Economic Growth in Context of Institutions and Fiscal Policy

• Author: GHULAM RASOOL MADNI and MUHAMMAD ASLAM CHAUDHARY

Abstract. The aim of present study is to investigate the relationship between economic growth, institutional quality and fiscal policy over the period of 1984-2015, in the case of Pakistan. The unit root analysis reveals that all variables are non-stationary at level, but some are at first difference. The ARDL bounds testing approach to integration is employed to determine the long and short run relationship among the variables. Principal Component Analysis (PCA) is carried out to construct an index for institutional quality. It was found that institutional quality and government spending were positively affecting the economic growth of the country, while educational attainment and private investment were also significantly contributing to enhance the economic growth of Pakistan. It was suggested that government needs to improve the institutional quality and growth oriented spending to further boost the economic growth.

Keywords: Institutions, Economic Growth, Fiscal Policy, ARDL, PCA

1. INTRODUCTION

   Economic growth is raise in an economy’s potential GDP and must be sustained for a developing economy. Economic growth is a fundamental instrument and indicator for sustainability and development of any economy. In long run, the focus of governments is to foster sustainable economic growth. The sustained growth of any country is helpful to improve the living standard of people in many ways like reducing the poverty, enhancing the infrastructure and educational facilities, combating increased inflation, and reducing the external vulnerabilities.

   It may be observed that no society reaped towering echelon of economic growth without the intervention of government. Economies without interference of government face diverse hue of chaos that freezes their economic growth with passage of time. There is contentious debate regarding the role of government spending. Government expenditures allow government to reallocation of resources from elite to poor. The effectiveness of fiscal policy on economic activities has been on applied and theoretical research agenda for both policy makers and academicians since the emergence of macroeconomics. It is obvious that fiscal policy is a pre-condition to achieve macroeconomic permanence and sustainable economic growth that can have foremost impacts on income generation and poverty alleviation through taxation, optimal revenues generation, public borrowings and public expenditures.

   However, conversely; a bungling fiscal policy curbs the options for government for optimal tax collection, sustainable economic growth and economic performance.

   Recently, role of public spending got a striking attention of the policy makers and researchers of the subject, especially after financial crisis of 2007. Endogenous and Keynesian growth theories proved the significant role of fiscal policy for economic development of an economy. The public spending may be helpful to raise the economic growth by developing the institutions like maintaining the law and order, protection of property rights, control over corruption, provision of public goods, and other social services that may lead to improve the aggregate demand and sustainability of economic growth.

   The institutional role in growth route of economies got importance in decade of 1990, when two pioneer studies by Knack and Keefer’s (1995) "Institutions and Economic Performance", and Mauro’s (1995) "Corruption and Growth” were published. By relying on new dimensions of property rights and institutions, these items ushered in a new generation of devoted research to prove importance of institutional framework in economic performance across the countries. Knack and Keefer (1995) considered the data of 97 economies from 1974 to 1989 and concluded that institutional quality is working as a protection of property rights and contract enforcement is an essential difference for investment and growth. In the same way, Mauro (1995) found that the corruption rates have negative association with economic growth and private investment. The other experimental evidence supports these preliminary results.

   For example, Alesina (1998) indicates that institutional quality plays a vital role for growth and this quality of institutions was measured by bureaucracy, corruption, property rights and law and order. As concerned for these results, it seems that literature provide pragmatic assistance to views of Douglass C North and Olson, who emphasized upon importance of contract enforcement and property rights in defining the prosperity and growth of economies.

   According to new institutional economics, institutions play a pivotal role in determining the fate of the country. Unlike the neo-classical theories, it does not take institutions as given. The reason is claimed as that some countries may develop because of the institutional framework that enhances agents’ efficient behavior, while others are facing problems because their institutional framework does not put off abusive behavior and methods that are ineffective, so there is frustration in investment and economic agents have hesitation to make contracts or agreements. “This negates some of the benefits of specialization, because agents are more vulnerable to others as they need to buy and sell products constantly” (North, 1990).

   We consider that the two backward economies are very identical in human, technical and physical conditions and both are intended to acquire a plan to improve the economic performance. After adopting the recipes of neo classical theories, we would know about the main disadvantages of these economies, we applied the same models and there was expectation of similar outcomes in both economies. But results will not be to those as there were expectations in both countries where same models were implemented and similar countries meet the different fate as observed experimentally having very divergent paths of the countries that have applied the same types of policy. Why this is a difficult question to answer. But we know that in addition to all issues that involve concentrating on a particular idea and direct support to a certain point; we should keep in view the conditions of existing institutions in these economies.

   Pakistan is a developing country of the world depending on agriculture, industry, manufacturing and remittances. The trend in economic growth of Pakistan is presented in the following figure. The growth rates of Pakistan remained relatively higher and impressive in the decades of 1960’s and 1980’s. The next decade of 1990’s remained worst, not due to poor economic performance but also due to poor governance, political instability (during the period of 1988-99, eleven governments were changed resulting loss of confidence of investors and growth), debt burden (accrued during the period of 1977-88, resulting in annual interest payments made equal to 60 percent of budget and 25 percent for defense, so development expenditures were reduced significantly), and imposed sanctions on Pakistan in the decade of 1990’s relevant to nuclear propagation.

   The last year of 90’s decade (1998-99) was most difficult year in history of the country due to many significant domestic and regional events. These included the nuclear tests of Pakistan and India, later on dismissal of the voted political government in October that same year. In fact, the decade of 1990’s, as a whole, was the decade of under development, as compared with previous decades. The nuclear tests caused to impose large variety of sanction on Pakistan by developed countries.

   During the constitutional period of five years (2008-13) of Pakistan People Party, the fragile economy of Pakistan remained floundering, as the economic managers ineffectively made efforts to bridge the widening budget deficit year-after-year. Moreover, public debt was increased to a record level and other macro-economic indicators were on lowest ebb. The average GDP growth rate during...