Current management

Rajat Acharyya

Abstract This paper examines the relationship between trade openness and size of the government. Under homothetic taste, and thus without the real income effect, a more open (small) economy may indeed have a larger size of the government even when the public good that it produces is not traded. When the public good is the most labour intensive good, the absolute size of the government expands with a tariff reduction under a reasonable assumption regarding employment shares of the export good. An additional condition requiring a sufficiently small, although not necessarily less than unity, value of the price elasticity of demand for the public good ensures that the relative size of the government expands as well.

Keywords Government size

Externality

JEL Classification F11

1 Introduction

Growing concerns over huge budgetary and fiscal deficits in a large number of countries have inspired quite a few researchers in recent times to investigate the determinants of the size of the government. External risks and political instability are the two major explanations that are put forward for larger size of the govern-ment measured by the share of governgovern-ment expenditure in gross domestic product.

Rodrik (1998) argues quite convincingly that government spending provides social insurance in open economies that are subject to external shocks and risks due to

R. Acharyya (&)

Department of Economics, Jadavpur University, Calcutta 700032, India e-mail: [email protected]

© Springer India 2016

M. Roy and S. Sinha Roy (eds.), International Trade and International Finance, DOI 10.1007/978-81-322-2797-7_5

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terms of trade volatility. This is the reason we observe larger governments in more open economies.¹Annett (2001), on the other hand, argues that higher ethnolin-guistic and religious fractionalization within an economy increases the political risk for an incumbent government. This induces the government to pacify the excluded interest groups by increasing the level of government consumption.²Thus, whereas Rodrik finds government expenditure as means of lowering external risks for an open economy, Annettfinds it as means of lowering political risk and instability.

Measuring the size of the government by the share of expenditure on public good in the total expenditure on the private and public goods, Anwar and Zheng (2004) show that the size of the government is determined by the availability of the primary factors of production. In their two-sector, two-factor general equilibrium model of a closed economy, the public good is essentially a private good produced by the government and sold at the marginal cost. In such a framework, they show that an increase in the supply of capital (for example, through an inflow of foreign capital) lowers the size of the government sector (or the share of expenditure on the public good) if the production of the public good is relatively labour intensive.

An interesting implication of this result that the size of the government sector depends on factor endowments is similar to the Heckscher-Ohlin-Samuelson (hereafter HOS) pattern of relative size of different sectors and, therefore, of the comparative advantage of the economies endowed with different amounts of the primary factors. Their analysis thus creates scope for free international trade to have a similar impact on the size of the government sector as the international factor mobility when both the private and the public goods are traded in a standard HOS structure. This is a simple logical derivation from the celebrated Factor Price Equalization theorem. International trade by freeing up resources from the import-competing sectors allows production of exports to increase. If the public good is exportable, then it is straightforward to argue that the size of the govern-ment sector, both the absolute size and the share of expenditure, should increase with the opening up of trade. Thus the observed larger government size in open economies may be due to changes in effective factor supplies that free international trade brings in, provided, of course, the public good is exportable.

But such a result does not follow immediately in a standard HOS framework of an economy if the public good is not a traded good. It is thus non-trivial to examine the relationship between openness to external trade and the size of the government.

This is the primary concern of this paper. More precisely, I examine how freer international trade affects the size of the government through changes in the effective supplies of the primary factors of production, when the private good that the government produces is a non-traded good. In an extended HOS framework of a small open economy, I consider two privately produced traded goods and one government produced non-traded good (henceforth loosely called public good to

1Alesina and Wacziarg (1998) also have found that the government size is larger in smaller economies and the smaller economies are the ones usually more open to the external trade.

2Similar logic can be found in Blomberg (1996) and Velasco (1997).

differentiate it with the two goods produced in the private sectors), all using the same resources—labour and capital. A tariff reduction in such a context is shown to expand the absolute size of the government (defined as the expenditure on the public good), under a set of fairly general conditions. For example, if the export good is labour intensive relative to the import-competing good, by the standard price-magnification effect, a tariff reduction raises the money wage relative to the rate of return to capital. This change in relative wage raises the price of the non-traded public good if it, in turn, is labour intensive relative to the export good.

Production of the public good, on the other hand, falls by the consequent decline in its relative demand, but increases because tariff reduction raises, for certain values of the employment shares in the export sector, the output of the import-competing good which necessitates a proportionate increase in the production of the public good under homothetic tastes to clear the domestic market. This market-clearing expansionary effect appears to be stronger than the contractionary demand effect so that the production of the public good increases at the end. Accordingly, with both the price and the output of the non-traded good increasing following a tariff reduction, the absolute size of the government increases. The relative size of the government, defined as the share of total expenditure spent on the public good, on the other hand, increases when the ratio of the share of export production to that of the import-competing production in national income exceeds the ratio employment shares of the private traded sectors. Otherwise, the expansion of the relative size of the government depends on the value of the price elasticity of demand for the public good. However, if the public good is price-inelastic, the government size increases regardless of whether the share of export production is large or small. Since lower levels of tariffs essentially make an economy more open to the external world, these results should mean that, ceteris paribus, more open economies have larger gov-ernments as is in fact observed by Alesina and Wacziarg (1998) and Rodrik (1998).

The production of the non-traded public good may generate positive externality effects in the rest of the economy. If the public good is in the nature of physical and/or social infrastructure (such as hospitals or health care, building of paved roads and the like), such externality effects may be in the nature of improvement in productivity of labour and capital. When such productivity effects of the production of the public good are taken into account, a tariff reduction still may increase the size of the government sector but now under more stringent conditions.

The rest of the paper is organized as follows. In Sect.2we discuss the frame-work of our small open economy. Section3works out the effects of tariff reduction on the production of the public good and the size of the government and Sect.4 considers the positive externality effect of the production of the public good.

Finally, concluding remarks are provided in Sect.5.