Government expenditure, external and domestic public debt, and economic growth

• Author: Amélie Barbier‐Gauchard,Cuong Le Van,Duc‐Anh Le,Phu Nguyen‐Van
• DOI: http://doi.org/10.1111/jpet.12324
• Published date: 01 February 2019
• Date: 01 February 2019

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116 © 2018 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jpet Journal of Public Economic Theory. 2019;21:116–134.

Received: 10 March 2016Accepted: 18May2018

DOI: 10.1111/jpet.12324

ARTICLE

Government expenditure, external and domestic

public debt, and economic growth

Cuong Le Van1PhuNguyen-Van2Amélie Barbier-Gauchard3

Duc-Anh Le3

1IPAG,CNRS, PSE, APD, TIMAS, France

2BETA,CNRS, INRA and Université de Stras-

bourg& TIMAS, Thang Long University, Vietnam

3BETA,CNRS, INRA and Université de Stras-

bourg,Strasbourg, France

Correspondence

PhuNguyen-Van,Université de Strasbourg, 61

avenuede la Forêt Noire, F-67000 Strasbourg,

France.

Email:nguyen-van@unistra.fr

Fundinginformation

CuongLe Van is partially funded by Vietnam

NationalFoundation for Science and Technology

Development(NAFOSTED) under grant number

502.01-2017.12.

This paper analyzes the relationship between government expendi-

ture, tax on returns to assets, public debt, and growth in an endoge-

nous growth model. Public debt is composed of two components,

domestic debt and external debt. We show conditions for existence,

uniqueness, and multiplicity of the steady states. More precisely,

existenceof steady state requires a sufficiently high productivity and

a sufficiently low tax on returns to assets. Wealso provide the effects

of an increase in the tax rate on returns to assets on the steady state.

In particular, the relation between public spending and the tax rate

has a bell shape. Domestic debt unambiguously increases with tax

whereas external debt displays an inverted U-shaped curve. A high

tax rate leads to a reallocation of public debt in favor of domes-

tic debt (to the detriment of external debt). The effect of taxation

on consumption (and production) also displays a nonlinear pattern

when the output elasticity of capital is lower than unity (the effect

is monotonously increasing if this elasticity is unity). We also derive

the conditions under which a tax increase can boost or reduce the

balanced growth rate.

1INTRODUCTION

The impact of public investment on economic growth and the financing modalities are two major questions discussed

by academics and have been reflected in public debate. This is particularly true not only for the OECD countries but

also for emerging countries in recent years. Our paper contributes to this discussion, based on the existing literature

on these issues. Regarding public investment, since the seminal works of Aschauer (1989) and Barro (1990), a very

abundant literature has developed to assess its impact on growth.1In this debate, the nature of public expenditure

plays a major role (productive or unproductive,capital, education or health, infrastructure, social services, etc.).

The issue of financing public investment has long divided economists. This question has emerged as a crucial fac-

tor to consider when assessing the macroeconomic impact of public investment. Omitting the financing modalities of

1See, for instance, Devarajan, Swaroop, and Zou (1996), Mundle (1999), Glomm and Ravikumar (1997), Gupta, Clements, Baldacci, and Mulas-Granados

(2005),or, more recently, Felice (2016).

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public investment will bias the analysis. We must also consider the budget constraint of public decision makers. The

final impact on activity differs significantly depending on whether public investment is financed by public debt (in this

case, the cost of financing is borne by future generations) or bytaxation (in this situation, the financial resources of the

economic agents are immediately and directly affected). A very abundant literature now existson this issue.

Regarding the impact of taxeson growth, there are many works that differ in the type of taxes considered and in the

methodology used.2The debate focuses on the impact on growth of distorting taxation (taxes on income and profits,

social security contributions, taxes on assets, etc.) and nondistorting taxes (VAT, etc.), and on the different effects of

personal income tax rate versus corporateincome tax. No consensus seems to emerge from this work.

Concerning the impact of public debt, we can also note a great diversity of works. These studies focuses on the rele-

vance of this particular kind of resources to finance public investment.3Mostof the existing studies on the relationship

between public debt and growth consider public debt as a domestic debt (see, e.g., Bohn, 1998; Checherita & Rother,

2010; Greiner, 2007). Nevertheless, in such context, public debt composition matters as highlighted bythe seminal

paper of Diamond (2005). In the same vein, Turnovsky (1996), Calvo (1997), Calvo and Reinhart (2002), or Drazen

(2000) focused on public debt management, risk default, and credibility in economic policy. More recently,Dell'Erba,

Hausmann, and Panizza (2013) studied the relationship between sovereign spreads and the interactionbetween debt

composition and debt levels in advanced and emerging market countries (see also Panizza & Presbitero, 2014). Fer-

reirade Mendonça and Rangel Machado (2014) offered a contribution to the literature concerning the management of

the public debt in emerging economies. A novelty in this article is the introduction of a fiscal credibility index based on

the market'sexpectations in regard to the public debt–GDP ratio. Clements, Bhattacharya, and Nguyen (2003) investi-

gated the relationship between external debt, public investment, and growth in low-income countries and stated that

high levels of public debt can depress economic growth in low-income countries, and threshold levelsof external debt

was estimated around 50% of GDP.In Futagami, Iwaisako, and Ohdoi (2008), government has a target level of govern-

ment debt relative to the size of the economy.They showed that two steady states can emerge. One is associated with

high growth and the other with low growth. It is also shown that whether the governmentuses income taxes or govern-

ment bonds makesthe results differ significantly. According to Ejigayehu (2013), Zaman and Arslan (2014), and Soydan

and Bedir (2015), the empirical results generally reveal that the accumulation of external debt is associated with an

increase in economic growth up to an optimal level, and an additional increase of external indebtedness beyond the

level inversely contributes to the economy.In other words, there exists a threshold above which a too high level of

external debt has a negativeeffect on growth.

Recently,several developing and emerging countries have adopted aggressive policies aimed at substituting exter-

nal public debt with domestically issued debt (Panizza, 2008; Presbitero, 2012). Nevertheless,external debt continues

to play an important role in financing public debt in these countries. As underlined by Panizza(2008) describing recent

trends in the composition of public debt in developing countries, public debt corresponded to around 64% of GDP in

2005for all developing countries (40% in external debt and 23% in domestic debt). For East Asia and Pacific (EAP) coun-

tries, total public debt corresponded to 50% of GDP in 2005 (35% in externaldebt and 15% in domestic debt). Although

manyexisting studies assess the impact of the financing modalities of public investment, few of them consider different

modalities simultaneously.Our paper proposes to fill this gap by analyzing the impact on growth of public investment

and its financing instruments (external public debt, domestic public debt, and taxes). We focus on the government's

trade-off in terms of these financing instruments. We are interested in the impact of this trade-off on the economic

performance of a small economy in a dynamic perspective.

In this paper,we consider a neoclassical endogenous growth model and investigate the interaction between public

investment, tax, public debt, and growth. In order to isolate the role of taxes, we assume that tax on returns to assets

is the only kind of tax in the economy. The originality of this paper resides in the considerationof two kinds of public

2See, for example, Futagami,Morita, and Shibata (1993), Mullen and Williams (1994), Kneller, Bleaney, and Gemmell (1999), or K. Lee, Pesaran, and Smith

(1997).

3See notably Greiner (2007), Reinhart and Rogoff (2010), Checherita and Rother (2010), or, more recently,Herndon, Ash, and Pollin (2014) or Bom and

Ligthart(2014).