Public finance, governance and economic growth

This study runs a co-integration and Granger causality tests that corroborate the existence of long-run co-integration linkages of public finance and economic growth and a bi-directional causal correlation between tax revenue and government expenditure. This finding suggests that to control deficits, a government’s decisions on collecting taxes and government expenditure should be simultaneous. To verify the effects of governance represented by control of corruption on modifying the relationship between public finance and economic growth, this study applies a seemingly unrelated regressions model for the dataset, followed by a robustness check using a corruption perception index developed by the Transparency International organization. Measuring public finance by two factors: total tax revenue and general government expenditure helps this study to confirm the results, which reveal that the governance has a positive role in the economy. Additionally, the interaction between governance and tax revenue or government expenditure affects economy diversely depending on the different economic groups of developing and developed countries 1 . For instance, in developing countries, the interaction between public finance and governance always becomes a beneficial factor for growth. While in developed countries, this interaction does not have any meaning with taxation. Therefore, it may increase the efficiency of government expenditure only. On the first side, the findings also suggest that developing countries should focus on governance in anti-corruption to increase the effectiveness of public finance and promote their economic growth. On the other hand, developed countries should make the decision on public finance separately with control of corruption.

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

_

NGUYEN PHUONG LIEN

PUBLIC FINANCE, GOVERNANCE AND

ECONOMIC GROWTH

DOCTORAL DISSERTATION

Ho Chi Minh City - 2018

TABLE OF CONTENT

Table of Contents

COMMITMENT i

ACKNOWLEDGEMENTS ii

TABLE OF CONTENT iii

ABBREVIATIONS vii

LIST OF TABLES ix

LIST OF FIGURES x

Abstract: xi

CHAPTER 1 1

INTRODUCTION 1

1.1 Research background 1

1.1.1 An overview of the status of global economies in the period 1996–2016 1 1.1.2 The differences of public finance and growth between developed and developing countries 5

1.2 Research motivation 10

1.3 Research objectives and research questions 14

1.4 Research scope 15

1.5 Research methods 16

1.6 Research contribution 18

1.7 Structure of dissertation 20

CHAPTER 2: 23

LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT 23

2.1 Introduction 23

2.2 Some key concepts 24

2.2.1 Public finance 24

a) Tax revenue 25

b) Government expenditure 26

2.2.2 Governance and corruption 27

2.3 Theoretical literature on the relationship between public finance and economic growth 33

2.3.1 Public choice theory 33

2.3.2 Cost-benefit theory of taxation 35

2.3.3 Governance theory 37

2.3.4 Economic growth theory: Exogenous and endogenous growth theory 39

2.4 Empirical literature on relationships among public finance, governance, and economic growth 41

2.4.1 Empirical literature on relationships between public finance, and economic growth 41

2.4.2 Relationship between tax revenue and government expenditures 45

2.5 Designing the analytical framework and building hypotheses 52

2.6 Summary 56

CHAPTER 3 58

METHODS AND RESEARCH DATA 58

3.1 Introduction 58

3.2 Research models 58

3.2.1 Long-term linkages between public finance, and economic growth 58

3.2 2 Tax revenue and expenditure relationship 61

3.3 Research data and its source 64

3.3.1 Determining appropriate variables and its sources 64

3.3.2 Collecting secondary data 67

3 4 Check balance and essential test 68

3 5 Choose appropriate analytical methods 68

3.7 Summary 77

CHAPTER 4 79

PUBLIC FINANCE, GOVERNANCE, AND ECONOMIC GROWTH: A LONG RUN ANALYSIS 79

4.1 Research data 79

4.2 Long-run relationship between public finance and economic growth 83

4.3 Linkage between tax revenue and government expenditure 85

4.4 Results of examining role of governance in modifying effect between public finance and economic growth 86

4.4.1 The role of governance in modifying effect between public finance and economic growth in developing countries 86

4.4.2 The role of governance in modifying effect between public finance and economic growth in developed countries 88

CHAPTER 5: 93

CONCLUSION, IMPLICATION AND LIMITATION 93

5.1 Conclusion 93

5.2 Suggestion to policy makers 95

5.3 Research limitation and future research 96

LIST OF AUTHOR’S PUBLICATION 96

REFERENCES 99

APPENDICIES 1

Table Appendix A1 1

List of studied countries 1

Table Appendix A2 4

Table Appendix A3 8

Table Appendix A4 14

Table Appendix A5 17

Table Appendix A6 18

Table Appendix A7 19

Table Appendix A8 20

1 Description of variables 21

2 Correlation matrix 21

3 HT and IPS unit root test results (normal variables) 22

4 Results of co-integration test 29

5 Granger test results 30

7 Results of verification of governance role in modifying economic growth by SUR model 31

8 Results of verification of governance role in modifying economic growth by SGMM 38

9 Robustness check with CPI 43

ABBREVIATIONS

Words Meanings

OECD Organization for Economic Co-operation and

Development

RE

FE

OLS

Random-Effects Fixed Effects Ordinary Least Square SGMM

United States United Kingdom Business International Corporation International Countries Risk Guide World Bank

International Moneytary Fund

LIST OF TABLES

1 Table 1.1: the global economic growth rebound 1

2 Table 4.1: Description of variables ……… 78

3 Table 4.2: Correlation matrix ………82

4 Table 4.3: Results of unit root test for a panel with normal data for the whole sample in 1996-2016……… 83

5 Table: 4.4: Results of unit root test for a panel with data of first different values for the whole sample in 1996-2016……… 84

6 Table 4.5: Westerlund long-run cointegration test results (lrgdp)………… 85

7 table 4.6: Westerlund long-run cointegration test results (tax – exp)…… 87

8 table 4.7: Pairwise Granger test results……… 88

9 Table 4.8: Westerlund long-run cointegration test results (lrgdp; Taxrev, and Gexp)……… 89

10 Table 4.9: The results of verification influence of corruption on public finance and economic growth in completely 82 developed and developing countries……… 91

11 Table 4.10: The results of verification of the influence of corruption on public finance and economic growth in 44 developing countries……… 94

12 Table 4.11: The results of verification of the influence of corruption on public finance and economic growth in 38 developed countries……… 95

13 Table 4.12: Robustness check of the corruption role in all 82 countries, 44 developing countries, and 38 developed countries ………97

3 Figure 1.3: the shrink frequency rate 5

4 Figure 1.4: Line trend of tax revenue – government expenditure – GDP per capita for whole sample in 1996-2016 6

5 Figure 1.5: Line trend of tax revenue – government expenditure – GDP per capita for 44 developing cuntries in 1996-2016 6

6 Figure 1.6 : Line trend of tax revenue – government expenditure – GDP per capita for 38 developed cuntries in 1996-2016 7

7 Figure 1.7: The control of corruption indicators in 38 developed countries in

1996 and 2016 8

8 Figure 1.8: The control of corruption indicators in 44 developing countries in

1996 and 2016 9

9 Figure 2.1: Public sector in the economy……… 26

10 Figure 2.2: Analytical framework of correlation of public fiance, corruption and economic growth ……… 54

Abstract:

This study runs a co-integration and Granger causality tests that corroborate the existence of long-run co-integration linkages of public finance and economic growth and a bi-directional causal correlation between tax revenue and government expenditure This finding suggests that to control deficits, a government’s decisions

on collecting taxes and government expenditure should be simultaneous To verify the effects of governance represented by control of corruption on modifying the relationship between public finance and economic growth, this study applies a seemingly unrelated regressions model for the dataset, followed by a robustness check using a corruption perception index developed by the Transparency International organization Measuring public finance by two factors: total tax revenue and general government expenditure helps this study to confirm the results, which reveal that the governance has a positive role in the economy Additionally, the interaction between governance and tax revenue or government expenditure affects economy diversely depending on the different economic groups of developing and developed countries1 For instance, in developing countries, the interaction between public finance and governance always becomes a beneficial factor for growth While in developed countries, this interaction does not have any meaning with taxation Therefore, it may increase the efficiency of government expenditure only On the first side, the findings also suggest that developing countries should focus on governance in anti-corruption to increase the effectiveness of public finance and promote their economic growth On the other hand, developed countries should make the decision on public finance separately with control of corruption

1 In this study we call the “developed countries” are high-income countries, which were classified by World bank and determined as those with a GNI per capita, computed using the World Bank Atlas method On 1 July 2015, high-income countries gained more than $12,736 This study also calls the “developing countries” are those countries were classified by World bank as seen as below Low-income economies are determined

as those with a GNI per capita of $1,045 or less in 2014; Lower-middle-income economies are those with a GNI per capita of more than $1,045 but less than $4, 125; and upper-middle-income economies are more than $4,125 but less than $12,736

Keywords: long-term economic growth, co-integration test, governance,

government expenditure, total tax revenue

JEL Classifications: O40, C52, D73, H20

CHAPTER 1 INTRODUCTION

Table 1.1: the global economic growth rebound

Middle East, North Africa,

Afghanistan, and Pakistan 5.40 4.10 2.30 2.70 2.50 3.90 Latin American and the

Sub-Saharan Africa 6.10 5.00 5.20 5.00 3.80 4.30 Low-income developing

Figure 1.1: The line trend of global per capita income growth and ratio of tax revenue and government spending in 1996 and 2016 in 38

developedcountries

Source: World bank’s database – WDI and IMF’s database – GFS

From figure 1.1, we can see that there is a difference in income per capita between 1996 and 2016 in developed countries The maximum income per capita is more than 13.8 times the minimum in 1996 By 2016, this gap has declined to only 6.5 times In 1996, Norway had the highest income per capita

at more than 73,626.16 US dollars In contrast, Latvia had the lowest at almost 5,321.397 US dollars In 2016, Norway still had the highest GDP per capita, which was about 90,344.41 US dollars However, the Seychelles had the lowest income per capita (only 13,963.59 US dollars of GDP per capita) Additionally, most developed countries collected more tax and spent less In

1996, Norway’s tax revenue as a proportion of GDP was nearly 53.5 percent, while its expenditure was only 47.5 percent An interesting point is that Latvia, with the lowest income per capita, also collected less tax (36.38%) and spent more (37.03%) Norway continued to maintain its tax revenue proportion at more than 53 percent of GDP in 2016

Figure 1.2: the line trend of global per capita income growth and ratio of tax revenue and government spending in 1996 and 2016 in 44

developingcountries

Source: World bank’s database – WDI and IMF’s database – GFS

There is a large gap (152.43 times) between the highest and lowest GDP per capita in developing countries in 1996 At about 30,333.74 US dollars, Islamic Republic of Iran had the highest income per capita, while Ethiopia remained at the bottom with only about 199.005 US Dollars Islamic Republic of Iran collected tax revenue of 20.165 percent of GDP and spent more than 21.08 percent of GDP In contrast, Ethiopia collected only 14.86 percent of GDP in tax revenue and spent 18.79 percent of GDP In 2016, the gap between the highest and lowest GDP per capita in developing countries is lower than in 1996 at about 26.68 times Russia remained at the top with about 11,099.17 US dollars per capita, while Madagascar had only 416.0027 US dollars per capita Russia increased their tax revenue proportion more than 1.02 percent compared with 1996, however this country spent lower than 1996 (see figure 1.2)

1.1.2 The differences of public finance and growth between developed and developing countries

a) Growth rate and stability in economies

Figure 1.3 indicates that developed countries maintain stability in their economies better than developing countries

Figure 1.3: the shrink frequency rate

Source: World Bank group (2017)

b) Tax revenue, government expenditure, and control of corruption

Tax revenue is an important component of revenue for most

governments While most developing countries collected less in taxes than developed countries, they spent more, and their economies grew more rapidly from 1996 to 2016 (see figure 1.5 )

Figure 1.4: Line trend of tax revenue – government expenditure – GDP per capita2 for whole sample (82 countries) in 1996-2016

Source: World bank’s database – WDI and IMF’s database - GFS

Figure 1.4 shows the trend of spending more and fast trend of economic growth in whole 82 countries

Figure 1.5: Line trend of tax revenue – government expenditure – GDP per capita for 44 developing cuntries in 1996-2016

Source: World bank’s database – WDI and IMF’s database - WEO

Through figure 1.5, we can observe that the rapid economic growth trend in developing economies is the same as that of the whole sample

2

GDP per capita is gross domestic product divided by midyear population The World Bank

considered that GDP is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products This calculation

of GDP is without making deductions for depreciation of fabricated assets or for depletion and

degradation of natural resources Data are in constant 2010 U.S dollars

However, beginning in 2010 these countries have attempted to spend more and collect fewer taxes for rapid growth

Figure 1.6 : Line trend of tax revenue – government expenditure – GDP per capita for 38 developed cuntries in 1996-2016

Source: World bank’s database – WDI and IMF’s database - GFS

In contrast, developed countries prefer to collect more taxes and spend less to maintain a slow rate of growth in their economies (see figure 1.6) The World Bank’s report shows that a large gap exists between developed and developing countries in economic growth, as well as tax revenue What is the cause of the differences between two these groups of countries? Policy makers around the world have been challenged in dealing with this question In summary, the global economy from 1996 to 2016 varies from year to year There is a large gap in income per capita between developed countries and developing countries There is also a large gap in the ratio of contribution to global GDP growth As mentioned by Spence (2011), the global monitoring report 2015/2016 confirms that high-income countries contributed 60% to global GDP growth in 2014, but their population was less than 15% Moreover, the World Bank estimated that income per capita in this period might have increased more than it will in future periods There are also large differences between poor and rich countries in tax revenue, effectiveness of government expenditure, and corruption, in this period The maximum of real

GDP per capita can be bigger than the minimum by 490 times The largest gap between the highest rate of tax revenue or expenditure and its lowest is 7 times The highest indicator of control of corruption is 2.47, while the lowest

is only -1.53 (see table 4.1)

Figure 1.7: The control of corruption indicators in 38 developed countries

Figure 1.8: The control of corruption indicators in 44 developing

countries in 1996 and 2016

Source: World bank’s database –WGI

Through figure 1.7, we find that in 2016, with exception of Greece, which maintained a negative index of control of corruption, most other developed countries had a positive index of control of corruption However, figure 1.8 indicates that most developing countries showed a negative index of

control of corruption, and a lower index of human development of around 0.26

to 0.7 In 1996, the developing country with the highest index of human development is Bulgaria, and the lowest was Mali This index improved; in

2016, the highest index is 0.8 and belongs to Russia, while Mali remained the lowest (0.44) Georgia is a country that improved its corruption status too rapidly In 1996, this country had the lowest indicator of control of corruption (-1.53), and Namibia had the highest score of about 0.81 In 2016, Georgia became the country with the highest score of control of corruption (0.67), while Cambodia was at the bottom with a -1.3 score of control of corruption The real situation of global economies requires us to answer the question: How does public finance correlate with countries’ income? Does governance affect this linkage?

1.2 Research motivation

First, public finance is a key source of government budget and its effects are complicated Holley (2011) argued that any change in public policy could affect economic activities However, until now a little research examined the relationship between economic growth and public finance, which measure by total tax revenue and general expenditure Nevertheless, government expenditure is a major source of public goods Lump-sum taxes for each person should guide government expenditure In contrast, Barro’s (1990) argument is too simple, because his assumption relates only to income taxes Tax revenue and government expenditure can demonstrate the full effectiveness of government quality and capability For instance, the government can use the value from collecting taxes to develop labor force, to supply the appropriate infrastructure, or to invest the new technologies Additionally, the labor force, infrastructure, and new technologies are key sources, which promote the production and ensure the safety society Furthermore, any taxes change can drive the investors and households to make

a different decision (Aghion and Howitt, 2009) The total tax revenue includes sale tax, income tax, export-import tax, capital and environment taxes, etc In case if government increase or reduce any tax rate or expand the tax base, so investor or households could change their behavior in investment or consumption As we may know that, these activities can affect the capital stock, which is a major factor of the economic growth model However, the almost previous study argued the role of the subcomponent of taxes or expenditure only The question, therefore, is “How closely does public finance correlate with the economy?” In the last two decades, the results seem to be mixed and confusing Most researchers have examined and evaluated the growth effect of subcomponents of taxes, such as income taxes, sale taxes, property taxes, or direct and indirect taxes In contrast, a large body of literature has considered the influence of the share of government expenditure

on economic growth However, evaluating a government’s capabilities may require considering the full meaning of public finance Additionally, a few studies have revealed that the linkages between public finance and economic growth are ambiguous, and need to be clarified (Dzhumashev, 2014.) That is why this study measures public finance by the ratio between total tax revenue and GDP and total general government expenditure per GDP rate and we try

to examine the relationship between these variables and economic growth to fill in the above gap

Second, in the last two decades, both public choice theory and benefit theory posed the challenge for future research to determine the long-term relationship of economic growth with public finance In addition, short-term effects of tax changes can be different from long-term effects because of the elasticity of the demand curve For planning future economic activities, researchers should clarify these effects (Stiglitz, 2000; Holley, 2011) Additionally, determining the long-term economic relationship between tax revenue and expenditure supports policymakers worldwide in designing

cost-appropriate policies for taxes and spending, as well as avoiding deficits However, until now, the results of empirical research seem to be mixed and confusing Moreover, tax revenue and expenditure are two major components

in the creation of a government budget (Holley, 2011; Hillman, 2009) Governments will face a deficit if they spend more, or collect less in taxes Currently, the long-term relationship among tax revenue, expenditure, and economic growth is an important challenge, attracting more research to aid policymakers in developing appropriate fiscal policies for operating their economies, and handling future deficits That is why this study tries to confirm the persistence of this relationship in the long term (See Lien and Thanh, 2017) In addition, to help the government to handle the deficit, policymakers should understand the direction of links between tax revenue and expenditure This research continues to identify the direction between two major parts of public finance: tax revenue and expenditure.”

Third, the effects of corruption on economic activities and outcomes are ambiguous and diverse In the last decades, the results in the literature about the role of corruption in economies are unclear As we may know that, each economy has both sides of the private sector and public sector However, public finance is a major factor that led to both private and public activities depending on governance and its quality Until now, governance theory continues to argue the role of corruption and government in affecting the relationship between economic growth and public finance There are numerous debates about the complicated role of corruption in economic growth Some previous researchers have said that corruption has a “greasing” role and a “salting” role in the wheels of an economy, depending on different groups of countries Méon and Weill (2010) confirmed the hypothesis that corruption is “efficient grease” in extremely inefficient countries and it is less damaging to efficiency in countries with less institutional quality Through this research, we do not know how corruption does affect public finance and

under effects of anti-corruption how public finance does promote the economy Bird et al (2008) considered the tax revenue as a share of GDP and could represent the tax effort or tax capacity of a country They said that control of corruption positively promotes tax revenue Belkaoui (2008) used the data of control of corruption following Kaufman (2004) for 30 developed and developing countries and indicated that control of corruption has a significantly positive effect on both tax compliance and tax expenditure in both developed and developing countries Nevertheless, two above studies did not verify the influence of control of corruption on expenditure and growth Dzhumashev (2014) also showed that corruption forces government spending

to be more effective He suggested that increasing levels of corruption may improve economic growth in less developed countries, but it should be detrimental in developed countries due to higher costs of private production d’Agostino et al (2012) and Ugur (2014) indicated that corruption suggests weakness of institutional quality, and has a potentially harmful effect on economic growth Moreover, d’Agostino et al (2016) revealed that, although corruption does not directly affect the growth of economies, its interaction with spending on investment and military negatively affects economic growth

In summary, only those countries that maintain a low corruption index achieve high tax revenue, spend less, and maintain stable growth of their economy In the last decades, most previous scholars who assessed the crucial role of corruption noted the “greasing or salting” of the wheels of an economy, depending on the different groups of countries There is little literature that evaluates the way corruption modifies public finance before its direct effects

on economic activities Furthermore, the relationship between anti-corruption and other macroeconomic variables are complicated The role of corruption in

an economy depends on government size, as well as the quality of governance, and need to be clarified (Dzhumashev, 2014; Ugur 2014; Méon & Weill, 2010) Until now, the question: “How governance in anti-corruption does lead

the public finance and economic growth?” The answer to this question becomes challenged the economist in over the world

1.3 Research objectives and research questions

1.3.1 Research objectives

This dissertation attempts to obtain the three below research objectives:

First, this study investigates the long-run linkages between public finance and economic growth Examining the long-term relationships

between public finance and economic growth, encourages policymakers to show greater diligence when issuing policies related to public finance and growth, owing to the persistence of these variables

Second, to expand on the “tax and spend” hypothesis, this thesis

identifies the direction of causal linkage between tax revenue and expenditure The results may help governments balance spending and tax

collection in the future to control deficit The research findings may aid policymakers in better understanding the impact of these linkages, enabling them to avoid risk factors in planning

Third, to contribute to the quality of governance theory and the

endogenous growth theory, this research evaluates the influence of governance on the modifying effects of public finance on economic growth differently according to different group countries With this objective, the

study aims to help policymakers in both developed and developing countries understand the role of corruption and public finance policy, so that they can develop appropriate strategies in future

As the research scope plays a crucial role in the research approach, the next section will introduce the research scope

1.4 Research scope

The study investigates linkages among government expenditures, tax revenue, and economic growth for the whole sample (82 developed and developing countries) in 21-year period 1996-2016

The reasons for choosing research objects and research period are: First, government expenditures and tax revenue are the key factors to create and maintain a government budget They also help policy makers control deficits to maintain a stable economy

Second, control of corruption plays a crucial role in governance, which says about cause of difference of rich and poor countries

Third, in the period 1996–2016, the global economy witnessed the Asian financial crisis, which began in Thailand in 1997 and then affected the stock markets of Asian countries such as Malaysia, Taiwan, and others The

post-second financial crisis rose when the real estate bubble exploded in the US in

2007, driving the US financial crisis and influencing production and exports in numerous developing countries First, for the less data bias from these crises, this study used the annual inflation rate as a control variable in the estimating model Second, for solving the spillover effects of macroeconomic variables in their relationship with economic growth as well as deeper effects of two financial crises, this research applied the SUR model for estimation effect of public finance and control of corruption Additionally, SUR model helps researchers gain more efficiency than a single equation

Fourth, the differences of collection taxes, spending status, GDP per capita and governance showed a big gap between developed economies and developing economies, which attracts a large of literature and needs to be clarified Developing countries obtain the more than 60% of population of the world, but contribute less than 30% to global GDP (Spence, 2011)

1.5 Research methods

1.5.1 Research methods

First, for the first research question, this study employs a co-integration test to examine the long-run relationships among variables As we may know that, an co-integration test is often applied to investigate the long-run relationships between stationary variables (Ojede & Yamarik, 2012) Additionally, the existence of co-integration among nonstationary variables could avoid spurious regression (Gujarati, 2004; Persyn & Westerlund, 2008) There are numerous researchers who have designed co-integration tests to prevent spurious regression, such as McCoskey and Kao (1999), Bai and Ng (2004), Pedroni (2004), Breitung and Pesaran (2005), Westerlund and Edgerton (2008), and Persyn and Westerlund (2008) We follow Persyn and Westerlund’s (2008) test to identify the existence of co-integration linkages

among the variables in this study This test is very flexible technique and allows for an almost completely heterogeneous specification of the long-run portions of the error correction model, where the latter can be determined from the data

Next, the Granger test result helps this thesis to answer the research question 2 The Granger’s techniques could support this study to identify the direction of the link between tax revenue and expenditure

Furthermore, to reduce bias from extracting data in the period, which witnessed two financial crises and to ensure the efficient result of estimation from the system equations, this study employs a SUR model and two-step SGMM to estimate the role of governance in modifying the effect of public finance on economic growth

1.5.2 The research data

This study uses the strongly balanced panel data for 82 developed and developing countries from 1996 to 2016 (see table appendix A1) We extracted the data of GDP per capita, the ratio between trade value and GDP, inflation rate and foreign direct net inflow from World Banks’ database - World Development Indicators (WDI) To measure the role of governance, this study collects the “control of corruption indicators” from World Bank’s database - World Governance Indicators (WGI) In this study, the public finance variable was presented by the ratio between total tax revenue and GDP and the rate of total government expenditure and GDP, which were selected from International Monetary Fund (IMF)’s database - Government finance statistic (GFS) In addition, tries to investigate the role of human capital, this

research collect the data of human development index (HDI3) from United Nations Development Program (UNDP)

Additionally, the control of corruption indicator denotes a perception of private, elite governors and foreign investors about the public powers exercising for the private firms only For a robustness check of the role of governance, this study continues to explore the corruption perception index of business developed by Transparency International website (TI) The results may support this research’s contribution toward determining the role of governance in an economy

1.6 Research contribution

Contribution to public choice and cost-benefit literature

This thesis examines the long run relationship between public finance, governance and economic growth in developed and developing countries over the period 1996–2016 Furthermore, this thesis also evaluates the role of governance in modifying the influences of public finance on economic growth

The first research objective is to verify the persistence of a long-run relationship between public finance and economic growth in both developed and developing economies The finding supports the long run relationship between public finance and economic growth By adding the ratio between total tax revenue and GDP as well as the rate of government expenditure to GDP into economic growth model, this study enlarges the generation of economic growth by public finance’s factors Furthermore, this finding also supports the policymakers to concentrate on the relationship between public

3

HDI is human development index, is an index composed of four country variables: life expectancy, adult literacy, combined primary, secondary and tertiary gross enrollment and extracted from United Nations Development Program (UNDP)

finance and economic growth in the long-run for their developing appropriate fiscal policies in future

The second research objective is to confirm the taxation and spending hypothesis of a bi-directional causal linkage between total tax revenue and general government spending This result supports the synchronization hypothesis and confirms the public choice theory and the cost-benefit theory

as well as trade-off theory The finding suggests that policymakers in both developed and developing countries should focus on the role of every type of tax rate, tax base and the whole objectives of the government expenditure simultaneously to promote economies and handle the deficit

The findings of the first and second research objectives help this study become one of the scarce studies, which provide the evidence to prove the long run theory of the links between total tax revenue and general government expenditure as well as the long-run theory of economic growth in handling deficit and promoting growth in an economy

Evaluating the influences of governance on modifying public finance and promoting economic growth is the third research objective Firstly, investigating the effects of governance and public finance on economic growth helps this study to indicate that public finance differently affects economic growth depending on government taxes or spending Secondly, the effect of interaction between governance and public finance makes government expenditure become a beneficial factor for economic growth These findings provide the evidence supporting the theory of quality of government as well as the public choice theory for both developed and developing countries

Contribution to empirical study

Until now, both the public choice theory and cost-benefit theory posed big challenges to academic researchers in examining the role of public finance and governance on economic growth Few previous studies argued about the role of the subcomponent of tax revenue and each part of government expenditure on economic growth in the short run By applying the co-integration test and Granger test for a panel data of 82 developed and developing countries over the period 1996 - 2015, which witnessed the two financial crises, this thesis bridges the gap in understanding the long run relationship among public finance, governance and economic growth Additionally, this result also supports that the long-run relationship between public finance and economic growth has existed during the crisis time

Chapter 2: Literature review, and hypotheses development

This chapter introduces the critical literature review of the growth effects of government expenditure, tax revenue, and control of corruption It presents the methodology used by previous researchers to analyze research

data Moreover, this chapter also interprets the impact of the regimes under which the research variables affect economic growth

Chapter 3: methods and research data

Chapter 3 introduces the methods that this research applies to achieve the research objectives; for instance, Granger causality, co-integration tests, SUR and two-step SGMM models Base on the characteristic of these methods, this chapter also presents the research data and sources from which the data were extracted, such as the WDI and WGI from the World Bank’s database, the WEO from the IMF’s database, and corruption perception index

of business (CPI) from the Transparency International (TI)’s database

Chapter 4: Public finance, governance and economic growth: A long-run analysis

Chapter 4 interprets the empirical research results that introduce the confirmation of a long-run economic relationship with two factors of public finance: tax revenue and government expenditure The research findings in this chapter also confirm the direction of the causal linkage between tax revenue and government expenditure, which supports the fiscal synchronization hypothesis and suggests that policy makers implement joint decision making for taxes and spending

Chapter 4 also presents the means through which control of corruption affects the influences between public finance and economic growth depending

on the economic group

Chapter 5: Conclusions, implications, and limitations:

This chapter first summarizes the research results in general Second, based on the major research results, chapter 5 makes recommendations to help policy makers and governments design appropriate policies for improving

their economies, as well as for handling corruption Furthermore, this chapter discusses the study’s limitations and opportunities for future research

in anti-corruption and leading public finance to promote their economy This summary in literature helps this chapter to identify research gaps and to apply the theories related to public finance, governance, and economic growth to the development of an analytical framework

In addition to the introduction, section 2.2 summarizes the key concepts used in this thesis In section 2.3, this study presents the theoretical literature

on the relationship between public finance and economic growth First, it describes the previous theoretical arguments on the linkage between public finance and economic growth Second, this section shows the means through which corruption affects public finance and economic growth in an economy The literature on empirical research that aims to verify the relationship between public finance and economic growth as well as the role of corruption

in modifying the growth effects of public finance is discussed in section 2.4 Section 2.5 presents the process used to develop the analytical framework and research hypotheses The final section is a summary of this chapter

2.2 Some key concepts

2.2.1 Public finance

Public finance influences economic activities daily because of the relationship between government expenditure in providing public goods and the capacity of tax collection (Philips, 1957) Wagner (1883) noted that the science of public finance understands the nature of a fiscal economy; this addresses the two specific characteristics of a state, consumption and income, which should be understood as government expenditure and tax revenue

According to the traditional approach to public finance, we learn that public finance is a subcomponent in classical, neo-classical, and Keynesian economics Taxes and expenditure are two factors that have been studied to identify their effect on the activities of firms, families, and individuals People always make choices that will result in their highest utility, so any change related to public policy or public finance could affect the benefits of all partners in society (Buchanan, 1999.)

Hillman (2009) indicated that government has three major duties: preserving microeconomic stability, reducing unemployment and inflation, and maintaining the stability of banking and financial systems through public finance and public policy

Gruber (2011) shed light on how public finance enables governments to deal with economic crises On the expenditure side of public finance, governments should decide what kinds of goods or services it could provide

On the taxes side, governments should answer the question: “How much should a government tax its citizens?”

McGee (2013) suggests that to understand public finance, we should try

to answer the question “What should government do to provide its services and lead private firms as well as individuals to agree to pay taxes?”

In summary, in last two decades, most authors have considered public finance as a tool that supports governments in determining the level of spending for providing public goods or services to society Furthermore, public finance is a technique that can help governments make decisions regarding the level of taxes to charge its citizens for better provision of public goods in the future, as well as a means through which governments can control

deficits Two major components of public finance are tax revenue and government expenditure, as documented by Buchanan (1999), Wellisch

(2004), Kaul and Conceição (2006), and McGee (2013).”

a) Tax revenue

“Hillman (2009) considered that tax revenue includes different types of taxes and is a major source for financing government spending Moreover, tax revenue can be changed when tax rates are increased Wellisch (2004) suggested that the countries that produce products should collect the tax revenue, shifting the tax burden to residents of the countries where the goods are consumed

McGee (2008) described tax revenue as a tool, which evaluates the capacity of a country to enhance its tax efforts Furthermore, tax revenue as a percentage of GDP represents the variable for fiscal freedom As measured by the ratio of tax revenue to GDP, most developing countries collect only two-thirds of the amount collected by high-income countries (Rizvi, Bacha, & Mirakhor, 2016)”

b) Government expenditure

“Holley (2011) confirmed that governments spending tax

revenue to promote production and consumption is called tax expenditure In less developed countries, governments always face the pressure of economic development; thus, they should increase expenditure as well as enhance tax revenue to help them to generate more money (Philips, 1957).”

In summary, we can apply the geometric shape shown in figure 2.1 to describe the flow of creating a government budget

Figure 2.1: Public sector in the economy

Source: Musgrave and Musgrave (1989, p.16)

“In figure 2.1, the solid lines represent income and spending in the private sector The broken lines indicate the public sector First, we suppose that there is no public sector in the market Household income comes from

sales (line 1), which is then spent (line 4) or saved (line 5) Using savings, households can finance (line 6) Lines 6 and 4 combine the purchase of products in product markets When a government exists in the market, it can spend on public factors (line 2) or private products (line 7), and then payments are transferred (line 8) Additionally, governments could obtain revenue from the collection of taxes (line 9) and from borrowing (line 10).”

This figure provides a simplified view of the interaction between public and private sectors in an economy Figure 2.1 also indicates those whole objectives of government expenditure should affect the all of activities in the economy

2.2.2 Governance and corruption

Hague and Martin (2004) confirmed that governance stands for the activities of making collective decisions Therefore, these authors argued that the government’s decisions depend on the authority, who is the right to act, rather than the power to do However, an authority creates its own power so long as people accept that the authority figure has the right to make decisions,

so control of corruption or corruption may have an important role in the process of governance Additionally, Dzhumashev (2014) argued that corruption represents the quality of governance and influences an economy’s private and public production through its impact on the effectiveness of government spending as well as the control of production costs In comparison, Ugur (2014) debated that corruption stands for institutional quality and has diverse effects on the income per capita of an economy

“A substantial amount of literature in recent decades has introduced the concept of corruption Cintra et al (2017) confirmed that the concept of corruption is somewhat diverse, and that it was the most cited concept in articles in Scopus from 2000 to 2010 Corruption primarily injures the poor,

and it can subvert public support by creating an incorrect perception that corruption affects all progress Furthermore, corruption impedes the access of developing countries to private capital (World Bank, 1997) Jain (2001) identified three types of corruption First, “grand corruption” refers to issuance

of economic policies based on the power of politicians Second, “bureaucratic corruption” is a petty form of corruption and refers to acts of a bureaucrat when dealing with others and using their power to accomplish a task; the third

is corruption in making laws or voting for something Through this literature,

we can see that corruption is a complex phenomenon that has a complicated effect on economic activities Grossman (2003) noted that government corruption is disloyalty of an officer, which may be one of the following behaviors: bribery, fraud, graft, extortion, embezzlement, influence peddling, ticket fixing, or nepotism He also argued that political corruption has four definitions First, corruption is an illegal behavior, such as bribery The second meaning involves an unethical benefaction Third, corruption may be a conflict of interest on the part of a government officer Finally, corruption can

be related to political behavior that is a nonresponse to the public interest

Capasso and Santoro (2017) divided corruption into two groups: active corruption and passive corruption Government officials using their power to demand benefits or money in dealing with private suppliers that provide public goods is an example of active corruption People or private firms who want to give money or some other benefit to obtain a major agreement are engaged in passive corruption They also conducted an empirical study using Italian data and noted that active and passive corruption has different effects on government expenditure In most cases, the corruption that was pointed out involved public officials using their position to maximize their income by employing market mechanisms to make business decisions (Cintra et al., 2017; Brianzoni, Campisi, & Russo, 2017.)

Jain (2001) and Cintra et al (2017) confirmed that not only is the definition of corruption complex, but that corruption can also be difficult to measure A few ways of measuring corruption are described below

First, Business International Corporation (BI), which merged with the Economist Intelligence Unit, previously published ratings assessing corruption

by collecting and analyzing network data around the world The ratings were first published for the period 1981–1983; Mauro (1995) may have been the first author to use this data

Second, Political Risk Services, Inc publishes an annual report called the “International Country Risk Guide” (ICRG), which includes a corruption index

Third, the World Economic Forum in Switzerland has published the Global Competitiveness Report since 1989, which reports the minimum degree of care in academic research as corruption

Fourth, the Transparency International organization focuses on bribery, measuring the perception of corruption in different countries, and created a

“Bribe Payers Index” in 1999

A group of researchers lead by Kaufmann, Kraay, and Mastruzzi (2011) created six world government indicators that include a control of corruption index

Furthermore, previous empirical studies have often measured corruption at the country level using summary indexes (e.g., Transparency International’s Corruption Perceptions Index (CPI) or the World Bank’s Worldwide Governance Indicators (WGI)) (Nguyen et al., 2016) This supports using both CPI and WGI in this study to verify the role of governance

in control of corruption