European Journal of Political Economy

Vol. 15 1999. 359366

Growth and the public sector: A reply

Jonas Agell ) , Thomas Lindh, Henry Ohlsson
Department of Economics, Uppsala Uniersity, Box 513, SE-751 20 Uppsala, Sweden
Received 1 December 1997; accepted 1 December 1998

Abstract
Folster
and Henrekson wFolster,
S., Henrekson, M., 1999. Growth and the public sector:

A critique of the critics. European Journal of Political Economy 15, 337358x claim that,
by addressing a number of econometric problems, they can establish that it is likely that
economies with a large public sector grow more slowly than economies with a small public
sector. But their regressions are fundamentally flawed. Re-estimating their growth equation
using theoretically valid instruments, we find that the growth effect of the public sector is
statistically insignificant, and much smaller than the point-estimates that they report. This is
consistent with the agnostic conclusion, drawn by us and others, that cross-country growth
regressions are unlikely to provide a reliable answer as to whether a large public sector is
growth promoting or retarding. q 1999 Elsevier Science B.V. All rights reserved.
JEL classification: E62; H20; H50; O57
Keywords: Economic growth; Public sector; Cross-country regressions

1. Introduction
A few years ago, a think tank of academic economists argued that a substantial
scaling down of the Swedish welfare state would produce a large growth bonus.
An important link in their chain of argument was an evaluation of the rapidly
expanding literature on cross-country growth regressions. According to the authors, this literature had established . . . that there is a strong negative relation
between the public spending share and economic growth in the OECD-countries.
)

Corresponding author. Tel.: q46-18-471 11 04; Fax: q46-18-471 14 78; E-mail:

jonas.agell@nek.uu.se
0176-2680r99r$ - see front matter q 1999 Elsevier Science B.V. All rights reserved.
PII: S 0 1 7 6 - 2 6 8 0 9 9 . 0 0 0 1 1 - 7

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J. Agell et al.r European Journal of Political Economy 15 (1999) 359366

An increase in the public spending share of ten percentage points appears to

reduce the yearly growth rate with about 1.5 percentage points Henrekson et al.,
1994, p. 9..
When academics give policy advice, it seems reasonable that they provide a
balanced assessment of the research literature. The stunningly precise point
prediction of Henrekson et al.which was given much attention in the media
was the motivation for our recent review in this Journal Agell et al., 1997; see
also Agell et al., 1994.. Our agnostic punchline is that the literature on cross-country growth regressions is unlikely to come up with a reliable answer to the
question of whether a large public sector is growth promoting or growth retarding.
This is due to severe problems of data quality and methodology, which allow the
international evidence to admit no conclusion on whether the relation between
growth and the public sector is positive, negative, or non-existent. First, there are
potentially severe measurement errors in the right-hand side variables in the
estimating equations. Second, there is the issue of omitted variables that are
correlated with the size of the public sector, which is a point emphasized by
Levine and Renelt 1992.. Third, there are problems of endogeneity and simultaneity, which may occur along several dimensions.
Magnus Henrekson and Stefan Folster,
henceforth FH, very much believe that

the public sector is bad for growth. According to FH, the main reason that
wealong with Atkinson 1995. and Slemrod 1995, 1998. arrive at agnostic
conclusions is that we do not realize that there are fairly easy ways of addressing
the econometric problems. Once FH deal with these problems in their own
preferred way, they argue that there is . . . a more robust negative growth effect
of large public expenditures in rich countries. It should come as no surprise that
we remain unimpressed. FH claim that they solve important problems that plague
the literature, but their regressions are fundamentally flawed.
2. The flawed nature of the results of FH
Students of government and cross-country growth need to address a fundamental identification problem, which derives from the fact that there is a two-way
causation between growth and the public sector. The size of the public sector
affects growth via a standard supply side relation, while growth affects the size of
the public sector via the income elasticity of the demand for public sector
activities. As the observed data points can be interpreted as reflecting the
intersection of the supply and demand relations, a given partial correlation
between growth and the size of the public sector is not informative about the
relation that is of our primary concern, the supply relation. As discussed with great
care by Slemrod 1995., solving this identification problem requires that we
identify an instrument set consisting of exogenous variables that affect the demand
relation, but not the supply relation. In practice, finding such an instrument set is
bound to be very hard, and perhaps even impossible.

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361

FH base their argument on scores of regressions that purport to show that there
is a robust, or close to robust, negative relation between growth and the size of the
public sector in their panel of OECD countries. However, most of these regressions do not address the crucial problems of identification and endogeneity bias
this includes all the regressions that FH report in Tables 3 and 5.. Simply put, the
overwhelming majority of their regressions are not up to the standards of the
current research literature. It is only in Table 4, rows 34, that FH report
regressionsin the form of two stage least squares estimations, using first
differenced datathat attempt to deal with the problems of simultaneity and
endogeneity. 1
For an assessment of the credibility of the econometric work of FH, it is
instructive to elaborate on these regressions in some detail. In our Table 1, rows 1
and 6 are the TSLS-regressions as reported by FH. According to FH, both the
instrumented tax and expenditure shares have large negative coefficients, reported
significant at the 1% level. In rows 2 and 7, we show the results when
weunsuccessfullytry to replicate these findings, using a standard RATS-procedure. 2 While the point estimates are reasonably close, the estimated standard
errors are more than twice as large as those of FH. Our point estimates are,
therefore, not statistically significant at the conventional 5% level.
Another, equally worrisome, issue is that FH rely on instruments that are not
valid. To understand the issues, it is necessary to go into some formal detail.
Suppose that we want to estimate a cross-country growth equation using panel
data. Model 1. below is a simplified 3 version of the model underlying the
estimations of FH
yi t y yi ty1 s b 0 q b 1 g i t q b 2 yi ty1 q v i q d t q i t ,

1.

where yi t is log GDP per capita in country i in period t, g i t is log expenditure

share in country i in period t. Economic growth is yi t y yi ty1. There are three
1

FH spend several pages arguing that the simple cross-sectional regressions that we reported in our
previous paper disregard various econometric problems. Here FH bang hard on an open doorno
reader of our survey should have got away with the impression that we viewed our partial correlations
as a serious contribution to the empirics of growth. Our regressions had one limited purpose, namely to
illustrate the robustness-critique of Levine and Renelt 1992.. We wrote that if . . . this had been a
paper aiming at a thorough empirical analysis of the relation between the public sector and growth, we
would have introduced additional explanatory variables. We would also have been forced to take into
consideration potentially serious simultaneity problems . . . . We would also have experimented with
different selections of countries, and we would have repeated the analysis for alternative periods of
time. An additional complicating circumstance is that the aggregate tax burden is not a reliable
indicator of the marginal tax wedges suggested by theory Agell et al., 1997, p. 47..
2
FH have provided us with their OECD data set. It is important to note that we can replicate many
of the other results reported by FH in Tables 2 and 3. Thus, our inability to replicate their TSLS-results
does not depend on differences in our data sets.
3
We drop the dependency share under the assumption that it is exogenous anyway. It is also
convenient to assume that all variables are in logarithms.

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362

Table 1
Change in economic growth rate, panel regressions for 23r22 OECD countries over 5-year periods
between 1970 and 1995, by two-stage least squares
Estimation

1. FH, Table 4

Change Change
Change Change
Country Period Adj. R 2 d.f.
tax share expenditure initial
dependency dummies dummies
share
GDP
share

y27.8
8.1.
2. Our replication
y30.5
17.7.
3. Instruments for tax y14.7
share, including country 76.0.
dummies
4. Instruments for tax
0.30
30.9.
share, no country
dummies
5. Valid instruments
9.21
for tax share and initial 33.7.
GDP, no country
dummies
6. FH, Table 4
y26.19
6.14.
7. Our replication
y23.3
14.3.
8. Instruments for exp.
y23.8
27.6.
share, including country
dummies
9. Instruments for exp.
y13.4
16.0.
share, no country
dummies
10. Valid instruments
y6.97
19.0.
for exp. share and initial
GDP, no country
dummies

y0.06
15.2
0.021. 11.6.
y0.08
17.5
0.05.
25.5.
y0.13
112.0
0.14. 121.4.

yes

yes

0.66

yes

yes

0.16 63

yes

yes

y0.01 19

y0.04 y19.6
0.05.
36.3.

no

yes

0.35 41

y0.29 y57.1
0.71. 118.9.

no

yes

y0.08 41

y0.097
12.2
0.034. 17.29.
y0.13
7.60
0.07.
23.9.
y0.19
101.0
0.12.
78.1.

yes

yes

0.47

yes

yes

0.22 59

yes

yes

0.20 17

y0.07 y25.4
0.07.
33.0.

no

yes

0.49 38

y0.09 y31.4
0.17.
48.9.

no

yes

0.46 38

Standard errors are in parentheses. We use the standard two-step least squares estimator included in
RATS. In our replication, we use the same set of instruments as FH. In the set of valid instruments, we
include third lags of GDP, and of the tax and expenditure share levels. In addition, we include a
constant, the first difference of the dependency share, as well as current, second and third lags of the
dependency share levels. Time dummy variables and, in rows 13 and 68, country dummies are part
of the instrument set. The growth rate variable is in percent, while the tax and expenditure shares are
decimal fractions.

error components, v i is a country specific effect, d t is a period specific effect,

while the remaining error is i t . Rewriting the model in level form gives us:
yi t s b 0 q b 1 g i t q b 2 q 1 . yi ty1 q v i q d t q i t .

1a .

Two observations are in order. First, as long as GDP is of importance for the
expenditure share, there will be a correlation between the expenditure share and

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363

the error in 1. or 1a.. This correlation causes simultaneity bias. Second, the
country specific error component v i will affect GDP in all periods. Therefore,
there exists a correlation between lagged GDP and the country specific error
component. This causes endogeneity bias.
In their Table 4, FH try to address these problems by doing two things
although they are not very explicit.. First, they take first differences of their
equivalent to 1. to obtain

yi t y yi ty1 . y yi ty1 y yi ty2 . s b 1 g i t y g i ty1 . q b 2 yi ty1 y yi ty2 .

q d t y d ty1 q i t y i ty1 ,

1b .

which eliminates v i . Second, they instrument the change in the expenditure share
by using the predicted value from the first-stage regression of
g i t y g i ty1 s g 0 q g 1 g i ty1 q g 2 yi ty1 y yi ty2 . q g 3 yi ty1 q hi t ,

2.

where hi t is an error term. Then, the predicted change in the expenditure share is
used in 1b. as the second step in the TSLS-regression. In their regressions, FH
add country and period dummy variables to 2.. Although highly questionable,
they also reintroduce country dummy variables in 1b., in spite of the fact that the
country specific error component has been differenced out. 4
This procedure will, however, introduce more problems than it solves. First, in
1b. FH treat the lagged growth rate of GDP as an exogenous right-hand-side
variable, while in fact it will be correlated with the lagged error. 5 To address this
issue, we need to find instruments for yi ty1 y yi ty2 that are uncorrelated with
i ty1. Natural candidates for such instruments are GDP and the expenditure share
dated t y 3.
Second, the instruments used in the first-stage regression 2. are not valid. The
lagged expenditure share appears on both sides of the equality sign in 2.. If the
expenditure share is measured with error, the LHS will become too small and the
RHS too large. This will bias the g 1 coefficient downwards. Moreover, by
simultaneity between g i ty1 and the instrument yi ty1 , the latter will be correlated
with the error term. This will introduce biases in the estimates of both g 2 and g 3 .
Looking at Eq. 2. only, GDP and the expenditure share dated t y 2 constitute
instruments that remedy these problems. But in conjunction with the endogeneity
and simultaneity problems associated with Eq. 1b., these variables still need to be
lagged at least one more period if they are to be valid instruments.
As should be clear from these considerations, selecting a valid instrument set
that only includes truly exogenous variables is a difficult task. A first-stage
4

Adding country dummy variables to 1b. is tantamount to saying that there are country specific
trends in growth. For similar reasons, it is not obvious that country dummy variables should be
included in 2..
5
This is well known from the literature on dynamic panel models, see, for example, Baltagi 1995..

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J. Agell et al.r European Journal of Political Economy 15 (1999) 359366

regression that addresses mostbut not allof the issues that we have discussed
is the following
g i t y g i ty1 s g 0 q g 1 g i ty3 q g 3 yi ty3 q hi t .

2b .

3. Doing it more nearly right

The remaining rows in Table 1 report two-stage least squares regressions where
we improve the specification step-by-step. The general picture is that the point
estimates for the tax share and the expenditure share decrease, at the same time
that the standard errors grow larger. Throughout this exercise, the point estimates
are not even close to being statistically significant.
In rows 3 and 8, we report estimations where the change in the tax share and
the change in the expenditure share are instrumented with the third lag of the tax
share and the expenditure share, respectively. This is the only change compared to
the specification of FH. We thus keep the country dummy variables in the
instrument set, and weerroneouslydo not instrument the change in initial
GDP. The estimated coefficient for the tax share row 3. is halved, while the
standard error increases by a factor of four. 6 The estimated coefficient for the
expenditure share row 8. stays the same, but the standard error doubles.
When we also drop the country dummy variables rows 4 and 9., the estimated
coefficients decrease drastically. The tax share coefficient becomes slightly positive, with a t-value of 0.01 row 4.. This effect of the country dummies is a strong
indication of heterogeneity in coefficients over countries. Thus, a simple fixed
effects model will be subject to heterogeneity bias see Pesaran et al., 1996..
Finally, in rows 5 and 10 we report the results when we also instrument the change
in initial GDP. We have, in other words, arrived at regressions in the spirit of 1b.
and 2a.. Rows 5 and 10 report the results. The estimated coefficient for the
change in the tax share becomes more positive, but it is still a long way from
statistical significance. The estimated coefficient for the expenditure share decreases further.
A final observation is that the degrees of freedom go down as we move towards
more valid instruments. This is because we need to use the third lag of the tax
share and the expenditure share. The loss of observations and degrees of freedom
is, however, not an argument for using non-valid instruments. 7 Neither does it
6

The adjusted R-square in two of the tax share regressions attain negative values indicating a very
bad fit. Excluding New Zealand so we have the same sample as we have for the expenditure share.,
the pattern of R-squares becomes similar to that reported for the expenditure share. The pattern of
coefficients on the tax share does not change much, however. Also, the first step regression predicting
initial GDP growth for row 5 improves considerably when New Zealand is excluded.
7
The degrees of freedom can instead be increased by dropping the country dummy variables.

J. Agell et al.r European Journal of Political Economy 15 (1999) 359366

365

imply that we throw away observations. We use some of the data points to
estimate a correctly specified instrument regression in a first step, and the
remaining data points to estimate a correctly specified growth regression in a
second step.
In summary, once we deal with the problems of endogeneity and simultaneity
in a reasonably cautious manner, using the data set of FH, there is no evidence of
a robust negative effect from the aggregate public sector on growth. As we
emphasized strongly in our previous paper, this absence of clear statistical
relations is no proof that a large public sector lacks importance for growth. In
effect, it merely suggests that empirical cross-country regressions are too imprecise a business to shed any light on the substantive economic issue.

4. Concluding comments
The regressions of FH show that they fail in logic. But they also make a
number of other strong claims, which suggest that they also fail in judgment. A
main point of FH is that our agnostic survey leans too heavily on empirical studies
exploiting data sets that contain both rich and poor countries. When one confines
attention to studies that focus on rich countries only, FH argue that it is easier to
identify negative growth effects from a large public sector. This is simply wrong.
Our survey discusses several studies that only consider rich countries, and our
agnostic conclusion applies for this sub-sample as well. For very recent studies
that, unlike FH, report non-robust correlations between aggregate tax and spending
variables and growth in longitudinal data for the OECD, see Andres
et al. 1996.
and Mendoza et al. 1997..
A quite distinct novelty of FH is that they, towards the end of the paper, report
growth regressions which do not address the problems of endogeneity and
simultaneity, however. for an extended sample of rich countries. But as the five
non-OECD members of this sample were included simply because they were
relatively prosperous towards the end of the sample period in 1995., the selection
will not be unbiased. To avoid selection bias, the choice of additional countries
ought to be based on relative prosperity in the beginning of the sample period in
1970..
FH claim that they address a number of difficult econometric issues. But, if
anything, their regressions bear witness to the dangerous territory that awaits the
unsuspecting student of cross-country growth regressions.

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