Abstract

Many GCC countries are attempting to improve their fiscal positions through reductions in expenditures and, in some cases, by raising alternate non-oil sources of revenue (see Sassanpour (1996)). Kuwait is no exception to this pattern. Largely as a legacy of the 1990-91 conflict, and notwithstanding the beneficial impact of higher international oil prices, Kuwait faces important fiscal challenges as discussed in Section III. Like the other GCC countries Kuwait is concerned that the required fiscal retrenchment may have an adverse impact on domestic private sector activity in the short term. This is especially true since, in addition to controlling the natural resource wealth, the public sector is the primary engine for non-oil growth.

Many GCC countries are attempting to improve their fiscal positions through reductions in expenditures and, in some cases, by raising alternate non-oil sources of revenue (see Sassanpour (1996)). Kuwait is no exception to this pattern. Largely as a legacy of the 1990-91 conflict, and notwithstanding the beneficial impact of higher international oil prices, Kuwait faces important fiscal challenges as discussed in Section III. Like the other GCC countries Kuwait is concerned that the required fiscal retrenchment may have an adverse impact on domestic private sector activity in the short term. This is especially true since, in addition to controlling the natural resource wealth, the public sector is the primary engine for non-oil growth.

Against this background, this section examines the historical experience in Kuwait regarding the empirical relationship between the public sector and private, non-oil output. Since the concern in Kuwait is on the short-term impact of fiscal cutbacks, the section focuses on the “level” effects of changing both overall government expenditure and the composition of that expenditure. It first reviews the existing literature’s finding regarding the a priori expectations for the effect of the government on the private sector in Kuwait. It then describes the estimated impact of aggregate expenditure components on overall private output and the effects of expenditure changes on the sectoral components of private GDP. Private consumption behavior and its relation to fiscal expenditure are examined next, followed by the policy implications of the analysis.1

A Review of the Literature

The bulk of the recent literature looking at the impact of government actions on real activity has focused on the long-run growth effects of both government expenditure and tax policies from a supply-side perspective. Given the circumstances of Kuwait, however, the literature summarized here will deal only with the implications of expenditure policies, as in Kuwait there is no relevant history of taxation that would allow for extrapolation in order to analyze the impact of revenue changes.2

Most studies focus on expenditure policies that affect the productivity of labor (such as education, health care, and training) or those that affect the productivity of private capital (such as infrastructure and communications). It is argued that the government, by investing in physical or human capital, can enhance the long-run growth rate of the economy through increasing returns to storable resources and external effects of public services (see Lucas (1988), Uzawa (1961), Barro (1990), and Barro and Salai-Martin (1995) for a review of the theoretical literature).

Empirical evidence demonstrating the operation of transmission channels from fiscal policy to longrun growth has been mixed. In cross-sectional studies Easterly and Rebelo (1993) conclude that public investment in education drives overall growth, although the relation appears not to be robust. Otani and Villanueva (1990) determine that health and education expenditure has a significant positive impact, while Diamond (1989) finds only capital expenditure on social services to be significant. On the other hand Castles and Dowrick (1989) find neither education nor health spending to predict growth. Aschauer (1989) shows a positive impact of government size on productivity and suggests there are some increasing returns associated with the public capital stock. Similarly, Easterly and Rebelo (1993) demonstrate that capital investment in transport and communications is significantly related to growth (with a high coefficient), although relations with other forms of capital expenditure prove not to be robust.

Studies that look at aggregate government expenditure produce equally mixed results. Ram (1986) concludes that changes in government spending have a significant, positive effect on growth and attributes this to external effects associated with government size. Landau (1983), Kormendi and Meguire (1985), Grier and Tullock (1989), and Barro (1990), on the other hand, reveal a negative relation between government consumption share of GDP and growth, while Engen and Skinner (1992) and Dowrick (1992) show little effect of changes in government expenditure on growth after instrumenting the fiscal variables to control for endogeneity. Levine and Renelt (1992) also indicate that the relationships between growth and either government consumption share or total expenditure as a ratio of GDP are fragile and not robust to specification changes.

The approach of this section differs from that taken in the above-cited papers along two dimensions.

First, the section is concerned with private sector activity rather than overall output. One of the pit-falls, as Engen and Skinner (1992) point out, in examining the existence of an aggregate endogenous growth process is in disentangling the meaning of empirical correlations (that is, in determining whether government spending affects growth or vice versa). By adopting a narrower perspective, it is hoped there will be less of the reverse effect from growth to fiscal spending (especially in Kuwait where the private sector makes up a relatively small component of the overall economy). To control for the remaining endogeneity, an instrumental variables approach was tried; reliable instruments were not available for the time series of the study and results, using the instruments that were available, were mixed. In similar papers that examine the effect on the private sector Monadjemi (1992), using cross-country data, uncovers some effect of government investment and consumption on private investment but the effect and even the sign of the coefficient varies across countries. In a GCC context Looney (1992) shows, for the case of Saudi Arabia, that public expenditure actually has a negative effect on private sector investment. However, neither of these studies looks at the level of private activity but they focus instead on private investment.

In view of the above, this section envisages two primary transmission mechanisms from fiscal spending to private activity: (1) a direct demand effect from the public sector as a customer of the private producer, and (2) an indirect effect via private disposable income. Since the government employs over 90 percent of the population of Kuwait any change in expenditure on wages or subsidies will likely affect the private demand for domestically produced goods and services. By relating the disaggregated composition of expenditure to private output the section aims to identify the relevant transmission mechanism.

Second, the section envisages the impact of government spending in Kuwait to be predominantly from a demand-side perspective rather than the longrun supply-side arguments mentioned above. The emphasis therefore is on fluctuations in the level of private output as a response to changing government demand stimuli rather than a broad increase in the capacity to produce private goods through long-run growth channels of human and physical capital development.

In practice, identifying the demand-side effects as distinct from those on the supply side is not easy. The empirical exercise is likely to pick up both the demand-side and supply-side impacts of spending. By examining the composition of expenditure it is hoped to partially distinguish the short-run level and longrun growth effects of that spending. An example of this is the finding of a much larger effect of capital expenditure than current expenditure, suggesting that the higher private output is a result of not only the direct demand effect (through consumption of capital goods) but also of large spillovers from physical capital accumulation to growth in private capacity. Such results are in line with Aschauer (1989). Although it is not claimed in this section that there is no role for the government to encourage private activity through investments in human and physical capital accumulation, it seems the returns to growth from such investments are likely to be small in the specification of the equations presented in this section.

Impact of Expenditure on Aggregate Private Activity

As a first stage in the analysis, total expenditure was regressed on private sector output with a dummy for the period of the Iraqi invasion. As equation (1) in Table 4.1 demonstrates, total expenditure had a significant contemporaneous impact on output although there was strong evidence of residual auto-correlation.3 Introducing lagged values of expenditure resolved the dynamic misspecification and led to an increase in the long-run impact of expenditure (although estimation by autoregressive least squares (ALS) did reduce significantly the long-run impact). Finally, adding lagged output to the equation resulted in a long-run impact of total expenditure of 0.35, although expenditure was significant in the long-run equation only at the 12 percent level. These first impressions suggest a significant positive relationship between total expenditure and private sector output with the coefficient ranging from 0.2 to 0.4 (that is, a 200 to 400 fils rise in private output for every dinar spent).

Table 4.1.

Impact of Changes in Expenditure on Total Private Sector Output

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From the literature on private productivity and government expenditure (particularly Aschauer (1989) and Barro (1990)), it is reasonable to suppose that not all components of expenditure affect output equally. To examine this possibility, expenditure is split into current and capital components. Both components, as expected, are significant, but the different types of expenditure have very different impacts. Historically, current expenditure has a contemporaneous impact on private income of 180 fils for every dinar spent, while capital expenditure has a much bigger effect on output (an additional dinar of capital expenditure results in a KD 1.5 increase in private sector output). This is a very large impact by any standards and it is likely to be attributable partially to demand effects—with the state purchasing from private producers of capital goods (especially in the construction industry)—and, probably more importantly, spillovers from investment in infrastructure and communications—with such investments leading to increasing returns in private sector activity.

Again, the equation exhibits residual autocorrelation as indicated by a Chi-squared test for autocorrelation. Including lagged current expenditure resolved the serial correlation of the errors. This specification indicates that in the short run the impact of current expenditure on private output is 0.88, while in the long run the effect is rather smaller at 0.37. Capital expenditure again has a considerably larger effect. The equation was robust to tests for autocorrelation and heteroscedasticity. As a further guard against autocorrelated residuals, the equation was estimated by ALS, and it was found both that the coefficients on the error terms were not significant and the long-run coefficients in the equation were not significantly different from those obtained by OLS estimation using a likelihood ratio test.

Since both private GDP and expenditure are integrated, as demonstrated by the augmented Dickey-Fuller test statistics (see Appendix for test results), it is prudent to check that the inferences are not simply an artifact of the unit root in the regressors (see Granger and Newbold (1974) and Phillips (1986)). To this end evidence of cointegration between current expenditure, capital expenditure, and private GDP was investigated. Using Johansen (1988) cointegration methods, it was established there appeared to be one cointegrating vector and setting that vector equal to the long-run coefficients of 0.37 and 1.52 was not rejected at the 5 percent level using a likelihood ratio test.4 In addition, an error correction model was estimated between private GDP, current expenditure, and capital expenditure with the longrun restrictions on the error correction vector of (1, –0.37, –1.52) not rejected by a Wald test.

To summarize, there appears to be a robust and significant effect of government spending on the level of activity in Kuwait’s private sector. This is demonstrated both by regression techniques and examination of the long-run relationships between the variables through cointegration analysis. Capital expenditure in all specifications seems to have a much larger effect on output than current expenditure. This indicates the effect not only of the government’s demand for capital goods and services but also the longer-run effect on private sector development of increasing the public capital stock. By providing transport, communications, prepared industrial parks, utilities, and broad capital infrastructure, the government can provide an environment for a higher growth path of private sector activity and a resulting increase in the level of private value added. Nonetheless, such a large coefficient should also be interpreted with caution. For current spending, the short-run effect appears larger than that which persists in the long run. The immediate impact is from the demand effect of a rise in current spending through increases in state purchases of goods and services and by increasing private disposable income and thus private consumption. However, there is a secondary crowding out effect leading the longrun impact to be lower.

The Sectoral Breakdown

This subsection aims to provide a users’ guide to the estimated impact on sectors of various changes in government spending in order to assess which sectors will be most affected by fiscal retrenchment. In doing so it is hoped that it might be possible to assess those policies that could in the future best mitigate the effects of fiscal adjustment measures.

Manufacturing

Given the dominance of hydrocarbons in the Kuwaiti economy, oil GDP was included in a regression of private manufacturing on government expenditure on goods and services,5 wage expenditure, the tax rate, and lagged values (Table 4.2). The tax rate and the level of wage expenditure were included to pick up the effect of changing private sector demand for locally manufactured goods as a result of changes in disposable income, but these proved not to be significant, which suggests that there is only a direct channel of changes in government demand affecting private manufacturing output. The resulting parsimonious regression demonstrates a small but significantly positive impact of government goods and services spending on manufacturing and a smaller effect of changes in oil sector output. The equation was robust to autocorrelation and heteroscedasticity tests and estimation by ALS showed no significant serial correlation in the errors. Johansen tests identify one cointegrating relationship and the vector (1, –0.07, –0.02) cannot be rejected by likelihood ratio tests. Similarly, estimating the model in its error-correction form and restricting the error-correction vector to (1, –0.07, –0.02) was not rejected (although the error-correction specification was not a well-measured equation with some of the variables not significant). Given that much of the government goods and services consumption is not on domestic privately produced goods, it is not surprising to find the effect of changes in this component of expenditure to be small (only 70 fils for every dinar spent) but the relationship does appear significant and robust to various specifications.

Table 4.2.

Impact of Changes in Expenditure on Private Manufacturing

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Construction

Regressions were run to relate capital expenditure on housing and economic services6 to private sector construction activity (Table 4.3). The long-run impact of capital expenditure on housing and economic services was 0.64 and 0.035, respectively, although estimating the model by ALS produced varied results. There was evidence of one cointegrating relation between private construction, housing capital expenditure, and economic services capital expenditure but the restriction (1, –0.65, –0.035) was rejected. In addition, estimation of the error-correction model yielded poor results.

Table 4.3.

Impact of Changes in Expenditure on Private Construction

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Since there was a concern of multicollinearity among the regressors, housing expenditure was dropped, leading to a more robust relationship. Estimation by both OLS and ALS showed a long-run effect of economic services capital expenditure of about 0.3. There appeared to be one cointegrating vector equal to (1, –0.5), implying the effect of economic services capital expenditure to be significantly higher than that suggested by the long-run regression model although not as high as the effect of capital expenditure suggested in the aggregate specification of the section on the Impact of Expenditure on Aggregate Private Activity. Again the error-correction model was imprecisely estimated and placed little restriction on the possible long-run relation-ships between government expenditure and private construction.

Overall there is evidence that government economic services capital expenditure has a significant impact on construction, with cointegration analysis suggesting this effect could be as large as 0.5. In addition, there is some weaker evidence that capital expenditure on housing has an impact on private construction activity although the relationship is not particularly stable over time (which is further indicated by recursive estimation techniques not presented here). This is perhaps attributable to both the war and the Souk Al-Manakh collapse, which had significant effects on the construction sector.

Trade, Restaurants, and Hotels

In the belief that private activity in nontradables such as trade, hotels, and restaurants is dependent on private disposable income, private output in this sector was regressed on expenditure on wages and subsidies (Table 4.4). In addition, government goods and services expenditure was included to capture direct demand effects from public consumption. The equation performed badly and once residual autocorrelation, whose presence was indicated by the Chi-squared test, was corrected for by ALS these variables proved not to be significant. However, it is also true there was a large structural break in this sector following the Souk Al-Manakh collapse as well as after the Iraqi invasion. When a dummy was added to allow for the Souk Al-Manakh collapse and lags of the variables included to correct the dynamic misspecification, it was found that only subsidy expenditure and lagged wage expenditure had a significant effect, suggesting the impact on this sector of fiscal changes operates mainly through changing the private disposable income. The long-run impact of wage expenditure on this sector became about one-third, while interestingly subsidy expenditure has a significant negative impact on the sector as a whole with a long-run effect of –0.23. Johansen tests suggest there is one cointegrating vector between the series and a vector of (1, 0.23, –0.33) could not be rejected by a likelihood ratio test. Estimating the error-correction components reflects similar results. There is clearly a strong relation between activity in this sector and contemporaneous wage and subsidy expenditure. However, the long-run negative effect of subsidies is difficult to interpret and possibly the result of endogeneity problems (with subsidies perhaps being a response in part to weaknesses in this sector).

Table 4.4.

Impact of Changes in Expenditure on Private Trade, Restaurants, and Hotels

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Other Sectors

In examining the relationship between fiscal out-comes and private sector activity in the other sectors, little useful empirical relationship was found. For transport, communications, financial institutions, and real estate, the Souk Al-Manakh incident had a substantial impact causing a boom in the sector prior to the collapse and then a slump afterward. Since the liberation, the character of these sectors—in particular, financial services and real estate—has changed dramatically due in part to the state’s forgiveness of personal loans, the Debt Collection Program, and the divestiture of stocks held by the Kuwait Investment Authority (KIA). Even when these events are controlled for with dummies there still do not appear to be any strong effects of public spending on the sector (either through wages and subsidies or through direct purchase of goods and services). In the community and social sector, where less than 15 percent of the sector is private, activity is largely associated with personal and household services provided by expatriate labor. Although one might think this sector would be affected, from the labor demand side, by the level of Kuwaiti wages and salaries (since supply of expatriate workers is very inelastic) it is probably driven far more by the regulations concerning foreign immigration; as such no empirical relationship between salaries and activity in this sector was found.

Summary of Findings

Overall there appears to be fairly robust evidence that government spending on goods and services directly affects activity in the manufacturing sector, while capital expenditure has a significant impact on construction. However, the extremely large impact of capital expenditure exhibited at the aggregate level does not seem to be present in the sectoral analysis suggesting aggregation may be providing biased coefficients. In addition, it was found there is an indirect channel from fiscal outlays on wages and subsidies that has a significant relation with activity in trade, hotels, and restaurants. Production in the other sectors (which make up more than 50 percent of private activity with 40 percent being in financial services) either appears empirically unrelated to the structure of the budget or else has been subject to significant shocks (for example, the Iraqi invasion and the Souk Al-Manakh collapse) that make interpreting any long-run relationship difficult.

The Impact of Fiscal Policies on Private Consumption Expenditure

Having looked at the effects of changes in fiscal activity on the sectoral components of private output, this subsection examines in more detail the indirect channel whereby government expenditure on wages and salaries would affect private demand for privately produced goods and services (Table 4.5).

Table 4.5.

The Effect of Changes in Public Expenditure on Private Consumption

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As a first approximation of a private consumption relation, consumption was regressed on contemporaneous private sector income. Although the model fitted quite well, the estimated marginal propensity to consume under different specifications was implausibly high (that is, greater than 1). Since both consumption and income are 1(1) processes, the existence of a cointegrating vector was examined. There appears to be evidence of two cointegrating vectors that is contrary to the augmented Dickey-Fuller tests, which suggest both series are 1(1). Overall the simple relation between consumption and private GDP fits well but makes little economic sense and shows no robust long-run relationship as demonstrated by the cointegration analysis.

It is unreasonable to expect that the marginal propensity to consume would be so high, but it is also true that private GDP does not capture well private disposable income in Kuwait owing to the large government component of individual earnings (in the form either of government salaries or subsidies and transfers). A proxy for private disposable income was estimated to be equal to private GDP plus subsidies and transfers plus government wages and salaries. In a static regression of consumption on this disposable income proxy, the marginal propensity to consume was found to be 0.56 although the regression had autocorrelated errors. Adding lagged income and lagged consumption changed the long-run marginal propensity to consume to 0.46 but solved the specification problems. This function was robust to autocorrelation, heteroscedasticity, and test of functional misspecification. Cointegration tests support the existence of one cointegrating vector and the value (1, –0.46) cannot be rejected by likelihood ratio tests; how-ever, the estimated cointegrating vector suggests a marginal propensity to consume that could be as low as 0.2. Estimating the model in the first differences produced satisfactory results with the error-correction component suggesting a marginal propensity to consume of 0.46.

The analysis suggests that for every dinar spent on subsidies, transfers, and wages, between 20 percent and 50 percent of that value is consumed by the private sector. Since a portion of consumption is on importables, it is likely that cuts in such expenditures will improve the trade balance through a reduction in imports. However, given the high concentration of private sector activity in nontradables (two-thirds of private GDP is in nontradable sectors), it is also possible that a change in wages and subsidies will have a strong effect on private demand for local, privately produced goods and services. The data suggest that a reduction in wages will have a significant effect on wholesale and retail trade but it is possible also that there will be implications in the financial services sector although such effects are difficult to predict owing to the considerable shocks this sector has been subject to in the last 15 years.

Conclusions

The analysis suggests a strong relation between private sector activity and fiscal spending in Kuwait. In particular, capital expenditure appears to have a larger effect on private GDP than current expenditure.7 The manufacturing, trade, and construction sectors appear to be the most exposed to changing patterns of fiscal spending; spending affects these sectors either directly through changing government demand for products (as in manufacturing and construction) or indirectly by changing private disposable income and thus private consumption (as in the trade sectors). Estimation of a consumption relation suggests that between 20 percent and 50 percent of wage and subsidy expenditure is consumed by the private sector, although it is not clear what proportion of that consumption is on domestic, privately produced goods and services.

One drawback of the analysis has been the difficulty in establishing a relationship between the financial services sector and fiscal activity. This is particularly important in Kuwait since 40 percent of private value added is in this sector. However, given the shocks to the Kuwaiti economy and the changing nature of this sector, in particular after the Iraqi invasion, it is not surprising that an empirical long-run relation is difficult to uncover.

In terms of policy prescriptions, the analysis here suggests that care should be taken in designing fiscal consolidation efforts in order to minimize their impact on private sector activity. In particular, within the overall fiscal consolidation effort, the distribution of budgetary outlays should be shifted away from current expenditure and toward capital expenditure. It perhaps is inevitable that the reduction in government spending will, other things being equal, have an adverse impact on private sector activity in the short term. Determined efforts to intensify structural reforms and enhance private sector investment (from domestic and foreign sources) will mitigate this effect.

Appendix

Augmented Dickey-Fuller Tests and Johansen Test Results

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1

To facilitate this study, a data set was constructed, in collaboration with the Kuwaiti authorities, to cover the sectoral breakdown of private and public sector activity, the savings-investment relations, and the expenditure and revenue characteristics of the budget. The data in the sample broadly cover the period from 1977 to 1994. The private-public breakdown for the period of the Iraqi invasion and from 1977 to 1980 were spliced into the data set on the basis of the shares prevailing in the closest available year. In all estimations a dummy variable was included to control for the 1990-91 Iraqi invasion.

2

This is illustrated by the fact that including the average tax rate in any of the regressions did not yield a significant coefficient.

3

In the table, OLS refers to ordinary least squares estimation, ALS(n) refers to estimation by autoregressive least squares with n lagged error terms, ALS(n)** implies that the coefficients on these error terms are found to be significant at the 10 percent level. The number in parenthesis refers to the level of significance of that variable or test (for example (0.06) implies that the null for the test is rejected at the 6 percent level).

4

See Hamilton (1994) for a complete review.

5

Goods and services expenditure contains a large defense component. It would have been preferable to extract defense expenditure from this measure but comprehensive data are not available.

6

Capital expenditure on goods and services includes spending on infrastructure, communications, and others.

7

Although it seems capital expenditure has a larger effect on the level of activity than current spending (by affecting both the supply and demand side of private production) the very large impact seen in the aggregate level should be treated with caution, especially given that such increasing returns do not seem present at the sectoral level.