Azerbaijan State University Of Economics-UNEC

International School Of Economic

Bagirova Shafiga
Aliyev Ayxan
Mammedov Rufat

Lecturer: Rovshan Camalov

IMPACT OF GOVERNMENT EXPENDITURE

ON ECONOMIC GROWTH

1.Introduction;

As economists and policymakers struggle to determine the influence of government

expenditure on economic growth, the link between government spending and growth has
garnered a lot of attention over time. Because there has been no agreement on the findings and
conclusions drawn, the consequence of their labor has been more perplexing than useful.
From the theoretical perspectives, there are the Keynesians that advocate for the positive
impact of government spending on economic growth; and the Classicals and the Neoclassicals
that postulate that government spending has a negative impact on economic growth. There are
also those that found a middle ground where government spending is postulated to have a
positive impact on economic growth up to a certain optimal threshold, above which the impact of
government spending on economic growth turns negative.
The potential influence of government expenditure on economic growth has also been
inconsistent, even from an empirical standpoint. While some studies have indicated a detrimental
influence, others have found a favorable benefit. Several studies have also shown no discernible
relationship between government spending and economic growth.
With government spending still on the rise in many economies, on the one hand, and
declining economic growth rates in these economies, on the other, the debate on whether
government spending has a positive, negative or neutral impact on economic growth is still
raging today – with some studies going an extra mile disaggregating government expenditure
into various components.
 The document review process was applied in order to meet the study's objective. We collected
empirical research on how public spending affects economic development from a number of
recognized journals.

2.Literature review;

To explain the theoretical relationship between government spending and economic growth, we
refer to Keynes’ theory of government expenditure. In contrast to the Peacock-Wiseman
hypothesis and Wagner's organic theory, which view public expenditure as an endogenous
variable influencing growth, Keynes views government expenditure as an exogenous factor that
can be utilized as a tool for policy to affect economic growth. The Keynesian theory states that
through an expansionary fiscal policy, higher government spending results in higher economic
growth. Production rises in response to increases in government spending, and this raises
aggregate demand, which in turn raises GDP (gross domestic product). Consequently, output
rises if government spending rises, all else being equal. The Keynesian hypothesis generally
suggests that economic growth variations can be smoothed out theoretically through government
intervention. By putting in place sensible economic, political, social, and legal policies,
governments support social welfare and have an impact on the economy. Because of their
numerous effects on aggregate demand, public spending can therefore be utilized as an
exogenous fiscal policy tool to promote growth, particularly in recessionary times. Generally,
government spending has a twofold multiplier effect. The first section demonstrates how, if the
multiplier effect is equal to one, an increase in government spending will be offset by an increase
in tax income, which finally tends to maintain the fiscal balance. The second is the point at
which rising government spending is balanced by falling taxation. The multiplier will have a
value larger than one in this case. Thus, an optimal government size will lead to an increase in
aggregate demand, which in turn tends to boost a nation's output. Keynes argues that government
spending is a policy tool for raising GDP and that there is a causal relationship between
government spending and GDP. According to Keynesian economists, the purpose of government
is to mitigate oscillations in the business cycle. Moreover, Keynesian theory contends that any
type of government expenditure, even periodic expenditures, may promote economic growth.
The degree to which government expenditure is in competition with private investment and
consumption impacts the effectiveness of fiscal policy in maintaining aggregate demand. A
budget imbalance occurs when increases in government spending are not accompanied by
increases in taxes or fees. The issuing of domestic debt to finance the budget deficit could have a
negative impact on domestic interest rates since it would cause private spending to decline
(Kandil, 2000). When credit and liquidity are expanded as a result of a simple monetary strategy
to finance the budget deficit, inflationary expectations may be formed. This could lead to higher
nominal interest rates, which would be detrimental to investment and private consumption
(Loizides & Vamvoukas, 2005). The private sector could have to struggle for money that would
have gone into capital goods investments and consumer goods purchases in order to avoid
running deficits. On the other hand, Wagner (1883) thinks that government spending is an
endogenous factor rather than a driver of economic growth. The mathematical expression for his
hypothesis is Gt = f (Y t), where Y represents the rate of economic growth in a particular nation
and G represents the size of the public sector, which indicates the amount of government
spending. Wagner's Law, to add a few words for good measure, says that government spending
rises in tandem with a nation's economic development. But aside from Keynes and Wagner's two
theories, Solow's (1956) neoclassical growth model's findings demonstrate that government
spending has no long-term impact on economic growth. Neoclassical growth models suggest that
changes in output. This theory states that the three exogenous elements that affect the long-run
growth rate are the degree of technical improvement, labor force expansion, and population
growth.

Although favorable, the correlations between fiscal expenditure and real GDP growth are not
always clear-cut and raise additional issues for economic research, as the data in figure I.1
illustrates.

3.The magnitude of public expenditure as a share of GDP;

A quick summary of Mexico's, Central America's, and the Dominican Republic's fiscal
performance over the previous 25 years is provided in this section. The goal is to examine
spending dynamics across nations and identify any noteworthy changes in fiscal performance.

Fiscal income as a percentage of GDP has only slightly increased over the past 25 years, as
table I.2 illustrates. Throughout the 1990s, total income as a percentage of GDP varied from just
10.5% in Guatemala to 15.8% in Panama. Mexico, Central America, and the Dominican
Republic experienced a period of comparatively robust economic growth and fiscal incomes
between 2000 and 2008. The latter was mostly due to higher tax collections, notably value-added
and personal income taxes, as well as higher trade earnings. All of the subregion's countries saw
an increase in total income as a percentage of GDP as a result. During the worldwide financial
crisis that occurred in 2008 and 2009, only Guatemala decreased its fiscal income as.

After the 2008–2009 crisis, the fiscal incomes of Costa Rica, Mexico, Honduras, Panama, and
the Dominican Republic all decreased from 2010 to 2014. In contrast, Guatemala's fiscal income
stayed steady as a percentage of GDP, despite being the lowest in the region at just 11.5% on
average from 2008 to 2009 to 2014. As a percentage of GDP, only El Salvador and Nicaragua
were able to grow their central governments after the crisis.

From 1990 to 2008, most countries in the region had relatively healthy central government
balances, with modest surpluses in some and deficits of less than 3% in most cases, when
looking at fiscal expenditures including adjustments for pension commitments (see figure I.2).
Between 2003 and 2008, unprecedented levels of international trade flows and soaring global
commodity prices contributed to a period of relatively strong growth in Latin America, and to a
greater extent, Central America. In reaction to the financial crisis of 2008–2009, every nation in
the area increased the size of their overall budget deficits.

4.Model Specification;

Model specification is the mathematical justification for the relationship between the
independent and dependent variables. This section offers an econometric model for the
relationship between government spending and economic growth in Ethiopia, with a focus on
sectorial spending. The consumer price index (CPI) functioned as a control variable in this study,
while government investment spending was another relevant variable used. The VAR method is
employed in the empirical framework of this study to evaluate the relationship between
Ethiopia's economic growth and government spending on investment, health, education, defense,
and agriculture. The VAR approach is applied because government spending and economic
growth have a bidirectional relationship. The question of whether economic growth generates
demand for goods and services or the availability of public goods and services drives growth in
the economy remains unanswered.
 GDPGROWTH=f(public ExpenditureComponents),

GDP per Capitat−GDP per Capita t−1

GDP GROWTH= _____________________________
GDP per Capita t.

5.Public Expenditures in Azerbaijan;

Budget expenditures are necessary to ensure the nation's economic and social development as
well as to improve the well-being of the populace. Therefore, one of the most important
challenges of our day is ensuring that budget expenditures are spent appropriately, in line with
their intended purpose, and that their utilization is improved.

Being a powerful economic force is typically a state's top priority. Thus, the first step is to
determine the course or approach for economic development. Furthermore, it is crucial to focus
all national resources on implementing this idea to the best of the state's capacities. The state
may then be able to attain both economic strength and a strong economic position. It should go
without saying that the development concept that is selected has to be defined within the proper
and objective parameters.

The quantity of financial resources redistributed through the state budget or the percentage of
state budget expenditures in GDP are the most widely used indicators to describe the scope of the
state's economic activity. Table 1 displays the overall state of public finances as well as the real
GDP growth rate for Azerbaijan from 2000 to 2021. Table 1 indicates that the state budget's
expenses surpassed its receipts for the fiscal years 2000–2021. As may be observed, budget costs
only fell short of budget receipts in 2004, 2006, 2011, and 2013. However, out of all of these
years, 2013 had the largest budget surplus at 352,8 million manats, while 2017 had the most
budget deficit at -1077.8 million manats. The real GDP growth rate is also included in Table 1.
Azerbaijan's economy grew at an average real GDP growth rate of 8% between 2000 and 2021, ,
with notable variations in this rate noted during the period under review (Table 1). 2009 saw a
real GDP growth rate of 9.3% despite the recent Global Financial Crisis.

After graphing the overall government revenue and spending data from Table 1, Graph 1 was
produced. The series of governmental revenues and expenditures in Azerbaijan evolves with a
similar tendency, as shown in Graph 1. Government spending generally exceeds government
revenue, as Graph. 1 illustrates.

The impact of total government spending on economic growth was examined in the case of
Azerbaijan by a number of research studies, including Hasanov et al. (2016), Aliyev and Nadirov
(2016), Mukhtarov and Rustamov (2018), Hasanov et al. (2018), and Mukhtarov et al. (2018).
These studies did not include government spending on education (Mukhtarov, 2020).
 Studies show that whereas public budget expenditures as a percentage of GDP are more than
50% in European nations, in Azerbaijan they varied between 16 and 36% between 2000 and
2021. Therefore, even though the state budget's specific weight in our nation was 17.1% of GDP
in 2005, The percentages were 26,9% in 2011, 32,7% in 2015, 36,4% in 2020, 36,4% in 2021,
and 29,5% in 2021. According to research, this relationship between GDP redistribution by the
state and economic growth needs to be viewed within a larger historical framework in order to
find a general pattern.
States have been regulating the nation's economy for the past few years by creating budgets
and managing budget monies. On the other hand, since the world's financial issues have gotten
worse recently, budget procedures have become more and more crucial for controlling the
economy.

6. Definition and Measurement of Variables;

The significance of turning public capital into a stock variable in a growth model is hotly
debated in the literature (Berlemann & Wassermann, 2014; Kamps, 2006). This is so because it
is believed that capital depreciation will be proportionate to capital stock. Therefore, over the
course of the last few decades, numerous approaches have been developed by various scholars,
including Goldsmith (1951), Harberger (1978), Griliches (1980), Kamps (2006), Bertlemann
(2014), and others, to be used in the conversion of public capital to capital stock in order to
account for the depreciation pattern of capital goods prior to estimation. We used Goldsmith's
(1951) Perpetual Inventory Method (PIM), which was later improved upon by Berlemann and
Wasserth (2014), for the purposes of this investigation. The PIM was chosen because it is the
most widely used approach and may be used to interpret public capital as an inventory in an
economy (Berlemann & Wesselh¨ ll, 2014).Thus, total capital investment is added to generate
the data for capital expenditure, which is then converted to a stock variable using the perpetual
inventory approach to account for modifications to the consumption of fixed capital
(depreciation of fixed assets) from the investment statistics.The perpetual inventory technique is
represented, In Equation 5

where: r = Rate of depreciation at five percent; Kt = Capital stock at previous period; It =

Investment at current period; and Kt−1 = Capital stock at prior period.

The National Bureau of Statistics (2019) defines the labor force population as all individuals
between the ages of 15 and 64 who are able and willing to work, regardless of whether they are
employed or not.Recurrent expenditure is the term used to describe how much the government
spends on daily operations like payroll, salaries, and overhead.The federally collected revenue
from non-oil sources, which consists of taxes and other income from government services, is
added to determine the non-oil revenue variable.Moreover, trade openness, GDP, and inflation
continue to be defined and assessed as before.To preserve uniformity of measurement units, all
remaining variables are supplied in their log forms, even if inflation, trade openness, and labor
force are regarded as percentages.

7. Traditional Growth Rationales

Government spenders argue that their spending supports public goods like law enforcement,
military defense, and contract enforcement that are not typically provided by markets.1.
According to conventional economic theory, people are not really motivated to produce these
kinds of things as others usually consume them for free.

One of the most influential economists of the 20th century, John Maynard Keynes, supported
government expenditure even if it means incurring a deficit.2. According to his theory,
governments can spend money to employ capital that has been idle or underutilized and create
jobs when the economy is in a slump and there is a high unemployment rate among labor and
capital. One of the latent justifications for the current federal stimulus expenditure is Keynes's
theory: it is needed to boost economic output and promote growth.
These expenditure perspectives make the assumption that the government is fully aware of which
public products will be valued added, which are underutilized, and where resources should be
directed. Nevertheless, the government lacks access to any information that would enable it to
determine the most efficient locations for the use of products and services.4 When federal
expenditure is unable to precisely target the projects where it would be most effective, it is less
likely to spur growth.

8. Politics Drives Government Spending

Apart from the issue of information, the political procedure itself has the potential to impede economic
expansion. For instance, Gordon Tullock, an emeritus professor of law at George Mason University,
proposes that bureaucrats and politicians aim to control as much of the economy as they can.5.
Additionally, the private sector's desire for government resources results in a misallocation of those
resources through "rent seeking," which is the practice of businesses and individuals lobbying the
government for financial support. Legislators give funds to their preferred groups instead of where they
are most needed.Six This strategy is not conducive to economic progress, even though it might provide
incumbents running for reelection with a strong political return.
The theory is supported by the evidence. According to a 1974 study by Stanford's Gavin Wright, political
maneuvers aimed at securing the most votes could account for anywhere from 59 to 80 percent of the
variation in the states' per capita federal spending during the Great Depression.7. In the end, Western
states saw far more concentrated investment under the Democratic Congress and the president, owing to
considerably closer elections than the Democratically dominated South. According to Wright's analysis,
the party in power may decide to allocate cash during a crisis based on the possibility of political gains
rather than just economic need.

9 . The Consequences of Unproductive Spending and The Multiplier Effect

The fiscal multiplier is frequently used by proponents of government expenditure as an example

of how spending can spur economic growth. The multiplier is a quantity that determines how
much an economy-wide output metric, like GDP, rises in response to a specific level of
government spending. The multiplier theory states that the economy grows as a result of an
initial burst of government spending that permeates the system and is repeatedly spent. A
multiplier of 1.0 indicates that precisely 100 (100 x 1.0) persons would enter the workforce if the
government launched a project that employed 100 people. More employment is implied by a
multiplier greater than 1, and a net job loss is implied by a number less than 1.

The incoming Obama administration used a multiplier estimate of roughly 1.5 for government
spending for most quarters in its 2009 assessment of the stimulus plan's job benefits. This
implies that the GDP would rise by 1.5 dollars for every dollar spent on stimulus by the
government.8 In actuality, though, wasteful government expenditure probably has less of a
multiplier effect. Harvard economists Robert Barro and Charles Redlick calculated that the
multiplier from government defense spending hits 1.0 at high unemployment rates but is less
than 1.0 at lower unemployment rates in a September 2009 National Bureau of Economic
Research (NBER) article. There's a chance that non-defense spending has an even lower
multiplier effect.

This result is supported by another recent investigation. The expenditure multiplier range,
according to NBER economist Valerie A. Ramey, is estimated to be between 0.6 to 1.1 Barro
and Ramey's multiplier values, which are far lower than those of the Obama administration,
suggest that government spending may actually slow down economic growth because of wasteful
use of funds.

10 . Crowding Out Private Spending and Empirical Evidence

Since taxes pay for government expenditure, rising government spending also raises citizens'
current and future tax burdens, which discourages private investment and spending. We call this
phenomenon "crowding out."

Government expenditures have the potential to drive away interest-sensitive investments in

addition to private expenditure.11 Interest rates rise as a result of government expenditure
decreasing economic savings. This may result in less money being invested in projects like home
construction and productive capacity, which refers to the buildings and infrastructure that
support the output of the economy.

Additionally, there is a large negative association between government spending and company
investment, according to an NBER article that examines a panel of OECD countries.12 On the
other hand, private investment soars when governments reduce spending. Robert Barro talks
about a few of the key studies that show a negative relationship between GDP growth and
government spending.Thirteen Furthermore, Dennis C. Mueller of the University of Vienna and
Thomas Stratmann of George Mason University discovered a statistically significant negative
association between government size and economic growth in a study including 76 countries.

Some empirical studies have found a positive association between government spending and
economic growth, despite the majority of the literature finding no such relationship. For instance,
a 1993 study by economists William Easterly and Sergio Rebelo examined empirical data from
almost 100 nations between 1970 and 1988 and discovered a positive relationship between GDP
growth and general government investment.

The actual results are not in agreement, which highlights the challenges of evaluating
correlations of this kind in a complex economy. The theoretical literature suggests that
government spending is unlikely to be as beneficial for economic growth as merely leaving the
money in the private sector, notwithstanding the lack of empirical agreement.
11. Why Does It Matter Right Now ?

The American Recovery and Reinvestment Act, passed by Congress in 2009, authorized
spending of $787 billion to support economic recovery and job creation.sixteen Recent federal
outlays clearly demonstrate the fiscal effects of this legislation and other government expenditure
efforts meant to improve the economic picture for the federal budget. Figure 1 illustrates how
total government expenditures have increased over time, with a notable spike following 2007.
Figure 2 illustrates how, over the past two years, overall federal spending as a percentage of
GDP has increased significantly to almost 30 percent. As previously mentioned, this spending
might have unfavorable impacts that discourage private investment and impede economic
progress.