Mirmire Volume 10 No.

305 Year 2011

Increasing Government Expenditure in Nepal: How effective it is?

- Shashi K. Chaudhary
e-mail: saw_sea@yahoo.com

1. General View and Nepal

The relationship between government expenditure and economic growth is an important
subject of analysis and debate, especially for developing countries, most of which have
experienced increasing levels of government expenditure over time. The general view is that
government expenditure, notably on physical infrastructure or human capital, can be growth-
enhancing although the financing of such expenditures, if associated with taxation might be
growth-retarding because of disincentive effects. Besides, providing national defense and
securities and transfer payments to maintain social welfare and harmony, a government can
provide economic infrastructure to facilitate economic growth. Government expenditures on
health and education can improve labor force productivity. However, there are also possible
negative impacts on economic growth induced by a government’s revenue raising and transfer
mechanism. The government taxation may produce misallocation of resources as well as
disincentives. In the light of these facts, the central question that blinks is whether government
expenditure enhances the long run steady state growth rate of the economy.
Nepal has been practicing expansionary fiscal policy since long time. The most important
objective of Nepalese fiscal policy is to attain a significant economic growth with tolerable rate
of inflation. Of course, the government expenditure is not the only factor affecting the growth
rate, but it has remained the most important tool for the fiscal policy in Nepal. During the period
from1975 to 2010, social and political changes have accompanied by a sharp increase in
government spending. For example, while the ratio of total government expenditure to GDP was
9.13 percent in 1975, this ratio doubled in three decades, increasing to 18.57 percent in 2010.
During the mentioned period, the economic development efforts have yielded an average growth
of around three and half per cent per annum only. Therefore, the effectiveness of government
expenditure in Nepal has been reported unsatisfactory. The part of the capital expenditure has

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 fallen far below the expected level which is the central matter of concern. It has not exceeded
even 34 percent of the government expenditure in the last one decade. This is very pessimistic
scenario for Nepal as the low level of capital expenditure adversely hits the development
activities.
Table 1: Govt. Expenditure and Economic Growth Rate of Nepal
In million Rs
FY GDPc Govt. Exp (G) Capital Exp (C) C/G Growth rate G/GDPc
2001-02 459443.00 79835.10 24772.40 31.03 0.16 17.38
2002-03 492231.00 80072.20 22356.10 27.92 3.77 16.27
2003-04 536749.00 84006.10 22356.10 26.61 4.41 15.65
2004-05 589412.00 89442.60 23095.60 25.82 3.23 15.17
2005-06 654084.00 102560.40 27340.70 26.66 3.73 15.68
2006-07 727827.00 110889.20 29606.60 26.70 2.75 15.24
2007-08 815663.00 133,604.60 39729.90 29.74 5.80 16.38
2008-09 991316.00 161,349.90 53516.10 33.17 3.95 16.28
2009-10 1182680.00 219,661.90 73088.90 33.27 3.53 18.57
Source: Economic Survey, 2010: table 1.4, 1.7(b) & 2.1.

2. Concern of the topic

There are two schools of thought on the direction of causality between government
expenditures and economic growth. The Keynesian view argues that causality runs from
government expenditure via domestic demand to economic growth. On the other hand, the
Wagner’s theory suggests that the economic growth impacts government expenditure. Thus,
Keynesian propositions treat government expenditure as an exogenous factor, which could be
utilized as a policy instrument while the Wagner’s theory treats it as an outcome, or an
endogenous factor, rather than a cause of growth in national income. The pattern shows that the
government expenditure has been increasing at faster rate in Nepal, while the economic growth
has not shown any drastic change. As a result, the concern of direction of causality between
government expenditures and economic growth has become important here.
In fact, many of the macroeconomic indicators of Nepal have remained almost constant as if
there is no long run relationship between government expenditure and economic growth. In his
research work ‘Public Expenditure and Economic Development in Nepal’ (2010), the author
finds that the cointegration analysis provides positive evidence for the existence of a long-run

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 relationship between government expenditure (GR) and real GDP (YR). The estimated
regression equations are as follow:
Cointegration Regressions R2 F-statistic DW
lnYR = 4.39 + 0.68 lnGR
0.911 309.03* 0.29
(13.20)* (17.58)*
lnGR = - 5.07 + 1.32 lnYR
0.911 309.03* 0.31
(-6.56)* (17.58)*

The results indicate that the CRDW (Cointegration Regression Durbin Watson) statistic is
statistically significant at 5 percent level. The observed CRDW of 0.29 and 0.31 are greater than
5 percent value of 0.282 indicating the presence of cointegration. Thus, the CRDW statistic
confirms the long-run association between real government expenditure and real GDP. Further,
the long run causality test based on the standard t-test statistics from the ECM (Error Correction
Model) in equation (a) indicates that there is a unidirectional causality from real GDP to
government expenditure. The inverse relation does not hold true.

∆lnGRt = 0.0389 + 0.3173 ρt-1 + 0.5757 ∆lnYRt-1 - 0.2149 ∆lnGRt-1 + ut (a)

(1.62) (2.66)* (1.33) (-1.04)
2
R = 0.24 F-Statistic = 2.68***
∆lnYRt = 0.0396 - 0.0565 ρt-1 + 0.0073 ∆lnYRt-1 - 0.1804 ∆lnGRt-1 + et (b)
(2.68) (-0.77) (0.027) (-1.41)
2
R = 0.11 F-Statistic = 1.12
where ρt-1 = (lnYRt-1 - 0.9303 lnGRt-1 - 2.3207), is the error correction term. ( ) indicates t-statistic. ***
indicates statistically significant at 10 percent level.

The short run causality based on F-test statistics from the ECM indicates no causality between
real GDP to government expenditure. Thus, the results support the Wagner’s hypothesis that the
growth of government expenditure can be explained as a result of the increase in economic
activity. The findings suggest that the increase in the size of government expenditure has no
influence on the economic growth of Nepal. This finding is surprising since the general view
expects the existence of a bi-directional causality.

3. Policy Concerns and Conclusion

The budgetary operation in Nepal has been based on expansionary fiscal policies since long
back. It is believed that government can play influential role in economic development of Nepal
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 and therefore, the size of government should be increased. This view is the Keynesian one. But,
the finding of this paper suggests that the increase in the government expenditure has no
influence on the economic growth of Nepal. This puts question on necessity of the increasing
government expenditure and the sectors on which the expenditures are made in Nepal. In this
concern, Lucas (1988) argues that public investment in education increases the level of human
capital and this can be seen as a main source of long-run economic growth. Moreover, Barro
(1990) mentions the importance of government expenditure in public infrastructure for economic
growth and Romer (1990) stresses the relevance of research and development expenditure.
Therefore, composition of government expenditure is also a relevant issue, and if the aim is to
promote growth, the focus should be put on the more productive items of the budget.

References:
• Barro, R. (1990). Government Spending in a Simple Model of Endogenous Growth.
Journal of Political Economy 98 (5).
• Chaudhary, S.K. (2010). Public Expenditure and Economic Development in Nepal.
Economic Literature, IX: p.96-104.
• Lucas, R. (1988). On the mechanism of economic development’, Journal of Monetary
Economics, 22:p.3-42.
• MOF (2005 through 2010). Economic Survey. Kathmandu: G/N.
• NRB (2008). A Handbook of Government Finance Statistics. Kathmandu: Research
Department, Government Finance Division.
• Romer, P. (1990). Endogenous Technological Change. Journal of Political Economy, 98
(5):p.71-102.

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