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European Journal of Political Economy Vol. 15 Ž1999. 359–366

Growth and the public sector: A reply

Jonas Agell ^{)} , Thomas Lindh, Henry Ohlsson

Department of Economics, Uppsala UniÕersity, Box 513, SE-751 20 Uppsala, Sweden

Received 1 December 1997; accepted 1 December 1998

Abstract

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

A critique of the critics. European Journal of Political Economy 15, 337–358

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.

x claim that,

Folster¨

w

and Henrekson Folster,¨

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 au-

there is a strong negative relation

between the public spending share and economic growth in the OECD-countries.

thors, this literature had established ‘‘

that

^{)} 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: S0176- 2680 Ž 99 . 00011-7

360 J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

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

reduce the yearly growth rate with about 1.5 percentage points’’ ŽHenrekson 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 ŽAgell et al., 1997; see

also Agell et al., 1994 . Our agnostic punchline is that the literature on cross-coun-

try 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 Ž1992

Third, there are problems of endogeneity and simultane-

ity, 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

we—along with Atkinson Ž.1995 and Slemrod Ž1995, 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

a more robust negative growth effect

preferred way, they argue that there is ‘‘

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 fundamen- tal 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 Ž1995., 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.

J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

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 regres- sions do not address the crucial problems of identification and endogeneity bias

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 3–4, that FH report regressions—in the form of two stage least squares estimations, using first differenced data—that 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 we—unsuccessfully—try to replicate these findings, using a standard RATS-pro- cedure. ^{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

3 version of the model underlying the

estimations of FH

Žthis includes all the regressions that FH report in Tables 3 and 5

Ž

1

.

below is a simplified

y

it

yy

ity101

sb qb g qb y

it

2

ity1

qv qd q´

i

t

it

,

Ž1.

where y

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

it

ity1

is log expenditure . There are three

it

share in country i in period t. Economic growth is y y y

it

^{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 door—no reader of our survey should have got away with the impression that we viewed our partial correlations

simultaneity

Ž

1992 . . We wrote that if ‘‘

Ž

Agell et al., 1997, p. 47 . .

as a serious contribution to the empirics of growth. Our regressions had one limited purpose, namely to

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

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’’

^{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.

consideration potentially serious

illustrate the robustness-critique of Levine and Renelt

^{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.

362 J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

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 |
Change Change Change Change |
Country |
Period |
Adj. R |
2 |
d.f. |
||||||||||

tax share expenditure initial dependency dummies dummies |
||||||||||||||||

share |
GDP |
share |
||||||||||||||

1. FH, Table 4 |
y27.8 |
y0.06 |
15.2 |
yes |
yes |
0.66 |
||||||||||

Ž8.1. |
Ž0.021.Ž11.6. |
|||||||||||||||

2. Our replication |
y30.5 |
y0.08 |
17.5 |
yes |
yes |
0.16 |
63 |
|||||||||

Ž |
17.7 |
. |
Ž |
0.05 |
.Ž |
25.5 |
. |
|||||||||

3. Instruments for tax share, including country dummies 4. Instruments for tax share, no country dummies 5. Valid instruments for tax share and initial GDP, no country dummies 6. FH, Table 4 |
y14.7 |
y0.13 |
112.0 |
yes |
yes |
y0.01 19 |
||||||||||

Ž76.0. |
Ž0.14.Ž121.4. |
|||||||||||||||

0.30 |
y0.04 |
y19.6 |
no |
yes |
0.35 |
41 |
||||||||||

Ž |
30.9 |
. |
Ž |
0.05 |
.Ž |
36.3 |
. |
|||||||||

9.21 |
y0.29 |
y57.1 |
no |
yes |
y0.08 41 |
|||||||||||

Ž33.7. |
Ž0.71.Ž118.9. |
|||||||||||||||

y26.19 y0.097 |
12.2 |
yes |
yes |
0.47 |
||||||||||||

Ž6.14. |
Ž0.034.Ž17.29. |
|||||||||||||||

7. Our replication |
y23.3 |
y0.13 |
7.60 |
yes |
yes |
0.22 |
59 |
|||||||||

Ž |
14.3 |
. |
Ž |
0.07 |
.Ž |
23.9 |
. |
|||||||||

8. Instruments for exp. share, including country dummies 9. Instruments for exp. share, no country dummies 10. Valid instruments for exp. share and initial GDP, no country dummies |
y23.8 |
y0.19 |
101.0 |
yes |
yes |
0.20 |
17 |
|||||||||

Ž27.6. |
Ž0.12.Ž78.1. |
|||||||||||||||

y13.4 |
y0.07 |
y25.4 |
no |
yes |
0.49 |
38 |
||||||||||

Ž |
16.0 |
. |
Ž |
0.07 |
.Ž |
33.0 |
. |
|||||||||

y6.97 y0.09 |
y31.4 |
no |
yes |
0.46 |
38 |
|||||||||||

Ž19.0. |
Ž0.17.Ž48.9. |

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 1–3 and 6–8, 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 is a country specific effect, d is a period specific effect, while the remaining error is ´ . Rewriting the model in level form gives us:

i

it

t

y

it

s b q b g q

0

1

it

Ž

b

2

q 1. y

ity1

q v q d q ´ .

i

t

it

Ž.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

J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

363

the error in Ž.1 or Ž1a

country specific error component v 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

Žalthough they are not very explicit equivalent to Ž1. to obtain

First, they take first differences of their

This correlation causes simultaneity bias. Second, the

i

_{Ž} y

it

yy

ity1

.Žy

y

ity1

yy

ity2

.

sb

1

Ž

g

it

yg

qb q ´ y ´

ity1

ty1

it

2

y

ity1

ity1

,

.

Ž

q d y d

t

yy

ity2

.

Ž1b.

which eliminates v . Second, they instrument the change in the expenditure share by using the predicted value from the first-stage regression of

i

g

it

yg

sg qg g

ity101

ity1

qg

2

Ž

y

ity1

yy

ity2

.

qg y

3

ity1

qh

it

,

Ž.2

where h is an error term. Then, the predicted change in the expenditure share is used in Ž1b. as the second step in the TSLS-regression. In their regressions, FH

Although highly questionable,

they also reintroduce country dummy variables in Ž1b., 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

Ž1b. 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 y y y that are uncorrelated with

add country and period dummy variables to Ž2

it

ity1

ity2

. Natural candidates for such instruments are GDP and the expenditure share dated t y 3. Second, the instruments used in the first-stage regression Ž2. are not valid. The

If the

expenditure share is measured with error, the LHS will become too small and the RHS too large. This will bias the g coefficient downwards. Moreover, by simultaneity between g and the instrument y , the latter will be correlated with the error term. This will introduce biases in the estimates of both g and g . Looking at Eq. Ž2. 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. Ž1b., 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

lagged expenditure share appears on both sides of the equality sign in Ž2

´

ity1

1

ity1

ity1

2

3

included in

Ž

2 . .

^{4} Adding country dummy variables to Ž1b. 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

^{5} This is well known from the literature on dynamic panel models, see, for example, Baltagi Ž1995

364 J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

regression that addresses most—but not all—of the issues that we have discussed is the following

g

it

y g

s g q g g

ity101

ity3

q g

3

y

ity3

q h .

it

3. Doing it more nearly right

Ž2b.

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 we—erroneously—do not instrument the change in initial GDP. The estimated coefficient for the tax share Žrow 3. is halved, while the standard error increases by a factor of four. ^{6} The estimated coefficient for the expenditure share Žrow 8. stays the same, but the standard error doubles. When we also drop the country dummy variables Žrows 4 and 9., the estimated

coefficients decrease drastically. The tax share coefficient becomes slightly posi-

tive, with a t-value of 0.01 Žrow 4

indication of heterogeneity in coefficients over countries. Thus, a simple fixed

This effect of the country dummies is a strong

effects model will be subject to heterogeneity bias Žsee 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 Ž1b.

and Ž2a

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 de-

creases 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

Rows 5 and 10 report the results. The estimated coefficient for the

^{6} The adjusted R-square in two of the tax share regressions attain negative values indicating a very

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

bad fit. Excluding New Zealand

Ž

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) 359–366

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 impre- cise 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. Ž1996. and Mendoza et al. Ž1997

A quite distinct novelty of FH is that they, towards the end of the paper, report

growth regressions Žwhich 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 Žin 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 Žin

´

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.

References

Agell, J., Lindh, T., Ohlsson, H., 1994. Tillvaxt¨ och offentlig sektor. Ekonomisk Debatt 22, 373–385. Agell, J., Lindh, T., Ohlsson, H., 1997. Growth and the public sector: A critical review essay. European Journal of Political Economy 13, 33–52.

366 J. Agell et al.r European Journal of Political Economy 15 (1999) 359–366

Andres,´ J., Domenech,´ R., Molinas, C., 1996. Macroeconomic performance and convergence in OECD countries. European Economic Review 40, 1683–1704. Atkinson, A.B., 1995. The welfare state and economic performance. National Tax Journal 48,

171–198.

Baltagi, B.H., 1995. Econometric Analysis of Panel Data, Wiley, Chichester.

Henrekson, M., Hultkrantz, L., Stahl,˚ I., Soderstrom,¨ _{¨}

ofardstid.¨˚Konjunkturradets rapport 1994, SNS Forlag,¨ Stockholm. Levine, R., Renelt, D., 1992. A sensitivity analysis of cross-country growth regressions. American Economic Review 82, 942–963. Mendoza, E.G., Milesi-Ferretti, G.M., Asea, P., 1997. On the ineffectiveness of tax policy in altering long-run growth: Harberger’s superneutrality conjecture. Journal of Public Economics 66, 99–126.

Pesaran, H., Smith, R., Im, K.S., 1996. Dynamic linear models for heterogenous panels. In: Matyas,` _{`} L.,

, tions, Chap. 8. Second revised edition. Kluwer Academic Publishers, Dordrecht. Slemrod, J., 1995. What do cross-country studies teach about government involvement, prosperity, and economic growth?. Brookings Papers on Economic Activity No. 2, 373–431. Slemrod, J., 1998. How costly is a large, redistributive public sector?. Swedish Economic Policy Review 5, 87–105.

The Econometrics of Panel Data: A Handbook of The Theory with Applica-

i

H.T., Soderstrom,¨

_{¨}

L., 1994. Valfardsland¨¨

Sevestre, P. ŽEds

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