13 communications, education, health, etc.) have significant positive long-run growth effects...” (WB, 2007 pg. 42-43) The ambiguity of results is not surprising, as the relationship between public expenditure and growth is mediated by a long chain subject to multiple weak links that are not necessarily the same across countries, or even across expenditure programs within the same country.<sup>10</sup> This section examines the links between public expenditure and capital formation with particular attention to three topics: 1) the need of considering the link between expenditure and revenue, given that the additional funding will have an impact on growth; 2) the necessity of differentiating spending flows (investment) and capital stocks; 3) the importance of recognizing heterogeneity in output responses across countries, across types of infrastructure, and across levels of network development. The above considerations will require a more detailed analysis but will provide a more useful diagnosis of the role of spending on growth.

# **1. The impact of additional funding to finance more spending**

Regardless of the productivity of expenditure, both the policymaker and the economic analyst must consider the budget constraint, that is, how the additional expenditure will be funded. It is essential to include in the analysis of public investment the cost to society of raising an additional dollar to pay for more spending. This will be discussed in the next section, and momentarily, the focus is the distorting effect of the tax system and its negative growth effect. The impact of productive expenditure on growth will depend on the relative productivity of the private sector vis. a vis the public sector, on the size of the productive expenditure, and on the size of public sector. Both the size of public spending and public debt matter because they imply higher taxation levels which entail increasing more than proportionately the marginal cost of public funds. Appendix 2 summarizes a simple analytical model that shows how, unless public expenditure is extremely productive relative to the private sector and public debt is quite low, increasing taxation to fund productive expenditures will have a negative growth impact.

From the econometric viewpoint, the above consideration implies imposing a restriction when estimating the impact of expenditure on output. Otherwise regression models would be mis-specified (Kneller, Bleaney and Gemmell, 1999; Bleaney, Gemmell, and Kneller, 2001). Recently, many papers have estimated the growth impact of different types of spending (productive and unproductive) jointly with alternative forms taxation (income taxes vs. consumption taxes). Two good recent examples can be found in Adam and Bevan (2005) and World Bank (2007).

These studies have several common features and results: 1) they are panel studies, though covering different samples;<sup>11</sup> 2) both studies consider public investment (instead of public capital) in a category labeled “productive expenditure” that also includes health

> 10 The analogy of the chain with weak links is original from Filmer, et.al (2000) that analyze the relationship between public spending and health outcomes.

> 11 The Adam-Bevan paper includes 45 non-OECD countries, while the World Bank sample is limited to 21 countries of eastern Europe and Central Asia;