Public Expenditure & Economic Growth: Targeting, Social Spending, and Defence

Key ideas from Week 6 content

Government spending has a crucial role in reducing inequality and poverty. It can be directed through three policy instruments:
- Taxes
- Expenditure
- Regulation
Definitions:
- Primary income: actual value of personal income of an individual or household.
- Secondary income: Primary income – taxes + government services consumed.
In South Africa, reducing inequality and poverty is a primary policy objective.

Targeting and policy design considerations

Policy design goals when spending to affect inequality/poverty:
- Reach the intended beneficiaries and ensure spending is targeted to the poor.
- Ensure the incidence of taxes falls on the wealthy.
- Determine whether cash or in-kind transfers (goods/services) are most useful.
- Ensure quality of interventions.
Design considerations include:
1) Will the policy achieve its aims?
2) How will policies affect beneficiary behavior? Avoid perverse incentives (e.g., wage subsidies causing substitution away from work, cash transfers spent on luxury goods, leisure/work tradeoffs to avoid labour income taxes).
A central concept: targeting of government spending.

Targeting of government spending

Three targeting mechanisms:
- Means testing: using income or wealth to distinguish those eligible for government assistance.
- Indicator testing: using indicators correlated with income/wealth but easier to measure.
- Self-targeting: designing benefits that are unattractive to the wealthy.
Benefits of targeting:
- Budgetary savings and stronger poverty-reducing impact of interventions.
- Reduces two types of errors:
- Type 1 errors (exclusion): poor individuals are left out.
- Type 2 errors (inclusion): rich individuals receive benefits they should not.
Costs of targeting:
- Administrative costs to identify, reach, and monitor beneficiaries.
- Efficiency costs due to behavioural responses to incentives (e.g., distortion of work-leisure choices).
- Incentive costs.
- Social costs: loss of self-esteem and stigma from program participation or officials’ attitudes.

The Case for Cash Transfers: Strengths, Limitations & Targeting

Cash transfers and social services can reduce poverty and inequality when designed to reach the poorest and minimize leakage to the affluent.
Requirements for effective targeting:
1) Appropriate targeting mechanisms.
2) Adequate administrative capacity.
Visually representing universal vs means-tested outcomes (conceptual):
- Y_min-a-d: initial income.
- Z: poverty line.
- Y_min-a-z: poverty gap.
- Means-tested transfer: transfer amount T = c − Y_min (illustrated in figures such as Fig. 8.2 in Calitz et al., 2019).
- Non-targeted transfers vs perfectly targeted transfers yield different outcomes relative to poverty gaps.
Means testing can be costly to implement, so governments may opt for less sophisticated targeting while still aiming to minimize Type 1 errors (exclusions) and Type 2 errors (leakage).
Important figure references: Fig. 8.2, F8.2 (Calitz, Steenekamp, Siebrits, 2019).

Case Study: Composition of Government Expenditure – Defence Spending

Quick proposal options often discussed:
- Create proposals for spending cuts in defence.
- Increase defence spending in some contexts.
Key question: When and why should governments spend on defence?
Determinants include:
- Traditional military rationale: maintaining a standing army to exert hard power.
- Geopolitical instability and broader national security considerations.
- Peace-time benefits: large corps of skilled labour to support security, infrastructure, or development roles.
- An economics-based approach evaluates potential marginal returns to defence spending and tests for causal links with macro variables tied to citizen welfare.
Context: University of Cape Town ECO3023S, Week 6 material (Slide 14).

Interdisciplinary considerations and determinants

Defence burden decisions are shaped by strategic, political, ethical, interpretive, and psychological factors, not just economic considerations.
Arlinghaus (1984) argues arms transfers reflect responses to external threat and domestic discord, and can reinforce perceptions of independence and sovereignty.
In post-colonial Africa, defence demand is influenced by
- External threats and internal discord,
- The symbolic role of the military in nation-building and sovereignty (e.g., Diori’s Niger quote).

Effects of defence spending on growth

Defence spending tends to have distinct implications for Least Developed Countries (LDCs): potential marginal returns from public spending may be higher in LDCs than in the developed world, but the opportunity cost of spending in any single sector is also higher in LDCs.
Benoit (1973a, 1978) and Deger & Smith (1983) argue that the returns to public spending can be higher in LDCs, but this is context-specific and depends on structural factors.
The short-run vs long-run effects:
- Short run: defence budgets may substitute for other forms of public spending (crowding out) and have limited immediate growth effects.
- Long run: potential direct impacts on macro factors such as labour productivity, capital accumulation, and employment; indirect effects via socio-political channels.
Defence spending can influence socio-political conditions that affect development (D’Agostino et al., 2018; Elveren, 2019).

Theoretical approaches to defence spending and growth

Marxist perspective:
- Defence spending is dynamic and historically determined, tied to capitalist systems and the existing socio-economic hierarchy.
- Defence can support capitalist growth by sustaining industrial demand, expanding markets, and mitigating crises (Dunne & Nikolaidou, 2012; Elveren, 2019).
- Baran & Sweezy (1966) argued public defence spending can prevent capitalist stagnation by providing sustained demand for industry and R&D.
- Defence may extend the growth potential of an economy beyond household consumption needs or private investment alone.
Keynesian perspective:
- Defence spending as a demand-management tool via multipliers, especially when aggregate demand is weak.
- Some analyses suggest defence can be used counter-cyclically to stabilize the economy.
- Empirical findings often show negative growth effects in defence spending, but there are channels through which defence spending could positively affect growth (e.g., underutilised capacity, productivity spillovers from R&D, skill development).
Neoclassical perspective:
- Defence and security as non-rival, non-excludable public goods; national security can be treated as a public good.
- Policy should optimize marginal cost-effectiveness given the government’s risk preferences and the opportunity costs of defence spending.
- The overall impact depends on how defence affects the aggregate production function and whether security investments improve productive capacity.

Visual and analytical examples in Neoclassical framing

A figure illustrating marginal returns to defence investment shows diminishing returns as the number of missiles increases, highlighting the importance of optimizing the level of armament rather than assuming more is always better.
Key takeaway: the relevant question is the marginal gain from additional defence spending, not the absolute level of spending.

Defence procurement: content and pitfalls

Production for military purposes differs from civilian production.
- Fewer buyers (often monopsony) and a single customer (government) can lead to price setting and procurement dynamics distinct from civilian markets.
Government procurement practices:
- Competitive bidding is used to obtain the best price, but it can lead to cost overruns if contractors incur higher R&D or production costs than anticipated.
- Design specs may change during development, increasing costs.
- Uncertainty and the need for extensive monitoring can raise costs.
- Contractors may require the government to share some of the additional costs.

Key terms to remember

Primary income vs Secondary income definitions.
Means testing, indicator testing, self-targeting.
Poverty line (Z) and poverty gap concepts (Y_min, a, z) in universal vs targeted transfers.
Transfer design: T = c − Y_min in means-tested schemes.
Types of errors: Type 1 (exclusion) and Type 2 (inclusion).
Wage subsidies and programs: TERS, expanded public works programs (EPWP), learnerships; Employment Tax Incentive (ETI).
Minimum wage benchmarks in SA (as of March 1, 2025):
- National minimum wage: ext{R }28.79/ ext{hour}
- EPWP minimum wage: ext{R }15.83/ ext{hour}
- Learnerships: lower rates (as applicable).

Connections to broader principles and real-world relevance

Targeting is essential for policy efficiency: it helps reduce leakage and maximize impact on poverty and inequality.
Policy design must balance effectiveness with administrative feasibility and potential behavioural responses.
The defence expenditure literature integrates multiple perspectives (Marxist, Keynesian, Neoclassical) to explain how military spending interacts with economic growth, development, and political economy, especially in LDCs.
The procurement process highlights practical challenges in achieving cost-effective public spending and the importance of governance mechanisms to manage costs and risks.

Summary of core takeaways

Government spending can reduce inequality and poverty when implemented with careful targeting (means testing, indicators, or self-targeting) and appropriate instruments (regulation, expenditure, taxation).
Targeting reduces errors but introduces administrative and incentive costs; a balance must be struck between precision and feasibility.
Defence spending is a complex area with mixed evidence on growth effects, varying by short-run vs long-run horizons, country development level, and institutional context.
Different theoretical lenses (Marxist, Keynesian, Neoclassical) offer complementary explanations for why and how defence spending can influence growth and development.
Procurement challenges in defence demonstrate the trade-offs between achieving strategic goals and maintaining cost efficiency.

Formulas and numeric references used in the notes

Transfer under means testing (illustrative):
T = c - Y_{ ext{min}}
Definitions for poverty measures (conceptual):
- Initial income: Y_{ ext{min}}
- Poverty line: Z
- Poverty gap (illustrative): Y_{ ext{min}} - z
Minimum wage figures (as of 2025):
- National minimum wage: ext{R }28.79/ ext{hour}
- EPWP lower rate: ext{R }15.83/ ext{hour}