PB 4

See d is c u ssio n s, s ta ts , a n d a u th or p ro fil e s f o r t h is p ub lic a tio n a t: http s:/ /w ww.r e se a rc h ga te .n et/ p ub lic a tio n /2 4075708 Gro w th E ffe cts o f P ublic E xp en dit u re o n t h e Sta te a n d L oca l L ev el: E vid en ce f r o m a S am ple of R ic h G overn m en ts Artic le in Ap plie d E co n om ic s · J u n e 2 006 DO I: 1 0.2 139/s srn .6 63685 · So u rc e : R eP Ec CIT A TIO NS 28 REA D S 61 2 a u th ors :

So m e o f t h e a u th ors o f t h is p ub lic a tio n a re a ls o w ork in g o n t h ese r e la te d p ro je cts :

Gam e o u tc o m e u n ce rta in ty a n d G erm an f o otb all T V d em an d Vie w p ro je ct Exp lo rin g s e a so n t ic k e t h old er b eh avio r Vie w p ro je ct Chris to p h A . S ch alt e g ger Univ e rs it ä t L u ze rn 78 PU BLIC ATIO NS 939 CIT A TIO NS SEE P R O FIL E Ben no T o rg le r Queen sla n d U niv e rs it y o f T ech n olo gy 346 PU BLIC ATIO NS 5,5 92 CIT A TIO NS SEE P R O FIL E All c o n te n t f o llo w in g t h is p age w as u p lo ad ed b y Chris to p h A . S ch alt e g ger o n 0 5 F e b ru ary 2 017.

Th e u se r h as r e q ueste d e n han ce m en t o f t h e d ow nlo ad ed f il e . All i n -t e xt r e fe re n ce s un d erlin ed i n b lu e a re a d ded t o t h e o rig in al d ocu m en t an d a re l in ked t o p ub lic a tio n s o n R ese a rc h G ate , l e ttin g y o u a cce ss a n d r e a d t h em i m med ia te ly . CREMA Gellertstrasse 24 CH - 4052 Basel www.crema-research.ch CREMA Center for Research in Economics, Management and the Arts Growth Effects of Public Expenditure on the State and Local Level: Evidence from a Sample of Rich Governments Christoph A. Schaltegger Benno Torgler Working Paper No. 2004 - 16 Growth Effects of Public Expenditure on the State and Local Level: Evidence from a Sample of Rich Governments by Christoph A. Schaltegger Swiss Federal Tax Administration, University of St. Gallen and CREMA, Center for Research in Ec onomics, Management and the Arts and Benno Torgler Georgia State University and CREMA, Center for Research in Economics, Management and the Arts Abstract There is a vast empirical literature investigating the relationship be tween government size and economic growth. But the empirical evidence of growth effects of public expenditure using cross-country regres- sions is still inconclusive. According to a number of authors this is not surprising since the negative rela- tionship only applies for rich countries with a large public sector. Restricting their analysis on rich coun- tries only they can show the predicted negative impact. Naturally, a selection of a sub-sample of rich countries is always somewhat arbitrary. Anot her possibility is to concentrate on governments within a rich country. However, only few studies investigate the eff ect of state and local spending on economic growth.

This paper concentrates on the relationship between p ublic expenditure and economic growth within a rich country using the full sample of state and local governments from Switzerland over the 1981-2001 period.

The general finding is a fairly robust negative relationship between government size and economic growth. However, in contrast to public spending fro m operating budgets there is no significant impact on economic growth by expend iture from capital budgets. JEL-Classification: E62;H20;O23 Keywords: Economic Growth; Government expenditure; Public Sector The authors would like to thank BAK Basel Econo mics for the provision of data for cantonal GDPs and René L. Frey, Lars P. Feld and Gebha rd Kirchgässner for helpful comments. All re- maining errors are of course the authors’ responsibility. Mailing Address: Dr. Christoph A. Schaltegger Swiss Federal Tax Administration Eigerstrasse 65 CH-3003 Bern Switzerland [email protected] – 2 – 1. Introduction A common feature of all industrialized countries concerns an enormous expansion of the public sector. As measured by the sh are of GDP going to government expenditures the average OECD country has expanded its size of government fo r about 21 percentage points between 1960 and 1996. Today, average government outlays in the OE CD countries account for about nearly 50 percent of GDP. Such an enormous government involvement has attracted various critics includ- ing the argument of endangering economic prosperity. In particular, the influential empirical work by Barro (1991) covering a large cross-section of countries s upported the view that a large public sector impedes economic growth. Others provided further empirical evidence confirming the negative impact of the size of government on economic growth (Engen and Skinner, 1992; Grier, 1997; Hansson and Henrekson, 1994; Föls ter and Henrekson, 1999; Fölster and Henrek- son, 2001; Romero de Ávila and Strauch, 2003; Bernholz, 2004). However, some authors are very skeptical about the robus tness of the provided result. Atkinson (1995), Slemrod (1995, 1998) or Agell et al. (1997, 1999) find no stable negative correlation between the size of govern- ment and economic growth. The inconclusiveness of the empirical literature is not surprising from a theoretical point of view.

The relationship between government size and econom ic growth is expected not to be monotonic.

While public spending can crowd-ou t private investments, it may also stimulate private sector productivity by the externality of the provided public good. Furtherm ore, government activities to secure property rights, to enforce contracts and to guarantee a stable monetary regime provide the foundation for a smooth operation of a market economy. 1 Thus, the net impact on aggregate out- put is the sum of both of these effects. A ccording to Slemrod (1995), Tanzi and Schuknecht 1 In fact, Keefer and Knack (1997) provide evidence that a legal system protecting property rights and enforcing contracts enhances economic growth. – 3 – (2000) or Tanzi and Zee (1997), we should only expect a negative impact of the size of govern- ment on economic growth if the size of government exceeds a certain threshold. In the US- literature, the n-shaped relati on between government size and economic growth is often called the “Armey-curve”, according to Richard Armey, a Member of the House of Representatives (Ved- der and Gallaway, 1998). The ratio nale behind this argument is that in countries with big gov- ernments, the share of public expenditures designed to promote private sector productivity is typically smaller th an in countries with small governme nts (Fölster and Henrekson, 2001). For less developed countries, government spending may act as a signal that property rights will be enforced. 2 In this case, an increase of the size of government is likely not to hamper economic growth. Thus, small government by itself is not an asset. When a small government fails to pro- tect property rights and to enforce contracts, th ere is no reason to believe that it will promote economic growth (Gwartney, Lawson and Holcombe, 1998). However, it is a narrow path to the point where a growing size of government reflects excessive engagements in transfer programs and regulations that are growth impeding. As st ated by Weingast (1995, p. 1): “The fundamental political dilemma of an economic system is th is: A government strong enough to protect property rights and enforce contracts is al so strong enough to confiscate the wealth of its citizens”. There is a vast empirical literature investigating the relationship between government size and economic growth for OECD countries. However, according to Fölster and Henrekson (2001), analyzing the impact of the size of government on economic growth for a sub-sample of rich countries separately may give us a more detaile d picture on the issue due to the non-monotonic relationship. A common approach is to use a sub- sample of rich countries. Naturally, a selection 2 However, according to de Soto ( 2002) even though many developing coun tries face small governments measured by public spending per GDP they do not necessarily di rect the spending in productive government activities.

Thus typical problems involved with big governments can be observed in developing countries, too, like over- regulation, interventionism, corruption or bureaucratic slack. – 4 – of a sub-sample of rich countries is always somewhat arbitrary. 3 But according to our knowledge only few authors have been concer ned with growth effects on the sub-federal level. Exceptions are Holcombe and Lacombe (2004), Vedder and Ga llaway (1998) or Helms (1985) with evidence from the US state level. In this paper, w e investigate growth effects of government spending within a rich country on the state level. The sample consists of all state governments in Switzer land, the cantons, over the 1981-2001 period. 4 Analyzing growth effects within Swit zerland is reasonable for several rea- sons. First, the state level in Switzerland enjoys considerable fiscal autonomy (Feld, Kirchgässner and Schaltegger, 2003). This is especially true for the tax and expenditure policy. Cantons are free to set tax rates, tax tariffs, tax exemptions, tax deductions, to borrow and to spend to a far extent. Second, state governments in Switzerland have the legal instruments to conduct their own economic policy. The federal government has only very limited possibility to interfere with poli- cy decisions of cantons. Compared to other coun tries’ sub-federal governments, all state govern- ments within Switzerland can be considered as rich in terms of their GDP per capita. Third, ac- counting standards for government s are harmonized in Switzerland. This augments the compara- bility of our data on public spending of the cantons. In contrast, different accounting standards between countries might be very difficult to isol ate in a cross-country analysis. Lastly, all Swiss cantons separate public spending for current pur poses from spending for investments. Thus, a distinguishing feature of this paper is that we can separate the effect of public expenditure from operating budgets to t hose of capital budgets. 3 Agell et al. (2003, p. 363) argue that the results of cross-country regressions have to be interpreted with caution due to methodological reasons: “A policy-maker who wants to promote growth is well-advised to look for other evidence than cross-co untry regressions”. 4 There exists a time series analysis for Switzerland by Singh and Weber (1997) concluding that there is no clear empirical evidence on growth effects by government spending. – 5 – Our results indicate that the governm ent size sign ificantly retards econom ic growth when spend- ing is used for paym ents in the operating budgets , while paym ents in the capital budget have no significant effect on econom ic growth rates. Th ese findings underscore the im portance of differ- ent incentives provided by different spending policies on econom ic growth. The paper is organized as follows. In section 2 we present som e stylized facts on our database and conduct the em pirical analysis while section 3 discusses the obtained re sults from the regres- sions. Finally, section 4 concludes. 2. The si ze of Sw iss state and local governments and economic grow th In the past years a num ber of Swiss cantons have im plem ented budget rules in response to the revenue shortfall of the early 1990s (Schalte gger, 2002). Although much of the public debate since then is circling around pref erences of tax and expenditure com binations, the questions of how state an d local spen ding decis ions affect econo mic growth is a centra l issue to the discuss ion (Borner and Bodm er, 2004). Figu re 1 : Differe ncials of Econ om ic G row th in Swiss Cantons, 19 81 -2001 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Low est V alue of Grow th Average G row th Highes t V alue of Grow th – 6 – During the last 20 years the Swiss cantons have faced rather different developm ents. Zoug with 36,1 % represents the canton with the highest rate of real econom ic growth per capita over the 1981-2001 period. W ith an econom ic growth per capita of –14 % the developm ent in Nidwalden is on the other extrem e of the 26 cantons. On av erage, econom ic growth per capita accounted for 17 % over the last 20 years on the stat e and local level of Switzerland. Figure 2: Correlat ion Bet ween Gov ernm ent Siz e and Ec onom ic Grow th for 26 Sw iss Cant ons , 5-Year Av erages , 1981-2001 -4. 0% -3. 0% -2. 0% -1. 0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 10% 15% 20% 25% 30% 35% 40% Public Ex pendit ure in % of cant onal GD P Growth of real GDP per capita Figure 1 displays the m axim um, m inim um and aver age values of annual growth ra tes in Swiss cantons. A f irst look at the data on F igure 2 reveal s a slight n egativ e co rrel ation between the size of government and econom ic grow th (R2 = 0.06). Thus, the quest ion occurs whether and how public expenditures of Swiss canto ns system atically affect the steady-state rate of econom ic – 7 – growth as predicted by endogenous growth models (Romer, 1986; Barro, 1990; Barro and Sala-i- Martin, 1995; Mendoza et al. 1997). In order to test the impact of the size of gove rnment on economic growth for rich jurisdictions, we follow the methodology that has been applie d. (For example by Fölster and Henrekson, 2001 or Kneller et al., 1999). The empirical analysis is based on annual data for the 1981-2001 period for all 26 Swiss cantons. The dependent variable is cantonal GDP growth per capita and calendar year as calculated by BAK Basel Economics Ltd.. The explanatory variables fall into three cate- gories: (1) government expenditure per GDP as a proxy for government size and government expenditure per GDP split into public spending in the operating budget and public spending in the capital budget. Current and consumption spending appear in the former budget while the latter budget consists of investment spending. (2) Initia l GDP in order to incorporate the process of convergence as well as components of the production function: investment , labor force and hu- man capital, and (3) a set of soci o-demographic indicators of the can tons as control variables. Our regression equations have basically the following simplified form in logarithms: yit – y it-1 = β 0 + β 1 git + β 2 yit-1 + β 3 X it + ω i + δ t + ε it,, (1) where, y it is the log of GDP per capita in canton i of period t so that economic growth is de- scribed by y it – y it-1 The government size is specified by g it which consists of the log of public expenditure per GDP. y it-1 on the right hand side of the equa tion incorporates the convergence process of economic growth between cantons. X it is a vector of the different control variables of category (3) and the production function of categor y (2). Finally, there are three error compo- nents depicted by ω i,, δ t and ε it which represent state specific effect s, year specific effects and the remaining error, respectively. – 8 – 3. Results Table 1 displays the basic results. The first two columns use state fixed effects but do not control for time specific effect. The last two columns contro l for both effects. Unlike Easterly and Rebelo (1993) but in line with Fölster and Henreks on (1999, 2001), Agell, Lindh and Ohlsson (1997, 1999) or Barro and Sala-i-Martin (1992) initial GDP enters the regression with a highly signifi- cant negative coefficient. For the three condition ing variables, the investment ratio, labor force and higher schooling, there is no clear, empirically significant impact on economic growth for the Swiss cantons.

Table 1: Regression Results on the Impact of Government Size on Economic Growth, 26 Swiss Cantons, 1981-2001. Dependent Variable: Per Capita Growth Explanatory Variables CD CD FE FE -0.057*** -0.096*** -0.099*** -0.142*** Initial GDP p.c. (-3.00) (-4.86) (-5.66) (-7.27) -0.054*** -0.063*** -0.069*** -0.064*** Government Size (-3.64) (-3.82) (-5.02) (-4.53) -0.004 -0.005 0.006 0.003 Investment (-0.69) (-0.74) (1.07) (0.47) -0.042* -0.051** 0.023 0.046* Labor Force (-1.71) (-2.07) (0.91) (1.73) 0.135*** 0.897*** -0.013 -0.021 Higher Schooling (5.51) (3.41) (-0.64) (-0.97) -0.002*** -0.002*** -0.001** -0.002*** Unemployment Rate (-4.62) (-4.37) (-2.39) (-3.56) -0.008 0.012 Agglomeration (-0.38) (0.76) 0.045 -0.109*** Population (1.20) (-3.28) 0.335*** 0.129* Population > 65 (4.15) (1.92) -0.099 0.102 Population < 15 (-1.43) (1.63) 0.040 -0.031 German Language (1.08) (-0.96) Canton Effects Yes Yes Yes Yes Year Effects No No Yes Yes R-Squared 0.176 0.226 0.622 0.638 # of Observations 546 546 546 546 Note: t -statistics in parantheses. *,** and *** denote significance at the 10%, 5% and 1% level. For definitions of variables see Appendix. CD: one-way fixed effects estimates (canton dummies) FE: two-way fixed effects estimates – 9 – The governm ent size variable has st atistically a significant negati ve coefficient, and the point estim ate su ggests that a decrease by one percenta ge point of GDP ra ises the growth rate by around 0.06 percentage points. S ince the use of a shor t period of panel data may increase the risk that observ ed correlation s are driven by business cy cle effects , we include the unem ploym ent rate in the reg ression as a co ntrol variable that varies with the bu siness cycle. La ter, we will use addi- tiona lly f ive -year -ave rag es to t ackle problem s caused by business cycle effects (see Table 2). A typical business cycle correlation would im ply that when growth rates f all governm ent spending has to inc rease as a re sult of unemploym ent costs. Actua lly , it is as sumed that th is cyclical co- variation is already m oderated by controlling for period effects using tim e dummie s. However, the highly significant and negative coefficients suppor t the view that business cycles play an im - portant role in explaining econom ic growth fluc tuations. The agglomeration variable does not play a signif icant role in explai ning econom ic growth within Swit zerland. This is som ewhat sur- prising sin ce it contr adic ts the notion that urban clusters play a prom inent role in generating eco- nom ic pros perity by sp illov er ef fects. However , it could b e argued th at th ere is not a pe rfec t mapping of political borders with econom ic areas , which renders the a gglom eration variables insignificant. The other socio-dem ographic factors represent contro l va riable s to ca pture f urth er state specific characteris tics. This in cludes a lan guage varia ble to con trol f or syste matic cultur al differences accord ing to the four offici al languag es used in th e 26 cantons. In the following, we apply som e robustness tests of the above results. For exam ple, Easterly and Rebelo (199 3) argue in their ar ticle, that growth regress ion re sults a re sen sitiv e to the inclus ion of the initia l GDP. Theref ore, in a var iant of our ba sic regression, we exclude initial GDP. However, even though the coefficient of th e initial GDP is highly significan t in our basic regression, Table 2 shows that an exclusion of this variable hard ly changes the significance of the governm ent size coefficient. Also, the negative quantitative effect decreases on ly slightly from –0.064 to –0.040. – 10 – Second, we exclude the significant unem ploym ent variable to show the effect of business cycle correlation on the other explanatory variables. Agai n and as indicated in Table 2, the exclusion of the unem ploym ent rate h ardly chang es the re sults. Third, while the use of panel data is reasonable in order to lower risks of si multaneity and to allo w for within-state variation, there are also disad- vantages of using annual data (Fölster and Henrekson, 2001). Tabl e 2: Regressi on Resul ts on the Im pact of Gove rnment Si ze on Ec on om ic Gr owth for Di ffe rent Speci fica- tio ns, 26 Sw iss Can ton s, 198 1-200 1. Dep end ent Variab le: Per Cap ita Growth Explanatory Variables FE FE-I FE-II AV FD-IV -0.142 *** -0.132 *** -0.022 -0.751 *** Initial GDP p.c. (-7.27 ) (-6.73 ) (-0.85 ) (-9.35 ) -0.064 *** -0.040 *** -0.064 *** -0.044 ** -0.174 ** Go vernm ent Si ze (-4.53 ) (-2.78 ) (-4.51 ) (-2.01 ) (-2.06 ) 0.00 3 -0.002 0.00 9 -0.003 0.00 2 Invest ment (0.47) (-0.38 ) (1.42) (-0.25 ) (0.19) 0.04 6* 0.01 0 0.03 7 -0.084* 0.06 5** Lab or Fo rce (1.73) (0.37) (1.38) (1.91) (2.00) -0.021 -0.005 -0.029 -0.037 -0.015 Hi gher Sc ho oling (-0.97 ) (-0.22 ) (-1.31 ) (-0.88 ) (-0.76 ) -0.002 *** -0.001 ** -0.002 ** -0.001 Unem ploy ment Rate (-3.56 ) (-2.37 ) (-2.23 ) (-0.54 ) 0.01 2 0.00 1 0.01 3 0.00 1 0.00 7 Ag glom erat ion (0.76) (0.06) (0.81) (0.05) (0.27) -0.109 *** -0.016 -0.105 *** 0.011 -0.549 *** Po pul ation (-3.28 ) (-0.49 ) (-3.14 ) (0.28) (-4.41 ) 0.12 9* 0.06 9 0.05 1 0.01 45* 0.26 1 Po pul ation > 65 (1.92) (0.98) (0.79) (1.71) (1.20) 0.10 2 0.05 7 0.05 3 0.10 7 0.51 6** Po pul ation < 15 (1.63) (0.86) (0.85) (1.38) (2.57) -0.031 -0.014 0.016 -0.063 -0.004 German Languag e (-0.96 ) (-0.40 ) (0.54) (-1.38 ) (-0.07 ) Canto n Effects Yes Yes Yes Yes Yes Year Effects Yes Yes Yes Yes Yes R-Sq uared 0.63 8 0.59 7 0.63 5 0.56 0 # of Obser vations 54 6 546 54 6 104 54 6 No te: t -statistics in paran theses. *,** an d *** denot e significance at the 10% , 5 % and 1% level . FE: two -way fi xed effects esti mates, AV: 5-yea r averages , two-wa y fixe d effects FD- IV: first di ffe rences with instrum ental v ariables Fo r defin ition s of variab les see Ap pend ix. Estim ating a panel of annua l data without bias requ ires that the e rror in the growth regression affects governm ent spending in the sam e period, onl y. Presum ably, this is not the case. A solution to address these concerns is to focus on five-year averages. T he resu lts of the es tim ate using five- – 11 – year-averages indicate that the level of significance for the impact of the size of governm ent on econom ic growth drops to the 5 % level, approx im ately. However, public spending still affects econom ic growth significantly negative. Another way to address a possible endogeneity bias of governm ent spending requires the estim ation of in strum ental variables. A comm on m ethod is to use lagged values of the fiscal vari ab les as instru ments. However, in the f ixed effects dom ain it is not possible to use lagged values. We therefor e follow Kneller et al. (1999) and Henrekson and Fölster (200 1) and es tim ate the r egression in first differences. The choice of instrum ents contains state dummy variables, lagged va lues of the governm ent spending and in itial GDP. The resu lts of the instrum ental variable estim ates are displaye d in Table 2, colum n 6. Again, the im pact of pub- lic spending on econom ic growth is negative and significant. Figure 4: Correlation Betw een Pu blic Investment Spending and Economic Grow th, 26 Sw iss Cant ons, 1981-2001, 5-Y ear- Average s -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 0% 2% 4% 6% 8% 10% 12% 14% Public Expenditure in % of Cantonal GDP Growth of Real GDP per Capita Figur e 3: Correlation betw een C urrent Publ ic Spendi ng and Econom ic Grow th, 26 S wiss Cant ons , 1981- 2001, 5- Year - Averages -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 10% 15% 20% 25% 30% Publ ic Expendi ture in % of Cantonal GDP Grwoth of Real GDP Per Capi ta Anyhow, it has to be noted that even after introduc ing instrum ents, the results of the coefficients may be biased. For example, Agell et al. (1999) ar e very skeptical about th e instrum ental variable – 12 – techniqu e in this case since the im plem ented in strum ents may still be c orrelated with the er ror term .5 Com paring the res ults of Tab le 1 and 2, it can be assu med that the effect of fis cal po licy decisions on econom ic growth is not sim ply due to endogeneity. Tabl e 3: Regressi on Resul ts on the Im pact of Gove rnment Si ze on Ec on om ic Gr owth Di stinguishing fo r Di ffe rent Budgets, 26 Swi ss Cantons , 19 81 -2001. Dep end ent Variab le: Per Cap ita Growth Explanatory Variables FE AV FD-IV -0.239 *** -0.047 -0.710 *** Initial GDP p.c. (-10 .65) (-1.27 ) (-9.11 ) -0.148 *** -0.047 * -0.364 *** Go vernm ent Si ze I (Cu rre nt s pending ) (-8.89 ) (-1.76 ) (-4.62 ) 0.00 6 -0.003 0.01 5 Go vernm ent Size II (Inve stment spendi ng ) (1.62) (-0.34 ) (0.80) -0.007 -0.009 -0.005 Invest ment (-1.21 ) (-0.74 ) (-0.78 ) 0.03 8 -0.092** 0.06 0* Lab or Fo rce (1.51) (2.13) (1.77) -0.021 -0.035 0.007 Hi gher Sc ho oling (-1.02 ) (-0.82 ) (0.31) -0.003 *** -0.003 ** -0.001 Unem ploy ment Rate (-5.09 ) (-2.41 ) (-0.79 ) 0.00 6 0.00 3 0.01 3 Ag glom erat ion (0.39) (0.14) (0.46) -0.117 *** 0.003 -0.376 *** Po pul ation (3.72) (0.08) (-2.72 ) 0.01 8 0.14 1 0.07 0 Po pul ation > 65 (0.28) (1.62) (0.30) -0.001 0.07 7 0.35 6* Po pul ation < 15 (-0.02 ) (0.98) (1.70) -0.031 -0.063 -0.046 German Languag e (-1.02 ) (-1.35 ) (-0.71 ) Canto n Effects Yes Yes Yes Year Effects Yes Yes Yes R-Sq uared 0.67 1 0.56 0 # of Obser vations 54 6 10 4 54 6 No te: t -statistics in paran theses. *,** an d *** denot e significance at the 10% , 5 % and 1% level . FE: two -way fi xed effects esti mates, AV: 5-yea r averages , two-wa y fixe d effects FD- IV: first di ffe rences with instrum ental v ariables Fo r defin ition s of variab les see Ap pend ix. In spite of dif ferent ec onom etric r easons to b e caref ul with the interp reta tion of the estim ate d coefficients there is at least som e evidence suppo rting the view that the expansion of the size of 5 Ag ell et al. (1 99 9, p. 36 3) wri te: “Th is pro cedure will, howev er, in trod uce m ore p rob lems th at it so lves”. – 13 – government hampers economic growth in a rich country with a developed public sector. The es- timated results indicate a significant and nega tive correlation between public spending and the rate of economic growth throughou t the different specifications and estimation techniques. While the obtained results may be interpreted as evid ence for a crowding-out effect, where public ex- penditure displace private sector productivity, it is reasonable to assume that investment spending have a different impact on economic growth th an transfer spending or public consumption (Barro, 1990). The traditi onal approach is to divide public sp ending into the two broad categories of public consumption and public investment. The fo rmer is said to retard economic prosperity while the latter should pr omote growth prospects. Implicitly, consumption spending are classified as unproductive and growth-retarding public pro- grams whereas investments fall into the categ ory of productive and growth-inducing government activities. This distinction has an intuitive app eal but is also problematic since investment pro- jects can be wasteful as well while public consumption need not necessarily be unproductive (Tanzi and Zee, 1997).

Hence, some authors distinguish between produ ctive and unproductive government activities by sorting all spending tasks of the budget according to that criterion. For example, Kneller et al.

(1999) show that productive government expenditu re enhance growth rates of the 22 OECD countries over the 1970-1995 period an alyzed in their empirical study. In order to get a more detailed picture of di fferent public spending impacts on growth for the Swiss sub-federal governments, we distinguish between spending from the capital budgets to finance investments and spending in the opera ting budget to finance current expenditure. 6 Figure 6 However, as argued by Shepsle and Weingast (1984) it is possible that such a distinction of the budgets only affects the labelling of government spending without affecting the composition of spending. For example, can- tons with fiscal requirements for the operating budgets ma y try to relabel operating expenditure as capital projects – 14 – 3 and Figure 4 give us a first indication that growth impacts of the two budgets are different.

While the picture for current spending is very si milar to the picture for overall government spend- ing, there is no correlation betw een investment spending and economic growth. The first clue becomes confirmed in the multivariate analysis. As can be seen by Table 3, there is evidence that the growth impact differs betw een spending from the current budget and spending from capital budgets. While current spending have a significan tly strong negative impact on economic pros- perity of cantons, the same does not hold for inve stment spending. This result confirms that the type of government expenditure matters for economic growth. Thus, our results are very much in line with those obtained by Romero de Ávila a nd Strauch (2003) for the European countries.

Both studies find that government consumption negatively affect growth rates of GDP per capita, while public investment has a positive impact. 4. Conclusions There is a huge empirical litera ture investigating the relationship between government size and economic growth. To date, the cross-country empi rical evidence on growth effects of public ex- penditure is still inconclusive, however. Theoretic ally, this is not surprising since small or big government by itself is not an asset. A negative relationship should only apply for rich countries with a large public sector while in developing countries a growing size of government typically reveals safer property rights a nd the enforcement of contracts. Thus, there is no reason to believe that small governments will generally promote econom ic growth. In this respect, restricting the analysis on rich countries only may give us a more detailed picture of the issue. Naturally, a se- lection of a sub-sample of rich countries is alwa ys somewhat arbitrary. Another possibility is to in order to evade constitutional spending limitations. Pote rba (1995) finds empirical evidence for the US states that states with separate capital budgets spend more on public capital projects than comparable states with unified budgets. – 15 – concentrate on governments within a rich country. However, only few studies investigate the ef- fect of state and local spending on economic growth. This paper attempted to test the impact of the size of government on economic growth for the sub-federal level of a rich country using panel data of a full sample of the 26 Swiss cantons over the 1981-2001 period. The general finding is a fairly robust negative relations hip between government size a nd economic growth. Even though we do not claim to settle the issue, the results are found to be robust also after adopting changes in specification and applying di fferent estimation techniques. Anyhow, theory does not only predict that fiscal policy affects growth by the level of government spending but also by the expenditure structure. That’s why we test the effect of government spending of the operational budget separately from the impact of investment spending from the capital budget. Consistent with Barro’s (1990) pr edictions, an increase in public spending from operating budgets significantly reduces growth wh ile there is no significant impact on economic growth by expenditure from capital budgets. References Agell, J., H. Ohlsson and P.S. Thoursie (2003), Growth Effects of Government Expenditure and Taxation in rich Countries: A Comment, Working Paper University of Stockholm. Agell, J., T. Lindh and H. Ohl sson (1997), Growth and the Public Sector: A Critical Review Es- say, European Journal of Political Economy 13, 33-52. Agell, J., T. Lindh and H. Ohlsson (1999), Growth and the Public Sector: A Reply, European Journal of Political Economy 15, 359-366. Atkinson, A.B. (1995), The Welfare State and Economic Performance, National Tax Journal 47, 171-198. Barro, R.J and X. Sala-i-M artin (1992), Convergence, Journal of Political Economy 100, 223- 251. Barro, R.J and X. Sala-i-Martin (1995), Economic Growth, McGraw-Hill, New York. Barro, R.J. (1990), Government Spending in a Simple Model of Endogenous Growth, Journal of Political Economy 98, 103-125. – 16 – Barro, R.J. (1991), Economic Growth in a Cross Section of Countries, Quarterly Journal of Eco- nomics 106, 407-443. Bernholz, P. (2004), Der Wettbewerb der System e: Arten, Interaktionen und Folgen, in: C.A.

Schaltegger and S.C. Schaltegger (eds.), Perspektiven der Wirtschaftspolitik , Zürich, vdf. 241- 258. Borner, S. and F. Bodmer (2004), Wohlstand ohne Wachstum – Eine Schweizer Illusion, Avenir Suisse, Orell Füssli. de Soto, H. (2002), Law and Property Outside the West: A Few New Ideas about Fighting Pov- erty, Forum for Development Studies 29, 349-61. Easterly, W. and S. Rebelo (1993), Fiscal Poli cy and Economic Growth: An Empirical Investiga- tion, Journal of Monetary Economics 32, 417-458. Engen, E.M. and J. Skinner (1992), Fi scal Policy and Economic Growth, NBER Working Paper 4223. Feld, L.P., G. Kirchgässner and C.A. Schaltegger (2003), Decentralized Ta xation and the Size of Government, Evidence from Swiss Sub-Federa l Governments, CESifo Working Paper No.

1087. Fölster, S. and M. Henrekson (1999), Growth a nd the Public Sector: A Critique of the Critics, European Journal of Political Economy 15, 337-358. Fölster, S. and M. Henrekson (2001), Growth E ffects of Government Expenditure and Taxation in Rich Countries, European Economic Review 45, 1501-1520. Grier, K.B. (1997), Governments, Unions a nd Economic Growth, in: V. Bergström (ed.), Gov- ernment and Growth , Clarendon Press, Oxford. Gwartney, J.; R. Lawson and R. Holcombe (1998), The Size and Functions of Government and Economic Growth, Paper repared for the US Joint Economic Committee. Hansson, P. and M. Henrekson (1994), A New Fram ework for Testing the Effect of Government Spending on Growth and Productivity, Public Choice 81, 381-401. Helms, L.J. (1985), The Effect of State and Local taxes on Economic Growth: A Time Series- ross ection Approach, Review of Economics and Statistics 67, 574-582. Holcombe, R.G. and D. J. Lacombe (2004), The E ffect of State Income Taxation on per Capita Income Growth, Public Finance Review 32, 292-312. Keefer, P. and S. Knack (1997), Why Don’t Poor Countries Catch Up?, A Cross-National Test of an Institutional Explanation, Economic Inquiry 35, 590-602. Kneller, R.; M.F. Bleaney and N. Gemell (1999), Fiscal Policy and Growth: Evidence from EOCD Countries, Journal of Public Economics 74, 171-190. Mendoza, E.G.; G. Milesi-Ferret ti and P. Aseac (1997), On the Ine ffectiveness of Tax olicy in Alterino Long-Run Growth: Harberge r’s Superneutrality Conjecture, Journal of Public Eco- nomics 66, 99-126. Poterba, J. M. (1995), Capital Budgets, Borrowing Rules, and State Cap\ ital Sepnding, Journal of Public Economics 56, 165-187. – 17 – Romer, P.M. (1986), Increasing Returns and Long-Run Growth, Journal of Political Economy 99, 500-521. Romero de Ávila, D. and R. Stra uch (2003), Public Finances and Long-Term Growth in Europe – Evidence from a Panel Data Analysis, ECB Working Paper No. 246. Schaltegger, C.A. (2002), Budgetregeln und ihre Wirkung auf die öffentlichen Haushalte: Empi- rische Ergebnisse aus den US-Bunde sstaaten und den Schweizer Kantonen, Schmollers Jahr- buch 122, 369-413. Shepsle, K.A. and B.R. Weingast (1984), Legislative Politics a nd Budget Outcomes, in: G. Mills and J. Palmer (eds.), Federal Budget Policy in the 1980s , 343-367, The Urban Institute Press. Singh, R.J. and R. Weber (1997), The Composition of Public Expenditure and Economic Growth:

Can Anything be Learne d from Swiss Data?, Schweizerische Zeitschrift für Volkswirtschaft und Statistik 133, 617-634. Slemrod, J. (1995), What Do Cr oss-Country Studies Teach About Government Involvement, Prosperity, and Economic Growth?, Brookings Papers on Economic Activity 2, 373-431. Slemrod, J. (1998), How Costly is a La rge, Redistributive Public Sector?, Swedish Economic Policy Review 5, 87-105.

Tanzi V. and L. Schuknecht (2000), Public Spending in the 20th Century, Cambridge University Press. Tanzi, V. and H.H. Zee (1997), Fi scal Policy and Long-Run Growth, IMF Staff Papers 44, 179- 209. Vedder, R.K. and L.E. Gallaway (1998), Gove rnment Size and Economic Growth, Paper pre- pared for the US Joint Economic Committee. Weingast, Barry R. 1995. The Economic Role of Political Institutions: Market-Preserving Feder- alism and Economic Development, Journal of Law, Economics, and Organization 11, 1– 31. – 18 – Appendix A Data description Variable name Description Source Government Size Total cantonal expenditure per GDP Own calculations on the basis of Swiss Federal Finance Administration and BAK Basel Economics Current Spending Cantonal expenditure in the operational budget per GDP Own calculations on the basis of Swiss Federal Finance Administration and BAK Basel Economics Investment Spending Cantonal expenditure in the capital budget per GDP Own calculations on the basis of Swiss Federal Finance Administration and BAK Basel Economics GDP Real cantonal GDP BAK Basel Economics Investment Investment spending per GDP Swiss Federal Statistical Office Labor Force Share of employment on the cantonal popula- tion Swiss Federal Statistical Office Higher Schooling Share of population with secondary education on the cantonal population Swiss Federal Statistical Office Unemployment Rate Share of unemployment on the cantonal popu- lation Own calculations on the basis of Swiss Federal Statistical Office Agglomeration Proportion of local communities having more than 10'000 inhabitants. Swiss Federal Statistical Office Population Cantonal population Swiss Federal Statistical Office Population > 65 Share of cantonal population over the age 65 on total cantonal population Swiss Federal Statistical Office Population < 15 Share of cantonal population under the age 15 on total cantonal population Swiss Federal Statistical Office German Language Dummy = 1 for German speaking cantons Own investigations – 19 – Appendix B Table A2: Descriptive statistics Variable Mean Std. Dev. Minimum Maximum Government Size 0.226 0.047 0.118 0.386 Current Spending 0.183 0.037 0.098 0.291 Investment Spending 0.044 0.023 0.012 0.145 GDP 41590 13064 26324 117228 Investment 0.160 0.055 0.050 0.477 Labor Force 0.480 0.032 0.396 0.564 Higher Schooling 0.137 0.059 0.023 0.334 Unemployment Rate 0.018 0.018 0 0.078 Agglomeration 0.324 0.249 0 0.995 Population 261938 272497 12781 1228628 Population > 65 0.146 0.021 0.103 0.210 Population < 15 0.186 0.024 0.113 0.241 German Language 0.714 0.353 0.050 0.980 Note:

For a detailed description of the variables see Appendix A.

All statistics are computed for 546 observations.

View publication statsView publication stats