Abstract
This paper explores the effect of financial development on the composition of government expenditure. We establish an endogenous growth model to consider the role of financial development. We demonstrate that because of the efficiency loss induced by lower financial development, private investment is constrained and hence governments tend to spend on higher productive expenditure to maintain a certain economic growth rate. Relying on a large sample of 105 countries over 1984–2009, we find supporting evidence that countries with higher financial development tend to have lower productive expenditure. This result is robust across alternative measures of the key variables and alternative estimations with and without correcting the potential endogeneity issue of financial development.
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