There is, however, on important qualification to the relationship between size of government and growth: This relationship is likely to depend on public sector governance. In countries where public sector governance is weak, misallocations of public expenditures and weak administrative capacity are likely to be exacerbated, making the non-linear impact of large government programs more pronounced. In addition, taxes are likely to be more distortionary when governance is poor, with high compliance costs and bribery of tax officials adding to the impact of high and distorting tax rates. In contrast, the threshold effects of big governments on growth may be mitigated by strong public institutions. The quality of institutions can thus be expected to _mitigate_ the negative impact of public sector size on growth.

Indeed, the results in Table 5 indicate that public sector size negatively affects growth, but much less so in countries with good institutions. The results are broadly consistent with regressions based on the CPIA measure of public sector quality (Table 6). In particular, focusing on the fixed effects regression results, public spending has a negative impact, while at levels below the threshold, there is no measurable impact on economic growth, but the impact is mitigated by governance. Governance also appears to mitigate the payoffs from macroeconomic stability; in particular, payoffs from macroeconomic stability seem higher in an environment characterized by good public sector institutions. The coefficient of fiscal balance, in particular, is generally measurably higher when governments are relatively more effective (Tables 5 and 6).

Table 6. Economic Growth and the Size of Government By Government Effectiveness (CPIA Indicator for Public Sector Management)

|||All Countri|es|Relativ|elyMore Effectiv|e Government|Relativ|elyLess Effecti|ve Government|
|---|---|---|---|---|---|---|---|---|---|
||OLS<br>(1)|Fixed Effects<br>(2)|Random Effects<br>(3)|OLS<br>(1)|Fixed Effects<br>(2)|Random Effects<br>(3)|OLS<br>(1)|Fixed Effects<br>(2)|Random Effects<br>(3)|
|War dummy|-5.45*|-5.92***|-5.67***|4.00|4.79*|4.22*|-11.55***|-9.74***|-10.85***|
||(1.86)|(3.18)|(3.27)|(1.06)|(1.93)|(1.89)|(4.15)|(3.81)|(4.49)|
|Ln(inflation) (IMF)|-1.91***|-1.83***|-1.85***|-1.16***|-0.80*|-1.11***|-2.51***|-2.01***|-2.36***|
||(5.95)|(5.32)|(6.30)|(3.54)|(1.93)|(3.01)|(5.42)|(3.79)|(5.26)|
|Fiscal balance (%GDP) (EBRD)|0.51***|0.38***|0.49***|0.42**|0.72***|0.50***|0.44***|0.15|0.37***|
||(4.75)|(3.24)|(5.22)|(2.41)|(4.68)|(3.67)|(3.90)|(0.94)|(2.91)|
|Overall index of reform|-0.01|-0.11|-0.05|0.18|0.41**|0.17|-0.38|-0.2|-0.33|
||(0.08)|(0.68)|(0.40)|(1.22)|(2.18)|(1.14)|(1.56)|(0.75)|(1.47)|
|Expenditure (in percent of GDP) (<35%)|-0.14|-0.25|-0.17*|-0.51***|-0.02|-0.47***|0.13|-0.24|-0.01|
||(1.26)|(1.65)|(1.67)|(2.80)|(0.09)|(3.84)|(1.17)|(1.22)|(0.08)|
|Expenditure (in percent of GDP) (>=35%)|-0.13*|-0.41***|-0.26***|0.03|0.38**|0.13|-0.30**|-0.57***|-0.38***|
||(1.68)|(3.85)|(2.87)|(0.39)|(2.27)|(1.04)|(2.21)|(3.89)|(3.07)|
|Dummy (Expenditure>=35%)|-0.52|0.12|0.09|1.92|1.15|1.65|-2.49|-2.23|-2.09|
||(0.43)|(0.09)|(0.08)|(1.07)|(0.75)|(1.15)|(1.50)|(1.15)|(1.12)|
|Constant|16.10***|22.29***|18.14***|17.90**|-5.55|16.83***|19.00***|24.41***|21.58***|
||(3.42)|(3.34)|(4.41)|(2.13)|(0.61)|(3.54)|(3.19)|(2.64)|(3.05)|
|Observations|295|295|295|152|152|152|143|143|143|
|R-squared|0.56|0.6||0.39|0.4||0.68|0.72||
|Number of countries||25|25||13|13||12|12|

Robust t statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1%

# E. Does Public Investment Matter for Growth?

As previously discussed, the broad literature on economic growth has provided mixed evidence on the link between public investment and economic growth. The 20