As Mauritius prepares for its new budget speech on Friday, June 7th, 2024, aimed at proposing measures to boost the economy further, policymakers must critically assess whether the Keynesian multiplier effect remains relevant for the country's current stage of economic development.

Among the economists who have explored the relationship between public expenditure and economic growth, Adolph Wagner (1835-1917) and John Maynard Keynes are particularly notable for their contrasting viewpoints.

In general, public-sector macroeconomists have a pro-Keynesian outlook and view increasing government expenditures as beneficial to economic growth. According to Keynes, government expenditure causes national income to grow through a multiplier effect. While productive investment can generate future income streams, increasing consumption expenditures such as higher pensions do not. These types of spending can lead to economic leakages, as pensioners and low- to middle-income segments, who have a high propensity to consume, increase the demand for inelastic imports, exacerbating the trade deficit and inflationary pressure.

Additionally, from a political economy perspective, special interest groups like senior bureaucrats are unlikely to propose budget cuts. They will always justify higher budget expenditures as a means to propel growth, citing more projects and a growing workforce, through an optimistic economic growth lens.

Wagner's Law of "expanding state expenditures" gained traction in academic circles in 1958. Wagner posits a positive relationship between economic development and the size of the government sector relative to GDP over time. This theory suggests that as economies grow and develop, there is a natural tendency for government expenditures to increase both in absolute terms and as a percentage of GDP.

A large public sector is counterproductive to an efficient free market economy, especially after achieving minimal state capacity. There should be a proper balance between the size of the private and public sectors.

Using data from the World Bank from 1976-2022 and the V-Dem Report 2023, I examine the hypothesis of whether government expenditures stimulate economic growth, as per Keynesian theory, or whether economic growth drives government expenditures, as per Wagner's Law. I use the natural log Real Gross Domestic Product as a proxy for economic growth.

Evidence Supporting Wagner's Law for Mauritius:

Income Elasticity of Demand for Government Services: The first statistically significant evidence of the applicability of Wagner's Law for Mauritius stems from the income elasticity of demand for government services using a bivariate regression analysis of real government expenditure on real GDP for 1976-2022. The income elasticity of demand for real government expenditure is elastic at 1.02, suggesting that government expenditure rises at a slightly higher rate than GDP growth. Granger causality test: The results indicate robust unidirectional causality from real GDP per capita to per capita government expenditure. This implies that, as Wagner predicted, national output causes government expenditure to rise, while the reverse is not statistically significant for Mauritius.

Time Series Regression Analysis: The time series regression results also give strong statistical evidence that Wagner's Law applies to Mauritius. The natural log of Real GDP per capita is the most important explanatory variable impacting the natural log of real government expenditure per capita, after controlling for five independent variables: (a) share of agriculture as a percentage of GDP, (b) industry share as a percentage of GDP, (c) per capita final commercial energy consumption (d) trade openness, i.e., ratio of total trade to GDP, and (e) Democracy Index.

Democratic Institutions Impact: The V-Dem liberal democracy index is negatively correlated with the natural log of real government expenditure per capita, indicating that government expenditure increases when democracy declines.

Vector Autoregression Model: Finally, under a more dynamic setting, the Vector Autoregression (lag one) model confirms that Wagner's Law is forecast to persist in the short to long run and is statistically significant. When the lag one value of the natural log of Real GDP per capita rises by 10%, the contemporaneous value of the natural log of real government expenditure per capita increases by 4.3% and is statistically significant. The Impulse Response Functions analysis shows that a one standard deviation shock to the natural log of Real GDP per capita positively impacts the natural log of real government expenditure per capita, with an immediate rise of 0.38% in the first year, reaching a peak of 1.1% in the third year before stabilizing around 0.7% in the medium to long-run.

Conclusion

The findings of my study hold significant implications for Mauritian policymakers, who should follow a rule-based rather than a discretionary-based fiscal macroprudential approach to steer the economy on a more sustainable economic path.

Evidence suggests that government expenditures in Mauritius do not drive economic growth. Rather, economic growth increases government expenditures, consistent with Wagner's Law. It will be beneficial if policymakers focus on sustainable economic policies rather than increasing unsustainable government spending to stimulate growth.