Effect of size and mix of public spending on growth and inequality

1. Paris, 24 November 2016
The effect of the size and mix
of public spending on
growth and inequality
www.oecd.org/economy/economicoutlook.htm
ECOSCOPE blog: oecdecoscope.wordpress.com

2. Key messages
2
On the size and effectiveness of government
• Larger governments are associated with lower long-term growth
• For countries with well-functioning governments, the adverse growth effect is
smaller
• Large governments tend to redistribute more, which fosters equity.
On the structure of spending
• Higher public investment is associated with large growth gains and lifts “all boats” as
it raises average incomes without any adverse equity effects
• The growth gains from higher investment decline at a high level of the public capital
stock, though virtually all countries have room for additional spending
• Improving student performance yields large gains for all by raising skills
• Reducing the share of pension spending and of subsidies boosts growth. Lower
pension spending has no adverse effects on disposable income inequality, but lower
subsidies increase inequality
• Spending more on family and child care benefits reduces inequality as they benefit
lower-income families more

3. Impact of different instruments on
growth and equity
3
Policy Growth Equity
Income of
the poor
Countries with the most
room for growth gains
Decreasing the size of
government
Low to moderate
government
effectiveness
+ - +
BEL, CZE, FRA, GRC,
HUN, ITA, POL, PRT, SVN
High government
effectiveness n.s. - -
Increasing government effectiveness + + + FRA, GRC, HUN, ITA, SVN
Increasing education outcomes + 0/+ + CHL, GRC, MEX, PRT, TUR
Increasing public investment (including R&D) + n.s. +
BEL, DEU, GBR, IRL,
ISR, ITA, MEX, TUR
Pension reform + n.s. +
AUT, DEU, FIN, FRA, GRC,
ITA, JPN, POL, PRT, SVN
Increasing family benefits n.s. + + CHE, ESP, GRC, PRT
Decreasing public subsidies + - n.s. BEL, CHE
Note: + stands for a positively significant, – for a negatively significant and n.s. for non-significant effect.
Source: Fournier and Johansson (2016), “The Effect of the Size and the Mix of Public Spending on Growth and Inequality”,
OECD Economics Department Working Papers, No. 1344.

4. 4
1. Motivation and approach

5. Changes to the spending and tax mix have
gone in the wrong direction between
2007 and 2013
5
Source: OECD Public Finance Dataset, forthcoming.

6. Design of public spending, growth and
inequality: the approach
6
Key issue: Raising long-term growth while addressing inequality
Empirical setup:
• Growth: Neoclassical convergence model
• Inequality: Estimation of the impact of the mix of spending along the
distribution of household income
• The overall effect of public finance on the distribution of disposable income is
the sum of the direct effect on disposable income and the indirect growth
effect.

7. 7
2. Government size and
effectiveness

8. Long-term GDP gains from reducing the
size of government
8
0
5
10
15
20
25
30
35
Size of governmentPer cent
Note: In countries where the size of government is above the average level of countries in the bottom
half of the sample, the government size will gradually converge to this level (36% of GDP). The figure
reports the effect after 45 years of a reform phased in over 10 years.

9. Long-term GDP gains from
improving government effectiveness
9
0
5
10
15
20
25
30
35
Effectiveness of governmentPer cent
Note: In countries where the effectiveness of government is below the average level of countries in the
top half of the sample, government effectiveness will gradually converge to this level. The figure reports
the effect after 45 years of a reform phased in over 10 years.

10. Government effectiveness and growth
10
The adverse effect of government size on potential GDP decreases with
government effectiveness
GDP gain of one spending point increase of public spending, in per cent
Perception of government effectiveness
-20
-15
-10
-5
0
5
10
0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2

11. Government effectiveness and growth
11
Size of government and citizens’ perception of their effectiveness
AUS
AUT
BEL
CAN
CHE
CZE
DEU
DNK
ESP
EST
FIN
FRA
GBR
GRC
HUN
IRL
ISLISR
ITA
JPN
KOR
LUX
NLD
NOR
NZL
POL
PRT
SVK
SVN
SWE
USA
30
35
40
45
50
55
0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2
Perception of government effectiveness
Size of government (primary spending, % of potential GDP)

12. Illustrative gains from reducing government
size on poor, average and rich households
12
Effect of a reduction in government size on household disposable income
Note: In countries where the size of government is above the average level of that of countries in the
bottom half of the sample, the government size will gradually converge to this level (36% of GDP).
Rich and average households tend to gain from a reduction of government
size, while the effect on the poor depends on government’s effectiveness.
-30
-20
-10
0
10
20
30
40
Average effects Effects on the poor Effects on the rich
Per cent

13. 13
3. Changing the spending mix

14. Long-term GDP gains from increasing
public investment
14
0
5
10
15
20
25
30
Public investmentPer cent
Note: In countries where public investment to potential GDP is below the average ratio of
countries in the top half of the sample, public investment will converge to this average ratio. The
figure reports the effect after 45 years of a reform phased in over 10 years.

15. Decreasing returns to public investment?
15
The effect of public investment on potential GDP decreases with the level
of capital stock
GDP gain of one spending point increase of public investment, in per cent
Public capital stock, per cent of potential GDP
The analysis suggests that all OECD countries, except Japan, have room
for additional public investment.
-15
-10
-5
0
5
10
15
20 40 60 80 100 120

16. Long-term growth effects of an increase
in the education level
16
0
5
10
15
20
25
30
Quantity of education (years of schooling) Quality of education (PISA)Per cent
Note: In countries where the mean PISA score or average years of schooling are below the
average level of countries in the top half of the sample, educational attainment is assumed to
gradually converge to this level. The figure reports the effect after 45 years of a reform phased in
over 45 years..

17. Long-term GDP gains from decreasing
public subsidies
17
0
5
10
15
20
25
30
SubsidiesPer cent
Note: In countries where spending to the potential GDP ratio on subsidies is above the average
level of countries in the bottom half of the sample, spending will gradually decline to this level.
The figure reports the effect after 45 years of a reform phased in over 10 years.

18. Long-term GDP gains from decreasing
pension spending
18
0
5
10
15
20
25
30
Old age and survivors pensionsPer cent
Note: In countries where spending to the potential GDP ratio on pensions is above the average
level of countries in the bottom half of the sample, spending will gradually decline to this level.
The figure reports the effect after 45 years of a reform phased in over 10 years.

19. Illustrative gains from raising family and
child benefits on disposable income
19
Note: In countries where family benefits to potential GDP is below the average ratio of that of
countries in the top half of the sample, family benefits will gradually converge to this average
ratio.
-10
0
10
20
30
40
Average effects Effects on the poor Effects on the rich
Per cent

20. Illustrative gains from decreasing
public subsidies
20
Note: In countries where subsidies to potential GDP are above the average ratio of that of
countries in the bottom half of the sample, subsidies will gradually decline to this ratio.
-10
0
10
20
30
40
Average effects Effects on the poor Effects on the rich
Per cent

21. 21
More information
Fournier, J-M. and A Johansson (2016), “The effect of the size and mix of
public spending on growth and inequality”, OECD Economics Department
Working Papers, No. 1344.
Bloch et al. (2016), “Trends in public finance: Insights from a new
dataset”, OECD Economics Department Working Papers, No. 1345.
Johansson, A. (2016), “Public finance, economic growth and inequality: A
survey of the evidence”, OECD Economics Department Working Papers,
No. 1346.
Fournier, J-M. (2016), “The positive effect of public investment on
potential growth”, OECD Economics Department Working Papers, No.
1347.
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