CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
The impact of government size on economic growth has been the focal point ofacademic research for sometimes now.Some viewed a large government size as harmful to economic growth due to inefficiencies inherent in government, while others argued that a larger size of government is likely to enhance economic growth. Economists such as John Maynard Keynes and John Kenneth Galbraith have argued that an economy needs to be continually fine-tuned by an activist government to operate efficiently.This school of thought grew primarily out of the Great Depression (1929-1939), when markets seemed to fail and government intervention was viewed as the means to restore economic stability.The concept of state intervention to correct inefficiencies stresses that government activities contribute to the provision of vital public goods such as education, health, defense,security and infrastructure. Thus, as an economy grows, a growing government expenditure is also necessary to correct private-sector inefficiencies
(Garrett and Rhine, 2006; Gunalp and Dincer, 2010).Similarly, Grossman (1988) and Dalamagas (2000), posited that government provides defense, social security, judiciary, property rights, regulations, infrastructure development, workforce productivity, community services, economic infrastructure, regulation of externalities, and marketplace. To this end, when both public and private capital formations are complementary to each other, government activities may encourage the private sector to increase their investment which consequently boosts economic growth.
Conversely, other 20th century economists, such as Frederick von Hayek and Milton Friedman, have argued that an activist government is the cause of economic instability and inefficiencies in the private sector. Government should exist to ensure thata private market operates efficiently; it shouldnot act to replace the market mechanism as large government spending may have negative spillover effects on the economy.Therefore, an optimal level of government spending which maximizes growth exists, in view of the fact that if government spending is very small, or even equal to zero, the economic growth would be very limited due to difficulties in the provision of public goods(Ram,1986; Garrett and Rhine, 2006; Asimakopoulos and Karavias,2015; Munene,2015)).
One measure of the role of government is the size of government spending relative to the economy. The size of government could be seen as the degree of participation of the government in provision of goods and services. It can be measured by looking at government’s spending or revenues relative to the size of the country’s economy measured by the Gross Domestic Product and changes in real GDP over time reflect the pace of economic growth or economic performance (Chobanov and Mladenova,2009). Therefore, comparing the amount of government expenditure to the GDP gives a lot of useful informationsuch as measuring whether spending, borrowing and revenues are affordable. An increase in spending is considered affordable if economic growth outpaces the growth in spending.
Government as an institution, is an arrangement that people have for dealing with one another. It is an institution that provides for collective decision making and exercises influence and authority over people in the economy through the mechanisms of taxation, spending, regulation, and borrowing(North, 1987). Government is the single most pervasive institution of modern life, with all facets affected by public sector activities.Over the last 100 years, government spending around the world has grown in terms of both spending per capita and share of national output(Livio, 2013).With higher GDP, developed countries on the average spend a higher percentage of their GDP on provision of facilities such as health and social services than the developing countries.
Government expenditure is often regarded as a crucial stimulant of economic activities. In Nigeria, government expenditures enhance the operations of various economic agents and increase economic activities. Theoretically, the causes of government expenditure growth are as a result of increased need in the transport and education sectors, the introduction of welfare programmes and the rise in defence spending (Musgrave and Musgrave, 1982). It is presumed that government performs two basic functions – protection (security) and provision of public goods. The protective function entails creation of rule of law and enforcement of property rights which helps to minimize risks of criminality, protect life and property, and the nation from external attacks; while defence, roads, education, health, and power, among others, are goods provided by government. The annual budget of government spells out the direction of the expected expenditure, as it contains details of the proposed expenditure for each year, though the actual expenditures may differ from thebudget figures due to extrabudgetary expenditures or allocations during the course of the fiscal year (Oziengbe, 2013).
Forte and Magazzino(2011), stressed that government, at various levels, provide both intermediatepublic goods (that can be considered as factors of production and as factorsfor the private consumption) and goods for final consumption or/andfor redistribution purposes. While public expenditureis necessary to have a functioning market economy and to promote GDPgrowth, its expansion cannot necessarily be consistent with the maximizationof the long-run GDP growth rate. Therefore, an equilibrium among them has to be found.
The role of government expenditure size in inflationary movements is particularly of relevance considering the mode of financing the high and often arbitrary government spending in Nigeria. In the past years, excess revenue sharing has become the practice among the tiers of government and this has significantly increased the size ofgovernment expenditure(Egbe, 2015). Indeed, this has increased money supply and the attendant inflationary implications. Also, the increase in government expenditure financed by monetization of oil revenue and credit from the banking system were responsible for the expansion of money supply which in turn with a lagged-in-effect contributed immensely to inflationary tendencies.However, complementary fiscalpolicy measures have often been advocated bypolicy advisers in curbing the inflation menace. It has been argued that one of such fiscalmeasures is the reduction in government fiscalactivities which would directlyreduce domestic absorption and push down theprice level. Rapid output growth and low inflation are the most common objectives of macroeconomic policy in both developed and developing economies.However, most policymakers agree that inflation should not be allowed to fall below zero because the costs of deflation are thought to be high (Billi and Khan,2008). Moreever, studiessuch as Mubarik (2005) and Bassey(2010), suggested that moderate inflation helps in economic growth, whilehigh inflation rate is inimical to growth. To this end, policymakers support a low rate of inflation that maximizes general economic well-being.
According to Bhatia (1982), the critical-limit hypothesis which is credited to Collin Clerk (1943), contended that when the share of the government sector activity (represented by its expenditure) exceeds 25 per cent of the total economic activity of the country, inflation would be the natural result; and this would be so even when the county is operating under a balanced budget. Thus, when the government’s share of the aggregate economic activity reaches the critical limit of 25 per cent, the income earners would be affected by reduced incentives (owing to apparent high tax incidence), and this would jeopardize their level of productivity. The result is that they would produce less than what their capabilities and potentials can support. This would bring about reduced supply. On the other hand, the demand-effects to the government financing (i.e. expenditure) would become quite strong even when the budget remains balanced. This maladjustment between demand and supply would breed inflationary spirals in the economy as a net result (Ezirim and Muoghalu, 2006; Ezirimet al., 2008).
Therefore, the identification of the government share of GDP which maximizes the real GDP growth becomes necessary because economic growth has suffered from the increase of taxation and government spending which have been above optimal levels in most countries, even as Professor Arthur Lafferillustrated the existence of a tax revenue maximizing tax rate (Chobanov and Mladenova, 2009). Although, Kormendi and Meguire(1986) posited that increasing government expenditure will promote economic growth and improve the country’s investment environment, thereby causing a crowding-in effect on private investment, other studies (Folster and Henrekson,2001;Dar and AmirKhalkhali, 2002) found a negative relationship between government spending and growth and stressed that expanding government size has the effect of a decreasing return of government expenditure and can cause a crowding-out effect to private investment. In addition, high levels of government spending will have negative consequences because they distort the economy due to crowding out, inefficient allocation of government resources, and higher future tax burdens. However, Mitchell (2005),posited that economic theory does not automatically generate strong conclusions about the impact of government outlays on economic performance. The study argued that almost every economist would agree that there are circumstances in which lower levels of government spending would enhance economic growth and other circumstances in which higher levels of government spending would be desirable.
Similarly, Armey (1995) proposed an inverted U-shape curve, which showed the relationship between the ratio of public expenditure to GDP and the variation of GDP, as a measure of the general welfare of the country. The idea beneath that shape is that a too low level of public expenditure would not allow the government to guarantee the functioning of the market economy, and therefore a positive GDP growth rate. On the other hand, very high rates of public expenditure to GDP would discourage citizens from investing and producing because of the high fiscal burden. Thus, there is an optimal level in the relationship between public expenditure and GDP that maximizes the GDP growth.Other empirical evidence has shown that up to a point, government expenditure will boost economic growth, but past some point, the extra spending is mostly wasted (Barro, 1990). This evidence reveals that there is an optimal size of government expenditure and that as the public sector grows larger, its positive contribution to growth becomes smaller and eventually has a negative impact on economic growth.
Empirical studiessuch as Pevcin (2000), Gunalp and Dincer(2005), Scully (1994), among others,have shown that there is no unique optimal size of government expenditure for all countries. Every country has its own optimal size of government expenditure which depends on a number of factors and conditions, such as, the level of economic development, the level of permanency and effectiveness of the institutions of the market economy, the effectiveness of the public sector and the state administration and population preferences,among others(Mitchell, 2005).Also, openness is proposed as an additional factor that has a positive effect on the scope of government, with the relationship being robust when the risk associated with terms of trade is highest (Rodrik, 1998).
Since there is no empirical regularity as to a unique optimal size of government expenditure, there is need to empirically ascertain the optimal level of government expenditure size in Nigeria for the period 1970 to 2017.Thus, the general thrust of this study is to determine the optimal size of government expenditure that will maximize growth and enhance economic performance in Nigeriausing a threshold analysis.It would also shed more light on the short and long run relationship between government expenditure size and inflation in Nigeria.This wouldprovide useful information and policy recipe for effective and efficient growth inducing fiscal and monetary policy management in Nigeria.
1.2 Statement of the Problem
Government has an important role to play in promoting economic performance.This includes, protecting private property, building infrastructure, providing public goods, among others. However, over-expanding the size of government expenditure causes distortions and misallocations which can adversely affect the economy. Based on this, various arguments have been accentuated on the optimal size of government expenditure that would enhancemacroeconomic performance. While some believe that higher government expenditure is required for the economy to operate efficiently, others see increasing government expenditure as the cause of economic instability.In the same vein, a number of empirical studies have revealed that the effects of government spending on real GDP growth are found to be less positive or even negative for values of government spending above the threshold. Such a result suggests a situation in which government spending may have beneficial impacts on the economy up to a point, beyond which those positive impacts dissipate or turn negative (Ram, 1986; Kormendi,1983;Landau, 1983; Dar and AmirKhalkhali,2002).
Therefore, considering Nigeria’s development and growth status, with a population of over eighty percent living in relative poverty conditions, whose infrastructural facilities are in deplorable conditions, whose health, power, education and other growth and welfare enhancing sectors are in a state of near collapse, in spite ofthe huge government expenditure over the years(Oziengbe, 2013; WDI, 2012).The pertinent question therefore is, what is the right size of expenditure for the federal government of Nigeria from the standpoint of welfare maximization and economic growth? Has the size of government expenditure been too little, too much or about right from the standpoint of increasing the output of goods and services? In other words, what is the optimal size of government expenditure in Nigeria that would ensure macroeconomic stability, promote private investment and welfare maximization in the economy?The answer to these questions requires an empirical verification of the existence of ArmeyCurve in Nigeria; a concept that maintains that low government expenditures can increase economic growth until it reaches a critical level; and that excessive government expenditures could harm economic growth(Armey,1995).
Due to the fluctuating movements in the price of oil and its attendant effect on government revenues in recent years in Nigeria, the government has been looking for ways of securingor diversifying government revenue base in order to reduce the recessionary pressure on the economy. The need to alter fiscal policies and examine the size of governmentexpenditure has now become a practical necessity.This has translated into increased spending such that federal spending over the past decades has increased not only in absolute terms but also in relation to the Gross Domestic Product, yet the expected growth has not been achieved(Ekeocha and Oduh, 2012;Akpan and Udofia,2016; Nurudeen and Usman, 2010).
Similarly, it is further argued that, high government spending negates the domestic absorptive capacity of the economy and thus tends to be inflationary and ends up crowding-out the private sectorwhich could necessitate the adoption of tight monetary policy measure by the Central Bank to ensure macroeconomic stability. The implication of tight monetary policy measure might adversely affect other macroeconomic aggregates such as the level of interest rate and domestic investment. This invariably reduces growth and worsens the level of other macroeconomic variables in the country. Thus, this argument for increased government spending tends to support an empirical investigation. of any inverse U-relationship between the level of economic growth and the size of government expenditure in Nigeria, which is the focus of this study.
Considering the role of government expenditure size in inflationary movements in Nigeria, is particularly of relevance in view of the mode of financing the high and often arbitrary government spending which has increased the size of government expenditure and indeed, money supply and the attendant inflationary implications in the economy.Like many countries, industrialized and developing, one of the fundamental objectives of macroeconomic policies in Nigeria is to sustain high economic growth together with low inflation.The growing interest in price stability is an acknowledgement of the observed phenomenon that high inflation disrupts the smooth functioning of a market economy. In the past years, the pace of Nigeria’s economic growth has been epileptic but government expenditure as a proportion of Gross Domestic Product has kept a rising profile and the trend of inflation appeared to be on the path of increase. CBN(2013) posited that the percentage innovations in aggregate government sizewere; 9.52, -9.66, 20.59, 6.90 and -7.38 for 1981, 1991, 2001, 2010, and 2012 respectively with inflation rates responding as follows; 7.7 for 1981, 5.72 for 1991, 18.87 for 2001 and 13.72 for 2012. High inflation is known to have many adverse effects on the economy. It imposes welfare costs on the society, impedes efficient resource allocation by obscuring the signaling role of relative price changes, discourages savings and investment by creating uncertainty about future prices, inhibits financial development by making intermediation more costly, hits the poor excessively, because they do not hold financial assets that provide a hedge against inflation, and reduces a country’s international competitiveness by making its exports relatively more expensive, thus impacting negatively on the balance of payments, and perhaps more importantly, reduces long-term economic growth(Bawa and Abdulahi,2012; Ghosh and Phillips,1998),
It is therefore not empirically certain if there is a non-linear relationship between government spending andeconomic growthin Nigeria considering the size of government spending in Nigeria for the period under review with relation to the creeping growth nature of the Nigerian economy .Also, the uncorrelated level of economic prosperity with the vast amount of budgetary allocations, and the dilapidated state of social and human capital despite the government’s large foreign exchange earnings and expenditures over these periods 1970 to 2017, have accentuated the need for an empirical analysis of the growth inclusive level of government expenditures in Nigeria.Therefore, this studyseeks to determine the optimal size of government expenditure that enhanceseconomic growth in Nigeria. It also seeks to provide an insight into the impact of government expenditure size on inflation in Nigeria for the period under review.
1.3 Objective of the Study
The main objectives of this study is to determine the size of government expenditure that enhances economic growthin Nigeria from 1970 – 2017Based on this, the specific objectives of the study are to;
(i) examinee the nature of the relationship between government expenditure sizeandeconomicgrowth in Nigeria;
(ii) determine the optimal size of government expenditure that maximizes economic growth in Nigeria; and,
(iii) determine whether government expenditure size has induced
inflation in the short and/or long run in Nigeria.
1.4 Research Questions
In order to address the general and specific objectives of this study, the following research questions wereformulated;
(i) Is there anyrelationship between government expenditure size and economic growth in Nigeria?
(ii) What is the nature of the relationship between government expenditure size and inflation in Nigeria?
(iii) At what leveldoes government expenditure size enhance economic growth in Nigeria?
(iv) Does government expenditure size have any impact on inflation rate in the short run and/or long run in Nigeria?
1.5 Significance of the Study
This study shall be significant in the following ways;
i. This work will provide an insightinto growth inducing government expenditure size that will enable policy makers to control government spending at levels that will contribute positively to economic growthin Nigeria.
ii. The concept of Armey curve shall provide the possibility of calculating optimal government expenditure size in Nigeria which could serve as a policy tool as well as a valuable analytical and conceptual guide in determining the efficient levels of government expenditure.
iii. The knowledge of optimal government expenditure level in Nigeria will help policy makers and government agencies to achieve the objective of reducing public expenditure by dealing with factors that lead to its growth.
iv. This work will contribute to extant literature regarding the level of government expenditure that promotes economic growthwhich could be used as a policy guide in the determination of future growth maximizing level of government expenditure in Nigeria. Itwill shed more light on the short and/or long run relationship between government expenditure size and inflation in Nigeria.
v. Finally, the work will serve as a reference point to students.economic planners, government, among others.It will provide useful information and policy recipe for efficient and effective implementation of growth inducing fiscal and monetary policy in Nigeria.
1.6 Scope and Limitation of Study
This study examines the level of government expenditure size that promotes economic growth in Nigeria. It also focuses on the size of government expenditure that induces inflation in Nigeria in the short and long run. The study covers the period of 1970 to 2017. The federal government expenditure as a percentage of GDP, is employed in the determination of the optimal government expenditure size as well as the short and long run relationship between government expenditure size and inflation in Nigeria. This is due to the availability of data on revenue sources and expenditures of the federal government which consists of oil and non oil revenue sources, whereas, apart from data on revenues accruing to states from the monthly consolidated revenue allocation report of Federal Account Allocation Committee(FAAN), there are no available data concerning the Internally Generated Revenue(IGR) of many states in Nigeria over the period under review.Thus, it is difficult to ascertain the actual revenue and expenditure of states in Nigeria, hence the reason for the use of federal government revenues and expenditures in the analysis of this work. This constitutes the main constraint to this research work. However, in employing federal government revenues and expenditures data in this work, efforts were made to ensure that the data employed in this work are those published by the Central Bank of Nigeria, National Bureau of Statistics and World Bank Development Indicators.
1.7 Organization of Study
This workisstructured as follows: Following this introduction in chapter one, chapter two presents theoretical and empirical literature as well as summary and justification for thestudy. Chapter three explains the methodology of the research work, while chapter four presentsan overview of government expenditure, economic growth and inflation in Nigeria. Chapter five deals with the analysis and discussion of findings of this study, while the summary, conclusion and recommendations form the main thrust of chapter six.
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