The International Effects of Government Spending Composition

IMF Working Papers, January 1, 2005

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Resolves a paradox noted by Alesina and Perotti (1995): government employment is an important component of public spending, yet fiscal-policy debates concentrate on shocks to non-wage government consumption.
Incorporates the distinction between spending for government employment and spending for non-wage government consumption in a "new open economy macroeconomics" model.
Main research focus: how changes in public employment versus non-wage government consumption affect relative private consumption and the exchange rate across countries.

Framework: "new open economy macroeconomics" model that separates public wage (government employment) spending from non-wage government consumption.
Comparative scenarios examined: permanent reductions in public employment matched by either (a) reductions in taxes, or (b) financing increased non-wage government consumption.

A permanent reduction in public employment in one country, when matched by a reduction in taxes:
- Reduces relative private consumption.
- Appreciates the domestic exchange rate.
When the reduction in public employment is used to finance increased non-wage government consumption:
- The macroeconomic effects are ambiguous.
- Outcomes are affected by the initial level of the public wage bill.

Composition of government spending (public employment vs. non-wage consumption) matters for international spillovers and domestic macroeconomic outcomes.
Fiscal adjustments that change the mix between wage and non-wage components can have contrasting effects depending on whether they accompany tax changes or reallocation to consumption.
Policymakers should consider the initial level of the public wage bill when evaluating the international macroeconomic consequences of reallocating public spending.