Causality for the government budget and economic growth
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1 Department of Economics António Afonso & João Tovar Jalles Causal for the government budget and economic growth WP07/204/DE/UECE WORKING PAPERS ISSN
2 Causal for the government budget and economic growth * António Afonso $ and João Tovar Jalles Abstract We use a panel of 55 countries for to stud (two-wa) causal between government spending, revenue and growth. Our results suggest the existence of weak evidence supporting causal from expendures or revenues to GDP per capa and provide evidence supporting Wagner s Law. JEL: C23, E62, H50. Kewords: government expendures, goverment revenues, panel causal, GMM.. Introduction According to conventional wisdom larger budget defics have coincided wh wasteful government spending, large bureaucracies, and other counterproductive economic policies. Seminal earlier work on the impact of government expendure on long-run growth include studies b Landau (983), Ram (986), Grier and Tullock (989), Romer (990), Barro (990, 99), Derajavan et al. (996) and Sala-i-Martin (997), mostl using cross-section data to link measures of government spending wh economic growth rates. On the causal issue Hakro s (2009) finds evidence suggesting that government expendures are growth inducing. On the same sample Kumar (2009) using time series techniques instead infer that Wagner s Law does hold. Yuk (2005) takes a long term perspective on UK time series and, although support for Wagner s Law is sensive to the choice of the sample period, there is evidence that GDP growth Granger-causes the share of government spending in GDP We use a cross-sectional/time series panel of 55 developed and developing countries for the period In particular, we assess (two-wa) causal, and also the possibil of the Wagner Law. Therefore, we run panel Granger causal tests and assess the existence of cross- * The opinions expressed herein are those of the authors and not necessaril those of the ECB, or the Eurosstem. $ ISEG/ULisbon Univers of Lisbon, Department of Economics; UECE Research Un on Complex and Economics, R. Miguel Lupi 20, Lisbon, Portugal, aafonso@iseg.utl.pt. UECE is supported b the Portuguese Foundation for Science and Technolog through the project PEst-OE/EGE/UI0436/20. ECB, Directorate General Economics, Kaiserstraße 29, D-603 Frankfurt am Main, German. IMF, Fiscal Affairs Department, th street NW, Washington DC 2043, USA. jjalles@imf.org. An often quoted fact, Wagner's Law, about the long-run tendenc for public expendure to grow relative to some national income aggregate such as GDP (due to Wagner in 883).
3 sectional dependence amongst homogeneous groups of countries. Our results show the existence of weak evidence supporting causal from expendures (revenues) to GDP per capa and find supporting evidence for the Wagner s Law. 2. Methodolog and Empirical Results We perform a panel version of a Granger-causal test (Huang and Temple, 2005) between per capa GDP and fiscal variables, namel total government expendures and revenues retrieved from World Bank s WDI for 55 countries between 970 and 200. Since causal can run in eher direction, one cannot take government expendures and government revenues as strictl exogenous. Alternativel, we run partial adjustment specifications which allow feedback b means of sequential moment condions to identif the model (see Arellano, 2003). The standard approach in the lerature would be an AR() model as follows: where in our case x i t v, () i,2,... N; t,2,... T is real per capa GDP and x will be independent government expendures and revenues 2. The reverse relationship is also explored to test notabl the hpothesis of the Wagner s Law holding for the full sample and OECD sub-sample. The model () allows for unobserved heterogene through the individual effect i that captures the joint effect of time-invariant omted variables. t is a common time effect, while v is the disturbance term. We also assume that x is potentiall correlated wh i and ma be correlated wh v, but is uncorrelated wh future shocks v v,... To make use of available, 2 moment condions, we use Arellano and Bond s (99) difference GMM estimator (hereafter DIF- GMM), and use Hansen J's test to assess the model specification and over-identifing restrictions. As there are limations of DIF-GMM estimation, Arellano and Bover s (995) sstem-gmm estimator can be used to alleviate the weak instruments problem 3. In the AR() model, one hpothesis of economic interest is the null 0; a panel data test for Granger causal. Even though a Wald-tpe test of this restriction could be used, we estimate both the unrestricted and the restricted models using the same moment condions, and then compare their (two-step) Hansen J statistics using an incremental Hansen test defined as: 2 Total government expendures and revenues (% GDP) were converted to nominal levels, deflated using the CPI and scaled b population. 3 In our setting, the SYS-GMM uses the standard moment condions, while SYS-GMM (modified ) onl uses the lagged first-differences of dated t-2 (and earlier) as instruments in levels and SYS-GMM2 (modified 2) onl uses lagged first-differences of x dated t-2 (and earlier) as instruments in levels. 2
4 D RU ~ n( J( ) J( )) (2) where J( ~ ) is the minimized GMM crerion for the restricted model, J ( ) for the unrestricted model, and n is the number of observations. 4 The intuion is that, if the parameter restriction ( 0) is valid, the moment condions should keep their valid even in the restricted model. 5 There are some addional issues of interpretation. One ma be interested in the stabil of the estimated model. If our model is stable, we can compute a point estimate for the long-run effect of x on : LR /( ), 6 (3) Moreover, we can test for unobserved heterogene. In the absence of individual effects, the following addional moment condions become valid: E[ E[ x ( ( t 2,...,8 x x t )] 0 )] 0. (4) The valid of these addional set of moment condions (tested using an incremental Hansen test relative to difference or sstem GMM) can be evaluated wh a test for the presence of unobserved heterogene (H0: no heterogene). The motivation for using this test is that, if individual effects are absent, the pooled OLS will be a consistent estimator, despe not full efficient given the presence of heteroskedastic. We find ltle evidence of robust Granger causal from per capa GDP to government expendure across econometric specifications, wh onl one model indicating a negative short and long-run effect of total government expendure on output growth (Table ). However, there is stronger evidence supporting the reverse relationship, that is, from government expendures to per capa GDP, therefore favouring the idea of Wagner s Law. There are significant short and long-run effects, we reject the null of no Granger-causal using our twostep Hansen incremental test, and diagnostics are well behaved (Table 2). [Table -2] Redoing the OECD sub-sample (not shown), we get slightl stronger results favouring Granger causal from government spending to GDP for a posive short-run effect in 3 out of 6 models. Nevertheless, no significant long-run effect emerges. For the OECD the reverse relationship still holds wh evidence of Granger-causal from GDP to government spending, as well as posive and significant short and long-run effects in both the pooled OLS and FE models. t 4 2 Under the null, D is asmptoticall distributed as RU r where r is the number of restrictions. 5 See Bond and Windmeijer (2005). 6 Approximate standard error estimate for this long-run effect computed using the Delta Method. 3
5 3. Concluding remarks Using a panel data set of 55 developed and developing countries for the period , in a context where government spending and revenue have increased throughout time, we have assessed in which wa runs causal and also the possibil of the Wagner Law. We find ltle evidence of Granger causal from per capa GDP to government expendure across our econometric specifications. However, there is stronger evidence supporting the reverse relationship, from government expendures to per capa GDP, therefore favouring the idea of Wagner s Law. In particular, there are also significant short and long-run effects. References. Arellano, M. (2003), "Panel data econometrics", Oxford Univers Press, Oxford. 2. Arellano, M. and Bover, O. (995), "Another Look at the Instrumental Variable Estimation of Error Component Models", Journal of Econometrics, 68: Barro, R. J. (990), Government spending in a simple model of endogenous growth, Journal of Polical Econom, 98, S03-S Barro, R. J. (99), Economic growth in a cross section of countries, Quarterl Journal of Economics, 06, Bond. S.R. and F. Windmeijer (2005), "Reliable inference for GMM estimates? Fine sample properties of alternative test procedures in linear panel data models", Econometric Reviews, 24(), Devarajan, S. V., V. Swaroop and H. Zou. (996), The Composion of Public Expendure and Economic Growth, Journal of Monetar Economics, 37, Grier, K. B. and G. Tullock, (989) An Empirical Analsis of Cross-National Economic Growth: 95-80, Journal of Monetar Economics, 24(2), Hakro, A. N. (2009), Size of government and growth rate of per capa income in selected Asian Developing countries, International Research Journal of Finance and Economics, Huang, Y. and Temple, J. (2005), Does external trade promote financial development? Bristol Economics Discussion Papers 05/ Kumar, S. (2009), Further evidence on public spending and economic growth in East Asian countries, MPRS WP Landau, D. (983), Government and Economic Growth in the Less Developed Countries: An Empirical Stud for , Economic Development and Cultural Change, 35(), Landau, D. (983), Government Expendure and Economic Growth: A Cross Countr Stud, Southern Economic Journal, 49, Ram, R. (986), Government Size and Economic Growth: A New Framework and Some Evidence from Cross-Section and Time Series Data, American Economic Review, 76, Romer, P. M. (990), Endogenous technological change, Journal of Polical Econom, 98, Sala-i-Martin, X. (997), I just ran two million regressions, American Economic Review, 87, Yuk, W. (2005), Government size and economic growth: time series evidence for the UK , Univers of Victoria WP EWP050. 4
6 Table : Panel Granger-Causal GDP per capa and Total Government Expendures per capa (full sample) Dep.Var. real GDPpc OLS levels Whin Group (FE) DIF-GMM SYS-GMM SYS-GMM- SYS-GMM-2 Model () (2) (3) (4) (5) (6) Instrument set none none Full Full Reduced Reduced Lag GDPpc.02*** 0.90*** 0.48***.07***.08*** 0.99*** (0.005) (0.044) (0.33) (0.020) (0.028) (0.08) Lag totgovexppc ** (0.000) (0.000) (0.000) (0.000) (0.00) (0.000) Obs R-squared AB AR() (p-value) AB AR(2) (p-value) Hansen p-value Granger causal p-value Unobs. Heterogene LR effect point estimate * (standard error) (0.007) (0.009) (0.0002) (0.002) (0.008) (0.026) Note: Our five-ear averages dataset was used to assess Granger causal. Year dummies are included in all models (coefficients not reported). Figures in parenthesis below point estimates are standard-errors. The GMM results reported here are two-step estimates wh heteroskedasticconsistent standard errors. The Hansen test is used to assess the overidentifing restrictions; the test uses the minimized value of the corresponding two-step GMM estimator. The difference Hansen test is used to test the addional moment condions used b the sstem GMM estimators in which SYS GMM uses the standard moment condions, while SYS GMM- onl uses the lagged first-differences of GDPpc dated t-2 (and earlier) as instruments in levels and SYS-2 onl uses lagged first-differences of totgovexp_gdp dated t-2 (and earlier) as instruments in levels. The heterogene test is used to test the null that there are no individual effects (see text). The Granger causal test examines the null hpothesis that GDPpc is not Granger-caused b totgovexp_gdp; the test statistic is crerion based, using restricted and unrestricted models (see main text for details). The LR effect is the point estimate of the long-run effect of totgovexp_gdp on GDPpc. Its standard error is approximated using the delta method. *, **, *** denote significance at 0, 5 and % levels. Table 2: Panel Granger-Causal - Total Government Expendures per capa and GDP per capa (full sample) Dep.Var. totgovexppc OLS levels Whin Group (FE) DIF-GMM SYS-GMM SYS-GMM- SYS-GMM-2 Model () (2) (3) (4) (5) (6) Instrument set none none Full Full Reduced Reduced Lag totgovexppc ** -.63*** *** (0.20) (0.395) (0.476) (0.27) (0.073) (0.66) Lag GDPpc 2.43** 32.76*** * 9.49*** 2.29** (0.950) (8.946) (24.939) (3.635) (2.94) (6.223) Obs R-squared AB AR() (p-value) AB AR(2) (p-value) Hansen p-value Granger causal p-value Unobs. Heterogene LR effect point estimate 2.5* 6.54*** *** 4.59** (standard error) (.287) (3.053) (0.053) (3.649) (2.682) (2.66) Note: See Table, mutatis mutandis. 5
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