The Impact of Government Spending on the Private Sector: Crowding-out versus Crowding-in Effects

We contribute to the empirical literature on the effect of government spending on economic activity, by assessing the impact of changes in government spending-GDP ratio on (the short-term growth rates of) private consumption and investment. We do this by analysing a panel sample of 145 countries from 1960 to 2007. The results of our paper suggest that government spending produces important crowding-out effects, by negatively affecting both private consumption and investment. The result is broadly robust to both country and time effects, and different econometric specifications. In addition, we show that the effect of government consumption on private consumption and investment does not depend on the phase of the business cycle, but differs substantially among regions. The differentiated effects of government consumption on private consumption and investment among geographical areas are extremely important and need to be further investigated. In particular, it would be interesting to assess to which extent the effect of government spending on consumption and investment depends on political and institutional variables (e.g. democracy, corruption, political stability) as well as macroeconomic variables (income, interest rates, degree of openness). We leave this challenging avenue for future research.