Fiscal policy primarily denotes the use of government expenditure and revenue collection to influence the level of aggregate demand in the economy, in an effort to achieve price stability, full employment, and economic growth. In case that expenditures exceed revenues, the government runs a budget deficit and accumulates debt. Since the ability of governments to take on debt allows policy-makers to reduce fluctuations in economic activity either through automatic stabilization (Hiebert et al., 2009) or deliberately designed fiscal stimulus packages, public indebtedness in itself need not be a cause of concern. However, one should be aware thatexcessivelevels of debt compromise intergenerational equity by leaving the painful burden of fiscal consolidation to future generations.
Recently, a debate on the question where to draw the line between reasonable and exces-sive debt levels has emerged. This question was raised in light of the strikingly high levels of public indebtedness faced by several European countries. In May 2010, the Greek government deficit was estimated to be 13.6%, while accumulated government debt in Greece is forecast to hit 120% of GDP in 2010. In the meantime, confidence in other European economies such as Ireland, Spain, and Portugal has also decreased due to comparatively high government deficits of 14.3%, 11.2% and 9.4% of GDP, respectively (Eurostat, 2010).
From a supranational perspective, the recent news about the tight financial situation in several European countries casts doubt on the viability of the Economic and Monetary Union (EMU). In this context, the downfall of the Euro vis-`a-vis other major currencies has already been interpreted as a first sign of an impending dissolution of the EMU (The Economist, 2010c). Despite a e110 billion loan issued to Greece by the Eurozone countries and the International Monetary Fund and its explicit conditionality on the implementation of harsh austerity measures, concerns about high levels of public indebtedness remain.
The main challenge for the consolidation of public finances is the increasing cost of financing government liabilities due to the downgrading of government bond ratings and
proliferating interest payments (The Economist, 2010b). In addition, high levels of public debt weaken the capacity of the government to stimulate the economy during the recession that is continuing in some parts of Europe. Weak economic growth in turn implies fewer government revenues rendering the reduction of public debt even more difficult.
In order to understand how the current situation has come about and to what extent it can be observed in countries outside of the Eurozone, it might be worthwhile to take a closer look at the data on public finances. Figure 1.1 illustrates the evolution of public debt, public expenditures and public revenues as a share of GDP for three different groups of countries from 1980 to 2009. The objective is to compare the fiscal situation in the Eurozone (Euro13 countries) with that in the seven most powerful economies in the world (G7 countries) and in developed countries in general (OECD countries).1
Figure 1.1: Evolution of public finances for groups of countries, 1980 - 2009
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Gross debt as % of GDP
1980 1990 2000 2010
Euro13 Countries OECD Countries G7 Countries
303540455055
Total government expenditures as % of GDP
1980 1990 2000 2010
Euro13 Countries OECD C ountries G7 Countries
303540455055
Total government revenue as % of GDP
1980 1990 2000 2010
Euro13 Countries OECD Countries G7 Countries
Source: OECD Economic Outlook2
1Note that the three groups overlap given that some Euro13 countries are in the G7 group (France, Ger-many, and Italy) and that the G7 countries are all members of the OECD. Nevertheless, the comparisons are interesting considering that the G7 and the OECD include four and 19 non-Eurozone countries, respectively.
2The data has been obtained from the OECD Economic Outlook No. 86 published in December 2009.
Figure 1.1 illustrates that the pattern in the evolution of gross debt as a percentage of GDP is very similar across the three country groups, even though data for the Euro13 countries is only available as of 1990. The fact that public debt has grown more strongly in the G7 and OECD countries than in the Eurozone is at first sight surprising given that the newspapers mostly frame the current debt crisis in the context of this particular group of countries. More specifically, average gross debt as a share of GDP has increased from slightly above 40% in 1980 to 90% (OECD countries) and 101% (G7 countries) in 2009, compared to only 82% in 2009 in the Eurozone countries. This discrepancy can partly be attributed to the fact that entry into the EMU was conditional on convergence criteria including threshold debt levels.
These criteria continue to influence public finances of countries in the Eurozone even after entering the EMU due to the existence of the Stability and Growth Pact. What is also striking with regard to figure 1.1 is that about half ot the 50 to 60 percentage point increase in public debt in G7 and OECD countries has occurred in the first ten years of the 21st century.
The steady growth in public debt raises the question whether it has primarily been caused by an increase in expenditures or a decline in revenues. For this reason, the plots at the bottom of figure 1.1 are added to display the evolution of two additional fiscal variables.
The left-hand plot provides evidence for an increase in public spending as a percentage of GDP from 36% (OECD countries) and 38% (G7 countries) in 1980 to about 45% for both country groups in 2009, while the right-hand plot illustrates that government revenues have even slightly increased by two (G7 countries) or five (OECD countries) percentage points. This suggests that the growth in gross debt is driven by changes in public expenditures rather than revenues.3 In addition, the patterns in both plots are again very similar, even though public expenditures and public revenues divided by GDP are on average about 10 to 15 percentage points higher in the Eurozone countries than in the other two groups of countries. Finally, it should be noted that a particularly steep increase in public expenditures is observable at the end of the considered time period, while public revenues are slightly declining since 2006.
With regard to the future development of public finances, it can be stated that many of the highly indebted European governments announced to scale back expenditures rather than raise taxes (The Economist, 2010a), even though it is not clear how strongly these measures will contribute to a reduction of public debt levels. In any case, expenditure-based measures to achieve public debt reduction are justified by the economic literature providing evidence that this is the most promising approach to long-lasting fiscal consolidation (Alesina et al., 1998; Illera and Mulas-Granados, 2008).
Certainly, the current debt crisis can in part be attributed to macroeconomic shocks that can only to some extent be prevented by policy-makers. This includes the bursting of the “New Economy”-bubble at the turn of the century as well as the recent crisis in the banking sector. Moreover, the demographic shift towards an aging population necessitates
3The increase in public debt is much larger in percentage terms than the increase in public spending due to the fact that debt proliferates over time with increasing interest payments.
higher expenditures on health and social protection. However, especially with regard to the demography-induced deterioration of public finances, one can argue that appropriate reforms could have dealt with this challenge decades ago. In addition, the steady growth in public debt illustrated in figure 1.1 brings up the question why policy-makers were unable or chose not to reduce public debt in times of strong economic growth such as the 1990s.
More generally, this discussion casts doubt on the notion that representatives of the public sector exclusively seek to maximize social welfare. In this context, the political economy literature emphasizes the existence of a principal-agent conflict between representatives of the public sector and the general public, i.e. voters. One of the ideas that is very prominent in this literature and that relates to the aforementioned observations for figure 1.1 is that public expenditures are often raised shortly before elections to maximize re-election probabilities (Nordhaus, 1975). Since it is unpleasant to cut these expenditures in the post-election period, public expenditures are likely to grow over time. In addition, towards the end of a term period, a government that is likely to lose the next election has strategic incentives to increase public borrowing in order to limit the room for political maneuver for the political opponents (Pettersson-Lidblom, 2001). If this kind of behavior occurs repetitively, it is likely that public debt grows steadily as illustrated in the upper panel of figure 1.1.
Even though the literature on the political economy of fiscal policy is extensive, there are still some unanswered questions. This dissertation tries to address some of these remain-ing questions and fills gaps in the literature by means of three stand-alone research papers (chapters 2 to 4) that rely both on theoretical derivations as well as empirical investigations.
The focus is on public expenditures given that in contrast to public debt they can be directly influenced by policy-makers and do not result from an interplay between other variables (ex-penditures, revenues, interest payments, etc.). In addition, figure 1.1 clearly illustrates that the current debt crisis can be explained by the evolution of expenditures rather than revenues.
In particular, this dissertation investigates the following questions: has the growth in public sector size over the past few decades been in the interest of voters? Which groups in the population benefit the most from a large government? How important is the quality of in-stitutions in this context? Are public expenditures misallocated? Which spending categories are affected by this misallocation? What are the mechanisms that induce a distortion in the allocation of public resources?
The remainder of chapter 1 is structured as follows: section 1.2 reviews the related literature. In particular, section 1.2 starts out with an overview of the literature that justifies government intervention followed by a detailed portrayal of the political economy perspective.
Section 1.2 provides a description of the existing literature on the determinants of public expenditures and the literature that investigates the consequences of public expenditures.
Finally, section 1.3 outlines the structure and objectives of chapters 2 to 4.