THE IMPLICATIONS OF OPENNESS FOR WAGNER’S LAW. AN INTERNATIONAL COMPARISON OF 20 COUNTRIES, 1971-2000 SOBHEE, Sanjeev K.* JOYSUREE, Vivekanandsing
Abstract:
This paper revitalizes the Wagner’s law by integrating to its literature the increasingly essential role played by openness. It has been recently hypothesized that the growing size of the public sector in both developed and developing economies could be explained by the increasing degree of openness. We therefore believe that if this is so, then by simply testing the conventional wisdom whether public expenditure grows as output grows (the Wagner’s Law), and isolating the entire process of openness, may clearly lead to specification bias. Consequently, to improve on the robustness of econometric findings pertaining to this law, it is but necessary to control for openness. Thus, in this paper, we test the validity of the law, after controlling for openness, through a panel of 20 mixed economies over 30 years. Using alternative econometric scenarios, we conclude that Wagner’s law is not a myth and its validity is robustly supported as and when economies transit to become more open.
JEL Classification: E62, H5, F41
Key words: Fiscal Policy, Wagner’s Law, Public Expenditures, National Government Expenditures and Related Policies, Open Economy Macroeconomics
* Sanjeev K. Sobhee is Associate Professor at the Department of Economics and Statistics, University of Mauritius, Réduit, Mauritius. e-mail:
[email protected] and Vivekandansing Joysuree is Post-Graduate Student, University of Nottingham, UK
1. Introduction
Wagner’s law is one of the various theories that would explain public expenditure growth, particularly through growth of GDP. The actual postulate is that as economic growth sets in, public expenditure increases and, in the strict sense, increases more than proportionately. This could be aptly justified by the fact that in the initial phase of development, essential goods such as human capital - health and education - tend to command an elastic base. As a result, an expansion of the GDP, the tax-base, would encourage higher public expenditure and in the direction and magnitude defined already. In fact, this law diametrically opposes the Keynesian causality relationship that GDP grows because public expenditure grows. Econometrically, Wagner’s law provides a well-thought theory of consistency in the public finance literature that would best represent the potential endogeneity of public expenditure variable in macroeconometric modelling.
This is why for over more than three decades, researchers have been many a time trying to assess the validity of this law, as opposed to the Keynesian direction of causation, through standard Granger Causality specification or its variant. Results pertaining to the Wagnerian hypothesis remain mixed and are as one would expect sensitive to the data sets used, whether time series or cross sectional or panel data, as well as the specification adopted. At this stage, it is vital to pinpoint that because there exists no standard formulation of the Wagner’s law as such, researchers have contemplated to apply data in level as well as ratio form; to different levels of government (state, local or central) and to different categories of public spending (current and capital expenditure items). For a good review of the alternative methodologies adopted to test Wagner’s law, see Henrekson (1993). Moreover, recent literature on this issue is essentially marked with the application of greater sophistication of time series methods such as co-integration and error correction techniques. To summarise the recent empirical findings, we may cite works by Bohl (1996), Murthy (1993,1996) and Park (1996) that have lent support to the hypothesis in question while Henrekson
(1993), Ashworth (1994), Hayo (1994), Lin (1995) and Demirbas (1999) have rejected the hypothesis.
Parallel to this literature, there exists a theory propounded by Rodrik (1996) that established a fundamental relationship between openness and public expenditure growth. It emphasizes that public expenditure acts as an insulator against external shocks especially in economies which are more open. Hence, public expenditure share of GDP increases in such economies to neutralize any potential upheaval emanating from the external sector. Necessarily therefore, if Rodrik’s hypothesis is valid, then it may well play a major role in influencing the causal link between public expenditure growth and GDP growth. More precisely, to validate the Wagnerian hypothesis, we may need to control for the hypothesis propounded by Rodrik.
In other words, the Wagner’s law must be tested in conjuction with Rodrik’s hypothesis to avoid any mitigating effect or bias in the empirical findings. However, this particular aspect has not been investigated so far in the literature and if tested would provide additional and interesting insights of the dynamics characterizing the relationship between growth of public spending and growth of output. Altogether, use of panel data to study the hypothesis in question remains by and large rather scanty.
Therefore, in this paper, we intend firstly to integrate Rodrik’s hypothesis while testing for Wagner’s law especially in the context of economies becoming more and more open to control for any potential bias, and to provide more robust estimates through panel data. In this respect, rest of the paper is organized as follows: Section 2 analyses the data profile of the countries that would be surveyed in this work in relation to their openness, growth and public expenditure size; Section 3 provides an empirical specification to test our hypotheses and also addresses the empirical findings while Section 4 concludes.
2. Profile of public expenditure, openness and gdp in some selected countrie s
The data set employed in this study covers the period starting 1971 to 2000 and involves 20 countries both developed and developing (see Table 1 for the list) and has been obtained from the International Financial Statistics Yearbook (IFS) (Annual Issues). We focus on three aggregates; public expenditure, openness, both taken as a share of GDP, and per capita GDP. The average values are taken for each country over the said data set and these are represented in two folds;
firstly, in Table 1 and secondly in Figure 1. We take the Log of real per capita GDP for the sake of convenience especially to plot Figures 1 and 2. These figures provide insights regarding the correlation between public spending and openness with respect to per capita GDP.
From Table 1, it may be inferred that developing countries tend to be more open than developed countries. This is true as Mauritius;
Malaysia, Thailand and Philippines relative openness ratios exceed the most open developed country: Kuwait. We can explain the relative high degree of openness by the high imports fuelled by the high level of exports. Countries that have high level of openness do often have a very high marginal propensity to imports.
If Rodrik's hypothesis is to hold, it should be stronger in developing countries as they are more open and hence require a bigger public sector. This would be verified empirically in the following section. Moreover, Malaysia is the most open economy with an impressive openness ratio of 0.94. Kuwait is second with an openness ratio of 0.58. Mauritius comes third with an openness ratio of 0.50. On the other hand, India is the least open country in the sample shown by its openness ratio of 0.086.
Table 1: Macroeconomic Indicators (Average Values, 1971 - 2000) Country EXP/GDP X+M/GDP Log (RGDP/POP)
Haiti 0.15 0.15 3.05
India 0.14 0.09 2.82
Pakistan 0.20 0.18 2.84
Kenya 0.27 0.20 3.28
France 0.41 0.24 4.29
Germany 0.30 0.34 4.24
Kuwait 0.37 0.58 4.25
New Zealand 0.36 0.27 4.27
Switzerland 0.09 0.42 4.44
UK 0.38 0.27 4.26
Chile 0.26 0.22 4.83
Malaysia 0.29 0.94 3.44
Mauritius 0.24 0.50 3.56
Mexico 0.20 0.13 5.59
Uruguay 0.27 0.15 5.63
Peru 0.18 0.22 4.80
Guatemala 0.11 0.16 3.69
South Africa 0.26 0.20 3.97
Thailand 0.17 0.43 3.20
Philippines 0.15 0.32 3.34
Source: Computed by Authors from IFS issues
In Figure 1, we plot size of public expenditure against Log or real per capita GDP and notice that developed countries such as France, United Kingdom, Kuwait, New Zealand, Germany appear to be clustered together in an area characterised by a moderately-sized public sector with a high real per capita GDP. However, Switzerland is found to have a small public sector, actually having a size of 0.094.
In other words, this would imply that that over the 30-year period, the share of government expenditure in real GDP was on average 9.4% of the real GDP for Switzerland. The linear trend fitted to the cluster in Figure 1 indicates that a positive relationship exists between the size of the public sector and real per capita GDP. This
would suggest that countries with a high per capita GDP tend to have a bigger government and vice versa. However, given that this is just a graph, the reversal causality effect cannot be ruled out, that is, output grows because public expenditure grows. Hence, we treat the figures as being only indicative.
y = 0.0312x + 0.1162 R2 = 0.0774
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45
2 2.5 3 3.5 4 4.5 5 5.5 6
Log (real per capita GDP) [1971 - 2000]
Pulbic Sector Size (1971 - 2000)
swit gua
per mex
hai thaphil pak
mru S A chil
ken
mal ger
kuw NZ fra UK
ind
uru Figure 1: Public Sector Size and Real Per Capita GDP
Source: Computed
In Figure 2, we represent openness plotted against Log of real per capita GDP. The linear trend fitted to the cluster in Figure 2 reveals a negative slope. This would indicate that countries, which are more open to trade, tend to have a lower real per capita GDP. The opposite is also true.
y = -0.0358x + 0.4442 R2 = 0.0219
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
2 3 4 5 6
Log (per capita Real GDP)[1971 - 2000]
Openness Ratio (1971 -2000)
swit kuw
fra N UK ken
mal
SA chil
uru mru
pa hai tha
ind phil ger
mex
gu per
Figure 2: Openness Ratio and Real Per Capita GDP
Source: Computed
In Figure 3, we plot size of public sector against openness and observe that some developed countries (France, UK, New Zealand, Germany) appear to be clustered in an area of moderate openness but relatively greater public sector size. Contrasting findings are made concerning: Switzerland and Kuwait. On one hand, Switzerland is moderately open (0.42), but has a small government sector (0.095).
On the other hand, Kuwait is slightly more open (0.58) than Switzerland, but it also has a bigger government sector (0.37). From the line that runs through the several observations, we may discern that more open economies tend to have a bigger public sector and vice versa.
y = 0.106x + 0.2086 R2 = 0.0525
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45
0 0.2 0.4 0.6 0.8 1
Openness Ratio (1971 - 2000)
Public sector Size (1971 -2000)
mal
mru ku
phil
swi th ke
g chi er SA
u k N fr
pa h a ik
gua ur
mex
ind pe
Figure 3: Public Sector Size and Openness Ratio
Source: Computed
In this section, we have attempted to provide insights through the comparative size of government, openness and level of economic development. However, these tend to be just indicative of potential correlation between our aggregates and across the sample of countries under survey. An interesting observation that need be made at this stage is that growth of public expenditure as a proportion to GDP tends to vary positively with growth of openness again as a share of GDP. This correlation would just corroborate our motivation to control for growth of openness while investigating the validity of the Wagnerian hypothesis at least in our sample of countries. In the next section, we turn to an empirical specification that would try to fulfill this objective in a much more robust manner.
3. Empirical modelling and findings
To test Wagner’s law in a setup where openness is becoming increasingly important, we specify the following equation:
e
tM)/Y) (X
(RGDP/POP, f
EXP/GDP = + +
(1)where EXP/GDP is the Share of government expenditure in real GDP (Public sector size); RGDP/POP is real per capita GDP, and POP stands for population. (X+M)/GDP represents the openness ratio with exports plus imports as a share of GDP and is the error term having the usual properties: εt ~IID (0,s2)
However, equation (2) below is the specific econometric model that is ultimately tested:
t 2
1
0
(RGDP/POP) (( X M)/GDP) e
EXP/GDP = β + β + β + +
(2)In this equation, Wagner’s law would hold if parameter β1>0, while Rodrik’s hypothesis would hold if parameter β2>0. We use a panel data set consisting of 20 countries over the period 1971 to 2000 to investigate the above hypotheses which we test concurrently.
The empirical findings are shown in Table 2 and their discussion follows thereafter. We perform a battery of tests to ensure validity of the results and to provide the maximum insights possible. The test statistics are based upon the conventional work of Hausman and Taylor (1981) and using the approaches described in Baltagi (1995).
To start with, column (1) shows the results that pertain to the whole data set and in which all the variables are in level form. In fact, it can be observed that real per capita GDP and openness are both individually statistically significant at the 1% level. The coefficients also have the postulated signs. This implies that a 10% increase in real per capita GDP would lead to a 0.6% increase in public sector size, while an increase of 10% in the level of openness will lead to a 0.5% increase in public sector size. The relevant overall significance test, given by the Wald test, confirms the joint significance at the 1%
level. Therefore, real per capita GDP and openness exert a positive
effect on the size of the public sector. These first fold results preliminarily lend support to both the Wagner’s law and the Rodrik’s hypothesis. More importantly, Wagner’s law is robustly supported by our data set after having controlled for the openness hypothesis. In columns (2) and (3), however, we split the whole sample into two sub-groups; one representing developed economies and the remaining standing for developing economies.
Table 2: The Empirical Results
(1) (2) (3) (4) (5)
(1) 20 countries
(2) 6 countries
14 countries
20 countries
20 countries Ln
(EXP/GDP)
Ln (EXP/GDP)
Ln (EXP/GDP)
Ln (EXP/GDP)
∆Ln (EXP /GDP) Constant -1.931***
(-13.54)
-0.717*
(-2.03)
-1.937***
(-13.17)
-2.143***
(-15.2)
-1.27***
(-3.05) Ln
(RGDP /POP)
0.059***
(3.881)
-0.036 (-1.192)
0.047**
(2.476)
0.086***
(5.762)
∆0.063***
(2.1)
Ln (X+M/
GDP)
0.049***
(4.28)
0.126***
(7.166)
0.035**
(2.417)
0.057***
(5.11)
∆0.20***
(3.71)
F test n.a n.a n.a n.a 9.11***
Wald test 18.62*** 50.45*** 6.38*** 33.45*** n.a
R2 0.18 0.01 0.21 0.1860 0.005
N 544 167 377 528 572
FE/RE RE RE RE RE FE
Source: Computed. Notes: *, **, *** indicate significance 10, 5 and 1 percent levels. FE : Fixed Effects. RE: Random Effects. ( ) indicates the t-statistics for a Fixed Effect Model and the corresponding z-statistics for a Random Effects Model. ∆: first-order differenced variables, reducing non-stationary properties in the data.
Column (2) shows the results pertaining to the sub-sample of developed economies and column (3) depicts those of its counterpart.
While Wagner’s law is rejected and Rodrik’s hypothesis is supported in the former case, both of these are supported in the latter sample. In column (3), both real per capita GDP and openness are individually
statistically significant at 10% level. The coefficients have the correct postulated signs. An increase of 10% in real per capita GDP will lead to an increase of 0.4% in public sector size. On the other hand, a 10% increase in the level of openness would result in a 0.3%
increase in the size of the public sector. But, a word of caution is needed at this stage, given that the sub-samples are not symmetric.
The sample selection being random did not make provision for this at the start. Hence, the results should rather be considered as being tenuous.
According to Fielding and Spencer (2000), the instrumental variable (lagged variables) is the consistent estimation procedure whenever one suspects potential endogeneity of the explanatory variables. This problem may not be ruled out in our initial estimates and this prompted us to apply lagged openness and lagged real per capita GDP as instruments to improve our results. In column (4), these are found to be individually statistically significant at the 1%
level. Comparing with the results of column (1), the coefficients obtained for the lagged variables are much bigger. Additionally, the standard errors of the lagged variables are smaller thereby representing a gain in accuracy. Since the coefficients of the lagged variables are significant and bigger, this would also imply that past values of openness and real per capita have a stronger impact on actual public sector size.
The effects of changes in (RGDP/POP) and (X+M)/GDP) on the dependent variable (EXP/GDP) occur with a lag. Moreover, the Wald test confirms joint significance at the 1% level and this establishes the general positive link between openness and real per capita on public sector size. Controlled endogeneity in Column (4) generates yet better estimates, which are consistent and more reliable, and provides still greater robustness of the hypotheses being addressed empirically across the 20 countries. Finally, in column (5), we follow the line of thinking defined in Chow (1987) and apply a first-order differenced model to avoid spurious results. In this scenario, the first-order differenced real per capita GDP and openness remain individually statistically significant at the 1% level.
significance at the 1% level. Therefore, the validity of Wagner's Law and Rodrik's Openness Hypothesis for the whole sample of 20 countries is further strengthened.
4. Conclusion
This paper has revisited the Wagner’s law in an attempt to revitalize its underpinning literature by integrating the increasingly essential role played by openness. Rodrik (1995) particularly hypothesized that the growing size of the public sector in both developed and developing economies could be explained by the degree of openness. We therefore believe that if this is so, then by simply testing whether output growth alone impacts on public expenditure, and isolating the whole idea of openness in a specification, may clearly have serious testable implications of the Wagner’s law. Consequently, to avoid mitigating effects and to improve on the robustness of econometric findings pertaining to the Wagner’s law, it is but essential to control for openness.
Thus, in this paper we tested the validity of this law, after controlling for Rodrik’s theory, across a panel of 20 mixed economies over 30 years. Indeed, our findings strongly lend credence to the Wagner’s law after having even controlled for openness.
However, we did this exercise using a battery of empirical tests that did control for potential endogeneity of GDP and openness, as well as spurious results. After having taken these econometric methods into account, we could not again reject the Wagnerian hypothesis or the Rodrik’s hypothesis. All in all, we may conclude that Wagner’s law is not a myth and its validity is robustly confirmed as and when economies transit to become more open, implying that growth of GDP undeniably contributes to a larger public sector.
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