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Analysis of Public Expenditure

Growth: 3 Theories
Theory # 1. Wagner’s Hypothesis:

Adolf Wagner a noted German political economist (1835-1917) pro-

pounded an empirical law to analyses and explains the trend in the
growth of public expenditure. Wagner argued that a functional, cause
and effect relationship exists between the growth of an industrializing
economy and the relative growth of its public sector.

According to Wagner, relative growth of the government sector is an

inherent characteristic of industrializing economies. He illustrates this
with the examples of Great Britain, U.S.A, France, Germany and
Japan. He came to the conclusion that as per capita income and
output increases in industrializing nations, the public sectors of these
nations necessarily grow as a proportion of total economic activity.

Wagner hypothesized a functional relationship between industrial-

ization and the relative importance of public sector activity. He then
set out to test his hypothesis by examining the industrialization
process in various European countries and Japan. His observations
led to what is now called as Wagner’s Law of Increasing State Activity.

Statement of the Hypothesis:

The German Economist Adolf Wagner, systematically observed the
historical facts of increasing expenditure activities of public authori-
ties particularly of Germany, He then tried to explain the cause of
growth in public expenditure in terms of his famous “Law of Increas-
ing State Activities”.
According to Wagner there are inherent tendencies for the activities of
different layers of a government (such as center and state) to increase
both intensively and extensively.

Wagner presented his law in the following words “Comprehensive

comparisons of different countries and different times show that
among progressive people, with which we alone are concerned an
increase regularly takes place in the activity of both the central and the
local governments. This increase is both extensive and intensive. The
central and local governments constantly undertake new functions,
while they perform both old and new functions more efficiently and
completely.”

Wagner’s law of increasing state activities is a universal truth in recent

years. It is a fact that economic growth of a country has always been
accompanied by increasing state activities and hence increasing public
expenditure.

Empirical evidence indicates the hypothesis of continuous upward

trend in government activities. F.S. Nitty made an empirical study of
the expenditure trend of public authorities of varying countries of the
world, and concluded with empirical evidence that Wagner’s law was
not only applicable to Germany but to various governments which
differ widely from each other.

Nitty states all kinds of government, irrespective of their layers (say

central, state or local) intensions (peaceful or warlike) and size etc.,
had shown similar tendencies towards increasing public expenditure.

Wagner’s law was based upon historical facts. His law was applicable
to modern progressive governments only in which the state was
interested in expanding the public sector of the economy. Wagner
observed that there was a persistent tendency towards an ‘extensive’
and ‘intensive’ increase in the functions of the state.
Intensive increase means expansion of traditional functions of the
state on a large scale. Extensive increase relates to coverage of new
welfare functions.

According to Wagner’s law, the expenditure of public

authorizes has a continuous increasing trend due to three
reasons, they are:
a. Expansion of Traditional Functions:
ADVERTISEMENTS:

Traditional functions mainly include defence, administration of

justice, maintenance of law and order and provision of social
overheads. The coverage and variety of such functions have gradually
increased.

Defence expenditure has expanded rapidly because of a change in

military arts and sciences. In modern times military activities has
become sophisticated. From simple aggression, the modern warfare
shifted to prevention of attack and use of sophisticated weapons.

Defence outlays on men, materials and maintenance have been on a

rising trend in modern times. Similar is the case with expenditure on
internal protection and administration. Increasing areas of admin-
istration and spread of government machinery with expertise have
become more and more expensive.

b. Coverage of New Functions:

ADVERTISEMENTS:

Secondly the activities of the state were increasing in their coverage.

Traditionally the state activities were limited to only defence, justice,
law and order, maintenance of the states over heads etc. But with the
growing awareness of its responsibilities to the society, the
governments started expanding its activities in the field of various
welfare measures to enrich the cultural life of the society.
Along with this new welfare programmes were designed to provide
social security to the people. This required increasing government
expenditure on education, public health, low cost housing, subsidized
provision of food, agricultural inputs, old age pension, sickness benefit
etc.

c. Expanding Sphere of Public Goods:

Almost all modern democratic governments have increasingly rec-
ognized the need to provide and expand the sphere of public goods.

ADVERTISEMENTS:

The need and necessity to provide social and merit goods through
budgetary allocation was increasingly recognized by the modern state.
The state was trying to shift the composition of national product more
in favor of public goods.

As a result state activities expanded to areas like irrigation and flood

control projects, construction and maintenance of public parks,
provision of education and health care facilities, creation of economic
overhead capital etc., Provision of these public goods and merit goods
means heavy investment in public enterprises.

Apart from the above mentioned factors, Wagner also examined the
forces that operate on both the demand and supply side of public
sector activity and explained how they interact. Changing production
and marketing arrangements of public sector activity affect and are
affected by social organizations in different ways.

They are given:

ADVERTISEMENTS:

i. Factors that affect both demand and supply of public

expenditure activities:
(a) Per capital income and wealth exert a positive impact on the
demand as well as cost of government services.
(b) Coupled with this rate of growth of population and density also
affect the demand for public goods such as transport, communication,
hospitals etc., in addition to the cost of supply of these services.

ii. Factors affecting the demand side of public expenditure

activities. The major factors under this category are:
(a) Urbanization and industrialization.

(b) Structure and composition of the population which determine the

demand for educational facilities, old age pension, old age homes etc.

ADVERTISEMENTS:

(c) Specialization of labour and centralization of administration in

both private and public activities.

iii. Factors affecting the supply side of public expenditure

activities. On the supply side, the major factors affecting
public sector activities are:
(a) Changing scale of production of government activities.

(b) Quality of production.

(c) Intergovernmental grants.

Obviously the functional relationships Wagner sought to trace are

complex. Adolf Wagner believed that increased public expenditure was
the natural result of economic growth and the continued pressure for
social progress.

Wagner held that the income elasticity of government services is

greater than unity. In other words public expenditure will increase
faster than the increase in per capita income of the people.

Graphic Presentation of the Wagner Hypothesis:

The modern formulation of Wagner’s law is that “as per capita income
rises in industrializing nations, their public sector will grow in relative
importance” (Bird, 1971, p.2). The Wagner’s hypothesis of increasing
state activity is illustrated in Figure No.3.1.

In this graph the real per capital output of public goods (PG) is
measured on the vertical axis and real per capita income (Y) is mea-
sured on the horizontal axis.

Time is an important third dimension implicit in the graph, because

the growth in the real per capita output of public goods and in real per
capita income is realistically assumed to take place on a historical
basis over an extended period of time. Line PG 1 represents a
circumstance in which the public sector maintains a constant
proportion of the total economic production of the society over time.
In other words, as real per capita income increases, due to economic
development of the society, the real per capita output of public goods
remains at the same proportion of total economic activity. The
constant proportion line, PG1, can be used as a reference point to the
graphical presentation of Wagner hypothesis as depicted by the line
PG2.
All along the PG2 the proportion of resources devoted to the output of
public goods is expanding overtime.
The implication of Wagner’s law can be stated in the following
equations. When the real per capita output of public goods remains at
the same proportion of total economic activity, i.e. PG 1, the equation is
PGa/Ya = PGo/Yo

In other words the income elasticity of expenditure for public goods

(Ye) is elastic.

Wagner’s hypothesis provides the most suitable frame work for

explaining economic factors, as the most important determinant of a
relatively expanding public sector during industrialization and eco-
nomic growth.

The functional relationships, Wagner sought to trace are complex.

Wagner believed that increased public expenditure was the natural
result of economic growth and the continued pressure for social
progress.

Criticism of Wagner’s Hypothesis:

Although the Wagner hypothesis has many attributes, it also
has ‘several defects. Wagner’s law of increasing state activity
was criticized by Allan. T. Feacock and Jack Wiseman on the
following grounds:
i. Wagner’s hypothesis deals with inter-disciplinary phenomenon. But
it lacks interdisciplinary approach in its analytical framework.

ii. Lacks comprehensiveness in analysis Wagner’s law lacks

comprehensiveness. Political science, economics and sociology are
among the several disciplines to be incorporated in any theory of
public expenditure. The Wagner’s hypothesis excludes all these
characteristics.

iii. It is based on an organic self-determining theory of the state, which

is not the prevailing theory of the state in most western countries.

iv. The theory ignores the influence of war on governmental spending,

and
v. It stresses a long term trend of public economic activity, which tend
to overlook the significant ‘time pattern’ or process of public
expenditure growth.

Theory # 2. Peacock and Wiseman Hypothesis:

Another hypothesis regarding the growth of public expenditure was
put forth by Peacock and Wiseman, in their empirical study of public
expenditure in U.K. for the period 1890-1955.

Peacock and Wiseman emphasize the time pattern of public spending

trends rather than striving for a genuine positive theory of public
sector growth. The main thesis of the authors is that public
expenditure does not increase in a smooth and continuous manner,
but in jumps and jerks or step like fashion. Their analysis involves
three related elements.

These are displacement, inspection and concentration effects. Using

empirical data for the British economy after 1890, Wiseman and
Peacock observe that the relative growth of the public sector in the
United Kingdom has followed a discrete step like pattern rather than a
continuous growth pattern.

During the period under study they found that, government fiscal
activities, in the country have risen step by step to successive new
plateaus. Moreover the absolute and relative increases (steps upward)
in taxing and spending activities by the British government have
generally taken place during periods of major social disturbance or
crisis such as war or depression.

These kinds of changed fiscal situation cause the previous lower tax
and expenditure levels to be replaced by new, higher, budgetary levels.
This movement from the older level of expenditure and taxation to a
new and higher level is called the displacement effect after the social
disturbance has ended; the new level of tax is tolerated by the society.

The emerged new levels of tax tolerance make the society willing to
support higher levels of public expenditure. In other words the lax
threshold has increased. Thus there is no strong motivation to return
to the lower pre-crisis level of taxation.

Over the secular period, 1890 -1955, this displacement procedure

occurred several times in Great Britain. Thus when the major social
disturbance ends, no strong motivation exists for the society to return
to the lower pre-disturbance level.

The higher government revenues are used to support permanently

higher levels of public sector allocation. Figure No. 3.2 clearly shows
the displacement effect, as explained by Wiseman and Peacock.

Figure No. 3.2 demonstrates the displacement effect, tax threshold

behavior. Time (years) is measured along the horizontal axis, while
public sector revenues (mostly taxes) and public expenditures as a
percentage of gross national product are measured along the vertical
axis.

The figure reveals that as the social disturbance cause a relative

expansion of the public sector, the displacement effect which occurs
helps to explain the time pattern by which the government growth
takes place. This displacement effect does not require that the new
higher plateau of expenditure, continue the same expenditure
composition that was created by the social disturbance.
Some of the increased expenditures like debt interest are the direct
results of the social disturbance.

While other expenditures arose as a result of technological

development and expansion of government activity into new areas.
For instance, war and ‘other social disturbance, frequently force the
people and their government to find out a lasting solution to the long
standing and pending problems, which were previously neglected.

This is known as “inspection effect”. Inspection effect is the

inadequacy of revenue in comparison with the ‘required’ public
expenditure.
In addition to the displacement and inspection effect, Peacock and
Wiseman, also give narration about a concentration (scale) effect. It
refers to the apparent tendency for the central government economic
activity to become an increasing proportion of total public sector
economic activity, when a society is experiencing economic growth.

This occurs, because central government has to initiate a number of

measures to sustain higher economic activity. Since each major
disturbance leads to a situation in which, the central government
assuming a larger proportion of the total national economic activity,
the net result is “the concentration effect”.
Wiseman – Peacock hypothesis appears to be quite relevant. At the
outlet, the hypothesis looks quite convincing. It emphasizes jerks and
jumps in public expenditure, on account of unusual and abnormal
situations.

According to Prof. Aronson, for Peacock and Wiseman expenditure

growth is sporadic rather than constant and revenues create their own
expenditures. However, we must not forget the fact that, an account of
the advance of the economy and the structural changes therein, there
are constant and regular increments in public expenditure and
revenue.
Public expenditure has a tendency to grow on account of a systematic
expansion of government activities, both in terms of intensity and
quality.

The regular and dynamic changes in state activity and public spending
caused by macro variables like population growth, urbanization,
awareness of civic rights on the part of citizens and political and social
commitments on the part of democratic governments voted to power
are major factors giving a big push to upward trend in public
expenditure.

However, the influences of these factors on government spending were

not systematically analyzed by Wiseman and Peacock in their hy-
pothesis. However, Bernard. P. Herber sincerely argues that the
Peacock – Wiesman hypothesis of governmental spending trends, is
much more modest in what it intend to explain than in Wagner’s
hypothesis.

The fact is that, both the Wagner’s and Peacock. Wiseman narrations
contribute a lot in understanding the process of public sector growth
in industrialized nations.

Theory # 3. Colin Clark’s Critical Limit Hypothesis:

Another hypothesis relating to the growth of public expenditure is
provided by Colin Clark. The hypothesis is basically concerned with
the tolerance level of taxation. It was developed by Colin Clark im-
mediately after the Second World War.

The hypothesis draws conclusion from the empirical data drawn from
several western countries for inter-war period. Clark wants to point
out that in an economy; inflation emerges when the share of the
government sector, as measured in terms of taxes and other receipts,
exceeds 25 per cent of the aggregated economic activity in the country.

When public expenditure reaches 25 percent of the total economic

activity or aggregate amount of expenditure in the country, the tax
payers, ability to pay more tax is exhausted. Public expenditure
beyond this limit, means, disincentive to producers and fall in
production due to taxation beyond tolerance level.

The hypothesis rest upon the following two institutional

factors:
(a) When tax collection by government exceeds the critical limit of 25
percent of gross national product, the income earners are badly
affected by reduced incentives and decrease in their productivity. They
produce less than what they are capable of doing. This leads to a
reduced supply. In short, taxation beyond the critical limit, adversely
affect the incentive to produce and invest.

(b) On the other hand, even if the budget remains balanced, increase
in government expenditure would constitute rising demand. Therefore
inflation is generated from mal-adjustment between demand and
supply.

Even though Colin Clark’s critical minimum effort thesis is well

accepted by the business community, its significance in the academic
circle is very limited. Colin Clark gave undue emphasis on his critical
limit of 25 percent.

In the modern world a number of countries are incurring public

expenditure much beyond their limit, without facing worse situation of
inflationary pressure. Impact of budgetary spending on generation of
inflationary situation; depend upon the manner and nature in which
public expenditure is incurred.

Inflation is a complex economic phenomenon influenced and

characterized by a number of mutually exclusive and inter-dependent
factors. Hence we can only fairly conclude that in a marked economy,
increasing state activity may create inflationary pressure.