Abstract
Does fiscal discipline restrain the government from increasing its budget size? To answer this question, this paper investigates whether Wagner’s law is satisfied for two types of states: US states, in which fiscal sovereignty is established, and German states, in which fiscal transfer dependence is high and budget constraints are softened. In US states, we demonstrate that Wagner’s law is validated, while some of the balanced budget requirements weaken the validity of the law. In German states, we find an “inverse” law, especially after the bailouts of Bremen and Saarland. The “inverse” law is a new channel of growth in government size and means that soft budget constraints cause significant negative correlation between government size and output. These results are robust regardless of whether intergovernmental fiscal transfers are taken into account, while they quantitatively change the validity of the law. Our findings imply that the characteristics of fiscal discipline are the prime determinants of the channel and degree of growth in government size.
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Notes
In Narayan et al. (2012), Wagner’s law is considered public expenditure behavior, such that “as real income increases, over the long-run, the share of public expenditure relative to national income rises” (p. 1548). While, as Peacock and Scott (2000) suggest, the law does not build on an explicit theoretical framework by which cause and effect are clearly explained, Rowley and Tollison (1994) document that the law is in accord with the idea of comparative advantage.
See, for example, Kolluri et al. (2000) for support for the law, Chang (2002) for qualified support, and Shelton (2007) for no support. Although the literature on Wagner’s law is too voluminous to survey here, an extensive survey of the literature can be found in Durevall and Henrekson (2011, p. 720–721).
While the German federal government has prudent fiscal policies, state-level fiscal discipline is eroded. The “equivalence of living conditions” clause in the Basic Law compels the federal government to bail out a state that faces a debt crisis. Recent bailout episodes can be seen in the cases of Bremen and Saarland. See Rodden (2003) for more details on soft budget problems in German states.
While almost all researchers investigate the law using national-level data, a recent direction in the literature on Wagner’s law focuses on validity at the subnational or state level. Abizadeh and Yousefi (1988) produced the first paper to employ state-level data to test the law, using time-series data for 10 US states for the period 1950–1984, and their results support the law. More recently, applying a panel unit root, panel cointegration, and Granger causality analysis, Narayan et al. (2008a) examine the law on the basis of data from Chinese provinces and find mixed results. Narayan et al. (2008b) conduct time-series analysis for the Fiji islands and vindicate the law. Like Narayan et al. (2008a), utilizing panel-data techniques, Narayan et al. (2012) investigate the law for the 15 Indian states and provide strong support of the law.
The displacement effect is initially found by Peacock and Wiseman (1961), who show that the sudden increase in government expenditure during World Wars I and II does not return to the pre-war levels in the UK. In other words, Peacock and Wiseman find stepwise increases in UK government size through World Wars I and II. Such a long-run growth in government size makes an analysis of Wagner’s law difficult. Using historical data from Italy, Cavicchioli and Pistoresi (2016) find that military spending during wars results in nonlinearities between variables. See also Funashima (2017), who distinguishes between Wagner’s law and the displacement effect.
It should be noted that, in early 1987, the German central government started to provide special supplementary transfers for the states of Bremen and Saarland, in order to handle their high debts.
See Baretti et al. (2002) for details on the German fiscal equalization system. Note, however, that the current fiscal equalization system (“Länderfinanzausgleich”) will disappear in 2019 and a new intergovernmental transfer system will be introduced in 2020. In other words, the new system differs substantially from the current system in that there are not direct horizontal transfers between states.
See Qian and Roland (1998) for the relationship between the decentralization of government and the soft budget constraint.
Despite the original view, there is a strand of literature that investigates the causal relationship using Granger’s causality tests (e.g., Chow et al. 2002; Iyare and Lorde 2004; Kuckuck 2014; Thornton 1999). Reflecting such a situation in the empirical literature, Lamartina and Zaghini (2011) utilize the Wald exogeneity test to examine the causality, in addition to a rigorous panel cointegration analysis.
In the literature on Wagner’s law, when conducting cointegration analysis, all studies suppose a bivariate system between government size and economic development. One notable exception is Chow et al. (2002), who emphasize the importance of controlling the effects of a third variable on the cointegrating relationship between government size and economic development.
Net state fiscal transfers can be negative in Germany and ln tray is undefined. Baretti et al. (2002) focus on the German federal fiscal system and demonstrate that it is likely that the equalizing transfers reduce the tax revenue of the states.
Following Potrafke and Reischmann (2015), these three US states are excluded because they are outliers. Likewise, Berlin is not included in our sample. Further, the East German states cannot be examined because of the lack of fiscal transfer data before 1995.
It should be noted that, at the German state level, the net transfers-to-GDP ratios (tray) are exactly the same, regardless of the inclusion of the municipalities, because the municipalities only receive transfers from state governments, as stated in the preceding section.
In the DOLS results, heteroscedasticity- and autocorrelation-consistent (Newey–West) robust standard errors are used because of the autocorrelation of the residuals.
See Koester and Priesmeier (2013) for the national-level relationship between Wagner’s law and the sustainability of public finances in Germany.
Not surprisingly, in Germany, the positive effects of fiscal transfers are statistically significant only when municipalities are included. This is because the municipalities only receive transfers from state governments and are exactly the same, regardless of the inclusion of the municipalities, as already mentioned. In other words, the municipalities receive a portion of tray from state governments and increase spending, but such a positive relationship between tray and ln gs is not reflected when municipalities are excluded.
For details on the measures, see Mahdavi and Westerlund (2011).
See ACIR (1987) for more details.
When excluding municipalities, the coefficient of tray for 1993–2010 is significantly negative. This result arguably comes from the fiscal consolidation of the Maastricht Treaty as well as the bailout of Bremen and Saarland. In other words, for the purpose of fiscal consolidation, the state governments are forced to cut expenditures even when transfers increase.
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Acknowledgements
We would especially like to thank two anonymous referees and Markus Reischmann for their valuable comments and suggestions. We would also like to thank Tomomi Miyazaki, Masaki Nakahigashi, Katsuyoshi Nakazawa, Kengo Nutahara, Ryo Okui, Eric Weese, Hideo Yunoue, and participants at the 72nd Annual Congress of the International Institute of Public Finance (August 2016) for their helpful comments. The usual disclaimers apply. Hiraga acknowledges the financial support from the Japanese Ministry of Education, Culture, Sports, Science and Technology (Grant-in-Aid for Young Scientist (B), No.16K17135).
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Funashima, Y., Hiraga, K. Wagner’s law, fiscal discipline, and intergovernmental transfer: empirical evidence at the US and German state levels. Int Tax Public Finance 24, 652–677 (2017). https://doi.org/10.1007/s10797-017-9458-z
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DOI: https://doi.org/10.1007/s10797-017-9458-z