growth and poverty impact of expenditure policy choices. The framework encompasses a government’s development strategy with explicit recognition of its goals for growth, equity and poverty reduction as well as key social indicators. It underlines the importance of public economics principles in identifying the appropriate roles of the public and private sectors, and the recognition of the full scope of public policy instruments - the regulatory framework (broadly defined to include property rights, security and law and order), and tax and expenditure policy – available to achieve policy objectives. The framework allows a focus on the policy implications of allocating resources among sectors and government programs, with respect to their direct and indirect effects on poverty as well as their immediate and lagged impact. The paper also identifies ways of quantifying the links between variables in the framework using existing tools and reviews selected empirical work where this has been undertaken. Finally, Section V discusses the policy implications and suggests some practical operational guidelines for development agencies such as the World Bank for improving the analytical basis for linking public spending to economic growth, equity and poverty reduction.

# **III.   A SYNOPSIS OF THE LITERATURE ON EXPENDITURE ALLOCATION**

How should a government allocate public spending across various sectors to maximize prospects for achievement of its development (growth and poverty reduction) objectives? What principles and technical tools should guide the allocation of resources? What is current guidance on these questions?

It is important to recognize that, unlike tax policy, where the theory of optimal taxation was developed, there is not a comparable theory of optimal expenditure policy that provides comparably well-defined rules for expenditure allocation. The key ideas of expenditure policy were the concepts of externalities and market failure that suggested that only “efficiency enhancing” interventions that corrected for the underprovision of a product or service due to market failure justified public expenditure.<sup>6</sup> Because of the lack of clear theoretical results, the various guidelines proposed and used by public finance specialists and staff members of the World Bank<sup>7</sup> and other IFIs<sup>8</sup> for considering general issues on expenditure allocation are pragmatic “good analytical practice” adaptations to the current state of knowledge.<sup>9</sup>

> 6 Devarajan, et.al. (1996) observe that “neither economic theory nor empirical evidence provides clear-cut answers to how the composition of expenditure affects economic growth”.  It might be added that neither does theory indicate clearly how expenditure affects equity or poverty.

> 7 See for example, Devarajan et.al., 2001; Pradhan, 1996; IMF, 1995.

> 8 Such as the International Monetary Fund (IMF), the Asian Development Bank (ADB), and the Organisation for Economic Cooperation and Development (OECD).

> 9 While staff members of international organizations have recently developed practical guidelines for expenditure analysis, the theory of public expenditure has, as is well known, a very long history. Musgrave (1985) traces notable contributions in the development of principles of expenditure allocation, including those of Lindahl (1918) and Pigou (1928) in the application of the theory of marginal utility to government expenditures, Samuelson’s (1954, 1955) path-breaking linkage of externalities and social goods and integration of social goods into principles of efficiency, and the development of cost-benefit analysis in the 1960s. Walker (1930) provides one of the first surveys of the theory of public expenditures.

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