The Causal Relationship Between Government Revenue and Spending

Given their fiscal circumstances, our investigation should help determine proper reforms for these countries to cope more effectively with their current economic challenges. A crucial challenge facing Egypt is unemployment. According to current official estimates, unemployment of about 8 percent is accompanied with an annual growth rate of 3 percent in labor force. To reduce unemployment to more manageable levels, it is estimated that Egypt needs to achieve a healthy and sustainable annual growth rate of at least 6 percent in real GDP. In an attempt to reach this goal, Egypt has utilized a private-sector-led growth policy. Privatization and transition to a market economy are intended to improve productivity, efficiency, and competition in the domestic economy. However, the low levels of domestic saving and investment create an impediment for economic growth in Egypt. Improvements in the domestic saving rate stem from improving productivity, which, in turn, makes privatization an important factor in reducing unemployment and poverty.

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Promoting a more efficient pension system, restructuring the inancial system, and further developing capital markets have provided additional ways to increase the domestic saving rate. Eliminating the budget deficit is a further step to ensure the availability of domestic saving for private investment. To this end, it is essential for the government to implement policies that reduce and eventually eliminate the budget deficit. It is therefore the aim of this paper to offer such policy actions, using the evidence on the causal relation between government revenue and spending in Egypt. Unemployment is also a crucial challenge facing Jordan.

According to current official estimates, unemployment of about 15 percent is accompanied with an annual growth rate of 4-5 percent in the labor force. It is estimated that Jordan also needs a healthy and sustainable annual growth rate of at * Bassam AbuAI-Foul,Departmentof Economics and Public Administration,American Universityof Sharjah, Sharjah, United Arab Emirates, [email protected] ac. ae;Hamid Baghesteni, Department of Economics and Public Adminislration,American Universityof Sharjah, Sharjah, United Arab Emirates, [email protected] ac. ae. The authors gratefullyacknowledgethe commentsof an anonymousrefereeon an earlierdraftof this paper. See the WorldBankGroup(2001). ume 28 * Number 2 * Summer 2004 261 least 6 percent in real GDP to stabilize unemployment. 2 To encourage economic progress, Jordan has focused on a private-sector export-oriented growth strategy. The government has aggressively pursued privatization of most public enterprises in transportation, electricity, water, and telecommunications. In addition to increasing efficiency, productivity, and competitiveness of privatized companies, the aim has been to encourage domestic saving and stimulate private investment.

In terms of exportoriented growth, Jordan has established several free zones, including the Aqaba port along the Red Sea, Zarqa, the Sahab industrial estate, and lrbid. Private sector participation is encouraged through investment tax incentives. Licenses to operate within a free zone area are given to private companies if they have the potential of bringing new industries and technology to the country, utilizing local raw materials and components in the process of production, improving the Jordanian labor skills, and lowering the country’s imports. Despite these structural reforms, a healthy and sustainable growth in real GDP has not yet been realized. In addition to the lack of concrete export competitiveness, barriers to faster growth include the low levels of domestic saving and slow response of private investment. 4 Besides privatization, other efforts to increase the saving rate include further development of the pension system, the financial system, and the capital markets. As in the case of Egypt, eliminating the budget deficit in Jordan is essential to ensure the availability of domestic saving for private investment.

Providing evidence of the causal relation between government revenue and spending should thus help determine ways to reduce and eventually eliminate the budget deficit in Jordan. The rest of the paper is organized as follows. The next section theoretically discusses four hypotheses of government finance: (i) the tax-and-spend hypothesis, (ii) the spend-and-tax hypothesis, (iii) the hypothesis of causally independent tax and spending decisions, and (iv) the fiscal synchronization hypothesis.

Citing some empirical evidence, mostly on developing countries, augments this theoretical discussion. The third section describes the data and the econometric methodology. Such tests as a unit root and cointegration are necessary to identify the appropriate bivarlate model for investigating the directions of causation between revenue and spending. However, our sample periods are not sufficiently long to get any power for these tests. To overcome this problem, the causality tests are performed using three bivariate models.

These are (i) the vector autoregressive model in levels, (ii) the vector autoregressive model in first differences, and (iii) the error-correction model. The causality test results for Egypt and Jordan, presented in the fourth section, are not sensitive to the choice of the model. Accordingly, in the fifth section, we rely on these test results to discuss the policy implications and conclude the paper. Theoretical and Empirical Background Several alternative hypotheses of government finance characterize the causal relation between spending and revenue.

The tax-and-spend hypothesis, championed by Friedman (1978), theorizes a causal relation running from revenue to spending. It views spending as adjusting, up or down, to whatever level can be supported by revenue. Control of taxation, according to Friedman (1978), is essential to limiting growth in government. In reducing the budget deficit, for instance, one should not rely on raising taxes, since higher revenue invites higher spending. Like Friedman, Buchanan and Wagner (1977, 1978) advocate the tax-and-spend hypothesis.

But they warn that the tax-and-spend prediction may be distorted due to the fact that tax rate changes are accompanied by intense political debate and controversy over economic impact and income distributional issues. Deficit financing 2Seethe WorldBankGroup(2003). J See JordanlnvesanentBeard(2000). ‘ One should,of course, be mindfulof the fact that the political instabilityof the region is another impedimentto fitstereconomic8rowth,moreso in filecaseof Jordan than Egypt. 262 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 28 9 Number 2 9 Summer 2004 ather than tax financing by politicians may then become the source of growth in spending. Empirical evidence in support of the tax-and-spend view is presented by Baffes and Shah (1994) for Brazil, by Dan’at (1998) for Turkey, by Darrat (2002) for Lebanon and Tunisia, by Cheng (1999) for Columbia, the Dominican Republic, Honduras, and Paraguay, and by Ewing and Payne (1998) for Colombia, Ecuador, and Guatemala. The spend-and-tax hypothesis relies on the reverse relation, with revenue responding to prior spending changes.

In line with the Ricardian equivalence theorem, Barro (1974) maintains that the public fully anticipates and capitalizes the future tax liability implied by present government borrowing. Thus, in the absence of fiscal illusion, increases in government spending lead to increases in taxes. Peacock and Wiseman (1979) see natural, economic, or political crises as justifications for spending hikes that are subsequently approved by tax increases. According to this hypothesis, spending cuts are the desired solution to reducing the budget deficit, especially in the absence of crises.

Empirical evidence by Mithani and Khoon (1999) and Ram (1988) supports the spend-and-tax hypothesis, respectively, for Malaysia and Honduras. The third hypothesis emphasizes the institutional separation of allocation and taxation functions of government and the independent determination of revenue and spending. With respect to the U. S. , this hypothesis emphasizes the absence of coordination between spending and revenue decisions due to the lack of agreement between the executive and legislative branches of government participating in the budgetary process. [See Wildavsky (1988) and Hoover a~d Sheffrin (1992). Consistent with this view, Baghestani and McNown (1994) conclude that neither the tax-and-spend nor the spend-and-tax hypothesis accounts for post-World War II budgetary expansion in the U. S. Instead, they show that both the expansion in revenue and spending is determined by iong-rnn economic growth. With respect to developing countries, Ram (1988) provides empirical evidence in support of the institutional separation hypothesis for India, Panama, Paraguay, and Sri Lanka. The fourth hypothesis indicates bidirectional causation between revenue and spending. [See Musgrave (1966) and Meitzer and Richard (1981). This f ~ t l synchronization hypothesis postulates that the revenue and spending decisions are made simultaneously, by analyzing costs and benefits of alternative government programs. Therefore, this view precludes unidirectional causation from revenue to spending or from spending to revenue. Empirical evidence in support of the fiscal synchronization hypothesis is presented by Baffes and Shah (1994) for Argentina and Mexico, by Cheng (1999) for Chile, Panama, Brazil, and Peru, by Ewing and Payne (1998) for Chile and Paraguay, by Kimenyi (1990) for Kenya, and by Li (2001) for China.

For a comprehensive survey of the empirical evidence on the tax-spend debate for both developed and developing countries, see Payne (2003). Data and Methodology This study utilizes the annual data on government spending, government revenue, and Gross Domestic Product (GDP). These data for Egypt (1977-1998) and Jordan (1975-2001) are obtained from the International Financial Statistics tapes. Following Bohn (1991), among others, government revenue and spending are expressed as a ratio of GDP. While controlling for GDP, this treaunent alleviates the question of whether the revenue and spending variables should be in nominal or real terms.

The difference between the VAR-D in (2) and the ECM in (3) is the inclusion ofR,. I andX,. l. These series, of course, are from the long-run equilibrium relation in the ECM. The VAR-L in (1), as noted by Baghestani and McNown (1992, p. 130), is not inconsistent with the long-run equilibrium relation but requires restrictions across the two equations. 5 In order to determine the appropriate model, it is necessary to conduct unit root and cointegration tests. However, as also indicated by Hakkio and Rush (1991), a very long sample is required to get any power for such tests.

The lack of a long sample for Egypt and Jordan, therefore, prevents us from conducting the tests of a unit root and cointegration. To overcome this problem, all three bivariate models in (1)-(3) are employed in this study to investigate the causal relation between Rt and X,. A common practice in causality testing is to specify a common lag length on RI and X, in the VARs and ECM. Lee (1997) warns against this practice due to inherent misspecifications. Therefore, in line with Cheng (1999), among others, we utilize Hsiao’s (1981) version of the Granger causality test.

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