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 favor one or the other approach.
The substantial growth of the size of government expenditures in both the developed and developing nations since World War II, and its effect(s) on long-run economic growth (or vice versa), has spawned a vast literature that offers diverse attempts to explain the observed phenomenon. On the one hand, public finance studies have been directed towards identifying the principal causes of public sector growth. Wagner’s Law of public expenditure is one of the earliest attempts that emphasize economic growth as the fundamental determinant of public sector growth. The literature on this topic is immense to say the least. Some studies find a significant positive relationship between public sector growth and economic growth only developing nations but not for developed countries. Others even report a negative relationship between government spending and GNP.
On the other hand, macroeconomics, especially the Keynesian school of thought puts the emphasis on a different place. The analysis bears upon the question of the role of government in economic growth. A considerable amount of attention has been directed towards assessing the effect of the general flow of government services on economic growth. During the last twenty years or so, studying the underlying causal process Henrekson and Lybeck (1988) provide an excellent survey of various hypothesis between government spending and GDP, or their close variants, has made parallel efforts. The principle reason that led researchers to this field of analysis was the difficulty of a possible feedback in macro relations, which tend to obscure both the direction and the nature of causality.
According to some authors, there are two macroeconomic reasons why government spending can undermine economic performance. The first reason is “resource displacement.” Every time the government spends money, it is using labor and/or capital and those resources no longer are available for private sector uses.
The second macroeconomic issue associated with government spending is the “financing cost.” When government taxes, it not only takes money from the productive sector, but it also raises revenue by means of a tax system that generally reduces incentives to work, save, and invest. And if it finances spending with debt, it siphons money out of private credit markets.
The economic impact of government spending can be presented in graphical form by Rahn Curve ho is the equivalent for expenditure to Laffer Curve. In 1986, Richard Rahn, then the chief economist for the U.S. Chamber of Commerce, charted an inverse relationship between government spending and economic growth for the seven major industrialized countries in the form of a curve, not unlike the "Laffer Curve," which focused on the incentive effects of taxation.
The theory behind the "Rahn Curve" is that, at first, low levels of government spending on basic public services, such as law and order and a judicial system to enforce contracts, stimulate growth in the economy. But as spending rises as a share of the economy, its contribution to economic growth diminishes. Government spending eventually reaches a point where it actually retards economic growth.
There are several reasons for this. First, the growing public sector "crowds out" private sector activity, and it often uses the economy's resources far less efficiently. Second, as government grows bigger, it tends to accept broader responsibilities such as reducing poverty. This increased spending on welfare and income transfer programs, however, creates severe work disincentives. Third, an expanding government bureaucracy usually is accompanied by more complicated and burdensome regulation that stifles innovation and productivity. Fourth, the higher tax burdens necessary to finance bigger government at some point damage incentives to work, save and invest. The weakened economy fails to generate enough tax revenue to finance the ever-growing spending share, resulting in increased public sector borrowing and debt service burdens.
One should distingush between short-term and long-term impacts. Government spending in the short-run increases effective demand and by this if there is not supply-constraint economic growth. However, there is some debate on the long-term impacts. First government spending has to be financed. If the revenues do not come from taxing etc. the private sector it could be financed via adding to public debt.
Debt should be serviced at a later time. So higher growth now may lead to less growth later due to public expenditures. Some theretical extremists suggests that in the end this is a zero-sum game. It's just intertemporal substitution. The term describing this is Ricardian equivalence.
http://en.wikipedia.org/wiki/Ricardian_equivalence
Keynesian instead point out thqt higher growth now may lead not only to a higher growth now, but as well to higher growth in the future. Since idle economic ressources in particular unemployed people their additional output now contributes to higher growth as well in the future. The delicate question ist if this is sufficient to compensate for the transfers necessary to payback the public deficits which has a negative impact on growth. Keynes and his followers are convinced that the is a fundamental market failure that the private sector runs short of effective demand. This might be due to the rdistribution of incomes towards capital incomes in favor of labor incomes. Sonner or latrer this ends up in a savings glut. Capital income owners spend less than labor income owners and lower effective demand.
This is known as the paradox of thrift.
http://en.wikipedia.org/wiki/Paradox_of_thrift
Against this argument Hayek and oters of the Austrian school have conjected that the paradox of savings , i.e. the paradox of thrift in the keynesian terminology, can be overcome since if savings are allocated towards investments there should not occur an effective demand gap. In principle by using a mathematical model one can calculate an equilibrium solution, however, what is hard to show that the real economy follows such an ideal general equilibrium solution. Its not the pürinciple possibility that matters, but, if in an imperfect market system the real economy would tend to develop in such a direction. So the two camps face two different dilemma. The Keynesian have difficulties to prove that short-term grwoth benefits transform to long-term gains in growth The Neoclassical school has difficulties to prove that markets are perfect to establish aq long-term equilibrium and by this avoiding the paradox of thrift.
Devoid of the jargon, in simple terms, Govt expenditure is necessitated in developing economies, when private investment is lacking. When Govt spends, say in laying roads, bridges and railways or create a banking system, it generates lot of jobs, gives the much needed services to kickstart the economy, and increases money supply to boost demand. These lead to increased growth rate. But this may not be true for a developed or advanced economy- for - it increases fiscal deficit, it crowds out private investment, increases taxes therby reduces savings and therefore private investment. (All these apply to a developing economy also). However, since private is not coming forward to spend Govt has to chip in in a developing economy , whereas, in the developed economy Govt spending would chocke private investment which is disincentive for growth. Thus there is a trade-off, and depending on the context and circumstances the country is in, the choice is made to induce growth thru public spending.
Dr Durairajan
Yours is too big a question. Whole history of macroeconomics and development economics is concerned with your question. If I dare to say, your question is not well posed. As you and other responders indicate, there are so many different situations and the relations may be opposite. Economy is so complex that there are no firm relationships between two variables you have chosen arbitrarily. Then, what is well posed question? Here comes the role of theories.
Theory is not a model which combines everything. It clarifies or at least tries to clarify the causal relationship between economic states. In order to grasp a good causal relationship, you should break down your interested relationship into a series of short effects. When two states are connected by a long series of causalities or effects, the relationships become blurred for at each stage there are some extent of ambiguity or uncertainty.
Two days ago, I have posted a working paper which is a kind of critical review of growth theories. I feel there are many things to do with the growth theories. One of such topic is to make a growth theory in view of international competition.
Growth Theory As It Ought to Be: comments on Kurz and Salvadori's Two Survey Papers on Old and New Growth Theory
https://www.researchgate.net/publication/311439320_Growth_Theory_As_It_Ought_to_Be_comments_on_Kurz_and_Salvadori%27s_Two_Survey_Papers_on_Old_and_New_Growth_Theory
Working Paper Growth Theory As It Ought to Be: Comments on Kurz and Salvad...
It depends also on what government is spending and on its efficiency to deliver services and especially on ROI from its capital spending .
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