THEORETICAL AND EMPIRICAL FACTORS AFFECTING ECONOMIC GROWTH IMPACTS OF PUBLIC EXPENDITURE AND PUBLIC INVESTMENT ON ECONOMIC GROWTH

IMPACTS OF PUBLIC EXPENDITURE AND PUBLIC INVESTMENT ON ECONOMIC GROWTH Group 3 Class: K55B Lecturer: Mr.. Overview of Public and their effects to Economic Growth in developing countries

FOREIGN TRADE UNIVERSITY

HO CHI MINH CITY CAMPUS

MID-TERM REPORT

Major: International Finance

THEORETICAL AND EMPIRICAL FACTORS

AFFECTING ECONOMIC GROWTH

IMPACTS OF PUBLIC EXPENDITURE AND PUBLIC INVESTMENT ON ECONOMIC GROWTH

Group 3 Class: K55B Lecturer: Mr Nguyen Trung Thong

Ho Chi Minh City, January 2019

Table of Contents

Table of Contents 2

CHAPTER 1 Theoretical and Empirical F actors affecting Economic Growth 3

1.1 Theoretical factors affecting economic growth 3

1.2 Empirical factors affecting economic growth 3

CHAPTER 2 Impacts of Public Expenditure on Economic G rowth 6

2.1 The overall of Public Expenditure: 6

2.2 Impacts of Public Spending on National Economy: 6

2.3 Public Expenditure trend in Vietnam 6

2.3.1 Government expenditure has been maintained at a high level against GDP 6

2.3.2 The growth of spending on several key functions has been mixed 7

2.4 Effects of S tate Budget Deficit on Economic G rowth 8

CHAPTER 3 Impacts of Public Investment on Economic G rowth 9

3.1 Concept of Public Investment 9

3.2 Overview of Public and their effects to Economic Growth in developing countries 9 3.3 Impacts of Public I nvestment in Vietnam’s economy 10

References 12

CHAPTER 1 Theoretical and Empirical Factors affecting Economic Growth

1.1 Theoretical factors affecting economic growth

Growth is a complicated process, but the main theories of economic growth are conceptually simple There are basically two categories of economic growth theories—those based on the traditional Solow (1956) growth model and those based on the concept of endogenous growth

The Solow model emphasizes capital accumulation and exogenous rates of change in population and technological progress This model predicts that all market-based economies will eventually reach the same constant growth rate if they have the same rate of technological progress and population growth Moreover, the model assumes that the long-run rate of growth is out of the reach of policymakers

Endogenous growth theory holds that investment in human capital, innovation, and knowledge are significant contributors to economic growth The theory also focuses on positive externalities and spillover effects of a knowledge-based economy which will lead to economic development For example, subsidies for research and development or education increase the growth rate in some endogenous growth models by increasing the incentive for innovation

Denison (1962) affirmed there are four major determinants of economic growth: human resources, natural resources, capital formation and technology, but the importance that researchers had given each determinant was always different

Public expenditure, capital formation, private or public investment, employment rates, exchange rates etc have different impacts on economic growth There are also socio-political factors and events that have a major influence on the economic advancement of a country

1.2 Empirical factors affecting economic growth

a Labor force growth and depreciation

There is a reduction in the capital stock per worker because of an increase in the number of workers If there were no new investment and no depreciation, capital per worker would decline because of the increase in the labor force, resulting in a decline in the GDP per worker, and

therefore the growth rates

b Institutional variables

Size of government: The state has a role in providing a minimum level of certain services However, if the government is too large, it might be taking away resources that could otherwise

yield a higher rate of return If there were a greater volume of nonproductive government consumption, it would reduce the growth rate for a given starting value of GDP In this sense, big government is bad for growth Therefore, a certain "optimum" size of government might be indicated Growth rates tend to increase as size of government approaches the "optimum" and then decrease beyond this point

Economic institution and economic growth: Empirical evidence from the Economic Community of West Africa States also states the same

Rodrik (2000) stated that five kinds of institutional frameworks (property rights, regulatory institutions, institutions for macroeconomic stabilization, institutions for social insurance and institutions of conflict management) can have a direct outcome on growth and on other determinants of economic growth

c Foreign direct investment (FDI) has been a big source of external funding in developing

and developed countries There have been both positive and negative analysis of FDI on economic growth Most economists and policymakers believe that FDI stimulates development

in investment in technology, increases the capital stock, and increases employment Some worry, however, that it has a crowding out effect on domestic investment and eliminates competition in the local markets Foreign direct investment may also have negative effects on the recipient country Foreign firms may invest capital only on what they think is productive It drives away

domestic firms, which lowers the welfare of the nation (Hanson, 2001) So, while there is

optimism for the role of FDI in economic growth, there is some pessimism as well

d International trade enhances the economy of both importing and exporting countries

Kavoussi (1984) found that higher rates of economic growth were strongly correlated with higher rates of export growth Even in poorer countries, openness to trade enhances growth in

productivity, and thus, human capital (Harrison 1996)

e Initial Debt

Kumar and Woo (2010) found a linear inverse relationship between initial debt and subsequent growth in a sample of emerging and advanced economics The impact of high debt was smaller in developed economies They also found that only very high levels of the debt- -to GDP ratio had significant negative effects on economic growth

f Life expectancy

Acemoglu and Johnson (2006) agree that improvement in health conditions may lead to improvement in economic conditions

g Level of education

Barro (1999) found that an additional year of schooling increased the country’s growth rate by 0.7 percent per year Investment in human capital enhances the workforce’s ability to work and

increases productivity

h Corruption and poor governance

Annual economic growth increased 1.3 percentage points where corruption was reduced by one

standard deviation (Murro 1995)

i Initial GDP had a negative relationship with the growth rate If we had included richer

economies in the study, we could have verified that countries having a higher level of initial GDP per capita would grow at slower rates even when the change in their GDP per capita was

significantly higher than those of poorer countries

j Rate of government debt and foreign aid a country received

They had a negative coefficient implying that these factors had an inverse relationship with the economic growth These results were also consistent with existing theories that high debt and inflow of foreign aid may help a country develop in the long run but have a detrimental effect in the short term

CHAPTER 2 Impacts o Public Expenditure on Economic Growth f

2.1 The overall of Public Expenditure:

Before 19 century, economists held the view that public expenditure was consumption in th government’s activities and did not bring any returns to the national income

This old laissez-faire philosophy has now been discarded Every government is taking active part in the organization of its country The range of economic activity has too much widened Therefore, the modern economists have started analyzing the effects of public expenditure on production, distribution and the levels of income and employment in the economy

2.2 Impacts of Public Spending on National Economy:

The relationship between public spending and national income has been an important subject

of analysis and discussion for decades among economists Government spending has been used extensively as fiscal policy by the government in many countries, but its effect on economic growth is questionable Therefore, two well-examined economic hypotheses have been used by the economic analyst as a base to debate the effect of government spending in economic growth, i.e Wagner’s law and Keynesian hypothesis The fundamental arguments for these two

approaches are rely on causal link between public spending and growth (Samudram, 2009)

Wagner (1883) states public spending and growth have positive association He is of the view

that during industrialization process, government expenditure tends to expand in case of increase

in per capita income of a nation, which indicates causality flows from output to public spending

While, Keynes (1936) postulates government expenditure is exogenous policy instrument

which is used to accelerate growth and to correct short-run as well as long-run cyclical

fluctuations The public spending is not cause of economic growth and spending do not play

decisive role to accomplish growth, so that causality flows from public spending to national output

2.3 Public Expenditure trend in Vietnam

2.3.1 Government expenditure has been maintained at a high level against GDP

From 2011-2015, total state budget expenditure including capital outlays financed by off-– budget bonds averaged 29.2 percent; rising moderately from 28.9 percent in the previous – period and remains high compared with regional and peer income level countries Recurrent

expenditure grew faster than the growth of total revenue, mainly driven by increased outlays on social security, salaries, wages and allowances and by interest payments The wage bill outpaced average expenditure growth, expanding to about 20 percent of total budget expenditure The rapid growth of the wage bill was attributed mainly to increases in base and non-base salaries and allowances and in the number of civil servants and government employees The growth of public sector employment was much faster than population growth, particularly at subnational levels International benchmarking comparisons indicate that the total wage bill of Vietnamese civil servants is not overly high, but its rapid growth warrants caution

2.3.2 The growth of spending on several key functions has been mixed

Spending on education and health grew significantly above average, raising the shares of spending on education and health in total public spending to 19 percent and health 9.5 percent in

2012 respectively Spending on science and technology grew at an annual rate of 3.7 percent, which was below its average trend Spending on transport and agriculture was relatively stable at

11 percent and 6 percent Given the overall decline in the proportion of capital spending in total spending, capital spending in most of the above priority sectors declined in relative terms This reflects in part a deliberate gradual shift away from state budget spending on infrastructure development towards human capital development, reflecting the government’s expectation that the socialization agenda (i.e mobilization of private investment) in infrastructure sectors will advance at a faster pace than in social sectors

Vietnam Government Last Previous Unit

Government Debt to GDP 61.5 60.70 Percent

Government Budget -3.50 -4.20 Percent of GDP

Government Spending 325803.97 293105.82 VND Billion

Government Revenues 1288665.00 1101377.00 VND Billion

Government spending in Vietnam increased to 325803.97 VND billion in 2017 from 293105.82 VND billion in 2016 Government spending in Vietnam averaged 91084.96 VND billion from 1990 until 2017, reaching a total high of 325803.97 VND billion in 2017 and a record low of 3164 VND billion in 1990

2.4 Effects of State Budget Deficit on Economic Growth

State budget deficit has an impact on the supply-side of the economy depending on which – area of government spending is increased

Higher government spending could be on

 Welfare benefits – this spending will help to reduce levels of inequality

 Pension spending – ageing population, requires higher government spending, but this

has no impact on boosting productivity

 Education and training – if successfully, government spending can increase labor

productivity and enable higher long-term economic growth

 Infrastructure investment – higher spending on roads and railways can help remove

supply bottlenecks and enable greater efficiency This can also boost long-term economic growth

 Higher debt interest payments – if the government has higher debt and higher bond

yields, then it can cause increased costs of borrowing This spending will go to investors and have no benefit for the economy

The increased government spending may create a multiplier effect If the government spending causes the unemployed to gain jobs then they will have more income to spend leading

to a further increase in aggregate demand In these situations of spare capacity in the economy, the government spending may cause a bigger final increase in GDP than the initial injection Fiscal deficit if kept in a check is not bad The government in such a scenario can play the role of creating assets in the economy These assets in the economy will benefit in the long term

However, if the economy is at full capacity, the increase in government spending would tend

to crowd out the private sector leading to no net increase in Aggregate demand from switching from private sector spending to government sector spending

 The deficit is not the critical variable The key is the size of government, not how it is financed Taxes and deficits are both harmful, but the real problem is that government is taking money from the private sector and spending it in ways that are often counterproductive Fiscal policy should focus on reducing the level of government spending, with particular emphasis on those programs that yield the lowest benefits and/or impose the highest costs

CHAPTER 3 Impacts of Public Investment on Economic Growth

3.1 Concept of Public Investment

- World Bank Public investment is a public expenditure that increases physical capital : accumulation It includes investment in physical infrastructure by the central government, local government and public sector companies

- OECD (Organization for Economic Cooperation and Development): Public investment refers

to investment in physical infrastructure (roads, government buildings, ) and soft infrastructure (eg support for innovation, research and development, .) with a useful life of more than one year Therefore, OECD believes that the main component of public investment is the total fixed capital accumulation

- Vietnam: According to the Public Investment Law 2014, “Public investment is the

government investment in infrastructure constructions and socio-economic developing programs.”

3.2 Overview of Public and their effects to Economic Growth in developing countries

The share of public investment in developing countries, 1970-1990

The share of public investment(%)

Latin America 40,93%

Europe and Middle East 57,55%

All Developing countries 49,26%

(Source:https://core.ac.uk/download/pdf/7203380.pdf?fbclid=IwAR3uKCUP3DFeBZtWsOjgGU_1K_s-yJ6rj2u4WjGkw72rSEfA5KYLTDHvM2I)

It is inferred from the table that :

 In developing countries, public sector investment accounts for nearly half of total investment

 In Africa and the Middle East, the share of public investment in countries is higher than that of private investment and vice versa in Asian and Latin American

 The needs of developing countries for infrastructural and related capital are greater than those of the industrial countries So it is expected that the share of public investment might be higher in such low-income countries

In general, public investment in infrastructure could increase the marginal product of private capital This is most likely to be true in those developing countries where the exisiting stock of infrastructure capital is generally inadequate

However, in the last few years public investment in infrastructure may not automatically have a beneficial impact on private investment and growth

Reasons:

 Political-bureaucratic motivations have led to expenditures in infrastructure facilities that were sub-optimal

 The direct competition between public sectors and private ones in the provision of goods and services In these cases, an increase in public investment could have an adverse effect on private investment via the public sector budget constraint

For example, public investment is financed by increasing taxes, it may make distortions

in the economy more seriously and increase the costs of inputs, leading to an adverse effect

on expected output growth and private investment

Where it is financed by market borrowing, public investment could have an adverse effect on the availability of credit, as well as on the real cost of capital to the private sector

3.3 Impacts of Public Investment in Vietnam’s economy

ICOR(*) in public sectors ICOR in private sectors