Paris, 24 November 2016

The effect of the size and mix of public spending on growth and inequality

www.oecd.org/economy/economicoutlook.htm

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Key messages

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

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Impact of different instruments on growth and equity

Policy Growth EquityIncome 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.

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1. Motivation and approach

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Changes to the spending and tax mix have gone in the wrong direction between

2007 and 2013

Source: OECD Public Finance Dataset, forthcoming.

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Design of public spending, growth and inequality: the approach

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.

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2. Government size and effectiveness

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Long-term GDP gains from reducing the size of government

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.

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Long-term GDP gains from improving government effectiveness

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.

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Government effectiveness and growth

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

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Government effectiveness and growth

Size of government and citizens’ perception of their effectiveness

AUS

AUT

BEL

CAN

CHE

CZE

DEU

DNK

ESP

EST

FINFRA

GBR

GRC

HUN

IRL

ISLISR

ITA

JPN

KOR

LUX

NLD

NOR

NZLPOL

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)

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Illustrative gains from reducing government size on poor, average and rich households

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

40Average effects Effects on the poor Effects on the rich

Per cent

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3. Changing the spending mix

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Long-term GDP gains from increasing public investment

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.

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Decreasing returns to public investment?

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

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Long-term growth effects of an increase in the education level

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..

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Long-term GDP gains from decreasing public subsidies

0

5

10

15

20

25

30

Subsidies Per 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.

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Long-term GDP gains from decreasing pension spending

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.

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Illustrative gains from raising family and child benefits on disposable income

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

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

40Average effects Effects on the poor Effects on the rich

Per cent

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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. Disclaimers:

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

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