Budget Deficits, Economic Freedom, and Economic Growth in OECD Nations: P2SLS Fixed-Effects Estimates, 2003-2008

By Cebula, Richard | Journal of Private Enterprise, Spring 2013 | Go to article overview

Budget Deficits, Economic Freedom, and Economic Growth in OECD Nations: P2SLS Fixed-Effects Estimates, 2003-2008


Cebula, Richard, Journal of Private Enterprise


Abstract

This study empirically investigates the impacts of central government budget deficits and economic freedom on per capita real economic growth in OECD nations over the period 2003-2008. Economic growth is measured by the percentage growth rate of purchasing-power-parity adjusted real per capita GDP. Within the context of the Fixed Effects Model, panel two stage least squares (P2SLS) estimations using a six-year panel data set for 29 of the 30 the OECD member nations as of 2008 as a group reveal that economic growth is a decreasing function of higher central government budget deficits and an increasing function of economic freedom. It is suggested that governments can best promote real economic growth by limiting the size of their budget deficits (relative to GDP) and pursue policies consistent with increasing various forms of economic freedom.

JEL Codes: P10, P16, F43, H61

Keywords: Percentage per capita real GDP growth; Government budget deficits; Economic freedom

I. Introduction

Since the end of the Great Recession, economic growth in the United States has been anemic, and the unemployment rate in the United States has remained stubbornly high, the extraordinary policies of the Federal Reserve in purchasing massive quantities of toxic assets and U.S. Treasury issues notwithstanding. As this slow growth-high unemployment scenario has played out, two very interesting controversies have arisen. The first involves the massive size of U.S. federal budget deficits, whether measured in dollar terms, inflation-adjusted dollars, or as a percentage of GDP, and the argument that such deficits are both unsustainable and have contributed to the stubbornly poor performance of the U.S. economy (El-Shagi, 2010; Gartner, Griesbach, and Jung, 2011). The second controversy deals with economic freedom and findings that economic freedom in the United States has fallen and that the United States is now ranked only 19th among nations in the world in the overall level of its economic freedom (Gwartney, Lawson, and Hall, 2012). Arguably, this diminished economic freedom has also contributed to the stubbornly poor performance of the U.S. economy.

Given these two sets of circumstances, this study empirically investigates whether higher budget deficits and reduced economic freedom do in fact reduce economic growth and thereby raise unemployment. In particular, the fundamental purpose of this study is to investigate empirically not only the impact not only of central government budget deficits (as a percentage of GDP) on per capita real economic growth but also of the principal forms of economic freedom on per capita real economic growth. In the latter case, the focus is on the economic freedom measures developed by the Heritage Foundation (2013). The empirical findings in this study affirm that both controversies are well founded, namely, that large budget deficits and reduced economic freedom do in fact reduce economic growth.

Background for the empirical model is presented in the following section of this study. The model and data are described in Section III. The empirical analysis is provided in Section IV, where multiple estimates are undertaken. The first takes the form of a P2SLS (panel two stage least squares) estimation of the basic model using recent data from the OECD nations. Additional P2SLS estimates are then provided to test the robustness of the initial results. An overview is provided in the final section. The investigation is undertaken using a six-year panel data set for OECD nations covering the period 20032008.

The empirical evidence provided in this study shows that the pattern of massive budget deficits begun under the Bush Administration (2001-2009) but greatly expanded under the Obama Administration (since 2009) has created a persistent negative impact of per capita real GDP growth in the United States. This condition cannot be allowed to continue if economic freedom and growth are the desired outcomes of a healthy economy.

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