Interdependence of government expenditure among European countries: Productivity spillover and strategic interaction

We build an endogenous growth model that distinguishes productive and welfare government expenditures and embeds fiscal externalities. The model yields three testable hypotheses: (i) productive expenditure raises growth (Barro effect); (ii) productive expenditure generates cross-country productivity spillovers; (iii) government expenditure structure exhibits spatial dependence. Estimation with a spatial-panel dataset for 30 European economies (EU27+3) corroborates all three hypotheses. We further show that positive productivity externalities induce an international free-rider problem, causing systematic under-investment in productive expenditure, while negative welfare externalities trigger a “welfare tournament” and over-spending on non-productive expenditure.