Government Expenditure Composition and Growth in Chile January 2007

1. Government Expenditure Composition and Growth in ChileJanuary 2007 Carlos J. García Central Bank of Chile Santiago Herrera World Bank Jorge E. Restrepo Central Bank of Chile

2. Organization of the presentation: • Introduction and Stylized facts • Model. • Calibration of the model. • Policy Experiments. • Conclusions.

3. 1. Introduction The purpose of this paper is to examine and quantify the impact on growth of alternative budgetary compositions. We use a model that captures some of the specific stylized facts of the Chilean Economy. One of the specific targets is to test the effects of larger social security payments. This is relevant given that the pension system in Chile is being reformed.

4. Total Expenditure and GDP per capita Growth • Total public spending as a share of GDP has evolved through time and across regions with little or no relationship with growth rates. • The public spending ratio has decreased, while growth rates show diverse behavior. AFR – Africa, EAP – East Asia and Pacific, ECA – East Europe and Central Asia, INL – Industrialized Countries, LAC – Latin America and Caribbean, MNA – Middle East and North Africa, SAS – South Asia. Source: World Bank World Development Indicators and IMF Government Finance Statistics

5. Different Regions: Composition of Total Expenditure (%, consolidated central government) • The composition of public expenditure has varied significantly with clear patterns across regions and through time • A notable trend is the rising importance of social security payments. • Agriculture spending and transport and communication are decreasing in importance within central government budgets Source: Calculated using data from IMF Government Finance Statistics

6. Chile: Composition of Central Government Expenditure (% of GDP) • Health and education are increasing in importance within central government budgets • Social security payments is decreasing but important as % of GDP.

7. 2. Model: The Framework of General Equilibrium • The model is overlapping generation model was developed by Glomm-Rioja (2004) for Brazil, but this version include additional types of expenditure (maintenance of public capital) and changes in the calibration parameters. • The building blocks of the model are defined by the preferences, the technology, and the resource constraints. • Three crucial features are: • Consumption and leisure decisions are made by agents differentiated by their generation: they study when young, work in adulthood, and receive transfers (social security) payments when old. • Government expenditure is productive (in infrastructure and education) and unproductive (transfer payments to the old), affecting production and consumption decisions. • Interest rates depend on the size of public debt.

8. 2. Model: Preferences • Each generation of households lives for three periods: youth, adulthood and retirement. • Each individual, when young, is endowed with one unit of time which can be allocated to learning or leisure. • During adulthood the individual supplies labor inelastically, and allocate labor income between current consumption and savings. • When retired the individual lives on transfers and returns on savings. Specifically, preferences are given by • The evolution of human capital follows the rule below:

9. 2. Model: Preferences • The utility maximization problem is solved recursively, starting with the problem faced by adults: • First order conditions yields the savings decisions given by

10. 2. Model: Preferences • Replacing the optimal savings (equation (4) ) into the objective function in the consumer’s problem (3) yields an indirect utility function for the adult (5) • The problem for the young is hence to maximize (5) with respect to learning time, subject to the law of motion for human capital in (2). The solution to this problem is defined by the following nonlinear equation

11. 2. Model: Production • The aggregate production technology for the single non-storable consumption good is given by • Public infrastructure capital evolves according to • The private physical capital evolves according to

12. 2. Model: Production • The representative firm maximizes profits, taking as given the market factor prices. Perfect competition dictates that the followings first order conditions: • The firm’s profits maximization conditions in (10) imply that private physical capital will evolve according to the following path

13. 2. Model: Fiscal Policy • The government provides public goods, which is financed either by tax revenue or by borrowing • The government expenditure as percent of GDP is distribute on investment in infrastructure, on maintenance, on education, on transfers, and on other general public services (non-utility enhancing). • The government collects taxes on labor income at rate and on capital (interest) income at rate . It can also choose to raise debt to finance spending. • Formally, the government budget constraint is given by

14. 2. Model: Competitive Equilibrium

15. 3. Model Calibration for Chilean Economy

16. 4. Policy Experiments I: increase in expenditure (1% of GDP) GDP growth rate after a permanent increase in expenditure

17. 4. Policy Experiments II: increase in expenditure (1% of GDP) GDP growth rate after a temporary increase in expenditure

18. 5. Conclusions… • We think this is a useful first step in quantifying the impact on long run growth and income of alternative budget compositions capturing key elements in the Chilean economy. • The paper’s results provide quantitative evidence supporting the hypothesis of the importance of public investment in achieving higher income in the long run. • Even though the preliminary results of the simulations show that there is a cost, in terms of growth, of increasing social security payments, this cost is low.

19. 5. …and future work • It would be more realistic to model a non-linear elasticity of public investment such that productivity of public capital decreases as the amount of investment increases. • It could be useful to model a function of “efficiency” of investment, such that not all public investment is transformed into public capital. • We could also consider increasing administrative costs of taxation. • Future extensions of this paper could include public health expenditures that enhance human capital.

20. Government Expenditure Composition and Growth in ChileJanuary 2007 Carlos J. García Central Bank of Chile Santiago Herrera World Bank Jorge E. Restrepo Central Bank of Chile