The Effect of the Size and the Mix of Public Spending on Growth and Inequality

This paper provides evidence on the effects of the size and the composition of public spending on long-term growth and inequality. An estimated baseline convergence model captures the long-term effect of human capital and total investment on potential output for a panel of OECD countries. The composition of public spending added to this baseline provides evidence that certain public spending items (public investment and education) boost potential growth, while others (pensions and public subsidies) lower potential growth. There is also evidence that too large governments reduce potential growth, unless the functioning of government is highly effective. This paper also investigates the effect of public spending items on income inequality. Increasing the size of government, family benefits or subsidies decreases inequality. Reforms making the government more effective and an education reform that aims at encouraging completion of secondary education may also decrease income inequality. Simulations combining both growth and distributional effects illustrate that most reforms can deliver considerable growth gains and benefit the poor.