The composition of public spending in Europe and long-term growth

In March 2000, as part of the Lisbon Agenda, the European Council outlined a broad set of economic policy measures designed to help raise the potential growth rate of the European Union. The contribution that public finances can make to the attainment of this strategic objective is twofold. First, the achievement of balanced budgets and improvements in the sustainability of public finances promote long-term economic growth, by helping to maintain a stable macroeconomic environment, which facilitates expectations formation and decision making by private agents. Second, for a given level of public surplus or deficit, factors such as the composition of revenues and expenses, efficiency in the use of public resources and even the specific size of general government may affect long-term growth, to the extent that they help improve the allocation of resources in the economy. This second channel through which fiscal policy may affect economic growth is the subject of this article. More specifically, budget headings such as infrastructure investment and spending on education, health and research and development tend, a priori, to increase the productive potential of the economy. Also, the greater the efficiency of government activity (i.e. the smaller the volume of resources needed to achieve the target level of provision of goods and services), the higher the contribution of fiscal policy to long-term growth will be. The rest of the article is organised as follows: the second section outlines the main features of the theoretical framework within which fiscal policy may affect long-term growth and discusses the difficulties involved in its empirical validation. The third section explains the main channels through which public spending may influence long-term growth from a macroeconomic viewpoint. The fourth section considers the role of the institutional environment in which the spending decisions of fiscal authorities are made and, finally, the conclusions are set out in the last section.