Analysis of Public Expenditure Growth: 3 Theories

This article throws light upon the top three theories for the analysis of public expenditure growth. The theories are:

Theory # 1. Wagner’s Hypothesis:

Adolf Wagner a noted German political economist (1835-1917) pro­pounded an empirical law to analyses and explains the trend in the growth of public expenditure. Wagner argued that a functional, cause and effect relationship exists between the growth of an industrializing economy and the relative growth of its public sector.

According to Wagner, relative growth of the government sector is an inherent characteristic of industrializing economies. He illustrates this with the examples of Great Britain, U.S.A, France, Germany and Japan. He came to the conclusion that as per capita income and output increases in industrializing nations, the public sectors of these na­tions necessarily grow as a proportion of total economic activity.

Wagner hypothesized a functional relationship between industrial­ization and the relative importance of public sector activity. He then set out to test his hypothesis by examining the industrialization process in various European countries and Japan. His observations led to what is now called as Wagner’s Law of Increasing State Activity.

Statement of the Hypothesis:

The German Economist Adolf Wagner, systematically observed the historical facts of increasing expenditure activities of public authori­ties particularly of Germany, He then tried to explain the cause of growth in public expenditure in terms of his famous “Law of Increas­ing State Activities”.

According to Wagner there are inherent ten­dencies for the activities of different layers of a government (such as center and state) to increase both intensively and extensively.

Wagner presented his law in the following words “Comprehensive compari­sons of different countries and different times show that among pro­gressive people, with which we alone are concerned an increase regularly takes place in the activity of both the central and the local governments. This increase is both extensive and intensive. The central and local governments constantly undertake new functions, while they perform both old and new functions more efficiently and completely.”

Wagner’s law of increasing state activities is a universal truth in recent years. It is a fact that economic growth of a country has always been accompanied by increasing state activities and hence increasing public expenditure.

Empirical evidence indicates the hy­pothesis of continuous upward trend in government activities. F.S. Nitty made an empirical study of the expenditure trend of public authorities of varying countries of the world, and concluded with empirical evidence that Wagner’s law was not only applicable to Germany but to various governments which differ widely from each other.

Nitty states all kinds of government, irrespective of their layers (say central, state or local) intensions (peaceful or warlike) and size etc., had shown similar tendencies towards increasing public expen­diture.

Wagner’s law was based upon historical facts. His law was ap­plicable to modern progressive governments only in which the state was interested in expanding the public sector of the economy. Wagner observed that there was a persistent tendency towards an ‘exten­sive’ and ‘intensive’ increase in the functions of the state.

Intensive increase means expansion of traditional functions of the state on a large scale. Extensive increase relates to coverage of new welfare functions.

According to Wagner’s law, the expenditure of public authorizes has a continuous increasing trend due to three reasons, they are:

a. Expansion of Traditional Functions:

Traditional functions mainly include defence, administration of justice, maintenance of law and order and provision of social overheads. The coverage and variety of such functions have gradually increased.

Defence expenditure has expanded rapidly because of a change in military arts and sciences. In modern times military activities has become sophisticated. From simple aggression, the modern warfare shifted to prevention of attack and use of sophisticated weapons.

Defence outlays on men, materials and maintenance have been on a rising trend in modern times. Similar is the case with expenditure on internal protection and administration. Increasing areas of admin­istration and spread of government machinery with expertise have become more and more expensive.

b. Coverage of New Functions:

Secondly the activities of the state were increasing in their cover­age. Traditionally the state activities were limited to only defence, justice, law and order, maintenance of the states over heads etc. But with the growing awareness of its responsibilities to the society, the governments started expanding its activities in the field of vari­ous welfare measures to enrich the cultural life of the society.

Along with this new welfare programmes were designed to provide social security to the people. This required increasing government expen­diture on education, public health, low cost housing, subsidized pro­vision of food, agricultural inputs, old age pension, sickness benefit etc.

c. Expanding Sphere of Public Goods:

Almost all modern democratic governments have increasingly rec­ognized the need to provide and expand the sphere of public goods.

The need and necessity to provide social and merit goods through budgetary allocation was increasingly recognized by the modern state. The state was trying to shift the composition of national prod­uct more in favor of public goods.

As a result state activities ex­panded to areas like irrigation and flood control projects, construc­tion and maintenance of public parks, provision of education and health care facilities, creation of economic overhead capital etc., Provision of these public goods and merit goods means heavy in­vestment in public enterprises.

Apart from the above mentioned factors, Wagner also examined the forces that operate on both the demand and supply side of public sector activity and explained how they interact. Changing produc­tion and marketing arrangements of public sector activity affect and are affected by social organizations in different ways.

They are given:

i. Factors that affect both demand and supply of public expenditure activities:

(a) Per capital income and wealth exert a positive impact on the demand as well as cost of government services.

(b) Coupled with this rate of growth of population and density also affect the demand for public goods such as transport, communication, hospitals etc., in addition to the cost of supply of these services.

ii. Factors affecting the demand side of public expenditure activities. The major factors under this category are:

(a) Urbanization and industrialization.

(b) Structure and composition of the population which deter­mine the demand for educational facilities, old age pension, old age homes etc.

(c) Specialization of labour and centralization of administration in both private and public activities.

iii. Factors affecting the supply side of public expenditure activities. On the supply side, the major factors affecting public sector activities are:

(a) Changing scale of production of government activities.

(b) Quality of production.

(c) Intergovernmental grants.

Obviously the functional relationships Wagner sought to trace are complex. Adolf Wagner believed that increased public expendi­ture was the natural result of economic growth and the continued pressure for social progress.

Wagner held that the income elasticity of government services is greater than unity. In other words public expenditure will increase faster than the increase in per capita in­come of the people.

Graphic Presentation of the Wagner Hypothesis:

The modern formulation of Wagner’s law is that “as per capita in­come rises in industrializing nations, their public sector will grow in relative importance” (Bird, 1971, p.2). The Wagner’s hypothesis of increasing state activity is illustrated in Figure No.3.1.

In this graph the real per capital output of public goods (PG) is measured on the vertical axis and real per capita income (Y) is mea­sured on the horizontal axis.

Time is an important third dimension implicit in the graph, because the growth in the real per capita output of public goods and in real per capita income is realistically as­sumed to take place on a historical basis over an extended period of time. Line PG¹ represents a circumstance in which the public sec­tor maintains a constant proportion of the total economic production of the society over time.

In other words, as real per capita income increases, due to economic development of the society, the real per capita output of public goods remains at the same proportion of total economic activity. The constant proportion line, PG¹, can be used as a reference point to the graphical presentation of Wagner hypoth­esis as depicted by the line PG².

All along the PG² the proportion of resources devoted to the output of public goods is expanding overtime.

The implication of Wagner’s law can be stated in the following equations. When the real per capita output of public goods remains at the same proportion of total economic activity, i.e. PG¹, the equa­tion is

PGa/Ya = PGo/Yo

In other words the income elasticity of expenditure for public goods (Ye) is elastic.

Wagner’s hypothesis provides the most suitable frame work for explaining economic factors, as the most important determinant of a relatively expanding public sector during industrialization and eco­nomic growth.

The functional relationships, Wagner sought to trace are complex. Wagner believed that increased public expenditure was the natural result of economic growth and the continued pressure for social progress.

Criticism of Wagner’s Hypothesis:

Although the Wagner hypothesis has many attributes, it also has ‘several defects. Wagner’s law of increasing state activity was criti­cized by Allan. T. Feacock and Jack Wiseman on the following grounds:

i. Wagner’s hypothesis deals with inter-disciplinary phenomenon. But it lacks interdisciplinary approach in its analytical frame­work.

ii. Lacks comprehensiveness in analysis Wagner’s law lacks comprehensiveness. Political science, eco­nomics and sociology are among the several disciplines to be incorporated in any theory of public expenditure. The Wagner’s hypothesis excludes all these characteristics.

iii. It is based on an organic self-determining theory of the state, which is not the prevailing theory of the state in most western countries.

iv. The theory ignores the influence of war on governmental spend­ing, and

v. It stresses a long term trend of public economic activity, which tend to overlook the significant ‘time pattern’ or process of pub­lic expenditure growth.

Theory # 2. Peacock and Wiseman Hypothesis:

Another hypothesis regarding the growth of public expenditure was put forth by Peacock and Wiseman, in their empirical study of public expenditure in U.K. for the period 1890-1955.

Peacock and Wiseman emphasize the time pattern of public spending trends rather than striving for a genuine positive theory of public sector growth. The main thesis of the authors is that public expenditure does not increase in a smooth and continuous manner, but in jumps and jerks or step like fashion. Their analysis involves three related ele­ments.

These are displacement, inspection and concentration ef­fects. Using empirical data for the British economy after 1890, Wiseman and Peacock observe that the relative growth of the public sector in the United Kingdom has followed a discrete step like pat­tern rather than a continuous growth pattern.

During the period under study they found that, government fiscal activities, in the country have risen step by step to successive new plateaus. Moreover the absolute and relative increases (steps upward) in taxing and spend­ing activities by the British government have generally taken place during periods of major social disturbance or crisis such as war or depression.

These kinds of changed fiscal situation cause the previ­ous lower tax and expenditure levels to be replaced by new, higher, budgetary levels. This movement from the older level of expenditure and taxation to a new and higher level is called the displacement effect after the social disturbance has ended; the new level of tax is tolerated by the society.

The emerged new levels of tax tolerance make the society willing to support higher levels of public expendi­ture. In other words the lax threshold has increased. Thus there is no strong motivation to return to the lower pre-crisis level of taxation.

Over the secular period, 1890 -1955, this displacement procedure occurred several times in Great Britain. Thus when the major social disturbance ends, no strong motivation exists for the society to re­turn to the lower pre-disturbance level.

The higher government rev­enues are used to support permanently higher levels of public sector allocation. Figure No. 3.2 clearly shows the displacement effect, as explained by Wiseman and Peacock.

Figure No. 3.2 demonstrates the displacement effect, tax threshold behavior. Time (years) is measured along the hori­zontal axis, while public sector revenues (mostly taxes) and public expenditures as a percentage of gross national product are mea­sured along the vertical axis.

The figure reveals that as the social disturbance cause a relative expansion of the public sector, the dis­placement effect which occurs helps to explain the time pattern by which the government growth takes place. This displacement effect does not require that the new higher plateau of expenditure, con­tinue the same expenditure composition that was created by the social disturbance.

Some of the increased expenditures like debt interest are the direct results of the social disturbance.

While other expenditures arose as a result of technological development and expansion of government activity into new areas. For instance, war and ‘other social disturbance, frequently force the people and their government to find out a lasting solution to the long standing and pending problems, which were previously neglected.

This is known as “inspection effect”. Inspection effect is the inadequacy of revenue in comparison with the ‘required’ public expenditure.

In addition to the displacement and inspection effect, Peacock and Wiseman, also give narration about a concentration (scale) ef­fect. It refers to the apparent tendency for the central government economic activity to become an increasing proportion of total public sector economic activity, when a society is experiencing economic growth.

This occurs, because central government has to initiate a number of measures to sustain higher economic activity. Since each major disturbance leads to a situation in which, the central govern­ment assuming a larger proportion of the total national economic activity, the net result is “the concentration effect”.

Wiseman – Peacock hypothesis appears to be quite relevant. At the outlet, the hypothesis looks quite convincing. It emphasizes jerks and jumps in public expenditure, on account of unusual and abnormal situations.

According to Prof. Aronson, for Peacock and Wiseman expenditure growth is sporadic rather than constant and revenues create their own expenditures. However, we must not for­get the fact that, an account of the advance of the economy and the structural changes therein, there are constant and regular increments in public expenditure and revenue.

Public expenditure has a ten­dency to grow on account of a systematic expansion of government activities, both in terms of intensity and quality.

The regular and dynamic changes in state activity and public spending caused by macro variables like population growth, urbanization, awareness of civic rights on the part of citizens and political and social commit­ments on the part of democratic governments voted to power are major factors giving a big push to upward trend in public expenditure.

However, the influences of these factors on government spending were not systematically analyzed by Wiseman and Peacock in their hy­pothesis. However, Bernard. P. Herber sincerely argues that the Peacock – Wiesman hypothesis of governmental spending trends, is much more modest in what it intend to explain than in Wagner’s hypothesis.

The fact is that, both the Wagner’s and Peacock. Wiseman narrations contribute a lot in understanding the process of public sector growth in industrialized nations.

Theory # 3. Colin Clark’s Critical Limit Hypothesis:

Another hypothesis relating to the growth of public expenditure is provided by Colin Clark. The hypothesis is basically concerned with the tolerance level of taxation. It was developed by Colin Clark im­mediately after the Second World War.

The hypothesis draws conclu­sion from the empirical data drawn from several western countries for inter-war period. Clark wants to point out that in an economy; inflation emerges when the share of the government sector, as mea­sured in terms of taxes and other receipts, exceeds 25 per cent of the aggregated economic activity in the country.

When public ex­penditure reaches 25 percent of the total economic activity or aggre­gate amount of expenditure in the country, the tax payers, ability to pay more tax is exhausted. Public expenditure beyond this limit, means, disincentive to producers and fall in production due to taxa­tion beyond tolerance level.

The hypothesis rest upon the following two institutional factors:

(a) When tax collection by government exceeds the critical limit of 25 percent of gross national product, the income earners are badly affected by reduced incentives and decrease in their pro­ductivity. They produce less than what they are capable of do­ing. This leads to a reduced supply. In short, taxation beyond the critical limit, adversely affect the incentive to produce and invest.

(b) On the other hand, even if the budget remains balanced, in­crease in government expenditure would constitute rising de­mand. Therefore inflation is generated from mal-adjustment be­tween demand and supply.

Even though Colin Clark’s critical minimum effort thesis is well accepted by the business community, its significance in the aca­demic circle is very limited. Colin Clark gave undue emphasis on his critical limit of 25 percent.

In the modern world a number of countries are incurring public expenditure much beyond their limit, without facing worse situation of inflationary pressure. Impact of budgetary spending on generation of inflationary situation; depend upon the manner and nature in which public expenditure is incurred.

Inflation is a complex economic phenomenon influenced and characterized by a number of mutually exclusive and inter-dependent factors. Hence we can only fairly conclude that in a marked economy, increasing state activity may create inflationary pressure.