Relative price changes and the growth of the public sector

Abstract

Policy recommendations to reduce the growth of public spending are haunted by the inevitability of two factors. First Wagner's law, the hypothesis that with economic development an increasing share of GDP is devoted to public spending, and secondly, Baumol's effect, that as economies develop, public sector prices rise faster than prices in the general economy. Neither of these hypotheses has adequately been tested, largely because consistent public sector prices are unavailable for most developing countries. This paper proposes that the unavailability of consistent public sector price deflators can be overcome by econometrically estimating these series with the help of data on public spending and the widely available GDP deflator. This paper presents an anaylsis of time series data from 71 countries. The paper finds that although data support Wagner's law in the majority of developing countries, the degree of support varies with the level of development. Similarly, the average income elasticity of public spending drops from the low income economies through to the industrial economies. In the long run, the size of the public sector tapers off as the economies develop.Inequality,Environmental Economics&Policies,Economic Theory&Research,Achieving Shared Growth,National Governance