# **1 Introduction**

Starting from a “production function” view of the growth and development process with a narrow focus on physical capital, labor force, and exogenous technical progress, growth theory has come to acknowledge the role of an economy's endowment and continuing investment in human capital, physical infrastructure, research and knowledge development, institutions, and innovation in explaining its growth trajectory.

The implications for policy design are somewhat harder to divine. From the perspective of a government, which policies enhance an economy's growth prospects and how large are policy effects on growth? In part, the answer depends on the empirical approach taken. Studies based on cross-country regressions have explored a large number of forces of growth, but they face methodological perils such as the huge heterogeneity of countries (different technologies, institutions, and preferences across countries), and the uncertainty of presumed underlying models and parameters. Consequently, nonrobustness of the outcomes and ambiguous policy implications are a common criticism of studies based on cross-country regressions.<sup>7</sup> Greiner, Semmler and Gong (2005) argue that a time series perspective on economic growth may be more useful to pursue in designing growth and development strategies. Growth models, as advocated by Greiner and colleagues, (1) allow for better specification of microeconomic behavior of economic agents, (2) enable time series study of the forces of growth for a country or a group of countries at particular stages of economic growth, (3) permit analysis using econometric time series methods, and (4) allow us to spell out (though mostly in the context of small-scale models) important implications for growth and development policies.

Since such models, which lend themselves to some time series tests, are often difficult to treat when a larger number of forces of growth are introduced, Greiner and colleagues (2005) have suggested identifying the specific forces that are important in a particular country consistent with its particular stage of development. They mainly consider externalities and learning from others, education and human capital, the creation and accumulation of knowledge and public infrastructure as forces of economic growth in a time series context. Overall, this approach allows analysts to better derive the public policy implications for economic growth.

The primary interest of this paper is to explore, as the World Bank's papers to the Development Committee (2006, 2007) suggest, whether countries could better use fiscal policy (and in particular, the level and composition of public expenditure) to promote sustainable increases in growth and welfare for low- and middle-income countries. We are encouraged by some recent work by Glomm and Rioja (2006), Agenor and Neanidis (2006), and country studies undertaken by World Bank research.<sup>8</sup> Section 2 provides a selective discussion of recent literature and empirical evidence on public investment in infrastructure, health, and education and their effect on growth. In section 3 we sketch a general social planner type model that includes choices regarding the accumulation of physical capital as well as the composition of investment in infrastructure, health, and education. In section 4, the model is calibrated by matching actual differences in per capita income for three groups of countries (for low-income, lower-middle-income and upper-middle-income countries). In addition the effects of a change in foreign aid and other factors that have an impact on growth are explored. Section 5 undertakes a similar calibration exercise; here, however, by considering the growth and welfare effects arising from a change in the composition of the public expenditure. Section 6 discusses sustainability tests of fiscal policy. Section 7 concludes the paper and spells out some practical policy rules. In the appendix the data sources are discussed and the detailed results for the lower-middle-income and upper-middle-income countries are reported. Also, in the appendix the

> 7 See Rodrik (2005) for a methodological criticism of cross-country regressions in identifying growth effects of policies. See also Easterly (2005) in the Handbook of Economic Growth for a skeptical review of the role of policies in explaining cross-country growth.

> 8 See the papers by Arestoff and Hurlin (2006), Balonos (2005), Ferreira and Arajo (2006), and Suescun (2005).

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