Chapter Four Methodology 4.1 Introduction, ‘This chapter presents the methodology used for the study. It details the types and sources of data, the model used and the main criterion for accepting the resultant association between the dependent and independent variables after running the regressions. 4.2 Research Approach The deductive approach is used for this study. This approach allows for the development of a ‘ theory (theories) and hypothesis (hypotheses) and designing of a research strategy to test these as well as the anticipation of phenomena and prediction of their occurrence (Saunders etal, 2000). 4.3 Research Strategy The purpose of this research is to assess the impact of government fiscal policy on private investment and economic growth by disaggregating fiscal policy into its expenditure and revenue (mainly tax) components and regressing these on economic growth and private investment. Following Barro and Sala-I-Martin (1992) the fiscal policy variables are categorised as productive or non-productive for expenditure and distortionary or non- distortionary for tax revenue, The productive expenditure is expected to enter into the production function of the private sector, increase returns to investment and thereby foster economic growth. Government expenditure that falls into this category includes spending on roads, machinery and equipment and law and order.On the other hand, non- productive spending comprises of spending on the wage and salary bill of the public services and purchases of goods and services by the government. Wages and salaries of the public sector, the major component of non-productive expenditure, serve to put upward pressure on wages in the private sector thereby reducing returns to investment and thus affecting economic growth negatively. The major difference between productive ‘and non-productive spending is that while productive spending ends up in the production function of the private sector, non-produetive spending only ends up in the utility function. Recognising the budget constraint implies taking cognizance of the financing of these expenditure. Where tax serves as a disincentive to saving, especially in a useful form, it is considered distortionary and exerts a negative influence on economic growth. However, if the tax encourages savings (investment) for level consumption in the future, it is considered non-distortionary and exerts a positive influence on economic growth, 4.4 Justification of Variables 4.4.1 Government Current Expenditure. The general view among proponents of the endogenous growth model (Barro, 1990; Easterly and Rebelo, 199) ; Downes, 2001; and Alexander, 1990) is that government curren: expenditure has a negative relationship with economic growth. This negative influence is normally explained in two ways. One of the major propositions of the endogenous growth model is that growth is driven by accumulation of capital, specifically in the private sector since this sector is considered more efficient in resource allocation. Government current expenditure, which is made up of mainly wages and salaries to the public sector and transfers 46to state enterprises, serves to put an upward pressure on wages in the private sector thereby increasing the cost of private production and reducing returns to investment. The resultant effect is a reduction in private capital accumulation and as per the endogenous growth theory a reduction in economic growth, ‘The second channel through which government current expenditure influences economic growth negatively is by shifting scarce resources from productive sectors to sectors of the economy that are utility maximising only. Consequently, the output from these productive sectors and the econotny as a whole falls. The sign for government current expenditure is therefore expected to be negative in all specifications to be used in the study. 4.4.2 Government Capital Expenditure Public investment, specifically government capital expenditure on infrastructure is posited to have a positive relationship with economic growth because of the complementarities between government infrastructural spending and private capital investment with the direction of causality running from the former to the latter. Government capital spending enters the private production function and increases returns to factor thus encouraging capital accumulation. This positive relation is posited because government capital spending on core activities is considered non-rival, and enters the private production. According to Baldacci et al. (2003) fiscal tightening through reduction in government capital expenditure tends to shrink output and is unsustainable over the long-run, Given the expected positive impact of government capital expenditure on private investment, the effect on economic growth is also expected to be positive 47i ; 4.4.3 Tax Revenue According to Barro and Sala -I - Martin (1992), taxes can be categorized into two broad classes: distortionary taxes and non-distortionary taxes. As per this classification, distortionary (direct) taxes weaken incentives to invest in human or physical capital thereby reducing economic growth. Non-distortionary (indirect) taxes, on the other hand, serve to increase savings in the current period in order to maintain consumption level in future periods (Stiglitz and Atkinson, 1980). 4.4.3.1 Tax on Income and Property ‘Tax on income and property is one of the direct ways by which governments raise revenue to finance their expenses. Given its directness, it constitutes one of the most forthright ways to raise revenue, ceteris paribus. Unfortunately, however, tax on income and property is posited to have the most negative influence on the accumulation of both human and physical capital, the availability of labour and inevitably, economic growth (Creedy and Gemmell, 2005). The major effect of high income tax is that it lowers the marginal product of private capital and, therefore, serves as a disincentive for investment. It also decreases private capital accumulation by reallocating private resources from investment to consumption. With regards to the effect of income tax on labour supply, the impact results in one main way. It changes the after-tax wage rate, As this “price” of labor increases (lower tax rate), more individuals may be expected to enter (or remain in) the labor force and individuals already in the labor force may be expected to work longer hours. Economists call this effect of the after-tax wage rate on labor supply the “substitution effect. Higher income taxes on the other hand increase the disparity (create a wedge) between earned income and take-home pay 48,‘of employees. According to Mitchell (2005) and Saxton (2001), this has the effect of encouraging less productive activities (for example leisure) and simultaneously discouraging productivity (availability of labour). Based on these effects, tax on income and property is expected to have a negative relationship with private investment and economic growth 4.4.3.2 Tax on International Trade According to Kneller et al. (2000), the growth effect of tax on international trade is ambiguous. This is based on the fact that its effect on investment and long-run growth is « : 4 . dependent on the components of international trade (import or exports) that are taxed. Taxes on exports are normally passed on to the consumers of the products. As a result of the fact that this form of tax is not borne by the producer, it does not affect investment and economic growth in any significant manner In the instance, however, where the tax is levied on imported durable capital goods, it reduces private investment by increasing the private sector’s cost of production and reducing returns to private capital. On the other hand, if the tax is levied on consumables, the effect is, similar to that of consumption taxes; consumers save more in order to maintain current levels of consumption in future periods. These savings, in tum, serve as capital to finance investments in the private sector, thus providing a channel to boost economic growth. The net effect of tax on interna nal trade therefore lies in which component constitutes the larger percentage of revenue collected. Due to the inability to determine exactly which component of imports raises the most revenue (and ignoring exports since the country does not raise as much revenue from exports as from imports) the coefficients are expected to have one of the 49.ations, two or both signs (both positive and negative) across the speci 4.4.3.3 Tax on Domestic Goods and Services Considered in economic literature as a non-distortionary lump-sum tax, tax on domestic goods and services constitutes one of the most indirect ways for government to raise tax. revenue. According to Turnovsky (1998), reducing income tax and introducing taxon domestic goods and services yields substantial welfare gains and impacts pos vely on economic growth. This form of taxation is considered non-distortionary in the sense that it does not influence invgstment decisions in a negative manner. According to Stiglitz and Atkinson (1980), if an individual lives for two periods but only receives wages in the first period, the individual is likely to save more in the current period for future consumption if a consumption tax is introduced. This savings in turn serve as funds for investment in the private sector. The resultant effect is accumulation of private capital and inereased economic growth. Also, given the fact that this tax is bome by the consumer and not the producer, it does not affect the production function of the private sector. Based on these theoretical underpinnings, tax on domestic goods and services is expected to have a positive impact on growth and private investment‘Table 4.1: The Independent Variables and the Expected signs Variable Expected sign(s) Government Recurrent Expenditure | Negative (-) =a Government Capital Investment Positive () ‘Tax on Income and Property ~ | Negative -) ‘Tax on International Trade Positive (¥)/Negative (-) Tax on Domestic Goods and Services | Positive (+) « 4.5 Data Type and Sources. The study makes use of time series data spanning thirty-four (34) years for which the required data are available (1964 to 1998). The data is secondary in nature and collected from the Ministry of Finance and Economic Planning and the Statistical Service of Ghana. ‘The data collected include annual values of real GDP growth rates, government current expenditure, government capital expenditure, tax on income and property, tax on domestic goods and services and tax on international trade. All the expenditure variables, revenue variables and private investment are expressed as percentages of GDP (Gross Domestic Product), 4.6 The Model 4.6.1 Conceptual Framework Economists and policymakers alike have long believed that government tax and spending 31policies can have important impacts on long-run economic growth. In other words, the general view among many economists is that fiscal policy has an important role in stimulating investment and economic growth. Recent studies using endogenous growth models have also served to buttress the role of fiscal policy as a key determinant of long-run growth (see Barro, 1990; Barro and Sala-I-martin, 1992; Easterly and Rebelo, 1993). The early empirical literature on fiscal policy and growth focused on the relationship between growth and the size of goverment activity. In particular, it was conjectured that government spending and its associated levels of taxation would result isa reduction in the long-run rate of growth by reducing the return on investment. A relatively recent view, however, also holds that under the appropriate environment and with the right mixture of taxation and spending policies, the government can inerease the quantity and productivity of aggregate investment — human and physical capital, research and technology - and thus overall economic growth (Ram, 1986; Barro, 1990; Barro and Sala-I-martin, 1992; and Easterly and Rebelo, 1993). The usual approach to testing these conjectures was to regress the rate of growth of real GDP on measures of the average level of government spending or tax, In view of the fact that this study seeks to eliminate coefficient bias, the government budget constraint is recognized and as such both government expenditure and tax are regressed on. real GDP growth and private investment to assess the impact of government policy specifically fiscal policy. on private investment and economic growth in Ghana. The major assumption for the study is that the dependent and independent variables are related in a 52linear manner. To accomplish this, real GDP growth and Private investment are modelled, based on endogenous growth theory, as functions of government expenditure and tax revenue (equations 3.3 and 3.7) AGDP, = F(GCURR,GCAP, DTAX, TIP, TINTR) 33 Where AGDP = growth in real GDP GCURR = government recurrent expenditure GCAP = government capital expenditure DTAX = tax on domestic goods and services tip © = Tax onincome and propery TINTR = tax on international trade In order to measure the degree of coefficient biases arising from omission of variables, the dependent variables (growth in real GDP and private investment) are regressed on the expenditure variables and revenue variables separately and jointly. Simply put, economic growth is first be regressed on government expenditure, second, on government revenue and. lastly on both government expenditure and revenue. The study employs ordinary least squares and the regression functions for the study are thus be specified as: AGDP, = i, + BGCURR, + B,GCAP, +6, 34 AGDP, = fi, + B,DTAX, + B,TIP, + B,TINTR, +6, a5 Putting equations 3.4 and 3.5 together, we arrive at equation 3.6 AGDP. = fh, + AGCURR, + B,GCAP, + B.DTAX, + BTIP, + B.TINTR, +, 3.6Private investment is also modelled as a function of government fiscal policy variables. The private investment function is therefore specified as: P |, = F(GCURR,GCAP, DTAX, TIP, TINTR) 37 Where P I = private investment as a percentage of GDP The regression equation is also specified as: PL, = By + RGCURR, + B,GCAP, +6, 38 PI, = B, + B,DTAX, + B,TIP, + B,TINTR, + €, 39 Putting equations 3.8 and fo together, we arrive at equation 4.0. PI, = B+ B|GCURR, + P,GCAP, + B,DTAX, + B,TIP, + P.TINTR, +6, 40 4.7 Hypotheses According to the endogenous growth theory (Barro, 1990; Easterly and Rebelo, 1993) capital accumulation through government spending on infrastructure provision promotes economic growth by inereasing returns to capital accumulation. Government spending with respect to the wage bill on the other hand serves to put upward pressure on wages in the private sector thereby increasing cost of investment and lowering investment returns. This has the effect of discouraging investment, both in physical and human capital and affecting economic growth negatively. On the revenue side, indirect taxes, that is, tax on domestic goods and services and tax on international trade do not impact adversely on private investment and growth because they are normally borne by consumers and therefore do not affect investment decisions, Income and property tax on the other hand influence capital accumulation since it implies a ‘penaltyfor owning capital. Based on the above-mentioned reasons: Null Hypothesis: Fiscal policy variables do not have any relationship with private investment and economic growth ( =0, Bi =0 and fs ~0) Alternative Hypothesis: There is a relationship between fiscal policy variables and private investment and economic growth. (Bi #0. B2 40 and is #0) ‘ 4.8 Unit Root Test and Cointegration Anal Standard econometric theory requires that the variables be stationary if inferences from regressions are to be non-spurious. The null hypothesis for this test requires that the coeffi unt of the auto regressive parameter of the variable be equal to one and the alternate hypothesis states that i less than one. Where non-stationarity is established, using the Augmented Dickey-Fuller (1981) test, the variables are differenced (d) times to achieve stationarity and thus said to be integrated to the order (d). The variables are also tested for cointegration using the Augmented Dickey-Fuller (1981) test and where the variables are found to be cointegrated, an error correction model is estimated with OLS without generating spurious results 4.9 Test of Robustness. According to Bose et al, (2003), failure 10 recognise the budget constraint in growth regressions may give rise to biases in coefficient estimates. In the light of this, only the 35independent variables that remain significant and maintain their signs after the third regression, using equations 3.7 and 4.0 are certified as having a robust relationship with economic growth or private investment. 56