## _wp03237

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### Introduction and objective
- Definition: “Expansionary fiscal contractions” occur when sustained reductions in government budget deficits increase GDP or growth of real income.
- Objective: investigate why expansionary fiscal contractions occur in low-income countries by identifying the transmission channels through which fiscal policy affects growth in these countries.
- Principal policy conclusion (from study): Although increased investment is not the primary channel in low-income countries, high-deficit low-income countries can benefit from expansionary fiscal contractions through factor productivity improvements driven by governance-related reallocations.

### Theoretical predictions — transmission channels
- High-income countries (summary of predicted channels):
  - Principal channel: increased private investment following deficit reductions via reduced real interest rates and enhanced price and external stability.
  - Deficit reductions through lower current government expenditure are more growth-enhancing than through tax increases or reduced public investment.
  - Reduced deficits can stabilize exchange rates, restore investor confidence, moderate capital flight, and signal political stability.
- Low-income countries (predicted differences):
  - Wealth effects and interest-rate sensitivity are limited by underdeveloped financial markets and government-directed credit.
  - Private investment is predicted not to be the primary transmission channel for expansionary fiscal contractions in low-income countries.
  - Factor productivity (total factor productivity A in Yi = A * Π Vi^{αi}) is predicted to be the principal channel: reductions in unproductive public spending (wages, ghost workers, rents) and reallocation of resources to the private sector can raise average factor productivity.
  - Composition of public spending matters: shifting away from wages toward productive uses can raise factor productivity, but cutting critical services (education, health) or enabling corruption can offset gains.
  - Governance is fundamental: poor governance reduces the effectiveness of the investment channel and amplifies the importance of the factor-productivity channel.

### Empirical strategy and model specification
- System estimated: recursive system of four equations — (i) growth equation; (ii) gross investment equation; (iii) inflation equation; (iv) exchange rate equation.
- Causality direction used: fiscal policy → exchange rate movements → inflation → gross investment → growth.
- System expressed as ξ = (I − B) y − Γ x, reduced form ς = Π x + y, with Π = (I − B)^{-1} Γ and Θ = (I − B)^{-1} − I.
- Growth equation (dependent variable): log growth of per capita income )log(1−itit yy.
  - RHS covariates include: log initial per capita income; gross investment share of GDP (it I); population growth (it n); initial primary and secondary enrollment rates (0i pe, 0i se); terms of trade (it tot); country fixed effects (i η); fiscal deficit to GDP (it def); shares of expenditure categories (jit e); shares of revenue items (kit r); interaction deficit × low-deficit dummy (it defpost) where low-deficit countries have average fiscal deficit below 2.5 percent of GDP; high-inflation dummy (annual inflation > 20 percent); transition economy dummy (i trans).
- Investment equation (dependent variable: log gross investment) includes lagged income, fiscal deficit and interaction with low-deficit dummy, initial per capita income, inflation measures, transition dummy, and a corruption-government-size interaction capturing nonlinear government-size effects on investment.
- Inflation equation regresses log(1 + inflation) on fiscal deficit (and interaction), initial per capita income, terms of trade, currency depreciation (it excd), openness (it open), employment (it emp), and transition/low-deficit dummies.
- Exchange rate equation (it excd) regresses annual nominal exchange rate change on fiscal deficit (and interaction), terms of trade, openness, employment, transition/low-deficit dummies, and vector W containing external debt/GDP, government-size×corruption interaction, and spending/revenue composition (percent of GDP).
- Endogeneity and estimation: fiscal policy treated as endogenous; GMM estimator used with heteroskedasticity-robust residuals. Fiscal balance instrumented with lagged fiscal deficit and a democracy variable.
- Robustness: fixed effects (LSDV), FGLS, robust regression (Hamilton, 1991), EC2SLS, and fixed-effect instrumental-variable estimator used as checks.

### Data and sample
- Country sample: 39 low-income countries with IMF-supported programs for 1999–2001; includes transition economies; sample determined by data availability for all variables.
- All sample countries obtained concessional loans under ESAF (since 1987) or PRGF (since 1999).
- Classification notes: budget assistance (project and program loans) classified as external financing; grants classified above the line as revenue.

### Key descriptive statistics (selected exact figures from Table 1 highlights)
- Average fiscal deficit in the sample: 6.20 percent of GDP.
- Fiscal deficit fell from 7.6 percent of GDP to 5.4 percent of GDP between 1990 and 2001.
- Fiscal deficits were reduced on average by more than 1.5 percent of GDP during 1990–2001.
- External financing (percent of GDP): Mean 4.57.
- Domestic financing (percent of GDP): Mean 1.65.
- Real per capita GDP growth: point estimate minus 0.3 percent per year.
- Initial per capita GDP (national currency): Mean 145,809.02; Median 76,125.80; Standard Deviation 308,191.23; Kurtosis 21.63; Skewness 4.48; Observations 468.
- Capital expenditure (percent of GDP): Mean 9.02; Median 7.47; Standard Deviation 7.25; Observations 457.
- Corruption dummy: Mean 0.07; Median 0.00; Observations 468.
- Democracy index: Mean 2.97; Median 3.1; Observations 300.
- Exchange rate appreciation: Mean -15.31; Median -8.01; Standard Deviation 123.20; Observations 468.
- Inflation: Mean 130.11; Median 9.78; Standard Deviation 93.87; Observations 468.
- Tax revenue (percent of GDP): Mean 15.05; Median 13.67; Observations 459.
- Total external debt (US$B): Mean 2.98; Median 1.72; Observations 468.
- Transition economies dummy: Mean 0.21; Median 0.00; Observations 468.

### Main econometric findings — growth, investment, inflation, exchange rate
- Growth equation:
  - A fiscal surplus is positively related to growth, but expansionary fiscal contractions arise only for initially high-deficit countries.
  - For high-deficit countries, a reduction in the fiscal deficit by one percentage point of GDP raises the per capita GDP growth rate by around 0.2 percentage points.
  - Baseline coefficient on fiscal deficit (percent of GDP) = -0.188 (negative effect on per capita growth).
  - Interaction (deficit × low-deficit dummy) coefficients are positive in many specifications (example: 0.219), indicating nonlinear regime effects.
  - Population growth rate negatively related to per capita income growth.
  - Initial gross primary school enrollment rate positively associated with growth; initial gross secondary enrollment rate not consistently positive.
  - Investment: a 10 percent increase in gross investment-to-GDP ratio raises per capita GDP growth by almost one percent.
  - Government spending composition: a one percent increase in wages share of total spending reduces growth by 0.1 percent; a one percent increase in capital spending in total government outlays increases per capita GDP growth by less than 0.1 percent.
  - Deficit financing: reduced deficits financed domestically increase growth — a reduction in domestic deficit financing by one percent increases per capita GDP growth by 0.4 percent. Changes in external deficit financing do not have a significant effect on growth.
  - Inflation nonlinearities: countries with inflation above 20 percent have lower per capita growth by more than one percentage point.
- Investment equation:
  - Aggregate fiscal contractions do not significantly affect investment when using the aggregate deficit variable.
  - Decomposing financing: a reduction in domestic deficit financing ratio by one percent increases the investment ratio by 0.5 percentage point.
  - Education (initial primary and secondary enrollment) positively correlated with the investment ratio.
  - Inflation: a 10 percent increase in inflation reduces the investment ratio by 0.01 percent; if annual inflation > 20 percent, the investment ratio is lower by 2.5 percent than in low-inflation countries.
  - Governance/corruption: in high-corruption countries, a 10 percent increase in the growth of (government spending × corruption index) reduces the investment ratio by 1.5 percent of GDP.
  - Decomposition example: domestic financing (percent of GDP) coefficient in the investment equation reported as -0.619 in one specification (significant); external financing not significant.
- Inflation equation:
  - Large fiscal deficits associated with higher inflation: an increase in the fiscal deficit by one percent of GDP in high-deficit countries increases inflation by 0.1 percent (narrative).
  - When budgets are low-deficit, increasing the deficit has no significant effect on inflation.
  - Domestic financing appears positively associated with inflation (example coefficient 0.107 in a specification).
- Exchange rate equation:
  - Fiscal deficits associated with nominal exchange rate depreciation: a one percent increase in the deficit ratio leads to an exchange rate depreciation of 2.5 percent (narrative).
  - Expenditure composition effects: higher wages and capital expenditures lead to exchange rate appreciation; spending on transfers associated with depreciation.
  - Grants associated with negative effect on exchange rate stability.
  - Increasing government size in a high-corruption country associated with more depreciated currency.
- Transition economies:
  - Over 1990–2001, growth higher but investment lower in transition economies.
  - Being a transition economy beneficial for growth once initial conditions are controlled; fiscal policy effects on growth not statistically different between transition and non-transition economies.

### Path decomposition and relative channel magnitudes
- Total effects decomposition shows deficit reductions increase growth in high-deficit countries; total effect larger than direct effect but additional indirect effect small.
- Investment transmission channel contribution computed as product of fiscal deficit coefficient in investment equation and coefficient of investment in growth equation = (0.61 * 0.09) = 0.05 (reported).
- Direct factor productivity channel measured by fiscal deficit coefficient in growth equation ≈ 0.19.
- Thus factor productivity channel is roughly four times more effective than the investment channel in linking fiscal policy to growth in this analysis.

### Policy implications and numeric policy-relevant findings
- Evidence supports expansionary fiscal contractions in high-deficit, low-income countries.
- Principal transmission channel in these countries is factor productivity rather than private investment.
- Reducing domestically financed fiscal deficits matters quantitatively:
  - A one percent reduction in domestic deficit financing increases per capita GDP growth by 0.4 percent and raises the investment ratio by 0.5 percentage point.
- Inflationary financing and high inflation (>20 percent) harm growth and investment:
  - >20 percent inflation reduces per capita growth by more than one percentage point and reduces the investment ratio by 2.5 percent.
- Composition matters:
  - Lowering the wage share in public spending is associated with higher factor productivity and growth.
  - Reallocating spending toward productive capital outlays can increase growth, but governance quality conditions effectiveness.
- Practical recommendation: pursue sound fiscal policies that reduce domestically financed deficits and improve public spending composition (notably lowering the wage share and reallocating toward productive capital spending) to promote growth via improvements in total factor productivity, especially where private investment channels are weak.

*Source: _wp03237 - References*

### References..............................................................................................................

### _wp03237 - References

### Introduction: expansionary fiscal contractions
- Definition: “Expansionary fiscal contractions” occur when sustained reductions in government budget deficits increase GDP or growth of real income.
- Evidence in high-income countries: reported by Giavazzi and Pagano (1990), Bertola and Drazen (1993), Alesina and Perotti (1995), and Alesina (1997); Drazen (2001) reviews evidence regarding high-income countries.
- Evidence in low-income countries: reported by Gupta, Clements, Baldacci, and Mulas-Granados (2002 and 2003).

### Transmission channels linking fiscal policy and growth
- Principal channel in high-income countries:
  - Increased private investment appears to be the principal explanation for expansionary fiscal contractions in high-income countries.
  - Mechanism: sustained reductions in government budget deficits increase private investment through reduced real interest rates and enhanced price and external stability.
- Candidate channels in low-income countries:
  - Investment: investment is a prospective channel linking fiscal policy and growth, as in high-income countries.
  - Factor productivity: an alternative channel is factor productivity.
- Prediction for low-income countries:
  - Considerations set out in the paper suggest that factor productivity, and not investment, is predicted to be the primary channel linking fiscal policy to growth in low-income countries.
  - Rationale: governance characteristics of public sector spending and administration in low-income countries are often poor (see studies reported in Abed and Gupta, 2002). Poor governance is predicted to diminish the effectiveness of the investment channel while increasing the effectiveness of the factor-productivity channel in the link between fiscal policy and growth.

### Objective and organization of the study
- Objective: to investigate the reasons for expansionary fiscal contractions in low-income countries by identifying the transmission channels through which fiscal policy affects growth in these countries.
- Structure:
  - Section II: describes the transmission channels linking fiscal policy and growth in high- and low-income countries and sets out the basis for the prediction regarding the effectiveness of the investment and factor-productivity channels.
  - Section III: describes the specification for estimation.
  - Section IV: describes the data.

### Tables and figures listed in the content unit
- Tables (with exact numbering and titles as listed):
  - 1. Descriptive Statistics.......................................................................................................... 17
  - 2. Growth Regression: Dependent Variable-Average Per Capita Real GDP Growth Rate... 19
  - 3. Investment Equation Regression: Dependent Variable-Average Investment.................... 21
  - 4. Inflation Equation Regression: Dependent Variable Rate of Annual Inflation ................. 23
  - 5. Exchange Rate Equation Regression: Dependent Variable-Exchange Rate Appreciation 24
  - 6. Total Effects Decomposition: Exogenous Variables ......................................................... 27
  - 7. Total Effects Decomposition: Endogenous Variables ....................................................... 28
- Figures:
  - 1. Fiscal Balance, Growth, Investment, Inflation, and Exchange Rate Appreciation, 1990–2001.......................................................................................................................... 31

*Source: _wp03237 - References*

### Section V reports the empirical results. Section VI summarizes the conclusions: the principal

### _wp03237 - Section V reports the empirical results. Section VI summarizes the conclusions: the principal

### Principal policy conclusion
- Although increased investment is not a channel through which low-income countries might expect substantial benefit from fiscal adjustment, high-deficit low-income countries can expect to benefit from expansionary fiscal contractions through factor productivity, which can be expected to increase for governance-related reasons.

### II. Transmission channels — summary of theoretical predictions
- High-Income Countries
  - Fiscal expansions foster private-sector investment by sustaining or increasing domestic demand; adverse effects may occur via higher interest rates, inflationary pressures, and external-sector instability (crowding out).
  - Deficit reductions or fiscal contractions can increase investment and growth, particularly when deficit reductions occur through lower current government expenditure rather than tax increases or reduced public investment.
  - Reduced deficits may stabilize exchange rates, restore investor confidence, moderate capital flight, and preempt financial crises by signaling policy change.
  - A supply-side link: higher wages (including those induced by taxes on labor) raise the capital/labor ratio and can reduce investment; lower deficits can raise perceived wealth (reduced future taxes), increasing private consumption and investment.
  - Political-stability signalling: deficit reductions can signal an end to government discord, increasing private investment.

- Low-Income Countries
  - Wealth effects require developed financial markets; such markets are often absent or inadequate in low-income countries, limiting wealth-channel responses.
  - Investment is often insensitive to interest-rate changes when financial repression is present or when domestic credit and government bond markets are undeveloped.
  - Government-directed credit and dominant public-sector investment reduce the sensitivity of aggregate investment to market incentives and price stability.
  - Restricted economic freedom and weak protection of private property, remittance restrictions, and exchange controls depress private investment.
  - Because public investment is often financed by concessionary external loans, investment generally remains insensitive to market incentives that affect private investment decisions.
  - Prediction: private investment will not be the primary transmission channel for expansionary fiscal contractions in low-income countries.

- Factor productivity and public-sector governance
  - Aggregate production function specified as Yi = A * Π Vi^{αi} (index A measures total factor productivity).
  - Growth can come from increased factor inputs or from increases in A (total factor productivity).
  - Public sector noncompetitive conditions can produce rent components in public-sector wages; resources may be more productive in the private sector.
  - Reduced public expenditure that shifts resources to the private sector can increase average factor productivity if private-sector use is more productive.
  - Public-sector actions can impose externalities on private-sector productivity: positive (infrastructure) or negative (tax deadweight losses, corruption, ineffective public spending).
  - Unproductive public spending examples: wages/salaries of unproductive employees, ghost workers (example cited: payments of more than Rp 111.7 billion per month (US$13 million) in salaries to absentee public employees in Indonesia).
  - Rent-seeking diverts resources from productive activities; lowering contestable rents via deficit reduction can redirect resources to productive uses and raise factor productivity.
  - Governance-related considerations imply factor productivity — not private investment — is the principal transmission channel for expansionary fiscal contractions in low-income countries.

- Composition of public spending and factor productivity
  - For any given deficit level, the composition of public spending affects factor productivity.
  - Shifting composition away from wages toward more productive uses can raise factor productivity unless reductions cut critical services (education, health) or lower wages increase corruption.
  - In poor-governance settings corruption may bias capital spending toward projects amenable to bribe solicitation, reducing effectiveness of capital outlays.
  - Therefore, increases in unproductive categories of public spending can hamper growth; the role of spending composition is investigated empirically.

- Governance and investment
  - Poor governance reduces the effectiveness of both transmission channels: it makes private investment less attractive and reduces the productivity returns to public spending.

- Fundamental role of governance
  - Governance fundamentally affects prospective fiscal-policy transmission channels: poor governance underlies the prominence of factor productivity effects and reduces investment-channel effectiveness.

### III. Specification for estimation — model structure and estimation strategy
- System estimated: recursive system of four equations
  - (i) growth equation;
  - (ii) gross investment equation;
  - (iii) equation linking fiscal policy to inflation;
  - (iv) equation linking fiscal policy to exchange rate movements.
- Causality direction: fiscal policy → exchange rate movements → inflation → gross investment → growth.
- System expressed as ξ = (I − B) y − Γ x, with reduced form ς = Π x + y where total effects computed as Π = (I − B)^{-1} Γ and Θ = (I − B)^{-1} − I (indirect effects by subtracting direct effects).
- Recursive specification valid because feedbacks among endogenous variables were not statistically significant; an unrestricted system with feedbacks was also estimated and feedbacks were insignificant.

- Growth equation (log per capita income growth)
  - Dependent variable: )log(1−itit yy (growth of per capita income).
  - Right-hand-side covariates:
    - log initial per capita income (convergence; coefficient negative if conditional convergence).
    - gross investment as share of GDP (it I), expected positive.
    - population growth rate (it n), sign ambiguous.
    - vector X: initial primary and secondary school enrollment rates (0i pe and 0i se), terms of trade index (it tot), country fixed effects (i η).
    - fiscal variables: overall fiscal deficit to GDP (it def); shares of j-th expenditure categories in total public spending (jit e); shares of k-th revenue items in total budget revenue (kit r).
    - interaction: deficit × low-deficit dummy (it defpost) where low-deficit countries are defined as those with average fiscal deficit below 2.5 percent of GDP during the sample period.
    - dummy for high inflation (t dhi) where annual inflation exceeding 20 percent triggers the dummy.
    - dummy for transition economies (i trans).

- Investment equation (gross investment)
  - Dependent variable: gross investment (log).
  - RHS includes: lagged income, fiscal deficit and interaction with low-deficit dummy, initial per capita income, inflation measures (level and high-inflation dummy), transition dummy (i trans), and an interaction capturing nonlinear effect of government size on investment using a corruption index (it ext): zero for low-corruption observations and equal to change in government size for observations above a corruption threshold.

- Inflation equation
  - Regressed log(1 + inflation) on fiscal deficit and interaction with low-deficit dummy, initial per capita income, terms of trade, currency depreciation rate (it excd), degree of openness (it open), employment rate (it emp), and dummies for transition and low-deficit countries (vector Z).

- External sector (exchange rate) equation
  - Annual change in nominal exchange rate (it excd) regressed on fiscal deficit and interaction with low-deficit dummy, terms of trade, low-deficit and transition dummies, trade openness, employment ratio (vector Z), and vector W containing ratio of external debt to GDP, interaction between change in government size and corruption, and composition of government spending and revenue (percent of GDP).

- Endogeneity and estimation
  - Fiscal policy is treated as endogenous; GMM estimator used with heteroskedasticity-robust residuals.
  - Fiscal balance instrumented with lagged fiscal deficit and a democracy variable.

### IV. Country sample
- Data cover 39 low-income countries that had IMF-supported programs for the period 1999-2001.
- Sample includes transition economies and is determined by data availability for all variables used in the analysis.

*Source: Excerpt from the PDF chapter _wp03237 — Sections II–IV (transmission channels, model specification, and country sample).*

### Appendix I, along with descriptions of variables and data sources.

### _wp03237 - Appendix I, along with descriptions of variables and data sources

### Sample and Fund-supported programs
- All countries in the sample have obtained concessional loans from the Fund since 1987 under the Enhanced Structural Adjustment Facility (ESAF) or since 1999 under the Poverty Reduction and Growth Facility (PRGF) that replaced the ESAF.
- Countries remain in the sample even if the Fund-supported program was interrupted because performance targets under the program were missed.
- ESAF-supported programs and PRGF-supported programs envisaged concessional budget assistance from the World Bank and other multilateral and bilateral donors.
- Classification of external support in fiscal accounts:
  - Budget assistance in the form of project loans and program loans is classified as external financing in the fiscal accounts.
  - Direct assistance in the form of grants is classified above the line as a revenue source, thereby contributing to the reduction in the fiscal deficit.
- Differences between ESAF and PRGF:
  - For ESAF-supported programs over the 1986–95 period, the deficit was targeted, on average, to decrease by about one percentage point of GDP relative to the preprogram year.
  - PRGF-supported programs, on average, targeted relatively small increases in budget deficits to allow for higher poverty-reduction public spending.
  - A basic tenet of the PRGF is that a stable macroeconomic position is critical for promoting growth and reducing poverty; elimination of budget imbalances was not the sole aim.

### Descriptive statistics (high-level highlights from Table 1)
- Fiscal deficits:
  - Average fiscal deficit in the sample: 6.20 percent of GDP.
  - Fiscal deficits were reduced on average by more than 1.5 percent of GDP during the sample period 1990–2001.
  - Fiscal deficit fell from 7.6 percent of GDP to 5.4 percent of GDP between 1990 and 2001.
- Financing composition:
  - External financing (percent of GDP): Mean 4.57.
  - Domestic financing (percent of GDP): Mean 1.65.
- Growth and income:
  - Real per capita GDP growth: point estimate minus 0.3 percent per year.
  - Initial per capita GDP (national currency): Mean 145,809.02, Median 76,125.80, Standard Deviation 308,191.23, Kurtosis 21.63, Skewness 4.48, Observations 468.
- Other sample means (selected):
  - Capital expenditure (percent of GDP): Mean 9.02, Median 7.47, Standard Deviation 7.25, Observations 457.
  - Corruption dummy: Mean 0.07, Median 0.00, Observations 468.
  - Democracy index: Mean 2.97, Median 3.1, Observations 300.
  - Exchange rate appreciation: Mean -15.31, Median -8.01, Standard Deviation 123.20, Observations 468.
  - Inflation: Mean 130.11, Median 9.78, Standard Deviation 93.87, Observations 468.
  - Tax revenue (percent of GDP): Mean 15.05, Median 13.67, Observations 459.
  - Total external debt (US$B): Mean 2.98, Median 1.72, Observations 468.
  - Transition economies dummy: Mean 0.21, Median 0.00, Observations 468.
- Note: Table 1 reports full descriptive statistics; "Source: See Appendix I."

### Econometric approach and estimators used
- Baseline estimation: GMM estimation for each equation using both the overall fiscal balance and its financing components as regressors.
- Robustness checks and alternative estimators:
  - Fixed effects estimator (LSDV).
  - Feasible generalized least square estimator (FGLS).
  - Robust regression estimator (Hamilton, 1991) that eliminates the influence of outliers.
  - Error component two-stage least-square estimator (EC2SLS) allowing correlated error terms across equations.
  - Fixed-effect instrumental-variable estimator (Baltagi, 1995).
- Equations estimated: Eqs. (3)–(6) (as referenced in text) with tests relaxing the assumption that error terms are not correlated across equations to allow feedbacks among equations.

### Key econometric findings (Growth equation and fiscal policy effects)
- Growth equation main result:
  - A fiscal surplus is positively related to growth, but not for countries with low deficits.
  - Expansionary fiscal contractions arise only for initially high-deficit countries.
  - For high-deficit countries, a reduction in the fiscal deficit by one percentage point of GDP raises the per capita GDP growth rate by around 0.2 percentage points.
  - If a country has a low deficit, the positive effect on growth of deficit reductions is offset by the negative effect of the interaction between the fiscal deficit and the low-deficit dummy.

### Observed fiscal dynamics and composition
- Between 1990 and 2001:
  - The fiscal deficit declined from 7.6 percent of GDP to 5.4 percent of GDP.
  - This decline resulted from both an increase in the revenue-to-GDP ratio and a fall in the ratio of total government spending to GDP.
- Financing for deficits during the sample came mostly from external concessional sources: 4.6 percent of GDP (mean external financing).

*Source: Appendix I, along with descriptions of variables and data sources.*

### 5.5 percent of GDP, while per capita GDP grew on average by 0.4 percent per year.

### _wp03237 - 5.5 percent of GDP, while per capita GDP grew on average by 0.4 percent per year.

### Growth regression: key empirical findings
- Average per capita GDP grew on average by 0.4 percent per year.
- Initial per capita GDP is positively related to growth (absence of conditional convergence).
- Fiscal deficit:
  - Baseline coefficient on fiscal deficit (in percent of GDP) = -0.188 (robust z-statistics reported; negative effect on per capita growth).
  - Fiscal deficit in low-deficit countries (interaction) coefficients are positive in many specifications (for example, 0.219 in one specification), indicating nonlinear effects by deficit regime.
- Population growth rate is negatively related to per capita income growth.
- Terms of trade have little direct effect on per capita growth.
- Human capital:
  - Initial gross primary school enrollment rate shows a positive effect on per capita growth.
  - Initial gross secondary enrollment rate is not consistently associated with higher per capita growth.
- Investment:
  - Gross investment is a determinant of growth: the growth rate of per capita GDP increases by almost one percent when the gross investment-to-GDP ratio increases by 10 percent.
- Government spending composition:
  - A one percent increase in the ratio of total spending on wages to total expenditure reduces growth by 0.1 percent, ceteris paribus.
  - A one percent increase in capital spending in total government outlays increases per capita GDP growth by less than 0.1 percent.
- Deficit financing composition:
  - Reduced deficits financed from domestic sources increase growth: a reduction in domestic deficit financing by one percent increases per capita GDP growth by 0.4 percent.
  - Changes in external deficit financing do not have a significant effect on growth.
- Revenue composition:
  - Achieving fiscal consolidations by increasing the share of tax revenues to total revenue including grants is beneficial for growth.
  - Grants and non-tax revenue tend to be negatively correlated with tax revenue collection.
- Inflation and growth:
  - The direct effect of inflation on growth is nonlinear: countries with inflation above 20 percent have lower per capita growth rate by more than one percentage point.

### Investment equation: transmission channel evidence
- Overall, fiscal contractions do not significantly affect investment when using the aggregate fiscal deficit variable.
- When deficit financing components are examined separately:
  - A reduction in domestic deficit financing ratio by one percent increases the investment ratio by 0.5 percentage point.
- Education and investment:
  - Both initial primary and secondary school enrollment ratios are statistically significantly correlated to the investment ratio.
- Terms of trade have no significant effects on investment.
- Inflation effects on investment:
  - A 10 percent increase in the rate of inflation reduces the investment ratio by 0.01 percent.
  - If annual inflation rate exceeds 20 percent, the investment ratio is lower by 2.5 percent than in countries with low inflation.
- Governance and corruption:
  - In countries with high levels of corruption, an increase of 10 percent in the growth of the product of government spending and the index of corruption reduces the investment ratio by 1.5 percent of GDP.
- Decomposition of deficit financing:
  - Domestic financing (in percent of GDP) coefficient in the investment equation reported as -0.619 in one specification (significant), while external financing shows no significant effect.

### Inflation equation: fiscal deficits and other determinants
- Large fiscal deficits are associated with higher inflation:
  - An increase in the fiscal deficit by one percent of GDP in high-deficit countries increases inflation by 0.1 percent (reported in narrative).
- When budget deficits are low, increasing the fiscal deficit has no significant effect on inflation.
- Degree of trade openness, currency depreciation, and transition economy dummy were associated with reduced inflation in reported specifications.
- Domestic financing (in percent of GDP) appears positively associated with inflation in baseline specifications (e.g., domestic financing coefficient reported as 0.107 in a specification).
- High-inflation dummy (average annual inflation > 20 percent) is significant and associated with lower investment and growth outcomes described above.

### Exchange rate equation: fiscal deficits and expenditure composition
- Fiscal deficits are associated with nominal exchange rate depreciation in both high- and low-deficit countries.
  - A one percent increase in the deficit ratio leads to an exchange rate depreciation of 2.5 percent, irrespective of whether the country has a high deficit (narrative summary).
- Expenditure composition effects:
  - Higher wages and capital expenditures lead to exchange rate appreciation.
  - Spending on transfers is associated with currency depreciation.
- Grants:
  - Receiving a large share of overall revenue in the form of grants is associated with a negative effect on exchange rate stability.
- Governance:
  - Increasing government size in a high-corruption country is associated with a more depreciated currency.
- Caution: omitted variables could matter, but the sign and significance of the fiscal deficit variable are robust across specifications.

### Transition economies
- Over the sample period (1990–2001) growth was higher in transition economies but investment was lower.
- Being a transition economy was on average beneficial for growth once initial conditions are controlled for; the effect of fiscal policy on growth was not statistically different between transition and non-transition economies.

### Robustness analysis and alternative specifications
- Alternative estimators used: fixed effects (dummy variable least squares), feasible GLS, robust LAD estimator, error component two-stage least squares, and fixed effect instrumental variable estimator.
- Results from alternative estimation methods confirm baseline findings: fiscal consolidations are beneficial for growth in high-deficit countries.
- Alternative definition of high-deficit countries:
  - Baseline low-deficit dummy uses average overall deficit below 2.5 percent of GDP during the sample period.
  - Re-estimations using a dummy reflecting low levels of domestic financing of the fiscal deficit largely confirm baseline findings.
  - Main difference: effect of domestic financing on gross investment becomes less significant in some alternative specifications.
- Robustness conclusion: fiscal contractions increase growth in countries with large domestic deficit financing, confirming nonlinear relationship.

### Path analysis and total effects
- Total effects decomposition (Table 6) combines direct and indirect channels in the recursive system for endogenous variables: per capita GDP growth, investment, inflation, exchange rate appreciation.
- Overall:
  - Deficit reductions increase growth in countries with high initial deficits and do not significantly affect growth in other countries.
  - The total effect of fiscal deficits on growth is larger than the direct effect, though the additional indirect effect is small.
  - Largest indirect effects on growth are related to high inflation and transition economies.
  - Primary and secondary enrollment have direct positive effects on investment and indirect positive effects on growth through investment.
- Relative magnitude of channels:
  - The investment transmission channel contribution: product of fiscal deficit coefficient in the investment equation and coefficient of investment in the growth equation = (0.61 * 0.09) = 0.05 (reported).
  - The direct factor productivity channel measured by coefficient of fiscal deficit in the growth equation ≈ 0.19.
  - Thus, factor productivity channel is roughly four times more effective than the investment channel in linking fiscal policy to growth in this analysis.

### Conclusions and policy implications
- Evidence of expansionary fiscal contractions in high-deficit, low-income countries is present in the results.
- Transmission channels:
  - Contrary to high-income countries, where private investment is the main channel, in low-income, high-deficit countries factor productivity is the principal fiscal-policy transmission channel to increased growth.
  - Reductions in wage components of public spending are particularly associated with increased factor productivity.
- Policy-relevant numeric implications:
  - Reducing domestically financed fiscal deficits matters: a one percent reduction in domestic deficit financing increases per capita GDP growth by 0.4 percent and raises the investment ratio by 0.5 percentage point (reported).
  - Inflationary financing and high inflation (>20 percent) are harmful for both growth and investment (e.g., >20 percent inflation reduces per capita growth by more than one percentage point and reduces investment ratio by 2.5 percent).
- Practical implication:
  - Sound fiscal policies that reduce domestically financed deficits and improve public spending composition (notably lowering the wage share and reallocating toward productive capital spending) can promote growth in low-income countries with high budget deficits, via improvements in total factor productivity even when private investment channels remain weak.

*Source: Authors' calculations as presented in _wp03237.*

### REFERENCES

### _wp03237 - REFERENCES

### Overview
- Bibliographic list of works cited in the document, covering fiscal policy, governance, corruption, macroeconomic growth, public expenditure, econometric methods, and related empirical and theoretical studies.

### Books and Monographs
- Abed, George T., and others, 1998, Fiscal Reform in Low-Income Countries: Experience Under IMF-Supported Programs, IMF Occasional Paper No. 160 (Washington DC: International Monetary Fund).
- Abed, George T., and Sanjeev Gupta, eds., 2002, Governance, Corruption, and Economic Performance (Washington, DC: International Monetary Fund).
- Baltagi, Badi, 1995, Econometric Analysis of Panel Data (Chichester, New York: Wiley).
- Barro, Robert, and Xavier Sala-i-Martin, 1995, Economic Growth (New York: McGraw-Hill).
- Drazen, Allan, 2001, Political Economy in Macroeconomics (Cambridge, Massachusetts: MIT Press).
- Duncan, O. D., 1975, Introduction to Structural Equations Model (New York Academic Press).
- Easterly, William, 2001, The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics (Cambridge, Massachusetts: MIT Press).
- Hillman, Arye L., 2003, Public Finance and Public Policy: Responsibilities and Limitations of Government (New York: Cambridge University Press).
- Lindbeck, Assar and Dennis Snower, 1989, The Insider-Outsider Theory of Employment and Unemployment (Cambridge, Massachusetts: MIT Press).

### IMF and World Bank Working Papers and Occasional Papers
- Berg, Andrew, and Anne Krueger, 2003, “Trade, Growth and Poverty: A Selective Study,” IMF Working Paper, No. 03/30 (Washington DC: International Monetary Fund).
- Catao, Luis, and Marco Terrones, 2003, “Fiscal Deficits and Inflation,” IMF Working Paper, No. 03/65 (Washington, DC: International Monetary Fund).
- Gupta, Sanjeev, Benedict Clements, Emanuele Baldacci, and Carlos Mulas-Granados, 2002, “Expenditure Composition, Fiscal Adjustment, and Growth in Low-Income Countries,” IMF Working Paper, No. 02/77 (Washington DC: International Monetary Fund).
- Gupta, Sanjeev, Benedict Clements, Alexander Pivovarsky, and Erwin R. Tiongson, 2003, “Foreign Aid and Revenue Response: Does the Composition of Aid Matter?” IMF Working Paper, No. 03/176 (Washington DC: International Monetary Fund).
- Hillman, Arye L., and Eva Jenkner, 2003, “User Payments for Basic Education in Low-Income Countries,” Working Paper No. 02/182 (Washington, DC: International Monetary Fund).
- Rajkumar, Andrew, and Vinaya Swaroop, 2002, “Public Spending and Outcomes: Does Governance Matter?” World Bank Policy Research Working Paper, No. 2840 (Washington DC: World Bank).
- Hamilton, L. C., 1991, “How Robust is Robust Regression?,” Stata Technical Bulletin, 2: 21-26. Reprinted in Stata Technical Bulletin Reprints, Vol. 1, pp. 169–75.

### Journal Articles, Chapters, and Discussion Papers
- Acemoglu, Daron, and Thierry Verdier, 1998, “Reward Structures and the Allocation of Talent,” American Economic Review, Vol. 39, pp. 17-33.
- Adam, Christopher S., and David L. Bevan, 2000, “Fiscal Policy Design in Low-Income Countries,” paper prepared for UNU/WIDER research project on “New Fiscal Policies for Poverty Reduction and Growth.”
- Adam, Christopher S., and David L. Bevan, 2001, “Nonlinear Effects of Public Deficits on Growth,” paper prepared at the Cornell/ISPE Conference, New York.
- Alesina, Alberto, 1997, “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Staff Papers, Vol. 44, pp. 210–48.
- Alesina, Alberto, Silvia Ardagna, Roberto Perotti, and Fabio Schiantarelli, 1999, “Fiscal Policy, Profits, and Investment,” NBER Working Paper, No. W7207 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Alesina, Alberto, and Roberto Perotti, 1995, “Fiscal Expansion and Fiscal Adjustments in OECD Countries,” Economic Policy, A European Forum, No. 21, pp. 205–48.
- Bengoa, Marta, and Blanca Sanchez-Robles, 2003, “Foreign Direct Investment, Economic Freedom, and Growth: New Evidence from Latin America,” European Journal of Political Economy, Vol. 19, pp. 529–45 (Special Issue on Economic Freedom, edited by Jakob de Haan).
- Bertola, G., and Allan Drazen, 1993, “Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity,” American Economic Review, Vol. 83, pp. 11–26.
- Chauvet, Lisa, 2002, “Socio-political Instability and the Allocation of International Aid by Donors,” European Journal of Political Economy, 19, pp. 33–59.
- De Haan, Jakob, and Jan-Egbert Sturm, 2000, “On the Relationship between Economic Freedom and Economic Growth,” European Journal of Political Economy, Vol. 16, pp. 215–41.
- De Haan, Jakob, and Jan-Egbert Sturm, 2003, “Does More Democracy Lead to Greater Economic Freedom?: New Evidence for Developing Countries,” European Journal of Political Economy, Vol. 19, pp. 547–63 (Special Issue on Economic Freedom, edited by Jakob de Haan).
- De la Fuente, Angel, 1997, “Fiscal Policy and Growth in the OECD,” Centre for Economic Policy Research, Discussion Paper Series, No. 1755.
- Del Monte, Alfred, and Erasmo Papagni, 2001, “Public Expenditure, Corruption and Economic Growth: The Case of Italy,” European Journal of Political Economy, Vol. 17, No. 1, pp. 1–16.
- Economides, George, Apostolis Philippopoulos, and Simon Price, 2003, “How Elections Affect Fiscal Policy: Revisiting the Mechanism,” European Journal of Political Economy, Vol. 19, pp. 777-792 (November).
- Fischer, Stanley, 1993, “Role of Macroeconomic Factors in Growth,” Journal of Monetary Economics, Vol. 32, pp. 485–512.
- Fischer, Stanley, Ratna Sahay, and Carlos Végh, 2002, “Modern Hyper- and High Inflations,” Journal of Economic Literature, 40, No. 3, pp. 837–90.
- Gelb, Alan, Arye L. Hillman, and Heinrich W. Ursprung, 1998, “Rents as distractions: Why the exit from transition is prolonged,” in Economic Interdependence and Cooperation in Europe, Nicolas C. Baltas, George Demopoulos, and Joseph Hassid (eds.) (Berlin: Springer), pp. 21–38.
- Giavazzi, Francesco, and Marco Pagano, 1990, “Can Severe Fiscal Contractions Be Expansionary? Tales Of Two Small European Countries,” NBER Macroeconomic Annual 1990 (Cambridge, Massachusetts: National Bureau of Economics Research), pp. 75–110.
- Graeff, P. and G. Mehlkop, 2003, “The Impact of Economic Freeform on Corruption: Different Patterns for Rich and Poor Countries”, European Journal of Political Economy, Vol. 19, pp. 605–20 (Special Issue on Economic Freedom, edited by Jakob de Haan).
- Gupta, Sanjeev, 2003, “Fiscal Policy, Expenditure Composition, and Growth in Low-Income Countries,” forthcoming in the Journal of International Money and Finance.
- Gupta, Sanjeev, Hamid R. Davoodi, and Erwin R. Tiongson, 2001, “Corruption and the provision of health care and education services,” in Arvind K. Jain (ed.) The Political Economy of Corruption (London, Routledge), pp. 111–41. Reprinted in Abed, George T. and Sanjeev Gupta (eds.), Governance, Corruption, and Economic Performance (Washington DC: International Monetary Fund), pp. 245–79.
- Gupta, Sanjeev, Luiz de Mello, and Raju Sharan, 2001, “Corruption and Military Spending,” European Journal of Political Economy, Vol. 17, pp. 749–77. Reprinted in Abed, George T. and Sanjeev Gupta (eds.), Governance, Corruption, and Economic Performance (Washington DC: International Monetary Fund), pp. 300–32.
- Hjelm, Goran, 2002, “Effects of Fiscal Contractions: The Importance of Preceding Exchange Rate Movements,” Scandinavian Journal of Economics, Vol. 104, No. 3, pp. 423–41.
- Khan, Mohsin, and Abdelhak Senhadji, 2001, “Threshold Effects in the Relationship between Inflation and Growth,” IMF Staff Papers, Vol. 48, No. 1, pp. 1–21, (Washington, DC: International Monetary Fund).
- Kneller, Richard, Michael Bleaney, and Norman Gemmell, 1999, “Fiscal Policy and Growth: Evidence from OECD Countries,” Journal of Public Economics, Vol. 74, pp. 171–90.
- Lambertini, Luisa, and Jose Tavares, 2001, “Exchange Rates and Fiscal Adjustments: Evidence From OECD and Implications for EMU,” University of Los Angeles, unpublished paper.
- Mauro, Paolo, 1998, “Corruption and the Composition of Government Expenditure,” Journal of Public Economics, Vol. 69, pp. 263–79. Reprinted in Abed, George T. and Sanjeev Gupta (eds.), Governance, Corruption, and Economic Performance (Washington DC: International Monetary Fund), pp. 225–44.
- Van Rijckeghem, Caroline, and Beatrice Weder, 2001, “Bureaucratic Corruption and the Rate of Temptation: Do Wages in the Civil Service Affect Corruption and by How Much?” Journal of Development Economics, Vol. 65, No. 2, pp. 307–31. Reprinted in Abed, George T. and Sanjeev Gupta (eds.), Governance, Corruption, and Economic Performance (Washington, DC: International Monetary Fund) (2002), pp. 59–88.
- Von Hagen, Jürgen, Andrew Hughes Hallett, and Rolf Strauch, 2002, “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence,” Journal of the Japanese and International Economies, Vol. 16, Issue 4 (December), pp. 512–35.
- Berg, Andrew, and Anne Krueger, 2003, “Trade, Growth and Poverty: A Selective Study,” IMF Working Paper, No. 03/30 (Washington DC: International Monetary Fund).

### Topics and Themes Reflected in the References
- Fiscal policy design and fiscal adjustments in OECD and low-income countries.
- Expenditure composition, fiscal consolidation, and their effects on growth.
- Corruption: measurement, effects on public spending composition, and links to governance and service delivery.
- Relationships among inflation, macroeconomic stability, and growth, including threshold and hyperinflation studies.
- Political economy of fiscal policy, elections, and budgetary austerity.
- Econometric methods for panel data and structural equation modeling.
- Role of trade, foreign direct investment, foreign aid composition, and institutional quality in growth.

### Online Resource
- World Bank, Administrative and Civil Service Reform, http://www1.worldbank.org/publicsector/civilservice/common.htm (Washington, DC).

*Source: _wp03237 - REFERENCES*

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