Government Expenditure Composition and Growth in Chile

January 2007

Carlos J. García Central Bank of Chile

Santiago Herrera World Bank

Jorge E. Restrepo Central Bank of Chile

Organization of the presentation:

1. Introduction and Stylized facts

2. Model.

3. Calibration of the model.

4. Policy Experiments.

5. Conclusions.

1. Introduction

• The purpose of this paper is to examine and quantify the impact on growth of alternative budgetary compositions.

• We use a model that captures some of the specific stylized facts of the Chilean Economy.

• One of the specific targets is to test the effects of larger social security payments. This is relevant given that the pension system in Chile is being reformed.

• Total public spending as a share of GDP has evolved through time and across regions with little or no relationship with growth rates.

• The public spending ratio has decreased, while growth rates show diverse behavior.

80s 90s 2000s 80s 90s 2000s

% of GDP 28.3 27.2 23.1 25.1 22.3 21.8GDP p.c. Growth(%) 0.6 -0.6 0.7 2.5 2.5 2.4

% of GDP 37.9 33.5 29.4 36.8 37.1 29.2GDP p.c. Growth(%) 1.8 1.0 5.5 2.3 2.0 1.9

% of GDP 25.2 21.7 21.9 34.9 30.0 29.0GDP p.c. Growth(%) 0.1 1.8 0.2 -0.5 1.2 2.1

% of GDP 25.6 24.7 27.3GDP p.c. Growth(%) 3.5 3.3 2.0

SAS

INL

MNA

AFR EAP

ECA

LAC

Total Expenditure and GDP per capita Growth

AFR – Africa, EAP – East Asia and Pacific, ECA – East Europe and Central Asia, INL – Industrialized Countries, LAC – Latin America and Caribbean, MNA – Middle East and North Africa, SAS – South Asia.Source: World Bank World Development Indicators and IMF Government Finance Statistics

• The composition of public expenditure has varied significantly with clear patterns across regions and through time

• A notable trend is the rising importance of social security payments.

• Agriculture spending and transport and communication are decreasing in importance within central government budgets

1980 1998 2001 1980 1998 2001 1980 1998 2001 1980 1998 2001 1980 1998 2001 1980 1998 2001 1980 1998 2001Agriculture 6.7 4.8 4.6 9.7 4.9 2.4 3.1 3.3 2.9 3.8 2.6 1.4 5.5 2.3 1.5 4.9 5.3 0.5 8.1 4.6 3.8Education 12.8 13.9 14.7 14.1 12.5 13.4 5.7 6.6 6.4 8.5 7.9 6.0 12.5 15.7 17.4 12.8 15.0 13.3 5.2 10.3 9.3Health 4.2 5.3 8.4 5.4 5.6 7.1 1.4 8.6 8.8 9.0 10.3 12.1 8.0 9.1 10.9 4.7 5.2 7.8 3.1 6.1 5.0T & C 7.3 2.3 6.1 11.7 7.9 4.5 4.0 4.1 4.2 5.9 3.6 2.1 7.4 3.9 3.9 5.1 2.9 2.7 18.2 7.9 6.3Social Security 3.4 5.8 21.4 3.2 6.7 12.1 7.7 32.2 35.0 34.9 34.2 34.2 14.0 23.8 24.1 6.1 9.5 7.5 3.6 3.8 3.6Defense 8.8 9.1 0.8 18.8 13.6 8.3 23.0 6.1 5.2 8.5 6.6 12.9 6.5 4.5 4.2 17.7 14.7 15.2 11.8 12.3 11.1Order & Safety 0.0 4.6 7.2 0.7 4.8 7.0 0.0 5.8 6.0 0.5 2.8 2.9 0.4 5.7 6.5 0.0 7.8 12.2 0.0 4.1 3.9Fuel & Energy 1.3 0.4 0.1 2.0 0.9 1.0 2.0 0.6 0.8 0.8 0.5 0.1 1.8 0.9 0.4 5.1 5.8 0.3 3.9 6.5 9.0Mining & Manuf. 2.0 2.6 0.7 2.5 0.4 0.5 14.1 1.2 0.4 1.5 1.0 0.6 1.9 0.7 0.6 3.8 1.4 0.3 3.6 0.8 0.5Public Service 18.2 14.7 9.8 14.5 10.3 10.2 10.3 5.7 6.4 7.3 5.9 6.1 15.4 8.5 7.8 11.8 10.1 29.5 11.8 9.9 12.1Housing 1.5 1.6 6.6 2.7 5.4 3.9 1.5 1.3 1.1 2.4 2.5 2.9 2.9 3.4 3.2 5.4 3.1 3.7 3.6 5.3 4.3Recreation 1.3 0.6 1.3 0.7 2.8 2.1 0.1 1.8 1.6 1.0 1.3 0.9 0.7 0.5 0.6 3.0 2.1 0.5 0.6 0.4 0.2Other 32.3 34.4 18.3 13.8 24.2 27.6 27.1 22.7 21.0 15.8 20.8 17.8 22.8 21.0 18.8 19.5 17.1 6.3 26.7 28.1 31.0

LAC MNA SASAFR EAP ECA INL

Different Regions: Composition of Total Expenditure (%, consolidated central government)

Source: Calculated using data from IMF Government Finance Statistics

Chile: Composition of Central Government Expenditure (% of GDP)

1990 1996 2005

Agriculture and others 1.2 1.2 0.9

Defense 2.3 1.5 1.3

Education 2.3 2.8 3.3

Environment 0.0 0.1 0.1

Order & Law 0.9 1.0 1.3

Health 1.9 2.4 2.9

Housing 0.9 1.1 1.0

Public Service 2.8 1.4 1.3

Recreation 0.1 0.1 0.1

Social Security 7.4 6.4 5.8

Transportation 0.8 1.6 1.7

Others 0.1 0.0 0.1

Source: Estadísticas de las finanzas públicas Ministerio de Hacienda-DIPRES several issues.

• Health and education are increasing in importance within central government budgets

• Social security payments is decreasing but important as % of GDP.

2. Model: The Framework of General Equilibrium

• The model is overlapping generation model was developed by Glomm-Rioja (2004) for Brazil, but this version include additional types of expenditure (maintenance of public capital) and changes in the calibration parameters.

• The building blocks of the model are defined by the preferences, the technology, and the resource constraints.

• Three crucial features are: – Consumption and leisure decisions are made by agents differentiated by

their generation: they study when young, work in adulthood, and receive transfers (social security) payments when old.

– Government expenditure is productive (in infrastructure and education) and unproductive (transfer payments to the old), affecting production and consumption decisions.

– Interest rates depend on the size of public debt.

1,, lnln)1ln( ttttt ccn (1)

0,1,,0,11 BhEBnh tttt (2)

2. Model: Preferences

• Each generation of households lives for three periods: youth, adulthood and retirement.

• Each individual, when young, is endowed with one unit of time which can be allocated to learning or leisure.

• During adulthood the individual supplies labor inelastically, and allocate labor income between current consumption and savings.

• When retired the individual lives on transfers and returns on savings.

Specifically, preferences are given by

• The evolution of human capital follows the rule below:

2. Model: Preferences

• The utility maximization problem is solved recursively, starting with the problem

faced by adults:

• First order conditions yields the savings decisions given by

1,, lnlnmax tttt cc

tttLttt hwscts )1(.. ,, (3)

11,1, ))1(1( ttttKtt Tsrc

given )h,T,,,r,w( t1tt,Kt,L1tt ,

11,

1

)1(111

,1)1(

ttK

t

r

TtttLt hws

(4)

2. Model: Preferences

• Replacing the optimal savings (equation (4) ) into the objective function in the

consumer’s problem (3) yields an indirect utility function for the adult

(5)

• The problem for the young is hence to maximize (5) with respect to learning time, subject to the law of motion for human capital in (2). The solution to this problem is defined by the following nonlinear equation

(6) 11

111111

~)~1)(1(~)~1))(1(1(

ttttttttttt hEBnwrThEBnwr

)1

ln()~1)(1(ln~)~1(ln)1()1ln( 111

ttttttt rThwrnIUF

2. Model: Production

• The aggregate production technology for the single non-storable consumption

good is given by

• Public infrastructure capital evolves according to

• The private physical capital evolves according to

0,1,0,1 AHKAGY tttt (7)

tGttGt IGmG ,1 ))(1( (8)

tKtKt IKK ,1 )1( (9)

2. Model: Production

• The representative firm maximizes profits, taking as given the market factor prices. Perfect competition dictates that the followings first order conditions:

• The firm’s profits maximization conditions in (10) imply that private physical

capital will evolve according to the following path

)1(

)1(

KKY

t

HY

t

t

t

t

t

q

w

(10)

11

111

)()( 1111

Ktttt rHGAK (11)

2. Model: Fiscal Policy• The government provides public goods, which is financed either by tax revenue

or by borrowing

• The government expenditure as percent of GDP is distribute on investment in infrastructure, on maintenance, on education, on transfers, and on other

general public services (non-utility enhancing). • The government collects taxes on labor income at rate and on capital (interest)

income at rate . It can also choose to raise debt to finance spending.

• Formally, the government budget constraint is given by

ttKtttPtTtEtMtG

tttKtttLt

DrY

KrHwD

))1(1()( ,,,,,,

,,1

(12)

A macroeconomic equilibrium is defined by the following system, where uppercase letters indicate aggregate variables. 1. The household utility maximization problem is solved. That is, conditions (4) and (6) hold. 2. The representative firm’s profits maximization problem is solved. That is, condition (10) holds. 3. The government budget constraint (12) is satisfied. 4. The goods market clears: tKtttt KYTaxSC )1(

5. The competitive input market for human capital (labor) clears: tt hH

6. The interest rate is determined as suggested by Schmitt-Grohe and Uribe (2003), with a debt elastic interest rate as follows:

)(*t

t

YD

t Rrr (13)

2. Model: Competitive Equilibrium

Table 1 Benchmark Parameter Values

Discount Factor ( )

Total Factor Productivity ( ) Human Capital parameter ( B ) Capital’s Share of GDP ( ) Public Capital Elasticity ( ) Public Education Expenditure Elasticity ( ) Interest rate sensitivity to public debt ( ) Learning Time Elasticity ( ) Parental Human Capital Elasticity (ρ) Depreciation parameter - public capital ( )

Depreciation rate - private capital ( K )

(.973)30

13.0, calibrated to get balanced growth 3.87, calibrated to get balanced growth 0.5 0.3 0.1

0.04

0.137, calibrated to get 15.n

0.75, calibrated to get balanced growth

4.0, to match 10% depreciation per

annum

10% per annum

Tax Revenue as a fraction of GDP (Tax) Transfers as a fraction of GDP ( T ) Public Education Expenditure ( E ) Public Capital Expenditure ( G ) Public Expenditure on Maintenance ( M ) Non-utility enhancing Public Expenditure ( P ) Labor income tax rate ( L )

Capital income tax rate ( K )

20.5% 8% 6.3% 1.0% 1.0% 4.2% 20%

17%

World Interest Rate ( *r )

5.58%

3. Model Calibration for Chilean Economy

GDP growth rate after a permanent increase in expenditure

4.50

4.70

4.90

5.10

5.30

5.50

5.70

5.90

1 2 3 4 5

Benchmark Transfer Education

Infrastructure Maintenace

4.50

4.70

4.90

5.10

5.30

5.50

5.70

5.90

1 2 3 4 5

Benchmark Transfer Education

Infrastructure Maintenace

4. Policy Experiments I: increase in expenditure (1% of GDP)

GDP growth rate after a temporary increase in expenditure

4. Policy Experiments II: increase in expenditure (1% of GDP)

4.50

4.70

4.90

5.10

5.30

5.50

5.70

5.90

1 2 3 4 5

Benchmark Transfer Education

Infrastructure Maintenace

4.50

4.70

4.90

5.10

5.30

5.50

5.70

5.90

6.10

1 2 3 4 5

Benchmark Transfer Education

Infrastructure Maintenace

• 5. Conclusions…

• We think this is a useful first step in quantifying the impact on long run growth and income of alternative budget compositions capturing key elements in the Chilean economy.

• The paper’s results provide quantitative evidence supporting the hypothesis of the importance of public investment in achieving higher income in the long run.

• Even though the preliminary results of the simulations show that there is a cost, in terms of growth, of increasing social security payments, this cost is low.

• 5. …and future work • It would be more realistic to model a non-linear elasticity of public

investment such that productivity of public capital decreases as the amount of investment increases.

• It could be useful to model a function of “efficiency” of investment, such that not all public investment is transformed into public capital.

• We could also consider increasing administrative costs of taxation.

• Future extensions of this paper could include public health expenditures that enhance human capital.

Government Expenditure Composition and Growth in Chile

January 2007

Carlos J. García Central Bank of Chile

Santiago Herrera World Bank

Jorge E. Restrepo Central Bank of Chile