WPS4255

# **Public Finance, Governance, and Growth in Transition Economies: Empirical Evidence from 1992-2004**

Taras Pushak, Erwin R. Tiongson, and Aristomene Varoudakis<sup>1</sup> The World Bank 1818 H Street, NW Washington, DC 20433

## **Abstract**

This paper revisits the early empirical literature on economic growth in transition economies, with particular focus on fiscal policy variables: fiscal balance and the size of government. The baseline model utilizes a parsimonious specification, drawn from Fischer and Sahay (2000), of economic growth as a function of initial conditions, stabilization, market liberalization, and structural reform. The paper expands the data used in previous analyses by up to 10 years and finds unambiguous evidence that fiscal balance matters for growth, while confirming other previous findings on the correlates of economic growth in transition economies. In addition, the paper extends the baseline model and explores potential sources of nonlinearities in the relationship between growth and public finance. A key finding is that determinants of growth may vary in relative importance, depending on the underlying institutional quality. The evidence indicates that there could be higher growth payoffs from macroeconomic stability and public expenditure in countries characterized by relatively better public sector governance as measured by relevant indicators. In addition, the size of government matters for growth in a nonlinear manner: Beyond indicative thresholds of expenditure levels, public spending has a negative impact, while at levels below the threshold, there is no measurable impact on economic growth.

## JEL Classification Number: P24, P27, O57

Keywords: economic growth, public finance, stabilization, liberalization, initial conditions World Bank Policy Research Working Paper 4255, June 2007 _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._ 1 Authors’ names are in alphabetical order. This paper was prepared as a background for the World Bank’s Europe and Central Asia (ECA) Regional Study on Public Finance and Economic Growth. The authors are grateful for comments received from participants at the ECSPE Lunch Seminar series (December 19, 2006) and the Regional Public Finance and Growth Study, Roundtable Discussion (October 26, 2006). Valuable comments and suggestions were received from Cheryl Gray, Pradeep Mitra, and Guillermo Perry. Address all correspondence to: Erwin R. Tiongson, Europe and Central Asia Region, MSN H4-401, World Bank, 1818 H Street, NW, Washington, DC, 20433; telephone 202-458-2773; email: etiongson@worldbank.org.

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