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Fiscal Policy Government Size And Economic Essay

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Tran Thi Ha


Master’s Thesis

University of Tampere School of Management
Author: Tran Thi Ha
Title: Fiscal policy, government size, and economic performance: Empirical evidence from ASEAN countries Master’s thesis: 73 pages
Date: February 2012
Keywords: Fiscal policy, growth, government expenditure, ASEAN countries ______________________________________________________________________________


In an endogenous growth model with public finance including tax, expenditure and components of government expenditure by function, this study characterizes fiscal policy for some ASEAN economies, also the relationship between the growth rate, tax rate and expenditure shares on the GDP. Moreover, it examines the impact of different components of government expenditure by function on economic growth. I use panel data of two samples. There are seven ASEAN countries in first sample and five ASEAN countries in second sample over 28 years. I use linear regression techniques for panel data. According to estimation results, government spending has negative and significant effects on the growth rate. In contrast, tax revenue has positive impact on economic growth. My empirical results are obtained by using Barro model (1990) and Devarajan et al. (1996).




1. Introduction 5

1.1 research background 5
1.2 The research problems, delimitation, and the research target 6 1.3 research approach and methods 6

2. Related literature and theoretical focus 7

2.1 Public finance 7
2.2 Endogenous growth model 10
2.2.1 The Neoclassical model of exogenous growth 10
2.2.2 Endogenous growth model 12
2.2.3 Endogenous growth versus exogenous theory 15
2.3 Public finance in endogenous growth model 16
2.3.1 Government spending in a simple model of endogenous growth -Barro model 17 2.3.2 The Devarajan et al. (1996) model with optimal fiscal policy 23 2.4 Previous study 28

3. The fiscal policy of ASEAN countries 33

3.1. ASEAN countries and growth performance 33
3.2. A review fiscal policies of ASEAN countries 39
3.2.1 Government expenditure policy 39
3.2.2 ASEAN and Fiscal strength to continue recently 53

4. Empirical model of selected ASEAN countries 56

4.1 Building of growth model with fiscal policy for ASEAN countries 56 4.2 Data resources 59
4.3 Results 62
4.4 Conclusion and policies recommendation 67

References 70


Figure 1 : The neoclassical growth model 14
Figure 2: Government size and economic growth 33
Figure 3: Growth rate of ASEAN-3 countries, 1980-2010 (USD) 41 Figure 4: Growth rate of ASEAN-4 countries, 1980-2010 (%) 42 Figure 5: Revenue and Expenditure Shares 1993-2010 in ASEAN countries, Malaysia and Singapore 43 Figure 6: Revenue and Expenditure Shares 1993-2010 in ASEAN countries, Thailand, Philippines and Indonesia 44 Figure 7: Revenue and Expenditure Shares 1993-2010 of Vietnam 45 Figure 8: Government Expenditure on education in ASEAN countries 48 Figure 9: Tax revenue and economic growth in some selected ASEAN countries 54 Figure 10: The scater graph of government expenditure/GDP ratio and growth rate, Thailand 56


Table 1: ASEAN economy in 2009 38
Table 2: Land and population of ASEAN countries 2007 38
Table 3: GDP per capita of ASEAN countries (USA) 40
Table 4: Growth rate of GDP in ASEAN countries, 1980-2010 (%) 40 Table 5: Taxes Shares in ASEAN countries, 1993-2010 46
Table 6: Government Expenditure on Social Security and Welfare in ASEAN countries 47 Table 7: Government Expenditure on health in ASEAN countries 48 Table 8: Government debt in ASEAN countries (percent of GDP), 1991-20010 50 Table 9: Fiscal balance of ASEAN countries 1990-2010 53

Table 10: Statistical analysis of variables for first sample 64 Table 11: the estimation result of model 1 65
Table 12: the estimation results of model 2 68

1. Introduction

1. research background

ASEAN (Association of Southeast Asian Nations) was established in 1967 with five member countries, namely Indonesia, Malaysia, the Philippines, Thailand and Singapore. Brunei Darussalam then joined on 7 January 1984, Viet Nam on 28 July 1995, Lao PDR and Myanmar on 23 July 1997, and Cambodia on 30 April 1999, making up what is today the ten Member States of ASEAN. From 1980 to 2010, ASEAN economic growth increase strongly at average annual rate 5.5-10 percent, but implied risk. A unique characteristic of the ASEAN economies most badly damaged by the Asian financial crisis of 1997-98 was that fiscal policies and public debt levels had been relatively sound leading up to the crisis. Recently, concerns over European sovereign debt and the political battle over budgets in the US continue to cause market volatility. The ASEAN region has managed to find itself in a strong fiscal. It is worth to evaluate how fiscal policies can help to drive ASEAN economic development. Hence, the important tasks for policy maker in ASEAN countries before they carry out new fiscal policies is to evaluate the impact of public expenditure or/and tax rate on growth as well as to identify the government share in economy that maximize the performance of the economy. Do taxes and government expenditures enhance or impede economic growth? This question lies at the heart of public finance and taxation policy, both at the national and regional levels. The emergency of endogenous growth model has led to a surge of both theoretical and empirical research aim to discuss broad of issue related to growth experience of countries. Among them, the role of public policies, in particular fiscal policy, has attracted a number of studies analyzing the subject from different perspective. In general, the conclusion of this literature are rather inconclusive on the influence of fiscal policy on growth, which might be related to the fact that different fiscal policy instruments can lead to opposite effects on growth: on the one hand, a greater involvement of the public sector in the economy would tend to promote growth, but, on the other hand, higher taxes and regulation would affect growth negatively. For above reason, I use endogenous growth model of Barro (1990, 1991) and developed by Devarajan (1996) to analyzing the impact of fiscal policy on economic performance during 1980-2010 in some selected ASEAN countries. I hope that the results enable making policy recommendation public finance areas. Also, I add more evidences for the relationship between fiscal policies and economic growth and the hypothesis of endogenous growth model. 2. The research problems, delimitation, and the research target

The research question: How fiscal policy affects on economic performance of ASEAN countries?

To answer for this question, some sub questions will be analyzed follow. - How public expenditure affects on the growth in some selected ASEAN countries? - How tax revenue affects on the growth in some selected ASEAN countries? - How public expenditure by function affects on economic growth in some selected ASEAN countries?

Research aims: The aim of this thesis is to evaluate the impact of fiscal policy on growth, more generally on economic performance in ASEAN countries during 1983-2010. Firstly, I will review literature that is related to fiscal policy and growth. In section 2, I present a theoretical model in which those fiscal instruments presumed to influence the growth. In section 3, I deal with fiscal policy and the level of budget performance recently for ASEAN countries. Next I will offer an empirical application of the model in section 3, for the case of ASEAN countries during 1983-2010. Finally, the main conclusions and policy recommendations are presented in section 4.

3. research approach and methods

The study uses the quantitative method with database is collected from World Bank and Asian Development Bank of ASEAN selected countries during 1983-2010. Thus, I use the panel data for regression with fixed effect model and random effect model.

I use the endogenous model. In model, I would divide independent variable in two groups: Fiscal policy variables and non-fiscal variables. Fiscal policies variables include tax policy variables, government final consumption expenditure, government expenditures by function.

2. Related literature and theoretical focus

1. Public finance
Public finance is part of economics. It deals with the financial decisions; of public sector entitles. Traditionally it includes the following issues: The economics basis of government activity: What is the economic behind government? Why should they exist? What shouldn’t they do? Government expenditure: How should budgets/funds be allocated between various types of expenditure? How should expenditure be controlled? Government financing include taxation and debt financing. What kind of taxes are good and fair? What levels of government debt are sustainable? Empirically, public finance is at least trying to give a comprehensive picture of entire economic activity of public sector. It is described through the government financial statistics (GFS) which are part of national accounts. Public finance is less focused on decision making. It is assumed to be a similar way like other sector specific fields of economics such as the theory of households or theory of enterprises. The second issue considered in public finance is government expenditure. Here the main issue is government’s share of entire economy. There are various ways to measure this: - Government expenditure as percentage of gross domestic product (GDP) - Tax revenues and social security contribution as a percentage of GDP - Tax revenue as percentage of GDP

The third issue of public finance is government financing including taxation and public debt. During much of last century the focus was clearly on taxation, creating classifications for various forms of taxes such as direct, indirect, on flows, on wealth and developing principles of good or optimal tax. Good taxes are taxes that are fair, cause minimal disruption or side effect to the economy and minimal cost for collection. Public Finance is to provide information and to provide useful data as done for the developed nations that transferred Pubic Finance technology to developing countries. B.C.Oplopade (2010) citied the following: 1. Buchman (1970): public finance studies the economic activity of government as a unit 2. Musgrave (1993): the complex of problems that centre around the revenue expenditure process of government is referred to traditionally as public finance 3. Shirras (1969) the study of the principles underlying the spending and raising of funds by public authorities. 4. Hymann (1993): public finance is the field of economic that studies government activities and alternative means of financing expenditure. As you study public financed, you will learn about the economic basis of government activities. A key objective of the analysis is to understand the impact of expenditure, regulation on taxes and on borrowing to work … and good income. 5. Mayo (1996) public finance studies objectively the phenomenon of state finance without prior preferences and without wishing to provide duties for political action. The history of public finance is the reflection in the field of taxes, fees, revenue from demands and of public debts, while economic is defined as a branch of social science that is concerned with money, trade activities and industrial systems in a society. It uses scientific approach for developing economic theories (Kaewsuwen). 6. The economist need a model to explain economic process (b) to get reality from observed data i.e. an economic issue and (c) assist an economist to measure changes i.e. developing new economic theory. Public finance is to provide information to an economist hence it is one of the discipline to serve as an economist technologist. The relative scale of public finance

The ratio between public finance and gross domestic product (GDP) is a measure of the proportion of total output in a country accounted for by the government sector. The relative sizes of public and private sectors have recently been major issues of public policy in most countries.

GDP is thought to be the most accurate measure of the relative scale of public finance within the domestic economy. The public finance/GDP ratio most often is the proportion of public expenditure within GDP. However, there are four public finance/GDP ratios:

- Public expenditure/GDP ratio

- Tax/GDP ratio

- Public sector borrowing/GDP ratio

- Public sector debt/GDP ratio

The “public expenditure/GDP” ratio is an indication of the balance between public sector and private sector provision. Also, it provides an indication of the level to which government intervene in the economy and society, the government influence on the availability and consumption of public services.

Since public expenditure has to be financed, the higher public expenditure ratio, the higher the tax/GDP ratio and/or the public sector borrowing/GDP ratio. Moreover, in public sector borrowing leads to a rise in the public sector debt/GDP ratio.

The tax/GDP ratio provides an indication of the extent to which the state appropriates citizens’ income directly from employment, interest, dividends, capital gains and wealth or indirectly by taxing subsequent expenditure.

Meanwhile, the public sector borrowing/GDP ratio reflects the excess of public expenditure over the public sector revenue. It is affected by investment in physical infrastructure (roads, schools, hospitals), the extent to which current generation is living at the expense of future generations of taxpayers, views of legitimacy of negative rights versus positive rights. The public sector borrowing/GDP ratio will fall if those investment increase GDP by more than the cost of their provision or current income and current expenditure are balance over economic cycle. That means the economy moves from recession to recovery and GDP rises over the longer term as economic growth occurs. Thus public borrowing does not get out of control if government ensures that borrowing is repair once the recession over.

The public sector debt/GDP ratio is measure of the unavoidable commitment of public finance to paying the annual interest on that debt and also repaying over a period of years the original sums borrowed.

Thus, the four public finance/GDP ratios are interlinked, they provide strategically different measures of the relative scale of public finance and they have different implications for public policy. The four public finance/GDP ratios vary as a result of changes in both the numerator and denominator. The changes in GDP lead to decrease the share of public finance in GDP. The four public finance/GDP ratios tends to fluctuate from year to year. The four public finance/GDP ratios rise as an economy moves into a downturn or recession and fall as an economy moves from recession to full employment. Three causes of fluctuations in the public finance/GDP ratios are the economic cycles, economic shocks not associated with the economic cycle, discretionary government changes to the public finances.

Additionally, the public finance/GDP ratios display a long-term rising trend. Many analysts have sought to explain the rising trend in the public expenditure/GDP ratio. There is a two stage approach: develop a theory of growth of public expenditure and test that theory against the evidence. There are two alternative hypotheses in this approach. First, expenditure determines finance, In this case the primary decision is how much to spend and the amount of public finance raised depending on that decision. This is referred to as the “spend and tax model”. Second, finance determines expenditure, In this case government only spends what revenues they can raise from taxation, borrowing, user-charges and so on. This is referred to as the “tax and spend model”. The theories can attempt to explain: the totality of public expenditure, the individual components of public spending and growth of expenditures. A rising long-term trend in public finance is a cause for concern. The adverse outcomes will be created: high taxes destroy the incentives for enterprises and for self-reliance, high welfare payments and service levels create a dependency culture, so growth of the state is at the expense of the private sector, and government failure may be more profound than market failure. Therefore, the state should restrict itself to undertaking core functions and allow or enable the private sector to provide as many public sector services as possible. The state should be come enabling state than provider state. This is referred to as the shift from “government to governance”.

2. Endogenous growth model

1. The Neoclassical model of exogenous growth
Understanding economic growth has long been a central concern in economics. Adam Smith’s with Wealth of Nations (1776) emphasised the rising ratio of capital to labour as a key ingredient in economic growth. More generally, increasing the quantity of inputs (factors of production) will (usually) lead to an increase in the quantity of outputs, so studying factor accumulation is a key strand in attempts to explain economic growth. The second ingredient of economic thinking about growth is that of diminishing returns, which relates to the link between factor accumulation and output growth. In particular, diminishing returns capture the idea that doubling the amount of capital will in general lead to less than a doubling of output. The accumulation of productive factors and the existence of diminishing returns have found modern expression in neoclassical production theory in the form of a production function. The production function summarises the amount of output that can be produced with various combinations of inputs. The most commonly used form of the production function models output as depending on just two inputs—capital and labour, according to a particularly convenient mathematical form (the Cobb-Douglas production function). It is commonly assumed that the production function is “constant returns to scale”. This means that a doubling of all inputs will lead to a doubling of output. However, decreasing returns to scale apply to an input if other inputs do not increase. For instance, if the amount of capital is increased without any increase in labour, each subsequent addition of capital will yield smaller and smaller increments to output. The neoclassical growth model uses such a product...

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