Fiscal policy in models of economic growth: theory and evidence

Growth models contain strong predictions regarding the effect of fiscal policy on the steady state growth path. Fiscal policies have no effect on the steady state growth rate in the neoclassical model whereas fiscal policy does feature in the steady state of endogenous growth models. The number of alternative policies which have been found to effect growth in the endogenous growth models is large as one of the few restrictions placed upon policy in the models is which sector of the model is affected, demand or supply. Only policies that are included in the supply side of the model affect the growth rate. Despite the strength of the growth predictions regarding fiscal policy in growth models the empirical relationship between the two has proved more difficult establish. Even when comparisons are made between studies that purport to correct for many of the statistical biasesp resent in the data, non- robustnesss till abounds. We believe that this non-robustnessc an in part be explained by a failure to adequately account for the predictions from the theoretical models. We use four conclusions from our review of the theoretical literature (the method of financing changes in policy, differences between the transition and the steady state, the assumption of homogeneity of expenditures, and the direct versus indirect effects of policy) to provide the shape for new empirical tests. We find that once done, the strength of the empirical relationship is increased and matches the predictions from the basic public policy endogenous growth model of Barro (1990).