2.4.1 Empirical literature on relationships between public finance, and economic growth
According to Barro’s (1990) perspective, which explained the role of the interaction between government expenditure and taxes in household spending and income, we know that this might be a too simple social regime, where governments only collect taxes from income and property. The limitation of this research is that it does not evaluate the relationship between total tax revenue and total public spending, which articulates government capability.
In recent decades, two stances have emerged for evaluating the relationship between public finance and economic growth. First, a few scholars applied causality and co-integration tests to confirm the correlation between economic growth and tax structure or share of expenditure only (Ray, Pal and Ray, 2012; Azam et al., 2015.) Second, a group of researchers adopted the endogenous growth model to examine the linkage between a part
of tax revenue or share of government expenditure and economic only. For instance: Landau (1983, 1985), Grier & Tullock (1989), Barro (1990, 1991), Hitiris and Posnett (1992), Mankiw et al. (1992), Devarajan et al. (1996), Fửlster and Henrekson (2001), Bassanini and Scarpetta (2002), Lee and Gordon (2005), Aizenman and Glick (2006), Arnold (2008), Romero- Ávila and Strauch (2008), Cooray (2009), Baltagi and Moscone (2010), Mercan et al. (2010), Ojede and Yamarik (2012), Azam et al. (2015) d'Agostino et al.
(2016), Stoilova (2017), Ramírez, Díaz and Bedoya (2017).
In some previous studies, the income tax, sale tax, or property tax are very significant in reducing economic results in both developing and developed economies (Lee & Gordon, 2005; Ojede and Yamarik, 2012; Amir et al., 2013; Adkisson & Mohammed, 2014). In addition, Bujang et al. (2013) employed Kao’s co-integration test for a panel dataset of 24 developing and 24 developed countries over a 10-year period and found that tax structure and GDP in developing countries do not have a long-run co-integrating relationship, which only exist in developed countries. Furthermore, Easterly and Rebelo (1993) revealed that taxes that come from the income of any person or organization can make an economy to grow, while import or export tax may reduce it.
Other earlier authors also confirmed the mixed growth effect of government expenditure and tax revenue. By performing an empirical study of 98 countries from 1960 to 1985, Barro (1991) indicated that the relationship between public spending and economic growth is negative. Furthermore, Hitiris and Posnett (1992) analyzed the data of 20 OECD countries over a 28- year period and found that when a government uses expense for caring their peoples’ health, this spending can increase the country’s income per head.
Applying OLS, fixed effects (FE), and pooled OLS techniques; Kneller et al.
(1999) performed an analysis of a dataset of 22 developed countries between
1970 and 1995 and found that government spending positively affects income per capita, while taxation has a harmful effect on this variable. How do tax revenue and expenditure affect economic growth? Are their effects differ according to different economic groups? The next section of this thesis will show the solution for these questions.
Su Dinh Thanh (2011) applied the Granger test for a VAR model with a panel data of Vietnam from 1990 to 2010 and found that the government expenditure has a one-way directional causal link with economic growth, it also has a positive effect on raising economy. Furthermore, applying the first different GMM for a panel data of Vietnam in a 16-year period from 1997 to 2012, he also noted that the share of government spending and government revenue negatively affect economic growth with significance at 1% and 10%.
While government spending per capita, it has a positive effect (Su Dinh Thanh 2014). Unlike the studies of Su Dinh Thanh (2014), Roşoiu (2015) extracted the data from 1998 to 2014 by each quarter of the year in Romania then applying the Granger test for a VAR model, this researcher found that both government expenditure and government revenue could increase GDP.
Whereas the case of government expenditure, it has a higher effect on promoting the economy than government revenue. Olayungbo and Olayemi (2018) conducted an ECM model for a panel data of a 31-year period from 1981 to 2015 of Nigeria and confirmed that government spending has a negative effect on economic growth in both long run and short-run. In these countries, the non-oil revenue has a positive effect on raising economy.
Moreover, the results of these studies showed that total government revenue and spending could have ambiguous effects on the growth of the economy according to a specific country.
According to Barro’s (1990) argument, a government could raise the tax rate or expand the tax base to increase revenue. However, any action
related to increasing taxes may be detrimental to private investment and thus lessen the economic outcome. The research findings for cluster data may give an insufficient view of problems regarding the relationship between public finance and the economy. Although earlier research verified the impacts of these components of public factors on growth, at this time we do not easily arrive at a study that examines the effect of total tax revenue and general government expenditure on the economy. In this case, conducting experimental research with total tax revenue and general government expenditure could help researchers get a full view of the capability of a government and the economic situation.
From the nineteenth century, most scholars have considered the important role of tax revenue and government expenditure in creating government budgets as well as in providing fiscal regulations for conducting economic activities. On the one hand, some authors have indicated that public finance has a negative or positive effect on the economy, depending on the type of economy (Landau 1983,1985; Grier and Tullock, 1989; Barro, 1991;
Mankiw et al., 1992; Fửlster and Henrekson, 2001; Cooray, 2009; Azam et al., 2015; Lien and Thanh, 2017). While, other authors have shed light of that public finance depends on the kind of taxes or government spending and diversely affects economy (see Barro, 1990, 1991; Hitiris and Posnett, 1992;
Devarajan et al., 1996; Bassanini and Scarpetta, 2002; Lee & Gordon, 2005;
Aizenman and Glick, 2006; Arnold, 2008; Romero-Ávila and Strauch, 2008;
Cooray, 2009; Baltagi and Moscone, 2010; Mercan et al., 2010; Ojede and Yamarik, 2012; d'Agostino et al., 2016; Stoilova, 2017). In contrast, other scholars confirmed the causal linkage between tax revenue or government spending and economic growth (Ray, Pal and Ray, 2012; Azam et al., 2015).
Based on the complicated debates of the relationship between public finance and economic growth, we realize that this argument needs to be clarified and explored to explain the differences between developed and developing
countries. Nevertheless, most researchers verified the relationship of subcomponents of taxes or share of spending for their argument regarding the relationships among tax revenue, public spending, and economic outcomes.
However, these factors do not represent the full competency of government in operating their fiscal policy or in implementing financial regulations. To understand the full meaning of a government’s capability in managing public finance, we should examine total tax revenue and general government expenditure. At this time, we find little literature that describes the roles of total tax revenue and total government expenditure. Performing empirical research to explore the long-run relationship between public finance and economic growth is future research in a global economy. However, these authors analyzed the correlation between tax revenue and government expenditure using disaggregated components that contribute to general taxes or spending. In addition, the rate of growth of the economy depends on total production factors. Total tax revenue and general government expenditure are two of these total production factors. Based on this argument, only the total tax revenue and general government expenditure factors, which represent public finance, could fully explain the growing economies. In addition, to understand the capability of government as well as full efficiency in controlling economic activities, researchers should define the relationships of total tax revenue, government expenditure, and economic growth in their model. In recent decades, we found little research that examined total revenue and total government expenditure data. We can easily find a large amount of literature that argues about the role of efficiency in spending by share of expenditure or identify many studies that confirmed the role of subcomponents of taxes in promoting economic growth. On the one hand, we found studies that evaluated the complicated relationship between share of government spending and economic growth, such as Landau (1985), Grier and Tullock (1989), Barro (1990), Hitiris and Posnett (1992), Aizenman and Glick (2006),
Cooray (2009), Baltagi and Moscone (2010), and Annabi et al. (2011). Other researchers considered the diverse role of tax structure in the correlation with economic growth, including Samuelson (1954), Solow (1956), Koster and Kormendi (1989), Bovenberg and van der Ploeg (1996), Bassanini and Scarpetta (2002), Lee and Gordon (2005), Arnold (2008), Mercan et al.
(2010), and Ojede and Yamarik (2012). On the other hand, a small group of scholars has argued that the interactions among tax revenue, government expenditure, and economic growth differ according to different groups of countries (Barro, 1991; Engen and Skinner, 1996; Kneller et al., 1999; Barro and Sala-i-Martin, 2004; Romero- Ávila and Strauch, 2008). Stoilova (2017) conducted a regression on pooled panel data for EU-28 countries from 1996 to 2013 and found that consumption taxes, income taxes, and property taxes promote economic growth in EU-28 countries. The limitation of these studies is the lack of evaluation of total tax revenue and expenditure. This point poses a challenge to economic researchers for clearly evaluating the role of full fiscal competence of governments in promoting their economies.
2.4.2. Relationship between tax revenue and government expenditures
Unfortunately, the EC model does not indicate the direction of the relationship between tax revenue and expenditure. Although most researchers investigated and confirmed the long-run relationship between tax revenue and spending, these arguments are complicated and unclear, and a large amount of literature only verified the role of components of taxes or parts of spending objectives. Furthermore, most of these previous researchers applied co- integration and Granger tests to examine the relationship between revenue and government expenditure. Some scholars supported the fiscal synchronization hypothesis, which suggests that to control deficits, governments should raise revenue and cut spending simultaneously (Chang et al., 2002; Chang and Chiang, 2009; Chowdhury, 2011; Mehrara et al., 2011; Paleologou, 2013.)
Other researchers confirmed that to handle budget deficits, governments should reduce spending (Chang et al., 2002; Narayan, 2005; Saunoris and Payne, 2010; Chowdhury, 2011; Dalena and Magazzino, 2012; Paleologou, 2013) depending on different economic statuses. However, Chang et al. (2002) and Al-Khulaifi (2012) confirmed the tax and spend hypothesis, which denotes the role of taxes in leading expenditure to maintain more stable economies.
In summary, there are three strands of discussions about the relationship between tax revenue and government expenditure. First, there is the fiscal synchronization hypothesis that defines the bidirectional causal link between these two variables (Musgrave, 1966; Meltzer and Richard, 1981;
Bohn, 1991; Chang and Chiang, 2009). Second, the “spend-tax” hypothesis says that government expenditure can be a key reason for the change in tax revenue (Friedman, 1978; Darrat, 1998; Blackley, 1986). The last strand is considered in the “tax-spend” hypothesis that notes the role of tax revenue in enabling the government to manage expenses (Mahdavi and Westerlund, 2008;
Hansan et al., 2012.) However, most researchers examined the panel data of a single country or high-income countries and arrived at the main conclusion to justify these three hypotheses. Most of these previous studies used real data of only three variables: general revenue, expenditure, and GDP. Nevertheless, economic activities can be modified up or down depending not only on revenue or expenditure, but also on other macroeconomic variables, including investment, inflation, trade capability, and quality or quantity of human capital. To bridge this point, this research adds more macroeconomic variables in the experimental model and continues the analysis of the influences of the main variables and control proxies when there is interaction among them.
2.4.3. Influence of governance on public finance and economic growth
Corruption has different impacts depending on different times and different places; where it exists and its harmful consequences are complicated (Cintra et al., 2017.)
Arguments about the role of corruption in an economy can be separated into two parts. First, corruption can directly affect economic growth. Second, corruption boosts or reduces growth through its effect on the efficiency of the system of tax collection and government spending.
First, corruption directly affects economic growth. Attila (2009) applied endogenous growth theory to explain the two opposing effects of corruption on public revenue and public spending. Corruption can positively affect the growth rate, but it can exert negative effects on tax revenue. Méon and Weill (2010) conducted two tests for the hypotheses of corruption of “Grease the wheels” or “Sand the wheels” for a data set of 69 developing and developed countries in 3-year period, and found corruption positively affects growth in inefficient countries. Dzhumashev (2014) calibrated his argument with a data set of developing countries from 1960 to 2010 and confirmed that corruption reduces economic growth in low and middle-income countries, while it enhances growth in economies that are in transition from low to middle income. However, this study does not evaluate the growth impact of tax revenue and expenditure, which are both input factors of production functions.
These variables are also driven by corruption. Ugur (2014) argued that corruption represents institutional quality, and has diverse effects on income per capita of an economy in the long run. To calibrate this argument, he applied average data over 5 years, which can induce a biased result in the estimation.
Second, D’Agostino et al. (2016) applied the endogenous growth model for 106 developed and developing countries in the period 1996–2010 and showed that corruption not only directly and positively influences economies
but also indirectly boosts economic outcome depending on the method of government spending. D’Agostino et al. (2012) estimated the effect of corruption for 53 developing African countries in 5-year period from 2003 to 2007 and found that corruption directly and indirectly affects government spending for military investment. In general, it is an obstacle to economic growth in developing countries. However, it indirectly affects household utility functions. Bird et al. (2008) conducted 2SLS estimation for an unbalanced data set of 25 developed and developing countries in two periods, 1998 and 2000, and confirmed that in developing countries, governments should reduce corruption to increase their tax effort, which can promote economic growth.
Lien (2015) adopted GMM for panel data of 82 developing countries and found that control of corruption has a positive impact on tax revenue in low and lower-middle income countries, while this effect is negative in upper- middle income economies. Aizenman and Glick (2006) extended the Barro and Sala-i-Martin (1995) model and shed light on the idea that corruption has an impact on military spending through its impact on taxes and government spending for non-military. This effect helps government spending for military boost countries’ income. Acemoglu et al. (1998) explained the reason corruption promotes economic growth is that corruption is not an efficient allocation system, but it may be created from a re-distributing process by economic planners. Good governance, therefore, controls corruption and provides effective expenditure, which reduces child mortality rates as well as increases primary education, so it promotes economic growth. Ajaz and Ahmad (2010) adopted GMM for a panel dataset of 25 developing countries from 1990 to 2005 and argued that control of corruption is one of the most important factors that affect results of tax collection. Samimi and Abedini (2012) ran fixed effects and random effects models for a panel dataset of 40 developing economies in the Middle East and North African regions and confirmed that corruption is one of the most
harmful factors for economic activities, and that a higher index of control of corruption leads to low inflation rates of taxes. Aghion et al.(2016) proved that a lower rate of corruption increases the effective use tax revenue, which can provides higher welfare and indirectly increase economic outcomes.
Furthermore, the difference in tax revenue between high-income countries and low-income countries is 10% (Sttauss, 2001; Lien, 2015). Some studies indicate corruption causes the loss of more than 50% of tax revenue in developing countries (Richupan, 1984; Alm et al., 1991; Bird, 1990, 1992;
Krugman et al., 1992). Cerqueti and Coppier (2009) proved that in a country where people feel little shaming effect of corruption being detected in any transaction, tax revenue grows as the tax rate increases. However, in a country where people feel shaming effects more strongly, tax revenue increases up to a threshold value and then moves downward. Brianzoni, Campisi, and Russo (2017) shed light on the persistence of stable corruption in the long run, which exhibits complex dynamics of capital per capita. Applying the endogenous growth model to examine the influences of corruption in government procurement, these authors indicated that corruption diminishes truth in government and affects economic growth by decreasing the quality of public goods.
Most previous researchers applied a production function for the endogenous growth model to evaluate the relationship between public finance and economic growth. These authors were also concerned about the effects of corruption, so they used the theory of quality of governance to explain the role of corruption in economies, as well as its effect on the linkage between taxes or spending with economic outcomes.
Furthermore, D’Agostino et al. (2016) followed the argument of Barro (1990), Devarajan et al. (1996), and Acemoglu et al. (1998), and designed a model to estimate the role of corruption in economies as seen as below.
Physical dynamic capital is given by:
where y represents the production function, which is evaluated by the interaction between private capital k and government expenditure divided into three parts: spending for military m and investment i and current government consumption cp . stands for the income tax rate. Based on Barro’s (1990) argument that government should use the total amount of tax revenue to provide government spending ( ̅), h1, h2, and h3 indicate the coefficients of inefficient government distribution though the three components of government spending. The steady state growth equation presented by D’Agostino et al. (2016) is seen below:
= ̇=1=
[(1 − − − )(1 − ) (ℎ1 ) (ℎ2 ) (ℎ3 ) ( ̅) + + − ], (3)
The equation (3) does not explain the full meaning of public finance, while the economic rising depends on a whole tax rate and tax base as well as general government expenditure.
In addition, Dzhumashev (2014) argued that public expenditure depends on effectiveness of governance as well as the level of corruption.
Imam and Jacobs (2007) applied both a control of corruption indicator and corruption perception index and argued that corruption only affects tax administration.
In summary, most previous research investigated the role of corruption or governance in the short-run or long-run relationship between each part of public finance, running regressions with a single regression for the secondary
and cross-countries data. In addition, governance and public finance have a complicated link with economic growth. For the less bias from cross-countries data, we should apply the appropriate statistic technique. However, almost previous studies applied the single regression for estimation. To fill in this gap, this study applied seemingly unrelated regression to determine the role of governance in modifying the growth effect of total tax revenue and total expenditure. Zellner (1962) confirmed that for the less bias by using macro data to estimate with single equation could be fixed with estimation of the parameters of a set of regression equation as seen as below:
= + , where is a Tx1 vector of observation on ′ ℎ “dependent” variables, is a Tx matrix with rank of observation on ′ ℎ “independent” variables, is a x1 vector of regression coefficient and is a Tx1 vector of random error terms, each with mean zero. This system may be written as seen as below:
1
2
.
.
.
[ ]
Which can be re-write as below:
( ) = (⊕ =1 ) ({ } ) + ( ), where,
(4)
(5)
= ( 1 … . ), = ( 1 … ),⊕ =1, = ( 1 … ), { } denotes a set of M vector and vector ( ) is the vector operator that stacks the columns of a matrix or set vectors. The disturbances, vec ( E ) in (5) have zero mean and variance-covariance matrix ∑ ⊕ , i.e. vec ( E ) ∼ (0, ∑⊕ ), where