Copenhagen, May 24, 2017

The long-term effect of the sizeand the mix of public spending

on growth and inequality

http://www.oecd.org/eco/the-effect-of-the-size-and-mix-of-public-spending-on-

growth-and-inequality.htm

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Finansudvalget 2016-17FIU

Alm.del Bilag 117

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Key messages

2

Changes of public spending size, mix and effectiveness can have large

effects on growth and inequality

• Improving student performance yields large gains for all by raising skills.

• Higher public investment is associated with large growth gains and lifts “all boats” as it

raises average incomes without any adverse equity effects.

• Reducing the share of pension spending and of subsidies boosts growth. Lower pension

spending has no adverse effects on disposable income inequality, but lower subsidies

increase inequality.

• Spending more on family and child care benefits reduces inequality as they benefit

lower-income families more.

• Room for improvement is limited in Denmark.

Country-specific characteristics matter

• The design of education policy matters more than education spending.

• The growth gains from higher investment decline at a high level of the public capital

stock, though virtually all countries have room for additional spending.

• The effect of government size depends on government effectiveness.

3

1. Motivation and approach

Changes to the spending and tax mix have

gone in the wrong direction between

2007 and 2013

4

Source: OECD Public Finance Dataset, forthcoming.

AUT

BEL CHE

CZE

DEUDNK

ESP

EST

FIN FRA

GBR

GRC

HUN

IRL

ISL

ISR

ITA

JPN

KOR

LUX

NLD

NOR

POL

PRT

SVK

SVN

SWE

USA

-10

-8

-6

-4

-2

0

2

4

-10 -8 -6 -4 -2 0 2 4 6 8Change in share of personal income tax, social security contributions and corporate income tax

Change in education and public investment share

Higher productive spending and lower distortionary taxes

Lower productive spending and higher distortionary taxes

Design of public spending, growth and

inequality: the approach

5

Key issue: Raising long-term growth while addressing inequality

Empirical setup:

• Growth: Neoclassical convergence model

• Inequality: Estimation of the impact of the mix of spending along the

distribution of household income

• The overall effect of public finance on the distribution of disposable income is

the sum of the direct effect on disposable income and the indirect growth

effect.

6

2. Growth and inequality

effects can be large.

3. Room for improvement is

limited in Denmark

Illustrative long-term growth effects

of an increase in the education level

7

Note: In countries where the mean PISA score or average years of schooling are below the

average level of countries in the top half of the sample, educational attainment is assumed to

gradually converge to this level. The figure reports the effect after 45 years of a reform phased in

over 45 years.

0

5

10

15

20

25

30

Quantity of education (years of schooling) Quality of education (PISA)Per cent

Illustrative long-term GDP gains

from increasing public investment

8

Note: In countries where public investment to potential GDP is below the average ratio of

countries in the top half of the sample, public investment will converge to this average ratio. The

figure reports the effect after 45 years of a reform phased in over 10 years.

0

5

10

15

20

25

30

Public investmentPer cent

Illustrative long-term GDP gains from

decreasing pension spending

9

Note: In countries where spending to the potential GDP ratio on pensions is above the average

level of countries in the bottom half of the sample, spending will gradually decline to this level.

The figure reports the effect after 45 years of a reform phased in over 10 years.

0

5

10

15

20

25

30

Old age and survivors pensionsPer cent

Illustrative gains from decreasing

public subsidies

10

Note: In countries where subsidies to potential GDP are above the average ratio of that of

countries in the bottom half of the sample, subsidies will gradually decline to this ratio.

-10

0

10

20

30

40

Average effects Effects on the poor Effects on the rich

Per cent

Illustrative gains from raising family and

child benefits on disposable income

11

Note: In countries where family benefits to potential GDP is below the average ratio of that of

countries in the top half of the sample, family benefits will gradually converge to this average

ratio.

-10

0

10

20

30

40

Average effects Effects on the poor Effects on the rich

Per cent

12

2. d

3. Country-specific

characteristics matter

In advanced economies, the link between education

spending and student performance is weak

Luxembourg

SwitzerlandNorwayAustria

Singapore

United States

United Kingdom

Malta

Sweden

BelgiumIceland

Denmark

Finland NetherlandsCanada

Japan

Netherland

AustraliaGermany

IrelandFranceItaly

PortugalNew Zealand

Korea

SpainPoland

Israel

Estonia

Czech Rep.Latvia

Slovak Rep.

Russia

CroatiaLithuaniaHungary

Costa Rica

Chinese Taipei

Chile

Brazil

Turkey

Uruguay

Bulgaria

MexicoThailand

MontenegroColombia

Dominican Republic

PeruGeorgia

R² = 0,04

R² = 0,36

300

350

400

450

500

550

600

0 20 40 60 80 100 120 140 160 180 200

Sc

ien

ce

pe

rfo

rma

nc

e (

sc

ore

po

ints

)

Average spending per student from the age of 6 to 15 (in thousands USD, PPP)

The analysis provides no evidence of the growth effect of education spending.

14

-20

-15

-10

-5

0

5

10

0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2

Perception of government effectiveness

GDP gain of one spending point increase of public spending, in per cent

Finland, Sweden, Denmark, Norway

Government size and effectiveness

The adverse effect of government size on potential GDP decreases with government effectiveness

15

Government size and effectiveness

Size of government and citizens’ perception of their effectiveness, 2013

AUS

AUT

BEL

CAN

CHE

CZE

DEU

DNK

ESP

EST

FINFRA

GBR

GRC

HUN

IRL

ISLISR

ITA

JPN

KOR

LUX

NLD

NOR

NZLPOL

PRT

SVK

SVN

SWE

USA

30

35

40

45

50

55

0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2

Perception of government effectiveness

Size of government (underlying primary spending, % of potential GDP)

16

Estimates of decreasing returns to public

investment

The effect of public investment on potential GDP decreases with the level of capital stock

-15

-10

-5

0

5

10

15

20 40 60 80 100 120

Public capital stock, per cent of potential GDP

GDP gain of one spending point increase of public investment, in per cent

Japan

United States, Luxembourg, Iceland

17

Estimates of decreasing returns to public

investment

Most countries have room to increase the stock of public capital (2013 data)

18

More information

Fournier, J-M. and A Johansson (2016), “The effect of the size and mix of public spending on growth and inequality”, OECD Economics Department Working Papers, No. 1344.

Bloch et al. (2016), “Trends in public finance: Insights from a new dataset”, OECD Economics Department Working Papers, No. 1345.

Johansson, A. (2016), “Public finance, economic growth and inequality: A survey of the evidence”, OECD Economics Department Working Papers, No. 1346.

Fournier, J-M. (2016), “The positive effect of public investment on potential growth”, OECD Economics Department Working Papers, No. 1347.

Disclaimers:

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area.

Impact of different instruments on

growth and equity

19

Policy Growth EquityIncome of

the poorCountries with the most

room for growth gains

Decreasing the size of

government

Low to moderate

government

effectiveness + - +

BEL, CZE, FRA, GRC,

HUN, ITA, POL, PRT, SVNHigh government

effectivenessn.s. - -

Increasing government effectiveness + + + FRA, GRC, HUN, ITA, SVN

Increasing education outcomes + 0/+ + CHL, GRC, MEX, PRT, TUR

Increasing public investment (including R&D) + n.s. +BEL, DEU, GBR, IRL,

ISR, ITA, MEX, TUR

Reducing pension spending + n.s. +AUT, DEU, FIN, FRA, GRC,

ITA, JPN, POL, PRT, SVN

Increasing family benefits n.s. + + CHE, ESP, GRC, PRT

Decreasing public subsidies + - n.s. BEL, CHE

Note: + stands for a positively significant, – for a negatively significant and n.s. for non-significant effect.Source: Fournier and Johansson (2016), “The Effect of the Size and the Mix of Public Spending on Growth and Inequality”,OECD Economics Department Working Papers, No. 1344.