The Implications of the Comprehensive Spending Review for the Long-Run Growth Rate: A View from the Literature

By Kneller, Richard | National Institute Economic Review, January 2000 | Go to article overview

The Implications of the Comprehensive Spending Review for the Long-Run Growth Rate: A View from the Literature


Kneller, Richard, National Institute Economic Review


Richard Kneller [*]

In 1998 the Government set out its expenditure plans for the remainder of the current Parliament in the Comprehensive Spending Review. Announced within this were large increases in expenditure on education, health and capital spending with the objective of meeting the Government's manifesto pledges. Yet as the recent report by the Treasury on the UK's trend rate of growth states, the expenditure plans of the CSR may also help to raise the growth potential of the economy, although no quantitative assessment of this was made. Using evidence from the empirical growth literature, this article examines the possible effects of these policies on the long-run growth rate of the economy. In general the results from the empirical literature are non-robust, but by conducting a very different style of review we are able to identify several studies from which to determine what these effects might be. Using a stylised version of the CSR we estimate that it may raise the long-run growth rate by as much as 0.1 of a percentag e point per annum, although there is some sensitivity to the underlying assumptions. This appears to confirm the likelihood of modest upside risk to the Treasury's estimate of trend growth.

Introduction

In July 1998 the Chancellor set out in the Comprehensive Spending Review (CSR) the government's expenditure plans for the next three years. Central within this review were large increases in expenditure on education and health, by around [pounds]4Obn. in total, and on infrastructure, by around [pound]6bn, over the next three years.

The aim of the CSR is to target expenditure at Labour's priorities of education and health and principally at its election pledges to reduce waiting lists in hospitals and class sizes in schools. Yet, as the Treasury [1] identifies, these policies may also raise the long-run growth potential of the economy. This article attempts to provide some quantitative assessment of the possible effect on long-run growth.

According to National Institute estimates (July 1998) the CSR will contribute approximately 1 percentage point to the growth rate of GDP in both 1999 and 2000. While such short-run impacts on the economy are reasonably easy to model, the potential impact on the long-run growth rate of the economy is less so. This can be attributed largely to conflicting evidence on the relationship between government spending and long-run growth.

We base our estimates of the growth effects of the CSR on the findings from a review of the empirical literature. Despite the size of the literature, finding a set of consistent results is difficult (Slemrod, 1995; Tanzi and Zee, 1997). In part this can be explained by a failure in most studies to account adequately for the statistical bias that plagues this area of research (Folster and Henrekson, 1997). However, as we show below, even if we compare studies that claim to correct for such bias and are based on similar data sets, non-robustness still abounds. Given this, we review the literature but take a different focus from previous summaries. While accepting that the effect of statistical bias is very important, we argue that the relationship between policy and growth within the model is more complex than that usually assumed when applying empirical tests. A failure to provide a clear theoretical foundation at the outset will mean that few conclusions about the empirical relationship between policy and gro wth can be drawn. At this point in time there are no studies that satisfy all of the issues we raise here but there is evidence to suggest that all play an important role in explaining the inconsistency of previous results.

The review of the literature steers our attention to two studies in particular. These are used to analyse the likely growth effects of the CSR. In order to perform this exercise it is necessary to stylise the CSR somewhat to concentrate on the three main changes to expenditure already mentioned above. …

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