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Composition of government expenditure and economic growth

Final Activity Report Summary - GSGM (Composition of government expenditure and economic growth)

We developed a two-sector model of physical and human capital accumulation, in which the government may allocate resources to both sectors, thereby enhancing productivity. One consequence of this is that unlike the traditional two sector growth model the dynamics of the system do not decouple; equilibrium prices and quantities are jointly determined. We analyse the impact of both the level of government spending and its composition on growth and welfare, and derive their respective growth-maximising levels. We show that at the growth-maximising composition, an increase in the fraction of government spending allocated to final output will reduce steady-state welfare, implying that the welfare maximising share of productive government expenditure is smaller than the growth-maximising share. The opposite occurs in the case of the tax rate. Finally, we supplement our theoretical analysis with simulations, both of the steady-state responses, but also of the transition dynamics following an increase in productivity.

With the aim of helping governments evaluate the impact of their policies, the goal for year two was to o estimate the theoretical model developed in stage one. This would allow us to estimate the returns on public and human capital. This is clearly a relevant issue, playing a key role not only to the European debate of real convergence, but also to the debate on how to classify public investment in the context of the stability and growth pact. Since the European structural funds aim at co-financing a series of government programs concerning not only public investment in infrastructures (e.g. airports, harbours, railways, roads or public sector R&D), but also human capital formation (education or health); it is relevant to provide a qualitative as well as a quantitative measure of the impact of both types of spending on the growth performance of receiving economies.