Public Choice (2007) 131:157175

DOI 10.1007/s11127-006-9111-3
ORIGINAL ARTICLE

The growth effects of fiscal policy in Greece 19602000

Konstantinos Angelopoulos Apostolis Philippopoulos

Received: 17 August 2005 / Accepted: 25 September 2006


C Springer Science + Business Media B.V. 2006

Abstract This empirical paper uses annual data for Greece 19602000 to study the link
between fiscal policy and economic growth. Our regression analysis implies that, although
a smaller public sector can be good for growth, it is necessary to look beyond size; the
composition and quality/efficiency of the public sector are equally important. The policy
lesson is that a smaller government share in GDP, a reallocation of funds away from the wage
bill to public investment, and an improvement in government quality/efficiency can become
engines of long-term growth.
Keywords Fiscal policy . Economic growth
JEL Classification: E6, O5
1 Introduction
The role of government, and in particular its fiscal policy, as determinant of economic growth
has received a lot of attention in the empirical literature. The evidence of the growth effects
of government expenditure and taxation has so far been mixed.1 This is consistent with the
predictions of the endogenous growth literature: government intervention may require higher
taxes, distort incentives, etc, but it can also protect property rights, address externalities, etc.
Thus, the relation between growth and fiscal variables need not be monotonic.2
1 See

e.g. Levine and Renelt (1992), Tanzi and Zee (1997), Folster and Henrekson (2001), Gemmel and
Kneller (2001), Mueller (2003, Chapter 22) and Barro and Sala-i-Martin (2004, Chapter 12).

2A

popular conceptual framework has been provided by Barro (1990).

K. Angelopoulos
Athens University of Economics and Business, and University of Stirling
A. Philippopoulos ()
Department of Economics, Athens University of Economics and Business, and CESifo, 76 Patission
Street, Athens 10434, Greece
e-mail: aphil@aueb.gr
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This empirical paper uses annual data for Greece to study the link between fiscal policy
and economic growth for the years 19602000 (our results remain practically the same if we
omit the 19972000 observations that have been recently revised by Eurostat). Following
most EU policy reports, we focus on the growth effects of the size, composition and quality
of the public sector.3 To do so, and since this is a time-series study, we use a small selective
number of time-varying growth determinants (fiscal policy measures and standard regime
dummies only).
The main results of our regression analysis are as follows. First, when we follow common
practice by using the government consumption share in GDP as a measure of the overall
size of the public sector, there is evidence that larger sizes hurt growth. Specifically, a rise in
the rate of change of government consumption share in GDP by one standard deviation (or
7.655%) decreases GDP growth by 1.38%. On the other hand, alternative measures of the
overall size, like total government expenditure or total tax revenue, both as a percentage of
GDP, are not found to be significant.
Second, when we use disaggregated fiscal policy data, a general message is that wages
and salaries in the public sector as a share of GDP are bad for growth. For instance, over
19721998, a rise in the growth rate of expenditure on wages and salaries by one standard
deviation (or 9.7%) reduces GDP growth by 1.72%. There is also evidence (although less
robust) that public investment as a share of GDP is good for growth, and transfers as a share
of GDP are bad for growth. On the other hand, constructed effective tax rates on various
sources of income do not seem to matter to growth.
Third, we construct a simple proxy for the quality of public infrastructure by using an
intuitive index with a sufficiently long time-series dimension, also used by Tanzi and Davoodi
(1998). Our regressions show that only in those years in which our measure of government
quality deteriorates relative to the previous year, a larger government size is bad for growth.
By contrast, when our measure of quality improves relative to the previous year, the growth
effect of government size is insignificant. It is the significantly negative effects that dominate
over time; this is why on average larger sizes are found to hurt growth (see the first result
above). Thus, what really matters to growth is the size-efficiency nexus, not size per se.
It is worth pointing out that the introduction of the above quality index improves the fit of
our regressions impressively. The growth in the share of government in GDP, when allowing
for a non-linear Laffer curve-type effect, can explain along with some simple political
dummies around 80% of the variation of the growth rate in the Greek economy over the
last forty years.
These findings imply some policy lessons. Other things equal, a reduction in government
consumption can become an engine of growth. But, it is necessary to look beyond size:
the composition and efficiency of the public sector are also important. In particular, a fiscal
consolidation can become especially expansionary if it takes the form of cuts in expenditure
on wages and salaries in the public sector. A reallocation of funds into public investment
could further contribute to growth. Concerning efficiency or quality, it is striking that in years
of improved government quality or efficiency, increases in an already over-sized public sector
have not hurt growth.
Our paper provides a relatively rich study of the Greek case. It also studies not only the
growth effects of the size and composition of the public sector, but also its quality. As far as

3 See

e.g. the special issue of the European Economy, no 3/2004, on Public Finances in EMU, part IV. See
also Tanzi and Schuknecht (2000).
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we know, there are no papers that study how public sector quality shapes the growth effect
of size.
The rest of the paper is as follows. Section 2 reviews the literature. Section 3 describes the
data and their time-series properties. In section 4, we test how the government size affects
growth. In Section 5, we analyze the effects of disaggregated fiscal-tax policies. Section 6
examines how the growth effects of size depend on the quality of government. Conclusions
and extensions are in Section 7.

2 Related literature and econometric problems

Empirical studies of growth have primarily focused on cross-country differences in long-time
period averages. In these cross-section and panel studies, there is some general indication
that the overall size of the public sector (see below how this size is measured) is negatively
associated with economic growth (see e.g. Barro & Sala-i-Martin, 2004; Folster & Henrekson,
2001).
But this negative association is statistically fragile and sensitive to model specification (see
e.g. Levine & Renelt, 1992; Tanzi & Zee, 1997). In their widely cited critique, Levine and
Renelt (1992, p. 951) have emphasized two reasons for non-robustness: (i) The overall size
of government cannot capture the different implications of different government activities.
Hence, several authors use disaggregated data to investigate the growth effects of specific
categories of public expenditure and taxation (see e.g. Kneller, Bleaney, & Gemmel, 1999).
(ii) Ignoring government efficiency may yield inaccurate measures of the actual delivery of
public services. Hence, Angelopoulos, Philippopoulos, and Tsionas (2006) have constructed
an indicator of public sector efficiency and have provided evidence that there is a non-linear
effect of government size, in the sense that efficient and inefficient governments are
situated on different sides of a Laffer curve in economic growth.
An obvious shortcoming of cross-section and panel studies is that they rely on the assumption of common coefficients across countries although different countries may have different
structures. This naturally leads to time-series studies of single countries.4 But time-series
studies are still liable to the criticisms of Levine and Renelt (1992) discussed above. In addition, they may suffer from two well-known problems: (a) If the series are non-stationary,
the regressions might be spurious. (b) The effect of government size might be biased due to
endogeneity if higher government spending is triggered by negative income shocks.
Our paper uses annual data for the period 19602000 to study the growth effects of fiscal
policy in Greece.5 In doing so, we will try to deal with all the above problems. Namely, we will
first pay attention to the time-series properties of the data to avoid the spurious regression
problem and to investigate for possible breaks or regime switches; second, we will test
for exogeneity of government size; third, we will examine whether different categories of
government expenditures and taxes have different implications for growth; fourth, we will

4 Time-series studies of single countries include Grossman (1988) who has estimated a non-linear effect of
the size of government on economic growth by using annual data for the US over 19291982; Peden and
Bradley (1989) who have used annual US data for the post-war period and report that increases in the scale of
government lead to a decrease in the growth rate; Ram (1986) who reports time-series regressions for many
countries by using annual data over 19601980 and finds that in most cases a higher share of government in
the GDP is associated with an increase in growth.
5 Hatzinikolaou (1997a, b) has also used annual Greek data over 19601993 and has found that an increase in
the growth of government expenditure reduces savings.

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examine whether the data reveal a non-monotonic growth effect of fiscal policy depending
on the mix between government size and government quality.

3 Data, integrability and breaks

This section introduces the raw data and looks at their statistical properties. We start with
data sources.
3.1 Data sources and graphs
There are annual data for various types of government expenditures and taxes for Greece,
which are available for different time intervals over 19602000. Our main data sources are the
Penn World Tables (PWT), version 6.1 (see Heston, Summers, & Aten, 2002), and the World
Development Indicators (WDI) dataset. To construct the economys growth rate (denoted as
growth in the regressions), we use real GDP per capita in constant prices (we use the PWT
measure of GDP per capita; there are no differences if we use the WDI measure instead).
The size of government is usually measured by government spending, tax revenues and
the budget balance, all expressed as shares of GDP (see e.g. Tanzi & Zee, 1997; Persson &
Tabellini, 2003). In our study, again following usual practice, by government spending we
mean the share of government consumption in GDP (denoted as govshare and being available
from PWT)6 and the ratio of total government expenditures over GDP (denoted as govexp
and being available from WDI).7
The evolution of these two measures of government spending is shown in Figure 1. As can
be seen, govexp is always larger than govshare, despite the fact that the former refers to the
central government and the latter to the general government. Their difference is primarily due
to interest payments and transfer payments, which are not calculated in GDP and thus are not
included in govshare. Also, notice that the govexp series is more volatile than the govshare
series. One can detect two breaks in govshare, a rise around 1974 and a fall around 1994.
The govexp series, on the other hand, reveals two big breaks, a sharp rise around 1980 and
an abrupt fall around 1991 (this fall is due not only to an actual decrease in some categories
of government spending, like transfers, but also to changes in accounting definitions as the
Greek governments started transferring central government deficits to public enterprises).
Concerning disaggregated government expenditure, and following most of the related literature,8 we use data from WDI coming from the Government Financial Statistics (GFS) Yearbook, for four types of central government expenditure as a share of GDP over 19721998:
government capital expenditure as a share of GDP (denoted as gcap), government goods and
services expenditure as a share of GDP (denoted as ggs), government wages and salaries expenditure as a share of GDP (denoted as gws), and government subsidies and other transfers
6 This

variable (govshare) refers to the general government and it comprises government spending on goods
and services that are included in GDP, except for fixed public investment (the latter is included in the PWT in
the investment share in GDP).

7 This

variable (govexp) includes all expenditures of the central government (thus, it includes capital expenditure, transfers, and interest payments on public debt on the part of the central government). Note that measures
of central and general governments may differ substantially (see also below).

8 Most of cross-country studies of the growth effects of the composition of government expenditure (see e.g.
Kneller et al., 1999; Gemmel & Kneller, 2001, for a review paper) have used the GFS dataset. This set provides
an explicit categorization of government expenditure both by type and by function (here we do not use the by
function decomposition because such data are missing for many years in Greece).

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Fig. 1 Government spending

as a share of GDP (denoted as gst).9 These four components are plotted in Figure 2A. The
evolution of gst is particularly striking: a tremendous rise in subsidies and other transfers
occurred in the late 70s that continued during the whole decade of the 80s and was reversed
in the early 1990s. At the same time (namely, early 1990s), there is also a clear fall in ggs
and gws.
In our regressions, we will also use the above four components as shares of total government expenditure: namely, capital expenditure as a share of govexp (denoted as gcapexp),
goods and services expenditure as a share of govexp (denoted as ggsexp), wages and salaries
expenditure as a share of govexp (denoted as gwsexp), and subsidies and other transfers as a
share of govexp (denoted as gstexp).10
Data on some categories of government expenditure can be also obtained from the OECD
Economic Outlook Database. The latter provides the share of government investment in
GDP (we denote it as ginv), the share of government wage consumption in GDP (we denote
it as gwag) and the share of government transfer payments in GDP (we denote it as gtran
and is obtained by summing the Economic Outlook variables social benefits paid by the
government, capital transfers and transactions and subsidies). Although this dataset
provides a less explicit categorization of government expenditure than the GFS (this is why it
is less popular), it has the advantage of being available over a longer time-period, 19602000.
As can be seen in Figure 2B, the motion of ginv, gwag and gtran is similar to that of gcap,
gws and gst in Figure 2A, at least for the time interval that both series are available.11
The WDI dataset also provides GFS data on total tax revenues of the central government
over GDP, denoted as trev in the regressions, and the overall budget balance as a share of GDP,
denoted as budget, both over 19721998. In addition, we will use effective tax rates on labor
9 Wages

and salaries are a subcomponent of goods and services.

10 WDI

also reports data on interest payments. However, since data are not available for all time periods, we
will not use this variable. We report that using interest payments for the yeas available does not change our
results.
11 Note that variables in the two datasets are similar but do not measure exactly the same things. Hence the
small differences illustrated in Figure 2B.

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Fig. 2 (A) Expenditure by type. (B) Components of expenditure

income (denoted as teflab), capital income (denoted as tefcap) and consumption (denoted
as tefcon), over 19702000, obtained from Martinez-Mongay (2000).12 It is recognized that
series that have to do with tax revenues are problematic measures of government size mainly
12 The original data series in Martinez-Mongay (2000) are CITR for the effective tax rate on consumption,
LETR for the effective tax rate on labour income and KETN for the effective tax rate on capital income. The
general idea behind effective tax rates is to compare the collected tax revenue to the associated tax base.

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Fig. 3 Tax revenue and effective tax rates

because of tax evasion (see e.g. Tanzi & Zee, 1997; Folster & Henrekson, 2001). The same
applies to the government budget since it includes tax revenues. Keeping these reservations
in mind, Figure 3 plots the tax revenue-to-GDP ratio and the three effective tax rates. Up to
1990, trev was higher than the effective tax rates, but after 1990 the situation has clearly been
reversed.
Our reading of Figure 3 is as follows. The recent increase of effective tax rates, combined
with the concurrent decrease in tax revenues as a share of GDP, implies smaller effective tax
bases in the 1990s (i.e. the denominator in the calculation of effective tax rates is smaller).
At the same time, there is international evidence that statutory tax bases have not been
narrowed during the nineties (see Devereux, Griffith, & Klemm, 2002). Therefore, in Greece,
the 1990s is probably associated with increased tax avoidance and/or tax evasion.
3.2 Integrability tests and structural breaks
Before proceeding to estimation, it is necessary to test for the order of integration of timeseries (when we do not have variables of the same order of integration, regressions are
unbalanced). As a first step, we use the standard augmented Dickey-Fuller (ADF) test for
unit roots. The test statistics from ADF tests (when a constant, a time trend and one lag
are included) are reported in Table 1 together with the critical values at 1%, 5% and 10%
significance levels. The ADF statistic for growth rejects the null of a unit root at the 10%
level, but the null cannot be rejected for the fiscal variables. When we use the growth rates
of fiscal variables (the growth rate of a variable is denoted by adding the symbol before it),
we find that most ADF test statistics reject the unit root hypothesis (at the 5% or 10% levels),
except for ggsexp, gstexp, and gst.
As is known, Dickey-Fuller tests can favor the null of unit roots when there are structural
breaks. Therefore, we also perform integrability tests by using the Zivot-Andrews (ZA) test
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Table 1 Unit root tests (augmented Dickey-Fuller and Zivot-Andrews)

Variable

Period for
which
available

ADF
test
statistic

1%
critical
value

5%
critical
value

10%
critical
value

Zivot-Andrews
(minimum DF
statistic)

GDP
growth
govshare
govshare
exp
exp
trev
trev
budget
budget
gcapexp
gcapexp
gcap
gcap
ggsexp
ggsexp
ggs
ggs
gstexp
gstexp
gst
gst
gwsexp
gwsexp
gws
gws
teflab
teflab
tefcap
tefcap
tefcon
tefcon
ginv
ginv
gwag
gwagp
gtran
gtran
govqual
govqual

19602000
19612000
19602000
19612000
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19721998
19731998
19712000
19702000
19702000
19712000
19702000
19712000
19602000
19612000
19602000
19612000
19602000
19612000
19602000
19612000

1.730
3.363
0.915
4.453
1.713
4.337
1.738
3.376
2.016
4.624
1.327
4.240
2.935
5.304
1.814
3.021
2.762
3.662
1.449
2.959
1.436
2.756
0.644
4.340
2.537
3.516
1.995
4.192
1.639
4.604
3.332
4.504
2.418
4.479
2.065
4.956
1.892
4.142
1.767
4.983

4.251
4.260
4.251
4.260
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.380
4.343
4.352
4.343
4.352
4.343
4.352
4.251
4.260
4.251
4.260
4.251
4.260
4.251
4.260

3.544
3.548
3.544
3.548
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.600
3.584
3.588
3.584
3.588
3.584
3.588
3.544
3.548
3.544
3.548
3.544
3.548
3.544
3.548

3.206
3.209
3.206
3.209
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.240
3.230
3.233
3.230
3.233
3.230
3.233
3.206
3.209
3.206
3.209
3.206
3.209
3.206
3.209

2.941 (1969)
7.709 (1974)
3.297 (1989)
6.911 (1994)
6.111 (1991)
6.183 (1991)
4.616 (1991)
7.340 (1991)
5.048 (1989)
6.650 (1980)
4.832 (1992)
6.469 (1991)
4.650 (1991)
5.511 (1987)
6.967 (1980)
4.903 (1983)
3.974 (1991)
5.289 (1991)
5.671 (1980)
6.010 (1982)
3.837 (1991)
6.382 (1983)
4.402 (1978)
5.004 (1983)
3.536 (1991)
6.305 (1991)
4.830 (1988)
9.189 (1985)
5.025 (1993)
5.884 (1988)
4.570 (1984)
5.243 (1987)
3.275 (1978)
6.404 (1980)
3.545 (1981)
8.963 (1973)
3.726 (1981)
6.735 (1982)
4.648 (1972)
8.047 (1967)

Notes. 1. ADF statistics for the variable X t are obtained from OLS estimation of the following autoregression X t = 0 + 1 t + 2 X t1 + 3 X t1 + u t . 2. The ZA test statistic
reported is the minimum Dickey-Fuller statistic calculated across all possible breaks in the
data, when both a break in the intercept and the time trend is allowed for. The year in parenthesis denotes the year when this minimum DF statistic is obtained. The 1% critical value
is 5.57 and the 5% critical value 5.08

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that allows for an endogenous break in both the intercept and the time trend.13 Apart from
statistical reasons, an advantage of the ZA test is that it can endogenously detect regime
switches. As can be seen in Table 1, the most important difference from the ADF tests is in
the series for total government expenditures and its components. Big breaks for these series
are evident as in the graphs discussed above. In particular, govexp and gst, turn out to be
I(0) once a break is allowed in 1991 and 1983 respectively, while ggsexp and gstexp turn out
to be I(0) once a break is allowed in 1980.14 The rest of the variables follow, more or less,
the pattern indicated by the ADF tests: namely, the levels of fiscal variables cannot reject the
null of a unit root, whereas their growth rates clearly reject the null at the 5% or even at the
1% level.
These statistical properties of the data will be taken into account in the regression analysis
below by, firstly, using the rates of change in the level of fiscal variables (rather than the level
itself)15 and, secondly, introducing appropriate dummies to capture the regime switches
suggested by the plots and confirmed by the ZA tests.16
Specifically, we will allow for four regimes: First, the early period 19601973, which
was an autocratic regime both politically and economically, especially the period of the
military junta 19671973. Second, the period 19741979, which is the beginning of the
democratic era without serious public finance problems. Third, the period 19801993, which
is a period of high spending and heavy public borrowing (in addition, all the breaks in
the public finance measures are taking place during this period). Finally, the Maastricht
Treaty period, 1994-onwards, during which the Greek governments started taking measures
to stabilize the macro-economy. Therefore, in addition to an intercept for the whole period,
we will also use a dummy for 19601973 (denoted as d(196073)), a dummy for 19801993
(denoted as d(198093)), and a dummy for 19942000 (denoted d(19942000)). Moreover,
in addition to a time trend for the whole period, we will use a time trend for 19601973 (this
is because the ZA tests in Table 1 indicated the presence of a structural break in the growth
rate of GDP at around 1973, in both the intercept and the trend).
These breaks are consistent with previous studies (see e.g. Alogoskoufis, 1995;
Makrydakis, Tzavalis, & Balfoussias, 1999; Lockwood, Philippopoulos, & Tzavalis, 2001;
Hondroyiannis & Papapetrou, 2001). In particular, Alogoskoufis (1995) describes a regime
switch in economic growth that took place at about 1974, the year of the restoration of democracy. This has been confirmed by our ZA test. Regarding the fiscal expenditure variables,
a structural break is usually argued to have occurred at around 1980, when the outgoing
conservatives and mainly the incoming socialists increased spending and deficits. This break

13 We use the routine written by Baum (2004). The ZA test can endogenously determine possible breaks in
the data mimicking unit roots. In particular, the ZA test rejects the null of non-stationarity when the minimum
value of the Dickey-Fuller statistic, calculated across all possible breaks in the data, is less than the critical
value of the test.
14 The ZA test for ggsexp cannot reject the null of a unit root at the 5% level. However, since the ZA statistic
is very close to the critical value, we will treat ggsexp as an I(0) variable. We report that including ggsexp
in our regressions (see Table 3) does not change our results.
15 Using the rates of change of fiscal-tax variables to assess the impact of the size of government on the GDP
growth rate is common in the empirical literature (see e.g. Tanzi & Zee, 1997, p. 188; see also the studies for
the USA mentioned above). Hatzinikolaou (1997a, b) is also using the growth rate of government expenditures
over GDP to study the implications of the size of government for the saving rate in the Greek economy.
16 Note

especially the cases of govexp, ggsexp and gstexp. As said, govexp, ggsexp and gstexp are found to
be I(0) by the ZA tests and can therefore be used in levels instead of growth rates. We present results using
govexp, ggsexp and gstexp so that our estimates can be comparable for all fiscal measures, but we report
that our qualitative results do not change if we use the levels instead.
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has been again picked up by the ZA test. Another structural break is believed to have taken
place around 1993, after the Maastricht Treaty. Again the ZA test has picked up a break in
the growth of the share of government in GDP at this time.

4 The growth effect of the size of public sector

This section runs least square regressions to examine the effects of aggregate measures of
government size on economic growth. Results are presented in Table 2.
4.1 The share of government as a measure of government size
We start by using the growth rate of the share of government in GDP (denoted as govshare)
as a measure of government size. Results are presented in columns 1, 2 and 3 of Table 2.
We start in column 1 by just including a dummy and a time trend, both for the early period
19601973 (in addition to an intercept and a time trend covering the full period). Recall
that these breaks have been picked up by the ZA test in the growth series. As can be seen,
govshare exerts a significantly negatively effect on growth, indicating that fiscal spending
in Greece has been growing too much, at least with respect to macroeconomic growth. The
quantitative effect is substantial too. An increase in the growth rate of govshare by one
standard deviation, or 7.655%, decreases growth by 1.38%.
The d(19601973) dummy is positive and significant, implying higher growth in the early
post-war period. This can simply be the result of convergence effects, since output in 1974
was much higher than in 1960. But it can also mean that certain features of the democratic
regime in the post-1974 era have not been favorable to macroeconomic performance (see also
the next section and the discussion in Alogoskoufis, 1995). Also, note that the time trends
are both insignificant. Finally, notice that this simple regression has a R2 of about 62%. Thus,
the growth rate of the share of government in GDP, together with a simple regime dummy,
can explain around 62% of the variation of the growth rate in Greece over the time period
19602000. Fiscal policy obviously matters to growth.
In column 2 of Table 2, we introduce the dummies for the high spending period, 1980
1993, and the Maastricht Treaty period, 19942000. Thus, now the effect of the regime
dummies has to be interpreted with respect to the omitted time period 19741979, which
is effectively picked up by the constant term. The effect of govshare is as before, and the
significant dummies are now d(19601973) and d(19801993). In other words, the autocratic
period is still associated with higher growth, while the period 19801993 is associated with
lower growth. The Maastricht Treaty dummy is not significant, as is also the case with the two
time trends. Since the time trends are not significant, we choose to drop them. The new results
are reported in column 3. This regression (column 3, Table 2) will serve as a benchmark. In
what follows, we will build on this.
4.2 Misspecification tests
A number of specification tests is undertaken.17 Results are presented in Table 2 below the
estimates. First, we test for serial correlation. The Durbin-Watson test for first-order serial
17 Apart from the tests discussed in this section, we have also tested whether GDP is co-integrated with govshare,
govexp or trev, using the Engle-Granger procedure, but the data do not support a long-run relationship between
GDP and fiscal variables.

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(2.95)

0.052 (1.94)

0.00002 (0.04)
0.0007 (0.38)
0.012 (0.62)
62.19%
d(5,40) = 1.76 du 1.79
X 2 (1) = 0.310 (0.577)
X 2 (2) = 0.489 (0.783)
t = 0.07 (0.946)
F(3,32) = 3.23 (0.035)
40

(3.18)

0.069 (2.13)
0.046 (2.43)
0.050 (1.49)
0.001 (128)
0.001 (0.49)
0.004 (0.16)
69.12%
d(7,40) = 2.19 du 1.79
X 2 (1) = 0.606 (0.436)
X 2 (2) = 2.214 (0.330)
t = 0.03 (0.976)
F(3, 30) = 3.07 (0.043)
40

0.180

0.178

(2)

(1)
(3.31)

0.041 (3.31)
0.027 (2.26)
0.011 (0.79)

0.029 (2.84)
67.42%
d(5,40) = 2.08 du 1.79
X 2 (1) = 0.196 (0.658)
X 2 (2) = 1.831 (0.400)
t = 0.04 (0.967)
F(3, 32) = 4.02 (0.015)
40

0.186

(3)

0.056 (1.13)

0.053 (1.69)
0.019 (140)
0.003 (0.20)

0.022 (1.86)
31.7%
d(5,26) = 2.188 du 1.83
X 2 (1) = 0.237 (0.626)
X 2 (2) = 1.475 (0.478)
t = 1.42 (0.172)
F(3,18) = 0.46 (0.715)
26

(4)

0.085 (1.27)
0.049 (1.56)
0.022 (1.58)
0.006 (0.35)

0.023 (1.94)
32.75%
d(6,26) = 2.208 du 1.89
X 2 (1) = 0.302 (0.582)
X 2 (2) = 1.402 (0.4962)
t = 0.83 (0.419)
F(3, 17) = 0.44 (0.730)
26

(5)

Notes. 1. t-ratios are shown in parentheses next to the estimated coefficients. denotes significance at the 10% level, at the 5% and at the 1% 2. DW is the
Durbin-Watson d-statistic to test for first order serial correlation in the residuals. The upper level for the significance level of d is shown in parentheses. 3. BG(1) (resp.
BG(2) ) is the Breusch-Godfrey LM statistic to test for first (resp. second) order serial correlation in the residuals. No serial correlation is the null hypothesis. The p-value
of the test is shown in parentheses. 4. The Hausman statistic is a t statistic to test the null of exogeneity of the relevant fiscal variable. The p-value of the test is shown in
parentheses. 5. RESET is the Ramsey regression specification error test for omitted variables and non-linearity. A correct functional form specification is the null. The
p-value of the test is shown in parentheses

govshare
govexp
trev
d(19601973)
d(19801993)
d(19942000)
trend
trend (19601973)
Constant
R2
DW statistic
BG(1) statistic
BG(2) statistic
Hausman statistic
Ramsey RESET
Observations

Dep. variable:
growth

Table 2 The size of public sector and economic growth

Public Choice (2007) 131:157175

167

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Public Choice (2007) 131:157175

correlation cannot reject the null of no autocorrelation, as the d-test statistic is either greater
than, or very close to, du , which is the upper level of significance. In addition, we perform
the Breusch-Godfrey LM test for higher-order serial correlation. Results of testing for firstand second-order autocorrelation are again reported in Table 2, and do not reject the null of
no autocorrelation. Thus, the residuals are not serially correlated.
The usual concern in growth regressions with annual data is the possibility that the effects
of fiscal policy may be estimated with significant biases due to possible endogeneity of
fiscal variables. We therefore use valid instruments for govshare to test the assumption
that any potential simultaneity does not introduce significant biases in estimating the effect
of govshare on growth. In particular, we use a Hausman-type test to test for endogeneity
of govshare, as suggested by Wooldridge (2002). As instruments for govshare, we use
the regime dummies, the lagged value of govshare to capture policy persistence, and a
pre-election dummy that takes the value of 1 in an election year and zero otherwise (see
Lockwood et al., 2001). These instruments are exogenous and so valid for our purposes.
The Hausman test, also reported in Table 2, does not reject the null that govshare is not
correlated with the error term of the growth equation.
There is, however, one catch. The Ramsey RESET test for functional form misspecification
rejects the null of a correct functional form specification. Recall that RESET is a general
specification test against possible omitted variables or nonlinearity in the data. We interpret
this rejection as an indication that something is missing from our story so far (we will come
back to this in Section 6 below).
4.3 Using other measures of government size
We now examine the growth implications of two other measures of the overall size of government. In column 4 of Table 2, we report results when we use the growth rate of total
government expenditure as a share of GDP, govexp, as a measure of size, while in column
5 we use the growth rate of total tax revenues as a share of GDP, trev, as a measure of
government size. Both variables are not significant and the associated R2 drop by almost
50% (both regressions pass the serial correlation, the Hausman and the RESET tests). As
argued above, tax revenue is a problematic variable. In the case of total expenditure, this is
a very general measure consisting of many components, each of which may have a different
effect on the growth rate. This explains the popularity of govshare in this type of studies.
Finally, we report that we have also tried budget as a measure of the size of government in
our growth regression. This variable is again insignificant.
4.4 Summary of the section
When we follow common practice by using the government share in GDP as a measure of
the overall size of government, there is robust evidence that larger sizes hurt macroeconomic
growth. Specifically, a rise in the growth rate of government share in GDP by one standard
deviation (or 7.655%) decreases GDP growth by 1.38%. On the other hand, alternative
measures of the overall size, like total government expenditures or tax revenues, both as
shares of GDP, are insignificant. Actually, the significance of the government consumption
share in GDP, combined with the insignificance of total government expenditure as a share of
GDP, imply that different components of fiscal policy may have different effects on growth.
This possibility is explored in the next section. Finally, there is evidence that endogeneity of
fiscal policy does not introduce significant biases in the above results.
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169

5 The growth effect of the composition of the public sector

Useful insights can be gained by considering the effects of sub-categories of expenditure and
taxes (see e.g. Kneller et al., 1999). To do so, we use the disaggregated data described in
Section 3 above.
5.1 Results from the WDI dataset
We start with decomposition by type, over 19721998, as obtained from WDI and illustrated
in Figure 2A. Column 1 of Table 3 augments the regression of column 4 in Table 2 by adding
some key components of government expenditure expressed as shares of total government
expenditure (see Baldacci, Hillman, & Kojo, 2004, for a similar specification). Specifically we
add gcapexp, gstexp and wsexp (which have been defined in Section 3) in the regression
of column 4 in Table 2.18 Although the effect of total expenditure remains insignificant, two of
its components are significant. In particular, capital expenditures are good for growth, while
wages and salaries are bad for growth. Hence, the composition of public finances matters to
economic performance. Also, notice that the R2 of this regression rises to 55.88% (compare
this to that in column 4 of Table 2) and that this specification passes the serial correlation
and the RESET tests.
It makes also sense to use the above fiscal components expressed as shares of GDP
(rather than as shares of total government expenditure). The results of regressing growth
on gcap, ws and gst (as defined in Section 3), as well as the usual set of dummies,
are presented in column 2 of Table 3. Capital expenditures (gcap) accelerate growth, while
wages and salaries (ws) reduce growth. Specifically, an increase in the growth rate of capital
expenditures by one standard deviation (or 10.7%) increases GDP growth by 1.21%, while
an increase in the growth rate of wages and salaries by one standard deviation (or 9.7%)
reduces GDP growth by 1.72%. Notice that the role of the regime dummies remains as in
Table 2, while the R2 is higher compared to that in e.g. column 4 of Table 2. Also, note that
our specification passes the serial correlation and the RESET tests.
We also include the effective tax rates tefcon, tefcap and teflab (as defined in
Section 3). The results, reported in column 3 of Table 3, show that the effective tax rates are
not significant, although the signs are intuitive. In this specification, tne effect of gcap is
positive but not significant, while the effect of ws remains as before.
These are intuitive results. Namely, public investment is usually associated with higher
growth (see e.g. Barro, 1990). On the other hand, the unprecedented increase in public sector
employment that took place in Greece after 1974, and especially during 19801993, has
imposed a significant burden on the economy. This can happen via various channels, e.g.
crowding out effects, distortion of private incentives, the creation of powerful interest groups
mainly in the form of public sector unions, etc.
In column 4 of Table 3, we use ggsexp (as defined in Section 3) instead of wsexp. As
can be seen, the former is negative but not statistically significant. In this specification, no
fiscal variable is significantly related to growth and the fit of the regression is reduced. This
is the reason we prefer the specification in column 1. The same results are obtained if we
replace wsexp with ggsexp in the previous regressions of Table 3.

18 Since wsexp is a sub-component of ggsexp, we cannot use both variables in the same regression. Here,
we present results with wsexp.

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Notes. See Table 2

0.022 (0.25)
0.062 (1.00)
0.151 (1.33)

0.021 (0.94)
0.075 (1.21)

0.113 (2.14)
0.177 (2.99)
0.158 (2.56)

0.006 (0.52)
0.007 (0.61)

0.105 (1.16)

0.156 (1.10)

0.019 (-0.051)

0.048 (1.76)
0.037 (1.17)
0.054 (1.68)
0.024 (1.93)
0.031 (1.92)
0.021 (1.75)
0.006 (0.43)
0.008 (0.053)
0.010 (0.07)
0.021 (2.01)
0.026 (2.38)
0.028 (2.20)
54.03%
61.29%
39.29%
d(7,26) = 1.83 du 2.1 d(10,26) = 1.91 du 2.40 d(8,26) = 1.97 du 2.20
X 2 (1) = 0.180 (0.671) X 2 (1) = 0.064 (0.8)
X 2 (1) = 0.002 (0.960)
2
2
X (2) = 0.763 (0.682) X (2) = 3.062 (0.216)
X2 (2) = 0.305 (0.858)
F(3, 16) = 0.25 (0.862) F(3, 14) = 1.66 (0.22)
F(3,15) = 1.18 (0.348)
26
26
26

0.025 (0.34)
0.125 (2.15)

0.234 (3.03)
0.001 (0.1)

0.047 (1.68)
0.021 (1.64)
0.010 (0.67)
0.018 (1.76)
55.88%
D(8,26) = 1.76 du 2.20
X 2 (1) = 0.368 (0.5443)
X 2 (2) = 1.502 (0.472)
F(3, 15) = 1.92 (0.169)
26

(4)

govexp
gcapexp
ggsexp
gwsexp
gstexp
gcap
gws
gst
tefcon
teflab
tefcap
ginv
gwag
gtran
d(19601973)
d(19801993)
d(19942000)
Constant
R2
DW statistic
BG(1) statistic
BG(2) statistic
Ramsey RESET
Observations

(3)

(2)

(1)

Dep. variable:
growth

Table 3 The composition of public sector and economic growth

0.028 (0.98)
0.226 (2.61)
0.081 (1.78)
0.033 (2.70)
0.033 (2.85)
0.007 (0.57)
0.038 (3.76)
73.06%
d(7,40) = 2.13 du 1.79
X 2 = 0.228 (0.633)
X2 (2) = 2.691 (0.260)
F(3, 30) = 3.39 (0.03)
40

(5)

170
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171

5.2 Results from the OECD Economic Outlook dataset

As a robustness test, we also use the variables provided by the OECD Economic Outlook
dataset that cover the whole 19602000 period and have been illustrated in Figure 2B. Results
are reported in column 5 of Table 3. The new measure of wages and salaries expenditure
(gwag) again exerts a significantly negative effect. The positive effect of government investment (ginv), on the other hand, is now not significant, while the new measure of transfer
payments (gtran) exerts a significantly negative effect at 10% level (compare this with the
insignificant effect of gst in the previous subsection). Therefore, the main result (namely,
that the composition matters) does not change when we use the OECD Economic Outlook
data instead of the WDI data (it should be noted however that the variables in the two datasets
do not measure exactly the same things). Finally, the RESET test rejects the null of a correct
functional form specification. In other words, all regressions for the whole period, 1960
2000, do not pass this test. Hence, as noted above, it seems that something is missing (see
below in Section 6).
5.3 Summary of the section
When we use disaggregated fiscal policy data, a general message is that wages and salaries
in the public sector are bad for growth. Specifically, when we use the GFS decomposition
over 19721998, a rise in the growth rate of wages and salaries by one standard deviation
(or 9.7%) reduces GDP growth by 1.72%. There is also evidence (although less robust) that
public investment as a share of GDP is good for growth, and transfers as a share of GDP are
bad for growth. On the other hand, as it was also the case with total tax revenue as a share
of GDP, various effective tax rates do not seem to matter; this is consistent with the related
literature where the link between taxes and growth is mixed (see e.g. Stokey & Rebelo, 1995;
Park, Philippopoulos, & Vassilatos, 2005).

6 Does the growth effect of the size depend on government quality?

We now explore the well-known prediction (implied e.g. by Barro, 1990) that it is not the size
of government per se that matters to growth, but the mix between size and efficiency/quality.
As said in Section 2 above, behind this there are two key issues: first, the effect of fiscal
policy on growth is not monotonic; and second, non-monotonicity is driven by efficiency or
quality in the public sector.
6.1 A measure of public sector quality and econometric specification
We need a proxy for the quality of public sector in Greece, which should have an annual variation. In Angelopoulos, Philippopoulos, and Tsionas (2006), we have constructed an index of
relative public sector efficiency for a group of 64 countries over four 5-year periods, 1980
1985, 19851990, 19901995 and 19952000, by following the methodology of Afonso,
Schuknecht, and Tanzi (2005) for the OECD countries. However, most of the data used for
the construction of that index are not available on a time-series basis. As far as we know, only
one of those indexes is available: the variable Electric Power Transmission and Distribution
Losses, which is available from WDI on an annual basis for the whole period 19602000.
Tanzi and Davoodi (1998) have also used this variable as a proxy for the quality of public
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infrastructure.19 Obviously, this index can only provide a crude approximation of the quality
of public sector; however, it is fortunate that there exists such a variable, which also fulfills
our time-series requirements. All related studies, we are aware of, are cross-section studies
(see Angelopoulos, Philippopoulos, & Tsionas 2006, for a review of the literature).
To get a proxy for the quality/efficiency of public sector, we first take the log of the inverse
of Electric Power Transmission and Distribution Losses and denote this as govqual. In turn,
by first-differencing, we get the growth rate of govqual, denoted as govqual. Table 1 reports
that govqual is an I(0) variable. As a preliminary step, we just include govqual in our
basic regression (the one in column 3 of Table 2). As can be seen in column 1 of Table 4, by
simply adding efficiency into the growth regression does not alter anything.
To test our main idea, we work in two steps. In the first step, we use our proxy for
government efficiency, govqual, to divide years into efficient and inefficient. In the second
step, we examine whether the effect of government size differs depending on whether we are
in an efficient or an inefficient year.
Consider the first step. When govqual is positive, which means an improvement in the
quality of public infrastructure relative to the previous year, we classify the government
in that year as being efficient. Conversely, when govqual is negative, we classify the
government in that year as being inefficient. This simple classification rule implies that the
Greek public sector is classified as efficient in 22 years and as inefficient in 18 years,
over the period 19602000.20
6.2 Estimation and tests
Given this classification, we move on to the second step by regressing growth on our principal
measure of the overall size of government (namely, the growth rate of the share of government in GDP, govshare) by allowing the size effect to differ between the efficient and the
inefficient sub-sample (denoted respectively as govshareeff and govshareineff). Results
are reported in column 2 of Table 4. As can be seen, govshareineff is significantly negative
at the 1% level, while govshareff (although negative too) is very small and insignificant.
While ideally one might also like the coefficient on govshareff to be significantly positive
(so as to get a typical Laffer curve result), what is important is that the two coefficients differ
and there are two different regimes. The hypothesis that the coefficients of govshareff and
govshareineff are equal is clearly rejected by an F-test; the relative F1,33 = 18.77 rejects
that null (the p-value of the test is 0.001). Therefore, the growth effect of the public sector
differs significantly depending on whether the latter has been efficient or inefficient. Note
that these results are net of any direct effect of govqual on growth since we have controlled
for govqual in the regression (the latter is positive but not significant).
The effects of dummy variables are also affected relative to Section 4 (compare the new
results to those in column 3 of Table 2). That is, the d(19601973) dummy is now insignificant
although still positive, while the d(19801993) period remains negative and significant. It is
interesting that the d(19942000) dummy now turns to be significantly negative. An obvious
explanation is that recent years have been classified as efficient, so that the positive effect on
growth has been already controlled for by the size-efficiency mix.

19 There are several references to this index and its importance as an indicator of public sector efficiency in
the Greek economic press (see e.g. Kathimerini, November 20, 2004, and Naftemporiki, January 21, 2005).
20 The Maastricht Treaty period, 19942000, is efficient (except for the last year). The rest of the efficient
years are more or less equally assigned to the three regimes over 19601993.

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Table 4 The quality of public sector and economic growth

Dep. variable: growth

(1)

(2)

govshare
govshareeff
govshareineff
govqual
d(19601973)
d(19801993)
d(19942000)
Constant
R2
DW statistic
BG(1) statistic
BG(2) statistic
Ramsey RESET
Observations

0.186 (3.26)

0.008 (0.16)
0.041 (3.26)
0.027 (2.24)
0.011 (0.78)
0.029 (2.81)
67.45%
d(6,40) = 2.093 du 1.79
X 2 (1)= 0.195 (0.658)
X 2 (2) = 1.184 (0.389)
F(3, 31) = 3.72 (0.025)
40

0.040 (0.71)
0.486 (5.84)
0.03 (0.08)
0.019 (1.71)
0.043 (4.06)
0.019 (1.57)
0.046 (4.97)
79.25%
d(7, 40) = 2.097 du 1.79
X 2 (1) = 0.166 (0.683)
X 2 (2) = 2.554 (0.278)
F(3,30) = 0.59 (0.627)
40

Notes. See Table 2

It is also important to note that the R2 in this model jumps to about 80%. This is a rather
impressive fit. It implies that the growth in the share of government in GDP, when allowing for
a non-linear Laffer curve-type effect, can explain along with some simple political dummies
around 80% of the variation of the growth rate over the last forty years. This again highlights
the importance of fiscal policy (now both its size and quality) for macroeconomic outcomes.
Finally, notice that the specification in column 2 of Table 4 passes the serial correlation
tests. Also, the RESET test for non-linear functional form cannot reject the null of a correct
specification. Since the RESET tests of the regressions in columns 13 of Table 2, column
5 of Table 3 and column 1 of Table 4 (namely, all regressions that cover the whole period,
19602000, without taking account of the size-quality mix) reject the null, this adds to our
confidence that there is a Laffer curve pattern from fiscal policy to growth, and this pattern
is captured by our model specification in column 2 of Table 4.
6.3 Summary of the section
Is a larger government size, as measured by the government share in GDP, always bad for
growth? Although this seems to be the case when one ignores efficiency in the public sector,
the results change drastically once we take account of the mix between size and efficiency.
Our regressions show that only when our measure of government efficiency deteriorates
relative to the previous year, a larger government size is bad for growth. It is the significantly
negative effects that dominate over time, this is why on average larger sizes were found to
hurt growth. Therefore, what really matters to growth is the size-efficiency nexus. This is
consistent with the theoretical literature (see e.g. the literature initiated by Barro, 1990) as
well as with empirical evidence for a number of countries (see Angelopoulos, Philippopoulos,
& Tsionas 2006).
7 Conclusions, limitations and extensions
Is public spending hampering growth? The answer is yes, but not all spending, and not
always. Our growth regressions for Greece over 19602000 showed that, although a smaller
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Public Choice (2007) 131:157175

public sector is good for growth, it is necessary to look beyond size; the composition and
quality/efficiency of the public sector are equally important.
The general lesson is that Greece needs fiscal rules that ensure overall expenditure contraction and are also complemented with reallocation of funds among expenditure categories
and a more efficient use of those reduced funds. The challenge will be to institutionalize
these changes.
We close with limitations and possible extensions. First, we have concentrated on growth
only. Stability, equality, etc, are other key indicators of macroeconomic performance. It is
thus useful to examine the implications of fiscal-tax policy for those indicators too. Second,
it is important to identify the transmission channels through which fiscal-tax policy affects
macroeconomic outcomes like growth (see e.g. Baldacci, Hillman, & Kojo, 2004). Crowding
out via interest rates, distortion of private incentives, etc, are potential transmission channels. Third, one could also investigate the determinants of large and inefficient government
size. Low discount factors, reelection policies, extra rents when in power, etc, are potential
determinants (see e.g. Lockwood, Philippopoulos, & Tzavalis, 2001, for Greece).

Acknowledgements We are grateful to an anonymous referee for comments and constructive criticisms. We
are also grateful to Elias Tzavalis. We thank George Economides, Dimitris Hatzinikolaou, Pantelis Kammas,
Jim Malley, Manolis Mamatzakis, Yiannis Mourmouras, Hyun Park, Makis Tsionas and Vangelis Vassilatos
for helpful comments and discussions. Any remaining errors are ours. The first co-author is grateful to the
Foundation Propondis for support.

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