Government size and economic growth under the smoothy transition autoregressivemodel (star)

In this paper, I examined the relationship between government size, proxied as general government consumption expenditure in GDP and economic growth, measured as real per capita GDP grow

DIEU THI HONG LE

GOVERNMENT SIZE AND

ECONOMIC GROWTH UNDER THE

DIEU THI HONG LE

GOVERNMENT SIZE AND

ECONOMIC GROWTH UNDER THE

SMOOTH TRANSITION AUTOREGRESSIVE MODEL (STAR)

Major: Finance – Banking Code: 60340201

MASTER THESIS SUPERVISOR:

PROF NGUYEN KHAC QUOC BAO

HO CHI MINH CITY – 2015

I hereby, declare that this thesis “Government size and economic growth

under the Smooth Transition Autoregressive model (STAR)” is my own study

Results discovered in this thesis are honest and reliable and they have not ever been published in any paper before

Author

DIEU THI HONG LE

TABLE OF CONTENTS

SUB-COVER PAGE

COMMITMENT

TABLE OF ABBREVIATIONS

TABLE OF TABLES

TABLE OF FIGURES

ABSTRACT

1 INTRODUCTION 1

1.1 Objectives 4

1.2 Overall methodology 5

1.3 Subjects 5

2 LITERATURE REVIEW 8

2.1 Government size and economic growth 8

2.2 Barro’s model 12

2.3 Empirical literature on government size and economic growth 15

2.3.1 Studies with a positive relationship found 16

2.3.2 Studies with a negative relationship found 17

2.3.3 Studies with non-linear relationship found 21

3 DATA AND METHODOLOGY 26

3.1 Methodology 26

3.1.1 Theoretical framwork 26

3.1.2 Econometric model 27

3.1.3 Process 28

3.2 Data descriptions and variable measurements 30

4 RESULTS 33

4.1 Variables’ descriptive statistics 33

4.2 Unit root tests 35

4.3 VAR estimation and tests for linearity 36

4.4 Smooth Transition Autogressive Model estimation 39

5 CONCLUSION 46 PREFERENCES

APPENDIX

TABLE OF ABBREVIATIONS

2SLS Two stages Least Squares

ADF Augmented Dickey-Fuller

AIC Akaike Information Criterion

ESTAR Exponential Smooth Transition Autoregressive

GDP Gross Domestic Product

GMM Generalized Method of Moments

GNP Gross National Product

LSTAR Logistic Smooth Transition Autoregressive

OECD Organization for Economic Co-operation and Development OLS Ordinary Least Squares

NPIs Non-profit institutions

SBC Schwarz Bayesian Information Criterion

SNA System of National Accounts

STAR Smooth Transition Autoregressive

TFP Total Factor Productivity

VAR Vector Autoregression

TABLE OF TABLES

Table 3: Summary of variables

Table 4.1: Descriptive statistics of variables

Table 4.2: Summary of unit root tests

Table 4.3: VAR lag selection based on AIC

Table 4.4: Results for VAR estimates

Table 4.5: Linearity tests and model selection

Table 4.6: ESTAR model estimated for China (1)

Table 4.7: ESTAR model estimated for China (2)

TABLE OF FIGURES

Figure 1.1: GDP growth (annual %) in three groups of economies over 2001-2014 Figure 1.2: General government total expenditure (% GDP) in three groups of economies over 2001-2014

Figure 1.3: Total expenditure and GDP growth in China (1982-2014)

Figure 1.4: Total expenditure and GDP growth in Japan (1980-2014)

Figure 2: Relationship between government size and economic growth

Figure 4.1: Government size and GDP growth in China (1971-2013)

Figure 4.2: Government size and GDP growth in Japan (1971-2013)

Figure 4.3: STAR versus Linear model residuals

Figure 4.4: The estimated transition function for China

In this paper, I examined the relationship between government size, proxied as general government consumption expenditure in GDP and economic growth, measured as real per capita GDP growth under Smooth Transition Autoregressive (STAR) approach in China (a developing country) and Japan (a developed country) over 1971-2013 period Results show that Exponential STAR (ESTAR) is better fitted for China Meanwhile, there is no convergence for Japan, means that this relationship should be explained by an alternative non-linear model The threshold value of government size for China is found at 14.23% (or 14.18%) However, BARS curve is not really supported Economic growth still is marginally positive when government expenditure exceeds this value In spite of that, this also implies inefficient use of resources and government should pay more attention on this issue

to enhance economic growth

Keywords: economic growth, government size, Smooth Transition Autoregressive, STAR

1 INTRODUCTION

Theories of growth have been developed for a long time Among of those, there are two prominent schools: exogenous and endogenous economic-growth models Exogenous models (also called neoclassical models) pioneered by Solow (1956) and Swan (1956) assert that long-run growth would be explained by capital accumulation, labor (or population) and technological process which enhance productivity Some remarkable conclusions of neoclassical models are that all countries would have a convergence in economic growth, developing countries could grow faster than developed countries and only technological innovations bring a steady-state growth Thus, public spending does not have effects on long-run growth in exogenous models On the other side, endogenous models developed

by Romer (1986), Barro (1990), Rebelo (1991) attempt to seek new motivation for economic growth after almost thirty years of stagnation They argue that long-run economic growth may be explained by various endogenous variables Among of them, fiscal policy is a factor which is attractive to many researchers Government spending has positive impact on growth through not only directly increasing outputs but also indirectly providing productive goods and services which are considered as inputs to private production (Grossman, 1988) In addition, government also establishes a legislative system which helps to protect property rights and provide

an investment-friendly climate However, over-expanding government size would also have an adverse impact on growth (Barro, 1990; Armey, 1995 among others) Distortion of resource allocation, crowding-out effects, tax burdens dampen private sector‟s incentives, hence affect growth

Statistical data recently shows that economic growth and government expenditure seem to have negative correlation (see Figure 1.1 and Figure 1.2) While a group of advanced countries has total government expenditure in GDP (2001-2014) of roughly 30-35%, especially in G7 countries, this range is 38-45%, this number in a group of emerging and developing countries fluctuates around 25-

31%, much lower than groups of advanced economies However, growth of GDP in advanced countries is lower than in emerging and developing countries by roughly from 2% to 5,5% (calculated by differencing GDP growth in emerging and developing countries and average of GDP growth in G7 and other advanced economies).

Figure 1.1: GDP growth (annual %) in three groups of economies over

Major advancedeconomies (G7)

Other AdvancedEconomies (ExcludingG7 and Eurozone)

Figure 1.2: General government total expenditure (% GDP) in three groups of economies over 2001-2014

Source: Collection from Economy Watch

Statistical evidence seems to support reducing for government size is necessary if developed countries expect higher growth in the future However, a question raised is that what magnitude government size should be reduced to Some studies find out that government spending have positive impact to growth (Ram (1986), Grossman (1990), Ghali (1999)) On the other hand, Landau (1983), Guseh (1997), Dar and AmirKhalkhali (2002) among others give evidence that shows a negative relation between growth and government expenditure Others demonstrate they have non-monotonic nexus As a result, the relationship between government size and economic growth becomes ambiguous However, evidence on non-linear relation seems more persuasive: under-expanding or over-expanding government size is not better Therefore, I support to the views that suggest an existence of optimal value which maximizes economic growth

In terms of methodology, almost authors in former studies use methods which incorporate cross-sectional or panel data in their work There are few studies which examine non-monotonic relationship with time-series data One of disadvantages of cross-sectional or panel data is that they do not reflect specific features for each

Major advancedeconomies (G7)

Other AdvancedEconomies (ExcludingG7 and Eurozone)

country, hence results might become unreliable In spite of difficulties in reaching time-series data, it has outstanding advantages that help us to have more reliable results One of ideal tools examining the non-linear relationship between two variables is non-linear Smooth Transition Autoregressive – STAR models Those models could allow us to detect a non-linear relationship with a smooth adjustment between regimes Moreover, they could be used to be a multivariate, thus they are appropriate to investigate effects of government size to growth In addition, they help us to find out the threshold value for government size which is meaningful for policy implications

All issues mentioned above motivated me to do a research, namely

“Government size and economic growth under the Smooth Transition

Autoregressive model (STAR)”

In this paper, I follow Chiou-Wei et al (2010) to investigate government size‟s impact on growth However, there are some points different from their paper First, instead of concentrating on developing countries, I study on two groups of countries depending on level of economic development for comparison purpose: a developed country and a developing country Second, the robustness test will be implemented with an alternative proxy for export

1.1 Objectives

Based on different results of previous studies, this paper mainly focuses on exploring the nature of the relationship between government size and economic growth with a non-linear technique Next, my objective is to examine whether there are differences in results between a developed country and a developing country, hence I involve China and Japan as subjects

With given objectives described above, there are two main research questions

as follows:

1 Which model should the relationship between government size (proxied as general government final consumption expenditure in GDP) and economic growth

be better explained? A linear or non-linear model (with STAR model implication)?

2 If a non-linear model is selected, what is magnitude of the optimal value for government size for each country?

1.2 Overall methodology

In this paper, a neoclassical production function model is employed In this model, government expenditure and openness are assumed to affect Total Factor Productivity (TFP) Therefore, economic growth is a function of capital accumulation, government size and openness Using descriptive statistics helps us have preliminary evaluations for two variables‟ relation Process to test linear and non-linear relationship and select the appropriate model for each country will be carried out after that Then I apply proper STAR model to describe the relation between government size and economic growth for each country I assume that government size is the threshold variable causing the smooth transition between regimes in growth Based on results obtained, I will estimate parameters‟ values for each explanatory variable and the threshold value for government size

1.3 Subjects

In this paper, I investigate whether the non-linear relation exists between government size and economic growth on data of two countries: China and Japan China is a developing country with the largest population in the world China realized the command economy was no longer proper in expecting higher economic development and living standard for its citizens Therefore, in 1979, China started to carry out a huge reform, switching to free-market economy After that, it experienced high economic growth for many years impressively In 2010, it officially overtook Japan to become the second largest economy (measured by GDP) We cannot reject that government spending is an important contribution to its growth Particularly, investment in infrastructure has been growing fastest in the

world Fiscal policy seems to have positive effects on growth Some empirical studies show that government expenditure is an incremental factor to growth (Shinha, 1998), Wagner‟s law does not hold in China (Huang, 2006) Large fiscal multiplier (more than 2) helps China preventing from economic slowdowns However, government spending also causes inflation and investment booms, then damages growth (Wang and Wen, 2013) Figure 1.3 presents GDP growth and total government expenditure in China from 1982-2014 Government spending tends to extend too much, meanwhile growth tends to reduce Chinese government is expanding spending, particularly in infrastructure investments in attempting to revive slowing economy Hence, dispute over government expenditures in China has been raised again

Figure 1.3: Total expenditure and GDP growth in China (1982-2014)

Source: Collection from Economy Watch

Japan is a developed country with the third largest GDP in the world After World War II, Japan experienced rapid economic growth Especially, in 1960s, the average annual growth is approximately 12%, much more than other G7 countries, however, it dropped quite quickly in 1970s Since the asset price bubble in earlier 1990s, Japan has been facing difficulties and economic growth has been at one of the lowest (Figure 1.4) In contrast, general government total expenditure has been increased, falling in the range from 30% to 40% since 1990 To stimulate the

GDP growth (%)

demand and remain the growth rate, Japan ran a huge budget on public work programs National debt is a problem that Japan is facing Some studies attempt to investigate the relationship between government spending and growth in Japan Terasawa and Gates (1998) show that government spending has decremental effect

on growth They argue that “government programs typically lack competition, profit incentives, quantitative output measures, and a link between production costs and consumer values” (p.217) On the other hand, Guerrero and Parker (2010) indicate that government spending really has a positive effect on real GDP and

“expansionary fiscal policy may have played the role of avoiding a deeper economic depression than the one observed during Japan‟s lost decades” (p.2)

Figure 1.4: Total expenditure and GDP growth in Japan (1980-2014)

Source: Collection from Economy Watch

The rest of this paper is organized as follows Section 2 summarizes related theories and previous empirical studies Next, Section 3 outlines methodology and describes data and variable measurements Section 4 provides empirical results and conclusion is given in Section 5

GDP growth (%)

2 LITERATURE REVIEW

2.1 Government size and economic growth

Economic growth is generally defined as an increase in the amount of goods and services produced by an economy over a period of time According to World Bank, this concept is “quantitative change or expansion in a country‟s economy” Economic growth is usually measured as the percentage increase in (real) Gross Domestic Product (GDP) or (real) Gross National Product (GNP)

According to World Bank, Gross domestic product (GDP) is “the value of all final goods and services produced in a country” over a period of time Following this notion, the value of final goods and services are produced by both residents and foreigners in a country will be added when calculating GDP There are two ways to measure GDP: first, GDP is a sum of all of an economy‟s incomes-wages, interest, profits and rents Second, it is a sum of all consumption, investment, government purchases and net exports (exports minus imports) Both methods should bring the same result Real GDP is inflation-adjusted GDP

Gross national product (GNP) is “the value of all final goods and services produced in a country in one year plus income that residents have received from abroad, minus income claimed by nonresidents” Thus, for countries which income from nonresidents is larger than residents from abroad, GNP may be less than GDP Conversely, GNP may be much than GDP when income received from residents from abroad dominates Real GNP is inflation-adjusted GNP

In addition, economic growth is also measured as the percentage rate of per capita GDP or per capita GNP Per capita GDP (GNP) is GDP (GNP) divided by

population

In terms of government size, in fact, it is a vague concept “It can refer to the number if existing functions of government, the number of public agencies, the number of public employees or the government budget size” (Su Dinh Thanh, 2015, p.2) Facchini and Melki (2013) define government size as the proportion of public

spending to the value of national output or real GDP Government size can be proxied by different variables such as government consumption, transfers and subsidies, the number of government enterprises or government debt…(Afonso and Jalles, 2011) However, this notion in both theoretical and empirical studies regarding economic growth frequently refers to government expenditures or government revenues, especially government consumption expenditures

Total general government expenditures include all kinds of outlays incurred by general government units According to System of National Accounts (SNA) 2008,

“government units are unique kinds of legal entities established by political processes that have legislative judicial or executive authority over other institutional units within a given area” “General government units include some non-profit institutions (NPIs) and public enterprises not treated as corporations”

Following Chobanov et al (2009), the general government expenditure can be divided into three sub-categories as follows:

1 The final consumption expenditures: “expenditures on a wide range of consumption goods and services are incurred by general government, either on collective services or on selected individual goods or services” “Final government consumption expenditures consist of the value of all types of output of general government less the value of output for own account capital formation and the value

of sales of goods and services at both economically insignificant prices and at economically significant prices plus the value of goods and services purchased from market producers for delivery to households free or at economically insignificant prices” (SNA, 2008) In other words, the final consumption expenditures by government are goods and services either purchased from private sector or produced

by government They are provided free or at economically insignificant prices

2 Government investment expenditures: consist of government capital formation, purchases of land and intangible assets as well as capital transfer to non-government sectors (Chobanov et al., 2009)

3 Transfer payments: consist of transfers paid to other institutions, mostly households, for redistribution purposes (SNA, 2008)

In addition, government revenue is also used as proxy for government size in some studies According to SNA 2008, “government revenue is usually dominated

by compulsory levies in the form of taxes and social contributions For some levels

of government, grants (transfers from other government units and international organizations) are a major source of revenue Other general categories of revenue include property income, sales of goods and services and miscellaneous transfers other than grants”

In this paper, general government consumption expenditure in GDP is used as

a proxy for government size

Regarding the role of institutions, no one can reject the important role of government sector in developing economy and society Vedder and Gallaway (1998) in their study explained quite fully this role How would our society be without government? Assets produced by society would be stolen by bullies and stronger people Anarchy causes an unsafe environment for living and production, hence no incentives for savings and investment Asset accumulation as well as growth is at the lowest level An existence of institutions makes many significant changes to development of society and economy That means an establishment of law and private property rights They make private wealth protected No one can steal others‟ assets without punishment Therefore, government could at least create safer environment for living and production Incentives for accumulation are higher and hence foster economic growth

Another reason supporting for government existence is ability of providing goods and services which are a productive contribution to private production such

as education, nation defense, infrastructure, a reliable medium of exchange… For example, transportation development helps to connect not only states within a country but also regions in the world; nation defense prevents a country from others‟

invasion; a reliable medium of exchange enhances trading… In the early state of government size, they all contribute to lower transaction costs, expand business activities and of course increase income and growth

However, what happens when government grows beyond a certain value? At that time, the law of diminishing returns would appear One additional unit of productive goods and services provided by government could not induce the same units of output like at the beginning, instead of that, induce a smaller number of units Moreover, government activities are financed by taxes A larger government means an increase in taxes levied and thus, they are incremental burdens to society Taxes change consumption and investment behavior In addition, transfer payments also expand along with government size When they are large enough, they also have negative impact on growth in reducing poor people‟s working incentives Taxes and transfer payments distorb economic activities, then dampen growth Besides that, other issues regarding the efficiency of public sector which affects output and growth is also mentioned in many theories According to Buchanan‟s and Tullock‟s theory, self-interest groups would obtain bigger benefits when the government size is larger Decisions made tend to favor of a small interest group instead of benefits of the whole society Particularly, rent-seeking activities of self-interest groups frustrate growth by two ways: unproductive allocation of resources and inefficiency from the use of the market power Bureaucratic government decides the size of the budget which maximizes his utility rather than the efficient size following Niskanen (1971) They are all deemed to discourage private sector‟s incentives and therefore they have negative effects to growth (See Grossman (1988) for a detailed exposition)

As we can see that, a society with both no government and dominated too much by government are not optimal to economic growth That might suggest a point at which maximizes the growth Next, we will discuss one of endogenous

frameworks developed by Barro (1990) This model shows how productive government spending affects economic growth

2.2 Barro’s model

Barro (1990) in his study “Government spending in a simple model of endogenous growth” developed a theoretical framework in which the nexus between government size and economic growth is the inverted U-shaped In short,

he asserts that there exists a threshold at which different government sizes have two different effects to growth When the government is small, below the threshold, an increase in government size will foster growth and the opposite effect will happen

in cases which government size is above the threshold His model will be explained

in more detailed

Let us begin with some assumptions with a closed economy in which lived household seeks to maximize the overall utility:

infinite-(2.1) Where c is consumption per person, ρ is the constant rate of time preference Barro uses the utility function as given:

(2.2) Where 0 <  < 1 to make sure that the marginal utility has the constant elasticity

Barro assumes that public services is a productive factor to private production, hence he modifies the simple production function in which output is a function of private capital, the new private production function is given:

(2.3)

Where assuming that constant returns on scale;  satisfies conditions of both positive and diminishing marginal products; k is the representative household‟s amount of capital; g is per capita amount of government purchases g is now treated

as an input that would have positive effect on growth Barro considers (2.3) as Cobb-Doughlas production function, therefore:

(2.4) Where 0 <  < 1

Assuming that government purchases is financed by flat-rate income tax, 

(2.5) Where T is government revenue Equation (2.5) also implies that the agent has

a balanced budget He spends all revenues to finance productive purchases which enter into the production function In this model, Barro assumes that government does not own his own capital and do production like private sector as well This makes the model more easily understood but does not change basic results

From equation (2.3), we have equation of the marginal product of capital as:

(2.6) Where  is the elasticity of y with respect to g

Barro said that “private optimization leads to a path of consumption” (Barro,

1990, p.S108) which satisfies the equation of the growth rate of consumption:

(2.7)

 is the growth rate of consumption

Barro argues that in cases which  and g/y are constant, then g, T, k and y would grow at the same rate of , “the economy has no transitional dynamics and it always in a position of steady-state growth” (Barro, 1990, p.S108) However when

 and g/y are not constant, there are two effects on growth rate,  He asserts that an increase in flat-rate tax  would lower  whereas an increase in g/y would increase the marginal product of capital y/k (then increase ) The second effect would be stronger than the first one when the government size, g/y is small

Denoted by Cobb-Douglas production function, first derivative of  with respect to g/y is:

(2.8) There are three outcomes When g/k is small enough in order that ‟ > 1, then the right-hand side of (2.8) > 0, growth rate increases with g/y And when g/k is large enough in order that ‟ < 1, then the right-hand side of (2.8) < 0, growth rate increases with respect to a decrease in g/y Finally when ‟ = 1 that means growth rate is maximized As a result of above demonstration, the relationship between government size and economic growth is inverted U-shaped and is plotted in Figure

In addition to analysing government size – economic growth relationship with income tax, Barro also considers this relation with lump-sum tax Now, the equation

of growth rate of consumption is given:

(2.9) Figure 2 also shows the relation between L and g/y with a Cobb-Douglas production function case An increase in g/y means an increase in y/k which in turn makes L increase Therefore, Barro asserts that “with lump-sum tax, households respond to the higher return on capital by choosing a higher growth rate

of consumption” (Barro, 1990, p.S114)

After reviewing the theoretical framework developed by Barro, now we will

switch to empirical studies on this issue

2.3 Empirical literature on government size and economic growth

In fact, there is no persuasive theory of impact of government size on growth However, in the real world, both the slower economic growth in almost countries (especially in developed countries) and the bigger government size in recent decades raise a question about their relationship as well as the role of government spending to growth The question about the relationship between government size and economic growth seems to be an interesting issue and this attractive topic has been pursued by many economists and researchers They empirically study this relationship on various samples and diversified methods These results seem not to

be consistent Some authors suggest large government size has a positive impact on economic growth by building and developing a system of legislation, administrative; protecting the private property rights; investing infrastructure; avoiding the market failures… On the other hand, government can create a burden

of tax and inefficiency in operations There also appear „crowding-out‟ effects

Government competes with private sector in using resources and makes resources used inefficiently As a result, government size has a negative impact on economic growth

2.3.1 Studies with a positive relationship found

Some studies find that the positive relationship between government size and economic growth Ram (1986) outlines the two-sector production function framework to model the overall effect and externality effect of government size and relative factor productivity between government and non-government sectors as well The author employs Summers and Heston‟s data of 115 countries over two decades 1960-1980 to discover empirical evidence of those effects Using growth of government size (∆G/G) and (∆G/Y) in equations instead of G/Y (a proxy used in Landau‟s paper (1983) which the author argued that it was not plausible), he finds the positive relation between government size and economic growth Besides, externality effect of government size is positive and government sector has higher factor productivity than non-government one although this declined over 1970‟s (compared with 1960‟s) A result also shows that the positive impact of government size seems to be stronger in nations with lower income levels

In his study, Ghali (1999) employs multivariate cointegration techniques introduced and developed by Johansen (1988) and Johansen and Juselius (1990) to identify the short-run and long-run impact of government size on economic growth

in every country He argues that cross-sectional growth regression techniques in former studies only investigate the pooled estimates of effects of government size

on economic growth, they do not capture the dynamics which might be greatly different from countries with various economic structures Thus, time-series analysis is preferable to cross-sectional one Results with system of five variables including rate of growth of GDP, investment, total government spending, exports and imports show that government size (proxied as the share of total government spending in GDP) Granger-causes growth in all 10 OECD countries with data from

1970Q1 to 1994Q3 For countries such as Australia, Canada and Switzerland, the change in government size explains from 26% to 60% for the total change in economic growth Especially for some countries government size has impact on economic growth via indirectly impact on either investment or the trade variables (imports and exports)

Grossman (1990) attempts to differentiate positive and negative effects of government on growth He develops a model adapted two-sector production functions presented by Feder (1983) and Ram (1986) The author develops a model

in which both growth in government spending of total economic output and growth

in the relative government size (government size is measured by the ratio of total government expenditures and total economic output) are involved While growth in government expenditures is expected to give positive indirect effects through supply

of Pigovian goods and services, the effects of distortion in resource allocations and unproductive use of resources are captured by growth in relative government size

He tests a model by using a cross-sectional sample of 48 countries over 1970-1983 and found that government has a net significant positive impact on overall economic growth, however the distortionary effects resulting from that

government‟s misallocation of resources are not also insignificant

2.3.2 Studies with a negative relationship found

While there is a little evidence showing positive effects of government size on growth, adverse effects seem to be found in more studies In their empirical works, they find that there exists a negative relationship between government size and economic growth Landau (1983) uses data of 104 countries over the 1960-1977 period to examine the relationship between the average growth rate and the average share of government consumption expenditure in national income The results show

“a significant negative partial correlation between the government share and the rate

of increase in per capita output” (Landau, 1985, p.460) Landau (1985) extends the analysis of Landau (1983) over 16 developed countries in 1952-1976 The author

discovers not only effects of the share of total government expenditure but also effects of the share of three components of government expenditure consisting of investment, consumption and transfer payments on growth rate of per capita gross domestic income Using various regression techniques (OLS, IV, HS corrected and OLS with observations weighted by population), the same results are found Government spending has negative impact on growth Especially, both government consumption and government investment also have negative effects on growth, however, no significant evidence found for government transfer Thus, “The growth

of government consumption and investment expenditure has helped „cause‟ slowdown in economic growth” (Landau, 1985, p.473)

Grier and Tullock (1989) in the empirical study on panel data of 113 countries over the 1951-1980 period aim to discover the effects of those variables on economic growth: initial per capita real GDP; the growth of government size (measured as the growth rate of the ratio of government consumption to GDP); the standard deviation of GDP growth; population growth; inflation; the change in inflation and the standard deviation of inflation Regarding government size, results show that government growth has negative impact on economic growth in three of four subsamples (OECD, Africa and America excluded Asia) Even though the growth of government size is significantly negative to GDP growth, the coefficients are smaller than the one observed in OECD One standard deviation increase in growth of government size reduces GDP growth by 0.39 percentage points Meanwhile, in Africa and Americas, those effects are respectively 0.58 and 0.25 percentage points Contrarily, in Asia, one standard deviation increase in growth of government size increases GDP growth by 0.38 percentage points

Barro (1989, 1991) investigates the relationship between share of government consumption in GDP and growth among other variables on a sample of 98 countries over 1960-1985 He argues that expenditures on education and defense “enters mainly into utility functions rather than into production functions or as influences

on property rights” (Barro, 1990, p.S122), they may belong to public investment

rather than public consumption (Barro, 1991) Therefore, he modifies data from Summers and Heston (1988) by subtracting the share of education and defense spending in GDP from the ratios of government consumption spending in Summers and Heston‟s data A negative association between government consumption and real per capita GDP growth is found He concludes that an increase in nonproductive government spending lowers economic growth Interestingly, when the ratio of public investment to GDP (gi/y) is considered as an explanatory variable

in growth equation, the coefficient is positive (0.13) but not significant In his study

in 1996, he extends from cross-country analysis to panel analysis on data of roughly

100 nations from 1960 to 1990 and finds the same results of this relation He emphasizes that due to measure of government consumption referring to non-productive spending, “a greater volume of non-productive government spending – and the associated taxation – reduce the growth rate” (Barro, 1996, p.18-19)

Guseh (1997) investigates this nexus among different political and economic systems Results on data of 59 middle-income developing nations over the 1960-

1985 period show that the growth of government size has negative effects on economic growth and the magnitude of negative effects also depends on political and economic systems He concludes that “the negative effects are three times as great in nondemocratic socialist systems as in democratic market systems” (p.175) Kneller et al (1999) argue that results of previous researches on fiscal policy and growth might be biased regarding to “incomplete specification of the government budget constraint” (p.171) Hence, they evaluate again the relationship between structure of taxation and government expenditure and steady-state rate of growth Employing data of 22 developed countries over 1970-1995 period, the results strongly support Barro‟s (1990) endogenous growth model Consequently, they find that distortionary taxation lowers growth and productive government expenditure boosts growth, meanwhile both non-distortionary taxation and nonproductive government expenditure do not affect growth

Tanninen (1999) in the study on economic growth and inequality, in turn,

finds evidence that the share of government consumption expenditure in GDP has

negative effects on growth for a sample of 52 available countries over 1970-1995

In average, reducing in government consumption expenditure by one standard

deviation would increase average growth rate of per capita GDP by one percentage

point Also, government transfer payments and growth have a positive relation The

positive effects are found in both OLS and 2SLS regression techniques

Dar and AmirKhalkhali (2002) use data of 19 OECD countries over the

1971-1999 period to examine the relationship between the government size along with

other variables and economic growth They assert that the assumption of the same

coefficients across countries seems not to be plausible Hence, they overcome this

issue by using random coefficient model which can capture intercountry differences

Results indicate that in average, government size (measured by government

spending to GDP) has negative impact on the economic growth via the adverse

impact on factor productivity However, when it is measured by the rate of growth

in government consumption instead, it showed a positive impact on economic

growth They suggest that the negative impact found may reflect the effects of

taxation and transfer payments, especially a significant increase in transfers over

past 30 years in studied period

Romero-Ávila and Strauch (2008) focus on the relation between fiscal

variables and long-term growth in Europe, incorporating data of 15 European

countries from 1960 to 2001 Using panel cointegration techniques, they find that

both sides of the budget, revenues and expenditures have long-term relationship and

co-move in the same direction They have opposite effects on growth therefore they

cancel out each other Authors then use distributed lag approach to estimate the

long-term effect of fiscal variables on growth Results show that government size

(measured as total expenditure or total revenue shares), government consumption as

well as direct taxation have a negative effect on per capital GDP growth, however

public investment has opposite impact, being a growth-enhancing factor

2.3.3 Studies with non-linear relationship found

It seems that the negative effect of government size on growth found is dominant over the positive one on a number of studies However, we cannot ignore the positive impact of government spending on growth Government supplies Pigovian goods and services and system of legislation which enhance growth As a result, questions have been queried on whether there exists a non-linear relationship between two variables There are many studies concentrating on testing the existence of BARS curve1

Grossman (1988) develops a model which enables the non-linear relationship measured Unlike former studies (Landau, 1983; Ram, 1986; Rubinson, 1977) which only examine the monotonic relation, he separately investigates both positive and negative effects of growth of government size on economic growth He argues that a change in relative size of government (measured as the share of government expenditure in total economic growth) would have negative effects on growth while

a change in absolute size would have positive effects on growth Results based on time-series data of U.S over 1929-1982 using 2-staged least squares technique strongly support his reasoning The non-linear model is preferable to the linear one Sheeley (1993) also argues that previous studies usually focused on testing for

a monotonic relation For this reason, he examines this nexus with levels of government size and development (measured as per capita GDP) Using data of 102 nations between 1960-1970 and 1970-1980 together with first differencing technique in the simple production function model, he proposes that a change in relative share of government consumption has significantly negative impact on high income countries and significantly positive impact on low income – low government share countries

1 This term is named after ideas of the non-linear relationship between government spending and economic growth presented by Barro, 1990; Armey, 1995; Rahn and Fox, 1996; Scully, 1994

Karras (1996) develops a new methodology which indirectly examines the non-linear relation between two variables through focusing on the productivity of government services The author exercises on a large panel of 118 nations from

1960 to 1985 and comes to conclusion that services which government provides are significantly productive, however, underprovided in Asia and overprovided in Africa, optimal provided in somewhere else Particularly, he found that the optimal government size (measured as government consumption in GDP) is 23% for the average country but has a broad spectrum geographically (from 14% for average OCED country to 33% for one in South America) Also, the marginal productivity

of government size has negative relation to government size

Vedder and Gallaway (1998) test an existence of Armey curve on very time U.S government spending and GDP data and some developed nations for robustness testing They discover the relationship between GDP (or GDP growth) and government spending by using a simple model (adding government spending –

long-G and this variable squared in growth equations) The results show that the Armey curve really exists and is robust Particularly, a tendency of larger transfer payments causes an economic slowdown Hence, they suggest government spending growth should be below the economic growth, especially focus on constraining the growth

Chen and Lee (2005) tests an existence of Armey curve for Taiwan by using data of Q1‟1979-Q3‟2003 The authors modify two-sector production function developed by Ram (1986) and employed Hansen‟s (2000) threshold regression model to test threshold effects of government size on economic growth Results show that when all three kinds of government size in sequence: “total government expenditure divided by GDP”, “government investment expenditure divided by GDP” and “government consumption expenditure divided by GDP” are set as the threshold variables, the threshold effects really exist in government size and growth relationship in Taiwan The threshold regimes found are 22.839%, 7.302% and 14.967% respectively When government is small and below the threshold value, an increase in size will boost growth and the opposite result will happen as government size expands beyond that one Those things demonstrate an existence of Armey curve in Taiwan

Chiou-Wei et al (2010) employ the non-linear Smooth Transition Autoregressive (STAR) models developed by Teräsvirta and Anderson (1992) and Teräsvirta (1994) to investigate the relationship between government size (proxied

by the share of government consumption expenditure in GDP) and economic growth in five countries including South Korea, Malaysia, Singapore, Thailand and Taiwan from 1961 to 2004 Results show the non-linear relationship is found for each country except Malaysia The threshold value of government size is around 11% in South Korea, Singapore, Thailand and 16% in Taiwan Interestingly, empirical results reveal the inverted U-shaped pattern is not confirmed in Singapore

In that country, when the government consumption is below 11%, the impact on growth is negative, however it becomes positive when this variable is larger than 11%

Following Vedder and Gallaway (1998), Altunc and Aydin (2013) do a research to test an existence of Armey curve for Turkey, Romania and Bulgaria Using data over 1995 – 2011 period with ARDL bound testing approach, results reveal that Armey curve does exists in all three countries and the optimal total