Can government spending boost firm sales?

We estimate the effect of government spending on firm production as measured by the value of sales in developing economies. We contribute to the literature by exploring the relationship between the size and composition of government spending on firm sales by workforce size and market destination of goods using instruments based on political institutions and fractionalization. We use a unique firm-level dataset across developing economies coupled with national government spending data. After instrumenting for the fiscal policies, we find that an increase in the proportion of spending that alleviates market failures significantly boosts sales output especially in non-exporting small and medium sized firms but not in large exporting firms. Total government spending positively affects sales output for firms of all sizes and non-exporters. The effect of the composition of government spending on firm output is more elastic than the effect of the size of government spending. The results are explained by the role of government spending in increasing bank loan access, allowing for technological innovation, and augmenting human capital thereby increasing firm output.