Abstract. This paper provides further evidence on the relationship between economic growth and government spending. For the first time two different panel data methodologies have been applied to seven transition economies in the South Eastern Europe (SEE), generating significant results which, if considered, may enhance the economic performance of the countries in the region. More specifically, the evidence generated indicate that four out of the five variables used in the estimation i.e. government spending on capital formation, development assistance, private investment and trade-openness all have positive and significant effect on economic growth. Population growth in contrast, is found to be statistically insignificant.
JEL Classification Codes: O10, O11.
Keywords: Government Spending, Economic Growth, Panel Data, SEE.
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Extensive research has been undertaken in an attempt to gauge the extent to which government spending (GS) affects economic growth (EG). Theoretically speaking, the pendulum appears to be swaying towards the conventional wisdom, i.e., GS is a source of economic instability. From an empirical perspective, however, the evidence generated points towards a more mixed picture.
In contrast to the multitude of previous studies conducted in this area, the originality of this study resides in three specific factors. Firstly, the treatment of GS in the distinction made between domestic GS on capital formation, and foreign receipts for development assistance. Secondly, the methodology adopted for the empirical investigation whereby two different econometric approaches are used. Thirdly, since the SEE economies share key economic and cultural characteristics they thus provide homogeneity in the group of countries selected for the study. In effect the resulting estimates are thought to contribute considerably to the understanding of the underlying relationship in the specific region.
The primary objective of this study is to empirically evaluate the impact of GS on EG for transition economies in the South Eastern Europe (SEE). The paper is organized as follows: Section two presents an extensive review of literature on the effect of GS on EG. Section three spells out the methodological approaches used in this study while section four elaborates on the estimates generated. Finally, section five suggests the significance of these findings for policy makers in the region.
2. Review of Empirical Findings
The question whether or not government expansion causes economic growth has divided policy makers into two distinctive theoretical camps, as proponents of either big government or small government. Economic theory would suggest that on some occasions lower levels of government spending would enhance economic growth while on other occasions higher levels of government spending would be more desirable. From an empirical perspective the evidence generated becomes more confusing as a number of studies favour one or the other approach. The main focus of this paper will be to concisely review the existing empirical literature rather than explicate the intricacies of theoretical issues.
Evidence pointing towards a negative relationship
Starting with the US economy, Knoop (1999) using time series data from 1970 to 1995 found that a reduction in the size of the government would have an adverse impact on economic growth and welfare. Estimates obtained by Fölster and Henrekson (1999, 2001) when conducting a panel study on a sample of rich countries over the period 1970-1995 lent support to the notion that large public expenditures affect growth negatively. In another empirical study, Ghura (1995), using pooled time-series and cross-section data for 33 countries in Sub-Saharan Africa for the period 1970-1990 produced evidence that points towards the existence of a negative relationship between government consumption and economic growth. …