Optimal size of governments and the optimal ratio between current and capital expenditure

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15. Optimal size of governments and the optimal ratio between current and capital expenditureFrancesco Forte and Cosimo Magazzino

1. INTRODUCTION

The concept of optimal size of governments finds its origin in a book of 1995 by Armey, who proposed the homonym curve, analogous to the Laffer’s inverted U- shaped curve, which represents the relationship between tax revenue and the average tax rate. The Armey’s curve shows the relationship between public expenditure (expressed as share of GDP) and economic growth. With very low levels of public expenditure, the State would fail to ensure contract compliance and protection of property rights, and it would result in a zero or negative rate of economic growth. On the contrary, with very high shares of public expenditure, citizens would have little incentive to invest and produce, since the levels of fiscal burden would be exorbitant, and also in this case the growth would suffer. Consequently, expenditure increases up to moderate levels of GDP gener-ate a strong boost to economic activity, while their expansion to high levels results in a slowdown of the economic dynamics. Thus, there is an optimal value of public expenditure share of GDP from the point of view of the maximization of GDP growth.

The analysis conducted by Forte and Magazzino (2011) revealed that, for the EU- 27 Member States, the peak of the BARS curve is attained for an expenditure of 37.29% of GDP, while the average effective ratio is 47.90%: that is, 10 p.p. more. For the 12 EU countries for whom an individual time- series analysis was meaningful (because of the availability of data), we found that the peak of the BARS curve ranges from 35.39 for Belgium and 35.52 for the Netherlands to 43.50 for the UK and 44.47 for Ireland. The minimum deviation from the level of the public expenditure that coin-cides with the peak of the BARS curve is that of Ireland with only 2.27%, followed by the UK with 7.67 p.p. in excess. The maximum deviation is that of Belgium (of about 18%), followed by Denmark (with a percentage of about 17%). As for the 27 EU member countries that we considered, a country having a public expenditure/GDP ratio above 10% of the esti-mated peak, on average, suffers a diminution in the GDP growth rate of

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Optimal size of governments 343

2.1% per year. Moreover, an increase of 1 percentage point in the variation of public expenditure approximately corresponds to a 0.04% reduction in the acceleration rate of GDP. However, the considered European countries are very heterogeneous in terms of the peak of the BARS curve.

Nevertheless, what about current versus capital public expenditure in the fiscal consolidation framework? To begin with, Figure 15.1 evidences a neg-ative association between current expenditure and growth rate for 2011. In fact, Eastern European countries (Lithuania, Estonia, Romania, Bulgaria, Slovakia, and Finland) exhibit a current expenditure between 30% and 35%, with a growth rate in the range 5–8%. On the contrary, Continental countries (France, Belgium, Austria, the Netherlands, Germany, and Slovenia) and Italy have a higher current expenditure (45–52%) and suffer from a low growth rate (2–4%). Finally, the graph underlines how the economic- financial crisis has struck Greece and Portugal, which registered a negative growth.

What clearly emerges in Figure 15.1 is the negative relationship between GDP growth rate (in the y- axis) and total current government expenditure (in the x- axis) for most of the European countries in 2011. Evidently, moving from the left to the right in the graph, while public current expenditure raises, the growth rate declines. What about countries with high debt, located on a hypothetical right side of that level? Contrary to the Keynesian wisdom, there is now an empirical literature which shows that large public debt hinders economic growth, while Fedeli and Forte (2010), Fedeli and Forte in the present book, and Fedeli et al. (2011) evi-dence a relation between high deficits and unemployment. Nevertheless, what about current capital expenditure? In the tradition of public finance, investment expenditure has more positive effects on growth than current expenditure, since the former is likely to be more productive in the long run. In the Keynesian tradition, investment expenditure plays a crucial role in a deficit spending policy, because of its great multiplier effects, even if it is intrinsically wasteful. In the more recent literature, the theme of current versus capital government expenditure has disappeared. Generally, from the growing economic literature on fiscal consolidation, following the great crisis of 2008, one may argue that what is important for the adjustment is, first of all, the deficit reduction, in order to dampen the debt burden, and secondly, as far as the public budget is concerned, to reduce the tax burden, to obtain a higher growth rate, to increase the denominator of the debt/GDP ratio. Nevertheless, one might argue, that an intrinsically productive government capital expenditure may spur growth both in the short and in the long run by providing a basic support to a more efficient, productive economy. And, in the short run, the deflationary effects of a given reduc-tion of current expenditure may be counteracted by a smaller increase of


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capital expenditure because of its greater impact on the aggregate demand via the interaction between the multiplier and the accelerator.

The purpose of this study is to analyze the optimal government size as for public current expenditure versus capital expenditure in relation to the policies of fiscal consolidation for the countries with large public deficits and/or public debt crisis. As shown in Forte and Magazzino (2011), if a reduction in public expenditure could bring about an improvement in the rate of economic growth, achieving a better level of public debt sustain-ability, one is faced with the question whether a fiscal consolidation policy, in these cases, should reduce current or capital expenditures, or both, or rather should increase capital expenditure while reducing additionally the current expenditure.

In section 2, we present a review of the recent literature on fiscal consoli-dation, which is as comprehensive as possible. This review shall show that, until 2012, while a few studies have pointed out that a reduction in public expenditure is preferable to an increase of taxes, the proper mix of current versus capital public expenditure has rarely been discussed.

In section 3, we examine the optimal size of current and capital expendi-ture of the European countries, comparing the results that we obtain by considering 11 EU countries with those of our previous study (Forte and Magazzino, 2011) on the optimal size of government for the European countries, in terms of total expenditure. The results that we obtain are startling, since they show that the size of current expenditure, from the point of view of the GDP maximization, is much lower than expected, if we consider the existing average levels of capital expenditures. These results are confirmed when we extend the analysis to panel data estima-tors, in order to be able to find out the optimal level of capital expenditure. The outcome is a capital expenditure much greater than the average of the last decades. Moreover, it fits the gap between the optimal size of current expenditure and the optimal size of total expenditure previously found. In addition, in the panel analysis, we create three different groups of coun-tries: with higher versus lower capital expenditure, with higher versus lower ratio of debt to GDP, and with the constraint of a common currency (the euro) versus the constraint of own currency, to inspect the differences in optimal capital and current expenditure. While the levels of optimal capital expenditure show appreciable variations, in relation to the effective levels of capital expenditure in these different situations, the differences in the optimal levels of current expenditure are slim.

Concluding remarks are summarized in section 4, together with reflec-tions on the stimulus to further research.


346 A handbook of alternative theories of public economics

2. A REVIEW OF THE LITERATURE ON THE REDUCTION OF PUBLIC EXPENDITURE IN A FISCAL CONSOLIDATION FRAMEWORK

In the years after the great crisis started in 2008, many papers have explored the problems of countries’ fiscal consolidation in the context of high public deficits and debt. Nevertheless, surprisingly, very few analyses have focused, directly or indirectly, on the optimal government size, as well as on the issue related to the composition of public expenditure.

Curiously, most of the papers that consider the issue of the optimal size of government, and which are devoted to developed countries, concern, instead, developing countries. Devarajan et al. (1996), Ghosh and Gregoriou (2006), and Bose et al. (2007), as for developing economies, underline that current expenditure has better effects on growth than capital expenditure. Devarajan et al. (1996) show that an increase in the share of current government expenditure has positive and statistically significant growth effects. By contrast, the relationship between the capital compo-nent of public expenditure and per- capita growth is negative. Thus, these seemingly productive expenditures, when used in excess, could become unproductive. Ghosh and Gregoriou (2006), using panel data for 15 devel-oping countries via GMM techniques, demonstrates that current (capital) expenditure has positive (negative) and significant effects on the growth rate, contrary to commonly held views. These results are in line with those obtained by Devarajan et al. (1996).

Notice that these results are related to countries at early stages of eco-nomic development, when the size of the government often is sub- optimal, and the improvement of human capital is a priority also for the appropri-ate deployment and usage of the technological infrastructural capital. Examining the growth effects of disaggregated expenditure for a panel of 30 developing countries, Bose et al. (2007) find that the share of govern-ment capital expenditure in GDP is positively and significantly correlated with economic growth, but current expenditure is insignificant.

On the other hand, Gregoriou and Ghosh (2009) investigate the impact of government expenditure on growth, in a heterogeneous panel, for a sample of developing countries, using GMM techniques in order to address the issues of endogeneity, weak instruments and measurement errors, show that these measures capture effectively the cross- country variations in the parameters of the model. And the results are mixed.

Actually, econometric results by Gupta et al. (2005) have shown that the composition of public outlays, in relation to its nature of current expendi-ture versus capital expenditures, does matter: countries where government expenditure is concentrated on wages tend to have lower growth, while



those that allocate higher shares to capital and non- wage goods and serv-ices enjoy faster output expansion.

Alesina and Ardagna (2009), studying the reduction in public debt/GDP ratio in previous episodes of consolidation, find that in the past, large public debt has been rapidly reduced thanks to sustained growth. This was the case for the reduction of the huge public debts of the belligerent coun-tries after World War II and for the US in the 1990s. Subsequently, as for the reduction of the debt/GDP ratio, growth policies have a minor impact and fiscal consolidation needs either tax increases or public expenditure reductions or both or greater expenditure reduction to leave room for tax cuts. Reduction of public expenditure associated with tax cuts shows better results than tax increases. The capital expenditures issue is not considered.

A somewhat different example is represented by the UK in its consolida-tion at the end of the World War II, with a debt/GDP equal to 200%. Yet, the country did not suffer a financial crisis due to a lack of trust in the public debt sustainability, thanks to the confidence invested by markets in UK fiscal authorities historically believed to be reliable. However, actu-ally, the definitive consolidation was realized thirty years later, during the period of Margaret Thatcher’s reforms, via the reduction of public expenditure and restrictive monetary policy (Magazzino, 2010).

A study conducted by Checherita and Rother (2010) finds a non- linear impact of debt on growth with a turning point at about 90–100% of GDP. At the same time, there is evidence that annual changes of public debt/GDP ratio and of budget deficit/GDP ratio are negatively and linearly associated with per capita GDP growth. The authors do not engage in the question of whether or not to increase taxes or reduce public expenditure.

The empirical results of Kumar and Woo (2010) suggest an inverse relationship between initial debt and subsequent growth. Controlling for other determinants of growth, on average, a 10 percentage point increase in the initial debt- to- GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year. The impact is somewhat smaller in advanced economies. The econometric evidence has shown that the ‘progressive consolidation’ processes tends to have more success than a consolidation with a ‘cold shower’. Some of these results are probably due to the effects of structural reforms, under-taken in the gradual consolidation. However, countries with higher levels of indebtedness that are facing serious problems of sustainability, should opt for a ‘cold shower’ consolidation, in order to re- establish credibility as well as market confidence and to contain the ‘snowball effect’, which could aggravate their precarious situation. The difference in success between the two types of consolidation is much lower than the average for adjustments implemented to face a big increase of the debt/GDP ratio. One may guess



that the authors include the structural reductions of public expenditures in the structural reforms.

The Barrios et al. (2011) analysis focuses on 14 European countries and two dimensions. The first dimension concerns the challenges that indi-vidual countries must face. The second dimension involves each country’s room for maneuver. The econometric analysis is done by dividing the analyzed countries into four groups. The first group (consisting of Greece, Ireland, Portugal, and Italy) involve countries that face the greatest chal-lenges in fiscal consolidation. Italy and Greece, however, have more leeway than Ireland and Portugal. Italy, indeed, may act both on the revenue side (raising taxes on black economy, estimated at 22% of GDP) and on labor participation. The second group, which comprises France, Germany, Netherlands, Spain, and the UK, faces a moderate challenge, with dif-ferent room for maneuver. While Spain has registered very high deficits in recent years, before the crisis, between 2004 and 2007, it had achieved budget surpluses. Despite the rapid increase in debt, it has sufficient room for maneuver (increasing the tax rate, which is relatively low, or increas-ing both retirement age and employment levels). Poland and Hungary form the third group, which is characterized by small fiscal challenges and having a medium to large room for maneuver. The fourth group comprises Sweden, Denmark, and Finland – countries without any budget threat. As one can see from this exposition, the attention of the paper to the role of public expenditure cuts is very limited, not to mention the mix between current and capital expenditure.

Empirical findings in DiPeitro and Anoruo (2012) indicate that both the size of government and the extent of government indebtedness have negative effects on economic growth. The results of the empirical research suggest that governments ought to take the necessary steps to curtail the excessive government of public expenditure and public debts in order to promote economic growth. Yet, no mention is made on the issue of current versus capital expenditure.

Alesina et al. (2012) study which fiscal corrections cause large output losses. Results show that adjustments based on public expenditure cuts are much less costly in terms of output losses than tax- based ones, as in Alesina and Ardagna (2009). Spending- based adjustments have been asso-ciated with mild and short- lived recessions, in many cases with no recession at all. Tax- based adjustments have been associated with prolonged and deep recessions. Moreover, the difference cannot be explained by different monetary policies during the two kinds of adjustments. Again, there is no specific mention of the debate on current versus capital expenditure.

Jaroensathapornkul (2010), analyzing the dynamic effects of propor-tional change in government expenditure on Thailand’s economic growth,



find that the expenditure variables have long- run equilibrium relation-ships with economic growth. The Error Correction Mechanism estimation reveals that the financial instrument, that is, expenditure budgeting, should be further applied to drive Thailand’s economic growth. However, the current expenditure scheme was considered unproductive. An increased expenditure proportion to enhance the quality of education is found to be ineffective.

Colombier’s (2011) findings provide strong evidence that government outlays for transport infrastructure, justice and defense are vital for output growth. In contrast, healthcare expenditure would appear to hamper growth. Nevertheless, because the healthcare sector suffers from Baumol’s cost disease, governments have a daunting task (Baumol and Bowen, 1966).

Several studies by Magazzino in the case of Italy have been devoted to the analysis of the relationship between aggregate and disaggregated public expenditure and national income (Magazzino, 2011, 2012a, 2012b).

3. DATA AND EMPIRICAL RESULTS

3.1 Time Series Analyses

We aim to ascertain whether there is an optimal size of current expenditure in relation to GDP growth in the European countries.

Our sample consists of 30 European countries, and the data used in this work were provided by AMECO database, which is freely downloadable on the internet.

In this section we use time series econometric methodology, while in section 4 we use panel type econometric estimators. Time series analyses involve a Robust OLS estimator, Quantile regression and the ARIMAX (Auto- Regressive Integrated Moving Average with Exogenous Variables) model.

Estimating the relationships between economic growth rate and current public expenditure, we assume that the GDP growth rate is a positive function of the current public expenditure share on domestic product and a negative function of its square (in order to capture eventual non- linear effects); thus, consider the following model:

yi,t 5 b0 1 b1 Gi,t 1 b2 G2i,t 1 ui,t (15.1)

where the i index standing for the country (i 5 Austria,. . ., UK), while the t refers to the period (t 5 1970,. . ., 2011). The dependent variable is the



GDP growth rate (y), while the independent variables are the total current expenditure share on GDP (G), and its square value (G2). First, we derived the logarithmic transformation for each series (Table 15.1).

We expect that the linear term, G, carries a positive sign to show the positive effects of current public expenditure on economic growth; on the contrary, the square term should take a negative sign, as it would measure the negative effects associated with the enlargement of the public sector. In other words, this second- degree term should stand for the decreasing marginal productivity of public expenditure.

The government current expenditure as a share of GDP that maxi-mizes economic growth from the quadratic function above it could be found as:

G*5 – b1/2b2 (15.2)

In fact, as we expect a positive sign for the linear term and a negative one for the square term, from geometry we can derive the formula of the peak of a concave parabola (a ‘U- shaped’ curve).

It is likely that economic growth may be a function of several factors related to the economy (productivity, unemployment, inflation, terms of trade, trade balance, interest rate, public revenues, and government debt), demography (population, share of persons above 65 years of age in the total population, and share of persons between 0 and 14 years of age in the total population), administrative and political system (electoral rule and degree of centralization), social system (ethno- linguistic diversity of the population, religious fragmentation, and linguistic fragmentation), geography (area of territory, distance from open seas, and length of coastline), climate (average annual temperature), and natural resources (balance of oil exports and imports, and balance of gas exports and imports). Thus, as in Forte and Magazzino (2011), we include the most relevant determinants of economic growth as control variables in our equation.

In Table 15.2, some preliminary descriptive statistics for each country

Table 15.1 List of the variables

Variable Explanation

Y Real Gross Domestic Product growth rateG Total current expenditure, % GDP

Source: AMECO database.



are shown.1 The Inter- Quartile Range shows, in general, the absence of severe outliers. While the current expenditure/GDP ratio is higher in the countries of Northern Central and Southern Europe, that have retained the tradition of the welfare state based on the social- democratic model without undertaking the structural reforms undertaken by the UK and

Table 15.2 Exploratory data analysis (1970–2011)

Variable Mean Median Standard deviation

Skewness Kurtosis IQR (mild, severe

outliers)

Austria YG

2.547947.2793

2.466647.5172

1.89272.5074

−0.7942−0.5641

4.57583.2707

1, 02, 0

Belgium YG

2.2507 2.3067 1.8534 −0.3152 3.3924 1, 047.6459 48.1628 4.9660 −1.0246 3.7368 5, 0

Denmark YG

1.8698 2.1605 2.2082 −0.8553 4.9399 1, 050.4259 52.6217 5.9300 −1.1134 3.0664 4, 0

Finland YG

2.7598 3.2365 3.1662 −1.5692 6.2850 1, 245.8170 45.6129 7.2052 0.2286 2.2329 0, 0

France YG

2.2859 2.2474 1.7811 −0.1911 3.7434 2, 047.6624 48.1446 2.9170 −0.6926 3.2755 2, 0

Germany YG

2.2784 1.9119 2.6928 1.4657 10.7300 1, 141.4046 41.6625 3.5473 −1.3153 4.4622 4, 0

Greece YG

2.2589 2.9431 3.7351 −0.3971 3.1294 2, 040.6671 40.1345 3.2272 0.8828 3.4255 0, 4

Ireland YG

4.4224 4.5077 3.6166 −0.5915 4.2595 2, 136.3948 37.0770 6.7268 0.0997 1.7095 0, 0

Italy YG

2.0245 1.8626 2.2955 −0.3735 5.0670 3, 045.1692 44.6832 3.1083 −0.3294 4.1339 1, 0

Luxembourg YG

3.8242 3.9515 3.5245 −0.6263 4.0893 1, 034.6693 34.4098 1.6727 0.1346 2.0229 0, 0

Netherlands YG

2.4521 2.3308 1.7996 −0.9660 4.5883 1, 046.1638 46.0936 4.7154 −0.0665 1.8404 0, 0

Norway YG

3.0754 3.2535 1.8673 −0.4410 2.4748 0, 044.1929 43.2904 7.1795 0.1551 1.8514 0, 0

Portugal YG

2.9837 2.3653 3.2841 0.1326 3.2357 3, 035.6485 36.4432 5.6620 −0.1346 2.3343 0, 0

Switzerland YG

1.5758 1.8507 2.1878 −1.6645 7.6603 1, 029.5828 29.8922 1.4826 −1.0142 3.8798 1, 0

UK YG

2.2378 2.6850 2.2213 −0.8595 3.9123 7, 140.3822 40.2110 2.7567 0.7983 3.0981 0, 0

Notes: Y: Real GDP growth rate; G: total current expenditure.



Germany, the mean of this variable is between 29.58% (for Switzerland) and 50.43% (for Denmark).

The estimates summarized in Table 15.3 show that only for Denmark and Ireland a BARS curve does not emerge. For the other 13 countries, the optimum size of current expenditure (the curve’s peak) could be between 29.59% (the Netherlands) and 31.57% (Switzerland). Two major empirical findings should be emphasized: (a) the three estimation methods

Table 15.3 Estimated curve’s peak by country

Country Robust OLSa

Median regression

Robust ARIMAX/GARCHa

Mean

A B C (A1B1C)/3

Austria 30.12 30.15 29.84AR(1) MA(1)

30.04

Belgium 30.16 30.29 31.18AR(2) MA(1) ARCH(1)

30.55

Denmark – – – –Finland 29.80 29.88 29.56

MA(1)29.75

France – 30.00 29.28AR(1) ARCH(1)

29.64

Germany 31.53 – 31.51AR(1)

31.52

Greece 30.25 30.26 30.12MA(1)

30.21

Ireland – – – –Italy 30.28 30.33 – 30.31Luxembourg – – 31.38

AR(1)31.38

Netherlands 30.26 30.29 28.22AR(1) ARCH(1) GARCH(1)

29.59

Norway 30.49 30.48 30.32AR(1)

30.43

Portugal 30.33 30.40 30.48MA(1) ARCH(1)

30.40

Switzerland 31.60 31.64 31.47AR(2) MA(1)

31.57

UK – – 30.83MA(1) ARCH(1)

30.83

Note: a Eicker/Huber/White sandwich estimator of variance is used.



used produce very similar results; and (b) the share of current public expenditure which maximizes the economic growth is very similar across countries, at around 30%. Furthermore, a compact group of three conti-nental countries with Germany in the center (Germany, Luxembourg, and Switzerland) show the highest peaks (see Appendix, Figures 15A.1 and 15A.2).

Let us now compare the results obtained in the present research focus-ing on current aggregate expenditures with those obtained in our previous research (Forte and Magazzino, 2011) that considered the total aggregate current and capital government expenditures in relation to GDP growth rate for these countries in the same time span.

In our present research, we find out that the optimal size of current expenditure ratio to GDP is much lower than the effective size of 2011. The average ratio to GDP of the actual capital expenditure is about 4–5% (and in no country is there actually a capital expenditure greater than 5%). Moreover, the optimal size of the current expenditure is similar for all countries, while the effective sizes are very dissimilar. In fact, the deviation from the 30% ‘optimality rule’ is minimal and negligible.

Notwithstanding, from the comparison does emerge another, more interesting, and counter intuitive result: whereas the optimal size of gov-ernment current expenditure is about 30%, the optimal size of total gov-ernment expenditure, inclusive of the capital expenditure, ranges between 35% for two countries (Belgium and the Netherlands), and 38–45% for the other eight countries. The range between the optimal capital and the optimal current expenditure is between 13.5% for the UK and 5.4% for Belgium, while, as noted above, in no country is there now an average capital expenditure higher than 5%. Should one infer from these results that Portugal, having a peak for current expenditure at 30.4% and for aggregate expenditure at 42.3%, should increase its capital expenditure by 11.9%, and that, because of the same kind of reasoning, the UK should have an optimal level of investment expenditure of 12.7%? This inference may appear too simplistic because when considering only the current government expenditure variable, one overlooks the effects of the capital expenditure variable, which operates jointly with it. One might argue that the existence of a capital expenditure jointly with the current expenditure allows an ‘optimal’ (in terms of GDP maximization) level of current expenditure greater than the level that might be optimal without the capital expenditure. Therefore, other researches must be done to control the above startling results. In any case, however, Table 15.4 suggests a warning against the easy solution of cutting capital expenditures in the general framework of public spending reductions to achieve fiscal consolidation under a sustainable growth path.



3.2 Panel Data Analyses

Unfortunately, given the actual modest amount of public capital expendi-ture, the econometric analysis for the 13 European countries does not give reliable results. Therefore, we conduct research on 30 European countries by panel data analysis with the following methods: GLS- FE (Generalized Least Squares- Fixed Effect), GLS- RE (Generalized Least Squares – Random Effect), PCSTS (Prais- Winsten Panel Corrected Standard Errors), FGLS (Feasible Generalized Least Squares), and IV (Instrumental Variables). Furthermore, in this analysis we shall distinguish three couples of countries: those with high and low capital expenditure; those with high and low debt/GDP ratios; and those with a common currency, that is, the euro, compared with those with their own currency (Tables 15.5 and 15.6). Table 15A.3 below (in the Appendix) shows results of paired samples statistics, which roughly validate our panel’s subdivision.

The distinction between countries with high and low capital expendi-ture may be relevant for the fiscal consolidation policies, in order to know whether low capital expenditure countries might be justified in continu-ing their investment policy, or rather they should devote new efforts to counter- balancing the cuts in current expenditure by a policy of fostering investments in infrastructures.

Table 15.4 Margins for expenditure’s reductions in 13 European countries

Country Total current expenditure

(% of GDP, 2011)

Estimated curve’s peak (% of GDP)

% Change in spending as a share of GDP

Optimal total expenditure

(% of GDP)a

A B C 5 B – A D

Austria 47.01 30.04 16.97 38.21Belgium 50.22 30.55 19.67 35.39Finland 51.17 29.75 21.42 40.38France 52.04 29.64 22.40 39.49Germany 43.04 31.52 11.52 41.99Greece 46.71 30.21 16.50 39.33Italy 46.88 30.31 16.57 37.68Luxembourg 36.78 31.38 5.40 – Netherlands 45.98 29.59 16.39 35.52Norway 40.70 30.43 10.27 – Portugal 45.15 30.40 14.75 42.28Switzerland 31.95 31.57 0.38 – UK 45.86 30.83 15.03 43.50

Note: a See Forte and Magazzino (2011).



In the Appendix, Table A15.4 underlines that our distinction is statistically confirmed, since the two groups evidence a mean statistically different to each other.

The distinction between high debt and low debt countries is rel-evant because the first fiscal consolidation plan shall require greater

Table 15.5 Total capital expenditure in Europe

Country Total capital expenditure(% of GDP)

1970–2011 mean

Total capital expenditure(% of GDP)

1970–2011 median

Group

Austria 4.9067 4.8488 1Belgium 3.3973 4.1099 0Bulgaria 3.9539 4.2058 0Cyprus 3.9711 4.0262 0Czech Republic 7.0541 7.9510 1Denmark 2.5581 2.8362 0Estonia 4.8274 4.9223 1Finland 3.9613 3.7886 0France 4.1229 4.1821 0Germany 4.2556 4.7822 0Greece 5.4301 5.2105 1Hungary 5.3555 5.6761 1Iceland 6.7827 7.3988 1Ireland 4.3822 5.2499 0Italy 4.3529 4.3024 0Latvia 3.9320 4.3510 0Lithuania 4.5471 5.0871 1Luxembourg 5.2805 5.2889 1Malta 4.4826 4.4597 0Netherlands 4.6249 4.7381 0Norway 4.3855 4.7349 0Poland 4.6244 4.9216 1Portugal 4.8656 4.8136 1Romania 4.8505 5.2097 1Slovakia 4.8684 5.6732 1Slovenia 4.6965 5.2454 1Spain 4.9224 5.0182 1Sweden 3.3151 3.5385 0Switzerland 4.8595 4.8740 1UK 3.4909 2.8726 0Panel 4.5858 4.8106 –

Notes: 1 5 high capital expenditure countries; 0 5 low capital expenditure countries.



adjustments, and the political pressures to preserve the welfare state may induce them to sacrifice capital expenditures to achieve public finance objective, having a smaller room of maneuver on the expenditure side. The distinction between euro and non- euro countries may be relevant because countries with a common currency could suffer for this con-

Table 15.6 General government consolidated gross debt in Europe

Country Government debt (% of GDP)

1970–2011 mean

Government debt(% of GDP)

1970–2011 median

Group

Austria 56.4850 50.4614 1Belgium 98.2006 97.1925 1Bulgaria 36.9640 44.1126 0Cyprus 59.5900 61.2162 1Czech Republic 27.9429 24.8237 0Denmark 49.5575 47.5084 1Estonia 5.7293 5.8043 0Finland 20.0869 28.4789 0France 49.2278 47.3565 1Germany 41.1910 45.9446 0Greece 72.8496 69.3771 1Hungary 62.9134 66.7600 1Iceland 33.5500 39.2907 0Ireland 64.4029 66.8372 1Italy 95.9279 87.8479 1Latvia 13.9267 18.1172 0Lithuania 19.2949 21.3521 0Luxembourg 9.2966 9.8472 0Malta 62.2531 59.7991 1Netherlands 60.7730 60.1871 1Norway 23.9500 23.5781 0Poland 45.6862 45.4113 1Portugal 53.6800 51.1465 1Romania 18.7400 19.1590 0Slovakia 35.5621 37.5154 0Slovenia 26.4274 27.3683 0Spain 42.0371 39.1997 0Sweden 48.4979 47.8858 1Switzerland 22.4000 21.4680 0UK 51.2685 52.0742 1Panel 43.8617 43.9040 –

Notes: 1 5 high government debt countries; 0 5 low government debt countries.



straint in the adjustment process needed for their fiscal consolidation policy.

Table 15.7 shows, for panel data, the optimal capital expenditure in 30 EU countries and in our three groups of countries. For the panel of 30 countries, the optimal size of public capital expenditure is about 10.50%, with a difference of 6 percentage points over the present amount. For the EMU countries, the optimal size of capital expenditure is slightly higher: 10.96%. The increase of capital expenditure needed to arrive to its optimal value is 7.03%, against the average of 6.25% for the 30 countries. For the non- euro area the peak is close to that of the 30 countries and the adjust-ment toward the optimal level is about the same. Notice that the division of the 30 countries into two groups of smaller size tends to increase the average level of the peak. Only for the high capital expenditure countries a BARS curve does not emerge. For low capital expenditure countries the peak is higher than that of the full sample, and the adjustment needed is greater (7.12%). High debt countries show a peak higher than the average (11%). While the low debt countries have a peak lower than the average (9.79%). And the adjustment needed to reach the peak level, in this case, is smaller. In conclusion, the peak is significantly higher than the average (10.50%) for the euro area countries, for the low capital expenditure coun-tries, and for the high debt countries, that is, for those with monetary constraints due to the common currency, for those whose governments disregarded the policy of high capital expenditure, as well as for those that have indulged in public debt.

One should remember that considering the optimal size of govern-ment capital expenditure in relation to GDP growth we have overlooked their interaction with current expenditure and the constraint given by

Table 15.7 Estimated curve’s peak for capital expenditure

Panel Total capital expenditure(% of GDP, 2011 mean)

Estimated curve’s peak(% of GDP)


A B C 5 B – A

All (30 countries) 4.25 10.50 6.25Euro area 3.93 10.96 7.03Non- euro area 4.67 10.69 6.02High capital expenditure countries 4.50 – –Low capital expenditure countries 4.00 11.12 7.12High government debt countries 4.14 11.01 6.87Low government debt countries 4.36 9.79 5.43



the aggregate size of public expenditure. Therefore the level of 10–11% of investment public expenditure as an optimal level must be taken with caution. However, the results of panel data analyses appear to suggest again that in the consolidation process by spending reviews policies a double effort has to be made in the reduction of current expenditure: that needed to reduce the size of the government and also that required to leave a greater room for public capital spending. The dimension of this addi-tional effort is bigger in the low capital expenditure countries, in the EU countries and in the countries with high public debt.

Let us consider whether the aggregate panel of 30 countries gives a different result regarding the peak of the optimal public expendi-ture and whether by splitting the aggregate panel into three groups, each with two opposite situations, gives us additional information about this peak.

The results of these panel data estimates have been summarized in Table 15.8. The peak for current expenditure in the whole panel of 30 European countries is 30.02% of GDP, while the peaks for the 13 European countries above considered exhibit a range between 29.59% and 31.57%, with a mean of 30.48% and a median of 30.40%. To sum up, the peak of the 30 countries panel is lower, but not by much. The general result is a concurrence of the estimators for an optimal level of current public expenditure around 30% of GDP. The difference of context in the three groups does not greatly influence the level of optimal current expenditure. Indeed, a strong concurrence among the different estimators emerges as for the peak of the current expenditure curve in the range of 29.42–30.31%, as in the above time series analysis of the 13 EU countries. However, some interesting differences do emerge. Non euro area countries are allowed a

Table 15.8 Margins for public expenditure reduction in panels

Panel Total current expenditure(% of GDP, 2011 mean)

Estimated curve’s peak(% of GDP)


A B C 5 B – A

All (30 countries) 41.71 30.02 11.69Euro area 43.69 29.42 14.27Non- euro area 39.12 30.11 9.01High capital expenditure countries 39.07 29.70 9.37Low capital expenditure countries 44.34 30.31 14.03High government debt countries 45.74 29.71 16.03Low government debt countries 37.67 30.25 7.42



greater level of current expenditure, likely because of the greater flexibility in their choice of the money exchange rate. Also, low capital expenditure is allowed to a greater level of current expenditure, since the size of their adjustment process remains much greater than that of countries with high capital expenditure. On the other hand, the high debt countries have a lower optimal current expenditure than the low debt countries, even if this implies an additional effort of cutting a large dimension of their govern-ment. Likely the explanation lies in their peculiar need to cut the share of current expenditure for debt services.

Moreover, in the panel data analysis on all three groups of countries, there emerge differences in the dimension of the cut in public expenditure needed to maximize GDP growth. The task is bigger for the countries with low government capital expenditures than for the countries with high capital expenditure, and for the countries with high ratios of debt to GDP compared to the countries with low ratios of debt to GDP as well as for the EU compared to the non- EU countries.

Indeed, comparing the peak of the estimated curve with the average share of current expenditure/GDP in 2011, one can note that, whilst the euro area and the group of countries with less capital expenditure should operate cuts at around 14%, countries that do not adopt the euro and those with higher capital expenditure should implement softer fiscal con-solidation (9%). Moreover, more indebted countries would be required to decrease current expenditure by around 16%, which is approximately twice that needed for the less indebted group (Table 15.8).

The explanation for this last result is that the countries with higher debt ratios to GDP have over expanded their public expenditures in comparison to those with lower debt/GDP ratios and, therefore, ought to reduce it proportionally more, also because in the burden there is a higher ratio of debt service to GDP. The euro area countries must realize a cut of public expenditures greater than the non- euro countries because they have increased differentially their ratio of government expenditures to GDP, likely fallaciously counting on the shield effects of the new common currency. And the reasons why the countries with lower ratios of capital expenditures must reduce their current expenditure by a much larger ratio than the countries with a higher ratio of capital expenditure is that the first group has expanded the ratio of current expenditures to GDP more than the second group. It seems clear that the differential increase of the current expenditures was, to a not irrelevant extent, financed at the expense of the capital expenditure (see Tables A15.1 and A15.2 in the Appendix for details).



4. CONCLUDING REMARKS AND POLICY IMPLICATIONS

The empirical results shown in this essay should be combined with those concerning the composition of expenditure (Magazzino, 2012b). Our econometric research captures the economic long- run laws relating to countries at a high stage of growth with an average excess of public expenditure that improperly developed current government expenditures. The estimates for the optimal total public expenditure on our panel roughly support previous findings, since they correspond nearly to the sum of estimated optimal current and capital expenditure. In Table 15.9, we sum up the main findings of our econometric analyses.

The results show, on the one side, the need to reduce current government expenditure, and on the other side, the need to increase capital expendi-tures, thus potentially reallocating public resources from unproductive or less productive to more productive items (as R&D or public investment in

Table 15.9 Principal empirical findings

Country Optimal total expenditure (% of GDP)

Optimal current expenditure (% of GDP,

2011)

Optimal capital

expenditure (% of GDP)

Austria 38.21 30.04Belgium 35.39 30.55Finland 40.38 29.75France 39.49 29.64Germany 41.99 31.52Greece 39.33 30.21Italy 37.68 30.31Luxembourg – 31.38Netherlands 35.52 29.59Norway – 30.43Portugal 42.28 30.40Switzerland – 31.57UK 43.50 30.83All (30 countries) 39.65 30.03 10.50Euro area 38.43 29.41 10.96Non- euro area 39.71 30.11 10.69High capital expenditure countries 38.81 29.54 –Low capital expenditure countries 39.62 30.01 11.12High government debt countries 39.30 29.42 11.01Low government debt countries 39.65 29.92 9.79



infrastructures). This reallocation would stimulate the long- run economic growth, while providing in the short- run an increase of the aggregate demand greater than the decrease in the same amount of private expendi-tures, because of the interaction between the multiplier and the accelera-tor. However, one should notice that what our empirical research reveals in terms of the optimal mix of government expenditure is that the invest-ments traditionally financed by public expenditure need to be increased because of their positive effect on growth, which is likely originated by the fact that their benefits up to their ‘optimal level’ exceed their costs. This does necessarily imply that they need to be entirely financed by the public hands. One may find ways of co- financing these expenditures by drawing on private initiative, as with PPP and PFI, thus reducing the share of public financing. Given the fact that the leverage effects of the above- mentioned methods of financing public investments may reach a high value, the cost of the public budget related to the rebalancing of public expenditure in favor of investments may be reduced to manageable pro-portions by appropriate innovations. Innovations have greatly changed the potentialities of the private financial intermediaries of the economy. The need for increasing public investments should stimulate a similar search of innovations in the public financial intermediaries.

NOTE

1. The details of unit root tests results have been omitted to save space; however, they are available upon request. Time series analyses have been constrained by data availability.

BIBLIOGRAPHY

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Lessons from past experiences, European Economy Economic Papers, 418, July.Baumol, W., Bowen, W. (1966), Performing Arts: The Economic Dilemma, New York: The

Twentieth Century Fund.Bavetta, S., Navarra, P. (2012), The Economics of Freedom, Cambridge: Cambridge University

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disaggregated analyses for developing countries, The Manchester School, 75, 5 September, 533–556.



Cecchetti, S., Mohanty, M.S., Zampolli, F. (2011), The real effects of debt, BIS Working Paper, 352, September.

Checherita, C., Rother, P. (2010), The impact of high and growing government debt on eco-nomic growth, ECB Working Paper, August, 1237.

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Devarajan, S., Swaroop V., Zou, H. (1996), The composition of public expenditure and eco-nomic growth, Journal of Monetary Economics, 37, 2, 313–344.

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OECD countries (1970–2009), XXII SIEP Annual Meeting, Pavia.Fedeli, S., Forte, F., Ricchi, O. (2011), On the long run negative effects of public deficit on

unemployment and the need for a fiscal constitution: An empirical research on OECD Countries (1980–2009), XXIII SIEP Annual Meeting, Pavia.

Forte, F. (2011), L’economia italiana dal Risorgimento ad oggi, 1861–2011, Siena: Cantagalli.Forte, F., Magazzino, C. (2011), Optimal size government and economic growth in EU coun-

tries, Journal of Analytical and Institutional Economics, XXVIII, 3, 295–321.Ghosh, S., Gregoriou, A. (2006), On the composition of government spending, optimal fiscal

policy, and endogenous growth: Theory and evidence, Economics and Finance Discussion Papers, 06–19.

Gregoriou, A., Ghosh, S. (2009), The impact of government expenditure on growth: Empirical evidence from a heterogeneous panel, Bulletin of Economic Research, 61, 1, January, 95–102.

Gupta, S., Clements, B., Baldacci, E., Mulas- Granados, C. (2005), Fiscal policy, expenditure composition, and growth in low- income countries, Journal of International Money and Finance, 24, 441–463.

Jaroensathapornkul, J. (2010), Spending for growth: an empirical evidence of Thailand, Applied Economics Journal, 17 (2), 27–44.

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Kumar, M.S., Woo, J. (2010), Public debt and growth, IMF Working Paper, WP/10/174, July.Magazzino, C. (2008), Modelli interpretativi della dinamica della spesa pubblica e ‘curva di

Armey’: il caso italiano, 1862–2001, Notizie di Politeia, XXIV, 92, 4–60.Magazzino, C. (2010), La politica economica di Margaret Thatcher, Milano: Franco Angeli.Magazzino, C. (2011), Disaggregated public spending, GDP and money supply: Evidence for

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Vedder, R.K., Gallaway, L.E. (1998), Government Size and Economic Growth, Joint Economic Committee.


363

APP

EN

DIX –4

0

–20020 –40

–20020 –40

–20020 –40

–20020 –40

–20020

2040

6080

2040

6080

2040

6080

2040

6080

2040

6080

2040

6080

Aus

tria

Bel

gium

Bul

garia

Cyp

rus

Cze

ch R

epub

licD

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Est

onia

Fin

land

Fra

nce

Ger

man

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Icel

and

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and

Italy

Latv

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Real GDP growth

Tot

al c

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nt e

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ditu

re

Figu

re 1

5A.1

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cono

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cur

rent

pub

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ditu

re (

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–201

1)


364

0204060 0204060 0204060 0204060 0204060

1970

1980

1990

2000

2010

1970

1980

1990

2000

2010

1970

1980

1990

2000

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1970

1980

1990

2000

2010

1970

1980

1990

2000

2010

1970

1980

1990

2000

2010

Aus

tria

Bel

gium

Bul

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Cze

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re 1

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To

tal c

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l exp

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(19

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011)


365

Tabl

e A

15.1

O

ptim

al p

ublic

cur

rent

exp

endi

ture

in 1

3 E

urop

ean

coun

trie

s (19

70–2

011)

Inde

pend

ent

varia

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Dep

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nt v

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ble:

Y

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FR

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stan

t9.

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***

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3)−

7.37

99**

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456)

4.95

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3570

***

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7)−

4.11

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*(.0

520)

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*(1

4.70

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***

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***

(.012

6)3.

0779

***

(.798

6)2.

6249

***

(.009

6)1.

2007

***

(.016

5)3.

2510

***

(.045

0)20

.808

5**

(10.

1815

)G

2−

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*(.0

962)

−8.

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***

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(16.

7196

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ve p

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*(.0

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ust S

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ard

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ors i

n br

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ts.


366

Tabl

e A

15.2

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ptim

al p

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cur

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exp

endi

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ls (

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–201

1)

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pend

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.466

2)−

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*(.7

854)

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(8.3

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ic c

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(1.4

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*(.0

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*(.0

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5)−

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7)−

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3***

(.000

6)N

745

474

275

414

409

321

Cur

ve p

eak

10.5

0%10

.96%

10.6

9%11

.12%

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1%9.

79%

Not

es:

1: A

ll (3

0 co

untr

ies)

; 2: E

uro

Are

a; 3

: Non

- Eur

o A

rea;

4: H

igh

capi

tal e

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ditu

re c

ount

ries;

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ow c

apita

l exp

endi

ture

cou

ntrie

s; 6:

Hig

h G

over

nmen

t deb

t cou

ntrie

s; 7:

Low

Gov

ernm

ent d

ebt c

ount

ries.

Sign

ifica

nce

leve

ls: *

10%

, **

5%, *

** 1

%. R

obus

t Sta

ndar

d E

rror

s in

brac

kets.



Table A15.3 Paired samples statistics (results for t- tests, ANOVA and other comparison methods) on total capital expenditure

Variable Group Mean N t Mann- Whitney

test

Bartlett test

Kruskal- Wallis

test

One- Way ANOVA

F test

Fisher’s exact test

TKE Low CE 4.14 437 −9.55634.91a

−11.939(0.0000)

4.493(0.034)

142.536(0.0001)

94.52(0.0000)

141.086(0.0000)High CE 5.41 317

Notes: TKE 5 Total capital expenditure; a Satterthwaite’s degrees of freedom.

Table A15.4 Paired samples statistics (results for t- tests, ANOVA and other comparison methods) on government debt

Variable Group Mean N t Mann- Whitney

test

Bartlett test

Kruskal- Wallis

test

One- Way ANOVA

F test

Fisher’s exact test

GD Low GD 28.20 389 −22.09892.25a

−18.384(0.0000)

60.424(0.000)

337.964(0.0001)

441.35(0.0000)

297.293(0.0000)High GD 61.48 514

Notes: TKE 5 Total capital expenditure; a Satterthwaite’s degrees of freedom.


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Optimal size of governments and the optimal ratio between current and capital expenditure

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