Current expenditure upswings in good times and capital expenditure downswings in bad times?: new evidence from developing countries 

Abstract

work is licensed under a Creative Commons IGO 3.0 AttributionNonCommercial-NoDerivatives (CC-IGO BY-NC-ND 3.0 IGO) license (http://creativecommons.org/licenses/by-nc-nd/3.0/igo/ legalcode) and may be reproduced with attribution to the IDB and for any non-commercial purpose, as provided below. No derivative work is allowed.Any dispute related to the use of the works of the IDB that cannot be settled amicably shall be submitted to arbitration pursuant to the UNCITRAL rules. The use of the IDB's name for any purpose other than for attribution, and the use of IDB's logo shall be subject to a separate written license agreement between the IDB and the user and is not authorized as part of this CC-IGO license.Following a peer review process, and with previous written consent by the Inter-American Development Bank (IDB), a revised version of this work may also be reproduced in any academic journal, including those indexed by the American Economic Association's EconLit, provided that the IDB is credited and that the author(s) receive no income from the publication. Therefore, the restriction to receive income from such publication shall only extend to the publication's author(s). With regard to such restriction, in case of any inconsistency between the Creative Commons IGO 3.0 Attribution-NonCommercial-NoDerivatives license and these statements, the latter shall prevail.Note that link provided above includes additional terms and conditions of the license.The opinions expressed in this publication are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent.http://www.iadb.org 2017 Abstract * This paper studies the cyclical properties of two key expenditure categories (current and public investment spending) during the different phases of the business cycle (good times and bad times). Anecdotal evidence suggests that policymakers usually cannot resist the temptation of spending more on current expenditure in good times, but only pick capital expenditures to adjust during bad times. The paper answers the following questions: do current and capital expenditures react to the business cycle? If so, by how much, and why? In a sample of more than 100 developing countries and 30 developed countries observed between 1980 and 2014, a new empirical regularity specific to developing countries is identified: upswings are associated with increases in current primary expenditures (e.g., wages, transfers) only, while public investment falls and current spending remains acyclical during downturns. Evidence is also presented that this asymmetrical response is more pronounced in countries where incumbent politicians face shorter time horizons and weak institutions. Other type of factors traditionally discussed in the literature (limited creditworthiness, fiscal rules, and tax base volatility) have limited explanatory power. JEL classifications: D72, E32, E62, H50

Can Automatic Government Spending Be Procyclical?

“…Industrial countries follow an acyclical pro…le and developing economies behave procyclically (see also "discretionary spending" box in Figure 2). This evidence is in line with previous studies focusing on government consumption and government investment (e.g., Kaminsky, Reinhart, and Vegh, 2004;Talvi and Vegh, 2005;Ilzetzki and Vegh, 2008;Ardanaz and Izquierdo, 2017;Izquierdo, Pessino, and Vuletin, 2018). 7    4 7 For brevity's sake, and since they are not the focus of our analysis, we do not show country-based cyclicality correlation …gures for public investment and public consumption.…”

“…Figure 6 shows the cyclicality of unemployment insurance spending. Unlike Figures 1, 4, and 5, unemployment insurance spending is overwhelmingly countercyclical both in the industrial and 8 Naturally, the speci…cs of the unemployment insurance program, including the type of unemployed workers entitled to bene…ts, the maximum time they are allowed to receive bene…ts, the source of funding, and the conditions under which these bene…ts are to be maintained vary across countries (e.g., Ribe, Robalino, and Walker, 2012;Cerutti et al, 2014;Asenjo and Pignatti, 2019). 9 See Appendix 3 for details.…”

“…2 In fact, the correlation is 0.35 for developing countries and -0.08 for industrial countries, in both cases statistically signi…cant (see also "primary spending"box in Figure 2).    1   2 Several hypothesis have been put forth in the literature to explain procyclical government spending, ranging from limited access to international credit markets (e.g., Riascos and Vegh, 2003;Cuadra, Sanchez, and Sapriza, 2010;Bianchi, Ottonello, Presno, 2019) to political economy distortions, institutional weaknesses, and over-optimism (e.g., Tornell and Lane, 1999;Talvi and Vegh, 2005;Woo, 2009;Frankel, 2011;Frankel, Vegh, and Vuletin, 2013;Avellan and Vuletin, 2015) which, in turn, generate "excessive"public spending during boom periods and "force"policymakers to cut spending in bad times.…”

“…Aggregate in the sense of having in mind some homogeneous good on the theoretical front and relying on measures such as primary government spending on the empirical front. Studies on the cyclical properties of speci…c government spending categories have mainly focused on government consumption and government investment (e.g., Kaminsky, Rein-hart, Talvi and Vegh, 2005;Ilzetzki and Vegh, 2008;Ardanaz and Izquierdo, 2017;Izquierdo, Pessino, and Vuletin, 2018). In terms of government consumption (which includes mainly wages and salaries and goods and services), the evidence indicates acyclicality in industrial countries and procyclicality in developing economies.…”

“…In fact, Keynes felt so strongly about the stabilizing role of government investment that he was of the view that budget policy should have an "ordinary budget" and a "capital budget" (Brown-Collier and Collier, 1995). The procyclical pro…le found in the developing world responds mainly to (i) the convenience of …scally adjusting in bad times by cutting pubic investment (Ardanaz and Izquierdo, 2017) and (ii) the low levels of trust and lack of commitment to long-term projects in the developing world, which generates a bias against government investment (Izquierdo, Pessino, and Vuletin, 2018).…”