:
y_
y ¼ dy
dt
=y ¼ dð lndtyðtÞÞ ≈γð ln y − ln yðtÞÞ, where, γ= (δ + n)(1 − α− β).
Furthermore, we can obtain the average of per capita of effective labor productivity growth rate:

θ
1 y_ αln½ð1−τÞð1 þ rdt Þ− 1−θ ϕ½ηd−ð1−τÞrd þ τ −γT
Ty¼λ ln A þ 1−α−β − ln yð0Þ where λ ¼ 1−eT .
1
þβ ln ð1−ϕÞ þ β ln½ηd−ð1−τÞrd þ τ−ðα þ βÞ ln ðδ þ nÞ
Appendix C
C.1. Private section max
_ _ _ _
In the balanced growth path, the growth rate satisfy φ ¼ yy ¼ cc_ ¼ kk ¼ ggc ¼ ggI ,
c I
Then we can derive the balanced growth path (BGP):
ð1−τÞαAα ð1−ϕÞα−1 ½τ−ð1−τÞrd þ ηdα−1 −ρ

1 1 1
φ¼ iff β ¼ 1−α: ðC1Þ

σ
C.2. Government section max

h i 1−σ
φt θ 1 −1 1 1 φt 1−θ
c0 e ϕð1−ϕÞα Aα ½τ−ð1−τÞrd þ ηdα k0 e −1
0
U ¼ ðC2Þ
1−σ
φ¼k_
Since ð1−τÞð1þrdÞy−c−ðnþδÞk .
k¼ k
And then we derive:
c0 1
¼ ð1 þ rdÞðσφ þ ρÞ−ðn þ δÞ−φ ðC3Þ
k0 α
Taking the derivative with respect to ϕ yields:
h i
∂c0 σ 1 α 1 1
−2 1
−1
¼ k0 ð1 þ rdÞ −1 ð1−τÞAα 1− ð1−ϕÞα ½τ−ð1−τÞrd þ ηdα ðC4Þ
∂ϕ α σ α
Using Eqs. (C1), (C3) and (C4), and dynamic optimization, the increase utility from government consumption expansion as a
larger government consumption size equals to the decrease utility from private consumption decline resulting from lower eco-
nomic growth as the lower share of productive spending, then we can derive the optimal condition for government (OCG) as
Table D-1
Likelihood ratio test of null hypotheses for parameters in SFA.
Null hypothesis (H0) LR test statistics Critical value Results
5% 1%
No inefficiency effects 10.8886 7.81 11.34 Reject H0

Technical efficiency to be constant 8.1957 3.84 6.63 Reject H0
There is no technical change 94.6906 7.81 11.34 Reject H0
Technical change is Hicks neural 71.4781 5.99 9.21 Reject H0
Notes: The critical value is taken from Kodde and Palm (1986).
Sources: World Bank. International Monetary Fund (IMF) and World Economic Outlook (WEO) for the period 1990-2014 and Appendix Table E-1.
follows:
2 3
1 1
−1 1
−1
1−α 1 1 −ð1−τÞð1 þ rdÞAα ð1−ϕÞα ðτ−ð1−τÞrd þ ηdÞα
4 σ 5
σ ð1−ϕÞ2 τ−ð1−τÞrd þ ηd þðn þ δÞ þ φ− ð1−τÞð1 þ rdÞ þ 1
α ðC5Þ
1 α −2 1
¼ 1− ð1−ϕÞ ð1 þ rdÞðσφ þ ρÞ−ðn þ δÞ−φ
α σ α
The left-hand side of Eq. (C5) is the marginal utility of government consumption spending with respect to the composition of
government consumption in the government spending, the right-hand side of Eq. (C5) is the marginal utility of private consump-
tion with respect to composition of government investment in the government spending, result from lower economic growth as
the decrease of the composition of government investment in the total government spending.
Table D-2
the estimated results by SFA.
Time-varying decay inefficiency model Number of obs = 1625
Number of groups = 65
Obs per group = 25
Log likelihood = 80.394355 Wald χ2 (7) = 967.27

Prob N χ2 (7) = 0.0000
ln(Yit) Coefficient Std. Err. z-statistics PNz [95% Conf. Interval]
Lower Upper
Constant 16.80125 1.36409 12.32 0.000 14.12768 19.47481

βt -0.00254 0.012418 -0.20 0.838 -0.026875 0.021804
βK 0.09506 0.008763 10.85 0.000 0.077889 0.112238
βL 0.45225 0.071512 6.32 0.000 0.31209 0.592413
βG 0.09915 0.009811 10.11 0.000 0.079924 0.118381
βKt -0.00307 0.000502 -6.11 0.000 -0.004049 -0.002082
βLt 0.00548 0.000811 6.76 0.000 0.003889 0.007066
βGt -0.00083 0.000415 -2.01 0.044 -0.001647 -2.09E-05
μ 2.27490 0.291425 7.81 0.000 1.703713 2.846077
η 0.00353 0.001216 2.90 0.004 0.001143 0.005908
ln σ2 0.29088 0.21828 1.33 0.183 -0.13694 0.7187
i ln γ 3.46144 0.229084 15.11 0.000 3.012442 3.910436
σ2 1.33760 0.291972 0.872023 2.051765
γ 0.96957 0.006759 0.953133 0.980362
σ2u 1.29690 0.292012 0.724569 1.869234
σ2v 0.04070 0.001467 0.037827 0.043578
lnY it ¼ β0 þ β t t þ βK lnK it þ β L lnLit þ βG lnGk;it þ βKt t lnK it

Notes: The empirical model is given as follow, , where, Yit, Kit, Gk,itand Lit respectively denote GDP,
þβ Lt t lnLit þ β Gt t lnGk;it þ vit −uit
private capital, government investment and labor force. The units of Yit, Kit, Gk,itand Lit are respective USD, USD, USD and number of people. η denotes the
trend of technical inefficiency, random error u ~ N(μ, σ2u),σ2is the total variance, σ2u and σ2v respectively denote the variance of random error and inefficiency
error, while γ=σ2u/(σ2u +σ2v). ** Significant at 5%, ***significant at 1%.
Table D-3
Intraperiod substituted elasticity between government and private consumptions.
Countries ln yit ln gcit Countries ln yit ln gcit
Coef. Std. Coef. Std. Coef. Std. Coef. Std.
Algeria 2.189⁎⁎⁎ 0.062 -1.492⁎⁎⁎ 0.065 Jordan 0.839⁎⁎⁎ 0.086 -0.037 0.092
Australia 0.291 0.212 0.568⁎⁎ 0.225 Korea, Rep. 0.751⁎⁎⁎ 0.161 0.079 0.172
Austria 0.421 0.259 0.420 0.275 Luxembourg 0.122 0.108 0.715⁎⁎⁎ 0.115
Belgium 0.014 0.433 0.846⁎ 0.456 Malaysia 0.305⁎⁎⁎ 0.112 0.544⁎⁎⁎ 0.121
Bhutan 1.212⁎⁎⁎ 0.129 -0.480⁎⁎⁎ 0.138 Mexico 1.025⁎⁎⁎ 0.130 -0.207 0.141
Bolivia 0.110 0.145 0.745⁎⁎⁎ 0.157 Morocco 0.267⁎⁎ 0.120 0.573⁎⁎⁎ 0.128
Botswana 1.585⁎⁎⁎ 0.110 -0.851⁎⁎⁎ 0.118 Netherlands 0.582⁎⁎⁎ 0.210 0.248 0.221
Bulgaria 0.787⁎⁎⁎ 0.053 0.022 0.055 New Zealand 0.483⁎⁎⁎ 0.133 0.352⁎⁎ 0.142
Cameroon 0.346⁎⁎⁎ 0.132 0.507⁎⁎⁎ 0.145 Nicaragua 0.038⁎ 0.021 0.854⁎⁎⁎ 0.027
Chile 0.820⁎⁎⁎ 0.172 0.000 0.188 Norway 0.412⁎⁎ 0.186 0.422⁎⁎ 0.197
China 0.399⁎⁎⁎ 0.137 0.448⁎⁎⁎ 0.147 Pakistan 0.746⁎⁎⁎ 0.077 0.080 0.084
Colombia 0.764⁎⁎⁎ 0.060 0.062 0.063 Panama 0.894⁎⁎⁎ 0.058 -0.107⁎ 0.063
Costa Rica 0.694⁎⁎⁎ 0.115 0.118 0.125 Peru 0.579⁎⁎⁎ 0.151 0.259 0.164
Cyprus 0.347⁎⁎⁎ 0.117 0.488⁎⁎⁎ 0.124 Philippines 0.521⁎⁎⁎ 0.073 0.321⁎⁎⁎ 0.081
Denmark 0.379 0.306 0.454 0.320 Portugal 0.622⁎⁎ 0.241 0.211 0.255
Dominican 0.440⁎⁎⁎ 0.149 0.421⁎⁎ 0.167 Saudi Arabia 0.746⁎⁎⁎ 0.101 0.062 0.105
Ecuador 0.517⁎⁎⁎ 0.094 0.322⁎⁎⁎ 0.103 Senegal 0.772⁎⁎⁎ 0.178 0.034 0.195
Egypt, Arab 0.247⁎⁎ 0.114 0.622⁎⁎⁎ 0.125 Singapore 0.236⁎⁎⁎ 0.059 0.613⁎⁎⁎ 0.065
Finland 0.683⁎⁎⁎ 0.135 0.136 0.143 South Africa 0.606⁎⁎ 0.249 0.229 0.263
France 0.562⁎⁎⁎ 0.278 0.281 0.292 Spain 0.584⁎⁎⁎ 0.175 0.259 0.185
Germany 0.305 0.293 0.559⁎ 0.309 Sri Lanka 0.238⁎⁎ 0.117 0.618⁎⁎⁎ 0.126
Ghana 1.320⁎⁎⁎ 0.054 -0.571⁎⁎⁎ 0.055 Sudan 1.180 0.945 -0.438 1.035
Greece 0.582⁎⁎⁎ 0.220 0.254 0.232 Sweden 0.697⁎⁎⁎ 0.138 0.121 0.145
Guyana 0.855⁎⁎⁎ 0.058 -0.078 0.062 Switzerland 0.034 0.158 0.854⁎⁎⁎ 0.171
Honduras 0.483⁎⁎⁎ 0.090 0.347⁎⁎⁎ 0.097 Thailand 0.179⁎ 0.096 0.682⁎⁎⁎ 0.103
Hungary 1.067⁎⁎⁎ 0.125 -0.268⁎⁎ 0.132 Tunisia 0.504⁎⁎⁎ 0.128 0.324⁎⁎ 0.136
Iceland 0.096 0.354 0.738⁎⁎ 0.371 Turkey 0.657⁎⁎⁎ 0.175 0.184 0.189
India 0.669⁎⁎⁎ 0.201 0.172 0.218 UK 0.937⁎⁎⁎ 0.202 -0.106 0.213
Indonesia 0.536⁎⁎⁎ 0.069 0.313⁎⁎⁎ 0.076 United States 0.947⁎⁎⁎ 0.149 -0.106 0.158
Italy 0.703⁎⁎ 0.308 0.137 0.324 Venezuela 0.841⁎⁎⁎ 0.070 -0.029 0.074
Japan 0.479⁎⁎ 0.187 0.379⁎ 0.197
Notes: According to the theory of Amano and Wirjanto (1997), the empirical model is given as follow, lnCit =di +d1i lnydit +d2i lnGc,it +εit, where lnCit, lnyit and
Gc,it is the log form of private consumption, income and government consumption in constant 2005 prices, and d2i denotes the intraperiod elasticity of substitution
between government and private consumptions. *Significant at 10%, ** Significant at 5%, ***significant at 1%.
Appendix D
According to the economic theory, and following the Stochastic Frontier Function Approach (SFA) provided by Battese and
Coelli (1995), we defined the semi-transcendental logarithmic production function in Eq. (D1):
ln Y it ¼ β0 þ βt t þ βK ln K it þ βL lnLit þ βG ln Gk;it þ βKt t ln K it

ðD1Þ
þβLt t lnLit þ βGt t ln Gk;it þ vit −uit
where, Yit, Kit, Gk,itand Lit respectively denote GDP, private capital, government investment and labor force. Hence, we can obtain
the time-varying technical efficiency as follows:
TEit ¼ expð‐uit Þ ðD2Þ
where, the non-negative technical inefficiency (uit) as follows:
uit ¼ exp½−ηðt−T Þui uit ≥0; i ¼ 1; …; N; t∈τ ðiÞ ðD3Þ
where, uit ∼N+(mit,σ2u). η denotes the trend of technical inefficiency, if η =0, meaning that technical inefficiency is constant, while,
if η N 0, indicating that technical inefficiency is increasing, If η b 0, indicating that technical inefficiency is increasing decreasing.
Therefore, we can obtain the elasticity of private capital to output (α), the elasticity of government investment to output (β)
and the elasticity of labor to output (α) as follows:
∂ lnY it
The elasticity of private capital to output ¼ ¼ βK þ βKt t ðD4Þ
∂ lnK it
∂ ln Y it
The elasticity of government investment to output ¼ ¼ βG þ βGt t ðD5Þ
∂ ln Gk;it
∂ ln Y it
The elasticity of labor to output ¼ ¼ βL þ βLt t ðD6Þ
∂ lnLit
Next we use the Likelihood ratio to test null hypotheses for parameters in SFA, which is given as λ = − 2 ln [L(H0)/
L(H1)]~ χ2(q), where L(H0) is the log-likelihood of restricted model, L(H1) is the log-likelihood of un-restricted model, q is the de-
gree of freedom, which is equal to the number of the restricted condition.
The LR test in Table D-1 all rejects the null hypotheses in 5% significant level, indicating that we have to use semi-
transcendental logarithmic production function by SFA to estimate the elasticity of private capital and government investment
capital to output, which is shown in Table D-2.
Therefore, we can use the estimated results in Tables E-1, E-2, E-3, E-4 to calculate the elasticity of private capital to output (α)
and the elasticity of government investment to output (β).
Following the theoretical model constructed by Amano and Wirjanto (1997), we use a panel data model with variable coeffi-
θ
cients to define the intraperiod elasticity of substitution between government and private consumptions ð1−θ Þ. The estimated re-
sults is shown in Table D-3.
Appendix E
Table E-1
Variables defined and data sources.
Denoted
Variables by Sources
Household final consumption expenditure, etc. (constant C World Development Indicators published by the World Bank, 1991–2013
2005 US$)
Adjusted net national income (constant 2005 US$) yd World Development Indicators published by the World Bank, 1991–2013
General government final consumption expenditure G World Development Indicators published by the World Bank, 1991–2013
(constant 2005 US$)
Gross domestic product (GDP) growth rate Y World Development Indicators published by the World Bank, 1991–2013
Private capital stocka K International Monetary Fund (IMF), World Economic Outlook (WEO), constructed
by perpetual inventory method
Labor L World Development Indicators published by the World Bank, 1991–2013
a
Provided by Aqib Aslam, Samya Beidas-Strom, Daniel Leigh (team leader), Seok Gil Park, and Hui Tong, IMF World Economic Outlook, Chapter 4 Private Invest-
ment: What's The Hold Up?.
Table E-2
Countries, regions and their codes.
Country/region Country code Country/region Country code Country/region Country code
Algeria DZA Greece GRC Pakistan PAK

Australia AUS Guatemala GTM Panama PAN
Austria AUT Guyana GUY Peru PER
Belgium BEL Honduras HND Philippines PHL
Bhutan BTN Hong Kong HKG Portugal PRT
Bolivia BOL Hungary HUN Saudi Arabia SAU
Botswana BWA Iceland ISL Senegal SEN
Bulgaria BGR India IND Singapore SGP
Cameroon CMR Indonesia IDN South Africa ZAF
Chile CHL Italy ITA Spain ESP
China CHN Japan JPN Sri Lanka LKA
Colombia COL Jordan JOR Sudan SDN
Costa Rica CRI Korea, Rep. KOR Sweden SWE
Cyprus CYP Luxembourg LUX Switzerland CHE
Denmark DNK Malaysia MYS Thailand THA
Dominican DOM Malta MLT Tunisia TUN
Ecuador ECU Mexico MEX Turkey TUR
Egypt, Arab Rep. EGY Morocco MAR United Kingdom GBR
Finland FIN Netherlands NLD United States USA
France FRA New Zealand NZL Venezuela, RB VEN
Germany DEU Nicaragua NIC Zambia ZMB
Ghana GHA Norway NOR
Table E-3
GDP growth, public debts, and government investment (1991–2014).
Government investment/GDP ratio GDP growth rate Public debts/GDP ratio GDP growth rate
≤10% 4.576% ≤30% 4.473%

10–20% 4.103% 30–60% 3.598%
20–30% 2.557% 60–90% 3.224%
N30% 1.152% N90% 2.628%
Sources: World Bank (http://data.worldbank.org/) and authors' calculations.
Table E-4
Mean values of the key variables from 1991 to 2014.
Year _
Y=Y _
K=K _
L=L _
G=G _
D=D G/GDP D/GDP
1991 2.8942 80.6485 2.1418 11.5038 31.4710 16.4133 55.0140

1992 3.4758 50.3684 1.8662 10.1269 59.5093 16.8815 61.2535
1993 2.9142 22.3526 1.6958 10.0889 22.0093 16.8007 60.3189
1994 3.9137 25.9861 2.1422 12.7871 26.7444 16.9735 64.2211
1995 4.1939 7.9188 2.1142 10.8780 24.4101 17.0012 61.1292
1996 4.2396 66.6832 2.2708 9.0943 15.4222 16.4581 59.1286
1997 4.3741 25.0628 2.0105 7.6819 29.3425 16.0097 58.1145
1998 2.6794 21.8868 2.1013 6.5376 13.7622 15.8973 58.7306
1999 3.3818 12.7050 2.1294 5.6467 11.1688 15.6806 59.7626
2000 4.4486 13.7285 1.8443 5.2509 14.6595 15.3678 59.5255
2001 2.5418 14.0459 2.0566 5.5236 10.0317 16.0216 60.1295
2002 3.0598 6.8440 1.6972 5.5266 9.2036 15.9319 60.3295
2003 3.4403 -1.4387 1.6293 6.3903 11.8998 15.9020 60.3706
2004 5.1268 -0.8490 1.7728 6.9235 5.8072 15.5130 57.4132
2005 4.6783 1.9567 2.1032 7.3419 2.9629 15.4763 54.3955
2006 5.3869 1.5918 2.1031 8.5352 1.1377 15.5282 49.1421
2007 5.6767 -3.3818 1.9887 9.7460 2.1182 15.7023 45.2470
2008 3.2386 -2.5704 1.9868 11.7471 12.9780 16.9750 45.5989
2009 -0.5080 11.0167 1.5715 9.0358 17.9831 17.4411 50.8584
2010 4.3158 0.0096 1.5375 9.0881 15.0660 17.3150 52.5993
2011 3.5930 -1.7276 1.5324 9.4738 12.2093 17.3371 54.4305
2012 2.7824 6.3491 1.6373 8.5567 11.6407 17.5138 56.7558
2013 2.9567 5.5725 1.5777 8.1697 10.6035 17.5305 58.9782
2014 2.9605 5.6853 1.5087 7.7401 11.5134 18.0046 60.7890
Notes: G/GDP = government spending/GDP ratio in %, D/GDP = public debt/GDP ratio in %.

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China Economic Review 45 (2017) 257–278

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China Economic Review

Optimal government investment and public debt in an

3.1. The household sector

where, ρ is a subjective discount factor, σ is a curvature parameter, andC∗1−σ

W tþ1 ¼ ð1 þ r ÞW t þ Y t þ rDt −C t −Gc;t ð3Þ

3.2. The productive sector

τðY t þ rDt Þ þ D_ t −rDt ¼ Gt ¼ Gc;t þ Gk;t ð4Þ

K_ t ¼ ð1−τÞðY t þ rDt Þ−C t −δK t ð6Þ

Incorporating Ct = θGc,t/(1 −θ) into the above equation yields:

g_ k;t ¼ ϕ½ηdt −ð1−τ Þrdt þ τyt −ðδ þ nÞg k;t ð8Þ

3.3. Fiscal policy effects

4. Empirical models and methodology

Variables Denoted Sources

Gross domestic product (GDP) growth _

Variables Average Median Maximum Minimum Std. dev.

Notes: The deﬁnitions of all the variables are provided in Table 1.

Model statistics Public investment Public debt

H0: γ = 0 VSH1: γ = 1 7.0893⁎⁎⁎ 14.6755⁎⁎⁎ 17.6918⁎⁎⁎ 36.1155⁎⁎⁎

Model Public investment Model Public debt

Coefﬁcient Std. error Coefﬁcient Std. error

Smoothing parameters 0.25069⁎⁎⁎ 0.0416 Smoothing Parameters 0.2308⁎⁎ 0.1008

8. Inﬂuencing factors of the elasticity5

∂U  θ 1−θ −σ 1−θ θ−1 ∂U 

Model(1) Model(2) Model(3) Model(4) Model(5) Model(6) Model(7) Model(8)

Constant 0.0301⁎⁎⁎ 0.0242⁎⁎⁎ 0.0294⁎⁎⁎ 0.0346⁎⁎⁎ 0.0196⁎⁎⁎ −0.0382⁎⁎⁎ 0.0229⁎⁎⁎ −0.0039

From Eq. (1a)we can derive:

C.1. Private section max

ð1−τÞαAα ð1−ϕÞα−1 ½τ−ð1−τÞrd þ ηdα−1 −ρ

φ¼ iff β ¼ 1−α: ðC1Þ

C.2. Government section max

And then we derive:

Taking the derivative with respect to ϕ yields:

Null hypothesis (H0) LR test statistics Critical value Results

No inefﬁciency effects 10.8886 7.81 11.34 Reject H0

Time-varying decay inefﬁciency model Number of obs = 1625

Obs per group = 25

Log likelihood = 80.394355 Wald χ2 (7) = 967.27

ln(Yit) Coefﬁcient Std. Err. z-statistics PNz [95% Conf. Interval]

Constant 16.80125 1.36409 12.32 0.000 14.12768 19.47481

lnY it ¼ β0 þ β t t þ βK lnK it þ β L lnLit þ βG lnGk;it þ βKt t lnK it

Countries ln yit ln gcit Countries ln yit ln gcit

Coef. Std. Coef. Std. Coef. Std. Coef. Std.

ln Y it ¼ β0 þ βt t þ βK ln K it þ βL lnLit þ βG ln Gk;it þ βKt t ln K it

TEit ¼ expð‐uit Þ ðD2Þ

where, the non-negative technical inefﬁciency (uit) as follows:

uit ¼ exp½−ηðt−T Þui uit ≥0; i ¼ 1; …; N; t∈τ ðiÞ ðD3Þ

Country/region Country code Country/region Country code Country/region Country code

Algeria DZA Greece GRC Pakistan PAK

≤10% 4.576% ≤30% 4.473%

Sources: World Bank (http://data.worldbank.org/) and authors' calculations.

1991 2.8942 80.6485 2.1418 11.5038 31.4710 16.4133 55.0140

Notes: G/GDP = government spending/GDP ratio in %, D/GDP = public debt/GDP ratio in %.

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∂U θ 1−θ −σ 1−θ θ−1 ∂U