The Role of the State in Economic Development. Do Government Expenditures Promote Growth in Developing Countries?

Master's Thesis, 2018

41 Pages, Grade: 7


Table of Contents


Table of Contents

Table of Figures

1. Introduction

2. Literature Review
2.1 Theories of Economic Development
2.2 The Role of the State in Economic Development
2.3 Government Expenditures, Institutional Quality and Growth
2.4 Sectoral Government Expenditures and Growth

3. Data and Methodology
3.1 Economic Model
3.2 Data Sources

4. Results
4.1 Baseline Results
4.2 Robustness Tests

5. Policy Implications and Concluding Remarks

6. Limitations

7. References

8. Appendix


This paper examines the role of the state in economic development. In particular, we test the impact of aggregated and sectoral government expenditures on economic performance in developing countries. Our findings suggest that total government expenditures are negatively related to economic development in both low income and middle income developing countries. However, we find particular evidence that government expenditures prove to be more beneficial for growth when a country is characterized by a well-functional institutional design. In contrast to previous studies, we do not find positive and significant results for sectoral government expenditures. In fact, our findings suggest that transport and communication, defense and health expenditures are negatively related to economic development. At the same time, public and private investments appear to be positively related to economic development throughout our analysis. Therefore, we conclude that – instead of government expenditures – stimulating investments and institutional reforms should play a major part on the political agenda of developing countries.

Keywords: government expenditures, institutional quality, economic development

Table of Figures

Table 1: Descriptive Summary Statistics

Table 2: Baseline Results – Standard Fixed Effects Estimation

Table 3: Robustness Test I – Time Lag Extension

Table 4: Robustness Test II – Sub Sampling

1. Introduction

The nation state and its policies played and still play an important role in the economic and socio-political development process of developing countries. In some developing countries, government activities and industrial policies were the main driver for growth, in other cases market liberalizations and a restrained government state were beneficial for economic development (Szirmai 2015). Therefore, it is not surprising that the role of the state in economic development remains one of the most controversial debates in economic literature. Whereas some researchers emphasize the developmental power of state interventions and government expenditures, others criticize that government activities may actually lead to market inefficiencies and therefore hamper economic development. For instance, Ram (1986), Romer (1989), Romer (1990) and Rubinson (1977) find that total government expenditures have a positive effect on growth and development. On the contrary, researchers such as Barro & Lee (1994), Afonso & Furceri (2010) and Dar & AmirKhalkhali (2002) emphasize that government spending has a rather deteriorative effect on economic performance.

In addition to that, other studies take the effect of disaggregated government spending into account and investigate the effectiveness of sectoral government expenditures for economic development, such as public education, defense, transport and health expenditures. In this regard, findings are equally ambiguous. For some sectoral government expenditures, researchers suggest a positive and significant relationship relative to economic development. Simultaneously, others doubt the relevance of sectoral expenditures with regard to growth and development (see for example Bose, Haque, & Osborn 2007 and Fan, Rao & Rao 2003).

Complementary literature underlines the fact that government expenditures alone are not an appropriate instrument to draw meaningful conclusions about the relationship between government intervention and economic development. In fact, researchers argue that any form of government expenditure is embedded in an institutional framework. Therefore, they state that the efficiency and magnitude of government expenditures may also depend on the quality of institutions and the political framework within an economy. As a consequence, researchers like Guseh (1997) and Afonso & Jalles (2016) include proxies for institutional quality in their analyses and illustrate that the quality of institutions considerably influences the economic performance and innovative capabilities of countries.

However, we identify that the above mentioned three factors – aggregated total government expenditures, disaggregated sectoral government expenditures as well as institutional quality – have mostly been treated separately in the existing economic literature so far. Therefore, the motivation of this paper is to estimate the effect of all three determinants in one combined analysis. The combination of all three factors in one econometric framework allows us to disentangle their respective effects and analyze the impact of government expenditures on economic development for a panel dataset of 35 developing countries between 1995 and 2012.

In this regard, this paper opts to make two main contributions to the existing literature.

First, this article examines the effect of both aggregated total government expenditures as well as disaggregated sectoral government expenditures on economic development. Indeed, we collect a variety of different government expenditure data. On the sectoral level, we make use of a novel sectoral government expenditure database that has not been used so far for empirical research. As a consequence, the integration of a new and consistent dataset allows use to analyze the effect of both aggregated and disaggregated government expenditures in one econometric framework. At the same time, we examine whether government expenditures prove to be more beneficial for growth when a country is characterized by a well-functioning institutional design. Briefly, we present one econometric framework that tries to capture the distinct effect of all three above mentioned factors.

Second, existing literature derives – based on its findings about the relationship between government expenditures and economic development – concrete policy recommendations for decision-makers in economic politics. On the one hand, we equally derive economic policy recommendations for policy makers in developing economies. On the other hand, we analyze our results with regard to the two main schools of thought in economic growth theory – notably the neoclassical one sector growth and the two sector structural change model. Based on our empirical findings, we try to evaluate the suitability of each of the two theories with regard to economic policies in developing countries. In particular, we critically examine the neoclassical and structural change model and provide closing remarks about the suggested role of the state in development policies.

To sum up, the aim of this paper is to examine the effectiveness of public government expenditures. We build upon recent findings in economic literature and analyze different government expenditures and their impact on economic performance in developing countries. Our motivation is being translated into the following research question: Can government expenditures promote economic development in developing countries?

The rest of this paper is organized as follows. Chapter 2 contains a literature review that presents the two schools of thought on the role of government in economic growth as well as previous empirical findings concerning the relationship between government expenditures and economic development. Chapter 3 illustrates our data and methodology. Chapter 4 presents our results and main findings. Chapter 5 contains policy recommendations and concluding remarks. Finally, Chapter 6 discusses limitations and possible extensions of this research paper.

2. Literature Review

To begin with, economic theorists have identified different sources of economic growth and development. In general, we can distinguish two distinctive schools of thought and economic lines of literature. On the on hand, there are neoclassical one sector models. On the other hand, there are two sector structural change models.

2.1 Theories of Economic Development

Neoclassical one sector growth models such as the Rostow (1960) model or the Harrod (1948) and Domar (1947) model focus on the importance of capital accumulation as prerequisite for economic growth. In their framework, increasing capital investment rates are the driving force for economic development (Ghatak 2003). Classical growth models build on a standard Cobb-Douglas Production Function and state that factor accumulation is considered to be a precondition for establishing higher outputs per worker. An accumulation of physical capital per worker is translated into a move along the production function and hence an increased output per worker. Such form of output growth can be characterized as “Extensive Growth”.

Although factor accumulation and investments are closely correlated with economic development, they are not the only condition for an economy to develop. Consequently, Solow (1956) extends the neoclassical growth theory and assumes that, without technological change, there will be diminishing marginal returns of capital. This corresponds to the idea that the same increase in capital stock has increasingly less impact on output growth. Therefore, Solow (1956) considers three distinct factors that influence economic development and output growth: these are increases in labor quantity and quality (represented by population growth and education), increases in capital (represented by savings and investments) as well as technological progress (Dang & Sui Pheng, 2015).

On the contrary to the neoclassical one sector growth models, economists later described the economic development process as structural change. Key aspect of these structural change models is the reallocation of labor and capital from the traditional sector (mostly represented by agriculture) to the modern sector that is characterized by a higher level of productivity (mostly represented by manufacturing).

Representatives of structural change models are the Lewis (1954) model and the two sector models by Diao, McMillan, & Rodrik, (2017) and Nelson & Pack (1999). In the latter case, Nelson & Pack (1999) assume two sectors, a craft sector and a modern sector. At the initial stage, all labor and capital are in the craft sector. Economic development and growth take place when labor and capital shift to the modern sector since the modern sector is characterized by a higher level of productivity.

As the two sector model of Nelson & Pack (1999) shows, structural change models distinguish themselves considerably from the neoclassical growth models. As stated above, classical growth models follow a single-dimension approach and emphasize the predominant role of capital accumulation for GDP growth. In comparison, structural change models follow a multi-dimension approach by emphasizing that capital accumulation, technological change, innovation and entrepreneurship are complementary variables that influence each other and output simultaneously. They emphasize that investments and capital accumulation are a necessary prerequisite, but that industrial development requires managerial learning, innovation and technological progress to shift factor inputs from low productive sectors to high productive and higher-value added activities (Nelson & Pack 1999). In contrast to the neo-classical capital accumulation approach, development in the structural change model is driven by technological innovation that is being represented by a shift in the Cobb-Douglas Production Function, as more output can be generated with the same amount of inputs. In this methodology, an increase in output per worker can be characterized as “Intensive Growth”.

After having described neoclassical and structural change growth theory, it becomes evident that both approaches differ considerably in their understanding of the role of the state in economic development. Whereas neoclassical growth theorists emphasize private capital investments and a more restrained role of the state, structural change theorists emphasize a more active role of the government and identify industrial policies as an important leverage to promote entrepreneurship, innovation and structural change. To sum up, neoclassical one sector models and two sector structural change models distinguish themselves among other things in their different comprehension of the role of the state in the economic and socio-political environment. Two categories of potential roles of the state in development will be presented in the following section. We will find that each of them can be more or less closely assigned to one of the above mentioned growth theories.

2.2 The Role of the State in Economic Development

In particular for developing countries, the exact scope and optimal degree of government intervention remains a controversial debate (Cimoli, Dosi, & Stiglitz 2009; Szirmai, Naudé, & Alcorta, 2013). In a nutshell: what role can or should the government play in the economic and socio-political development of developing countries? In general, economic literature distinguishes two categories of state regarding the economic development of countries and nations: classical states and developmental states.

On the one hand, classical states are characterized by the fact market liberalization, privatization and private investments are expected to promote entrepreneurship, technological innovation and economic development (North & Thomas 1973). The role of the classical states is to guarantee a functioning institutional framework, power and law enforcement, national defense, a stable macroeconomic environment as well as an adequate transportation and communication infrastructure (Weber 1922). To be more precise, the state’s role is limited to provide important public services such as education, infrastructure and a well-functioning institutional environment. At the same time, state interventions and excessive government size are considered to lead to inefficiencies and market distortions, therefore they ought to be reduced to a limited degree. Hence, the concept of classical states is referring closer to the neo-classical growth theory, represented by Solow (1956) or Harrod (1948) and Domar (1947). Since factor input accumulation is expected to be the primary source of development, classical states can be interlinked with the “accumulationists” perspective on economic development.

On the other hand, a developmental state is characterized by an active economic and industrial policy that tries to promote industrialization and economic development. As Chang (1999) points out “economic development requires a state which can create and regulate the economic and political relationships that can support sustained industrialization [sic]– or in short, a developmental state”. Therefore, developmental states distinguish themselves by state interventions and often aim to support domestic industries with the help of active industrial policies. These industrial policies can entail export subsidies, import substitutions as well as credit facilities. Therefore, developmental states are often characterized by active industrial policies that attempt to promote domestic industrialization and export-led economic growth. Compared to classical states, developmental states can be interlinked with the “assimilationists” perspective on economic development.1

In the last decades, both market liberalizations and privatization initiatives (classical state view) as well as state interventions and active industrial policies (developmental state view) have been used to foster and promote economic development in developing economies. In both cases, results have been manifold, both concepts have seen examples of success and failure in different countries.

For instance, in some emerging economies such as Chile and Ghana, market liberalizations and a lower degree of government intervention stimulated economic development. On the contrary, in other regions such as Africa and parts of Latin America, deregulation policies showed rather disappointing results and actually made a negative contribution to economic development (Szirmai 2015). The same conflicting results can be found for economic policies that relied on government interventions. On the one hand, South Korea in the 1960s and 1970s is a well-known example for a successful developmental state concept. In fact, the Korean government pursued active industrial policies to foster industrialization. It provided financial and administrative support for upcoming new industries (e.g. shipbuilding, automotive, electronics) and used import substitution and export subsidization to promote export-led economic growth. Governmental institutions played an important role in ‘picking winners’ and establishing the concept of infant industry promotion (Heo, Jeon, Kim, & Kim 2008; Wad 2009). This policy made a significant contribution to South Korea’s unprecedented success story and its transition from a developing country to one of the leading economic nations worldwide. On the other hand, government intervention failed in Indonesia, when active industrial policies were designated to promote the domestic aircraft and manufacturing industry in the 1970s (Chang 2010).

To sum up, and based on the above mentioned discussion, we raise the question whether government interventions or rather market liberalization policies are the more appropriate policy instrument to promote economic development. So far, a lot of empirical research has been done to examine the relationship between government intervention and economic development. Results are twofold. Whereas some economists emphasize the developmental power and advantages of active industrial policies, others warn of excessive government size that may lead to market distortions, inefficiencies and a misallocation of resources. In the following section, we will summarize the key findings of previous economic literature about government spending and its impact on economic development. Building upon these key findings, we will develop three hypotheses that will be examined in the main part of this paper.

2.3 Government Expenditures, Institutional Quality and Growth

To begin with, many researchers have examined the impact of overall government spending on economic development in a variety of countries. Results are double-folded. Barro & Lee (1994) find that economic development, measured as the growth rate of real GDP per capita, is negatively correlated to government size and the ratio of government spending. In addition to that, Afonso & Furceri (2010) examine the effect of government size and fiscal volatility on growth for a set of OECD and EU countries. Their overall results equally suggest that both indicators tend to hamper economic development in both country samples. Concretely, government’s total revenue as well as government’s total expenditures seem to impediment the real growth of GDP per capita for both OECD and EU countries. Moreover, Dar & AmirKhalkhali (2002) examine the role of government spending by explaining the differences in economic growth rates of 19 OECD countries over the 1971–1999 period using a random coefficients model. Their results show that “[…] on average, total factor productivity growth, as well as the productivity of capital, are weaker in countries where government size is larger”. Therefore, they conclude that greater government expenditures lead to policy-induced market distortions that may result in inefficiencies and crowding-out effects.2 According to them, these negative effects are actually expected to hamper private capital investments and technological innovation.

On the contrary, other studies find that government activities may have a positive impact on economic development. Ram (1986) analyzes a cross-sectional dataset of 115 countries from 1960 to 1980 and finds strong evidence that government spending has a positive effect on economic performance and growth. Furthermore, he concludes that the positive effect of government size on growth could be higher in low-income and developing countries. Ram’s findings find support in Romer (1989), Rubinson (1977) and Romer (1990) who equally emphasize the developmental power of government activities with regard to economic performance.

To sum up, it becomes obvious that empirical findings regarding government spending and its impact on development are contradictory. However, we acknowledge that previous studies indeed find evidence for the fact that the state can actually exert developmental power and foster growth. Our first hypothesis focuses on the above mentioned controversy between small and large government spending and its impact on economic development. Relying on Ram (1986) and others, we hypothesize that government expenditures are beneficial for development in developing countries.

Hypothesis 1: Government expenditures have a beneficial impact on economic development in developing countries

In addition to that, researchers find evidence that the efficiency of government expenditures and its impact on output growth is reliant on other components as well. In fact, the magnitude and significance of government spending may also depend on external factors, such as the governmental form or the institutional environment of an economy. For example, Guseh (1997) examines the relationship between government size and economic growth by taking the form of the political regime and the quality of economic and political institutions into consideration. He uses time-series data for 59 middle-income developing countries between 1960 and 1985. Guseh (1997) finds that government spending has adverse effects on growth in developing countries, but he emphasizes that these negative effects are even more substantial in non-democratic socialist regimes than in democratic and market-oriented societies. Apart from the economic and political regime, other studies also find that a country’s institutional quality impacts the effectiveness of government activities. Afonso & Jalles (2016) find a negative effect of government expenditures on development, but at the same time they show that institutional quality has a positive impact on the level of real GDP per capita. Thus, the effectiveness of government policy and the innovative capabilities of an economy are considerably interlinked with its institutional design (Acemoglu, Johnson, & Robinson 2001; Hall & Jones 1999).

Therefore, our second hypothesis focuses on the controversy between high quality and low quality institutional states and their potential impact on economic development. Considering the above mentioned empirical findings, we hypothesize that the potential positive effect of government expenditures on economic performance unfolds more considerably in developing economies with a well-functioning institutional regime.

Hypothesis 2: The beneficial impact of government expenditures on economic development unfolds more considerably in developing countries with higher institutional quality

In addition to the above mentioned discussion, some parts of the economic literature report an inverted u-shaped curve relationship between government spending and economic performance. This phenomenon describes the fact that government intervention is beneficial for economic development up to a certain threshold. As soon as government spending exceeds this threshold, it actually hampers growth (Barro 1990; Armey 1995; Rahn & Fox 1996). The reasoning behind this argumentation is that in countries with a larger share of government, the incentives for private sector productivity growth are smaller than in other economies with a respectively lower share of government spending (Folster & Henrekson 2001).

2.4 Sectoral Government Expenditures and Growth

In addition to the previous section, economic research has also focused on the relationship between government expenditures and economic development on the sectoral level. Sectoral government spending analyses disentangle the effect of overall government expenditures by decomposing them in its structural components. Hence, government spending and its impact on development is being analyzed on the sectoral level by separately investigating e.g. agriculture, defense, education, health, social security and transport and communication expenditures. Empirical findings for selected domains will be presented in the following section.

Agriculture expenditures

The agricultural sector often accounts for the largest share of the national economy in developing countries. Therefore, agriculture still plays a considerably important role in economic and social policies of these countries. Elias (1985) finds a positive relationship between governmental agriculture expenditures and output growth in Latin America. Simultaneously, Fan, Rao & Rao (2003) find that public agriculture expenditures were a vital aspect for the promotion of economic growth in Africa and Asia. In addition to that, Diakosavvas (1995) shows that agriculture expenditures directly influence the performance of the agricultural sector and therefore the imminent food supply of large parts of the population. Therefore, one can assume that agriculture expenditures and agricultural policies in general can directly influence the daily life of large parts of the population in developing economies.

Education expenditures

When it comes to human capital and education, many researchers including Bassanini & Scarpetta (2001), Cohen & Soto (2007) and de la Fuente & Doménech (2006) argue that there is a significant and positive relationship between human capital accumulation and economic development. For example, Hansson and Henrekson (1994) use a disaggregated analysis and find that government spending and transfers have a negative effect on development, whereas education expenditures induce a positive effect. Bose, Haque, & Osborn (2007) examine the growth effects of government expenditures for a panel of 30 developing countries over the 1970s and 1980s with a focus on disaggregated expenditures. The results of their analysis are twofold. On the one hand, they find that the share of government capital expenditures in GDP is positively and significantly correlated with economic growth, but current expenditures are insignificant. On the other hand, government investments in education and total expenditures in education are the only forms of disaggregated government expenditures that have a positive and significant impact on economic performance. For other forms of government spending, such as transport, communication and defense expenditures, this is not the case. These findings are supported by Blankenau (2005) who also finds that education spending is likely to increase growth.

Transport and communication expenditures

Investments in infrastructure, transport and communication facilities are a common instrument in developing countries to foster industrialization and promote economic development. Literature suggests that the economic impact of these investments is debatable, but some studies find a positive and significant relationship between infrastructure investments and development.

Although – as stated above – Bose, Haque, & Osborn (2007) do not find a positive relationship between public transport and communication investments and growth, other authors do observe one. Easterly & Rebelo (1993) use a cross-section dataset of 100 countries for the period 1970-1988. They find that “[…] the share of public investment in transport and communication is robustly correlated with [economic] growth […].” Their results are in line with Aschauer (1989) who equally states that there is a positive correlation between public investments in infrastructure capital and the level of output. Munnell (1990) emphasizes that government spending for capital and infrastructure is necessary to improve US infrastructure facilities. According to his findings, public infrastructure investments will raise the growth rate in capital per worker as well as overall labor productivity and GDP growth.

Health expenditures

For a long time, health has been considered as the result of increasing welfare and economic growth. But recently, attention has shifted and researchers also acknowledge that the relationship between health and economic development is not only demand driven, but that health can actually be a decisive determinant for positive income effects (van Zon & Muysken 2003). For example, Piabuo & Tieguhong (2017) use a comparative analysis to analyze the impact of health expenditures on growth in the ‘Economic Community For Central African States (CEMAC)’ and five other African countries. Their results show that health expenditures have a positive and significant effect on economic performance in both samples. Moreover, Fan, Rao & Rao (2003) state that government spending on healthcare was particularly effective in promoting economic growth in Africa. At the same time, all forms of government spending except health were insignificant for growth in Latin America. In addition to that, McDonald & Roberts (2002) find that health capital has a significant impact on economic growth rates, especially in developing countries. This is equally in line with the findings of Islam (1995).

However, these results are put into perspective by Webber (2002). He argues that reducing undernutrition would only make a modest contribution to economic development while increasing education and enrollment ratios have a positive and more significant effect. Therefore, according to Webber (2002), policies to increase economic development should favor investments in education over health.

To sum up, it remains debatable to what extent disaggregated sectoral government expenditures foster development. There is no clear indication about the positivity and significance of sectoral expenditures regarding economic performance. Anyhow, we assume that certain sectoral expenditures foster growth more than others, especially those two that have been identified as key prerequisites for development in both the neoclassical and the structural change growth models – notably investments in education and infrastructure. Therefore, our third and final hypothesis focuses on government expenditures on the sectoral level and their potential impact on economic development. We hypothesize that education and infrastructure expenditures are more beneficial for development than others, such as health or defense expenditures. In this regard, we assume that transport and communication expenditures are an appropriate proxy for infrastructure expenditures.


1 For a broader and more extensive discussion about accumulationists and assimilationists, see Nelson & Pack (1999)

2 Crowding out is defined as a situation where personal consumption of goods and services and investments by businesses are reduced due of increases in government spending and deficit financing that diminishes available financial resources and potentially raises overall interest rates

Excerpt out of 41 pages


The Role of the State in Economic Development. Do Government Expenditures Promote Growth in Developing Countries?
University of Groningen  (Faculty of Economics and Business)
Catalog Number
ISBN (eBook)
ISBN (Book)
government expenditures, institutional quality, economic development
Quote paper
David Schmengler (Author), 2018, The Role of the State in Economic Development. Do Government Expenditures Promote Growth in Developing Countries?, Munich, GRIN Verlag,


  • No comments yet.
Read the ebook
Title: The Role of the State in Economic Development. Do Government Expenditures Promote Growth in Developing Countries?

Upload papers

Your term paper / thesis:

- Publication as eBook and book
- High royalties for the sales
- Completely free - with ISBN
- It only takes five minutes
- Every paper finds readers

Publish now - it's free