Romero-Avila and Strauch (2008)

Available online at www.sciencedirect.
com
European Journal of Political Economy 24 (2008) 172 191

www.elsevier.com/locate/ejpe
Public finances and long-term growth in Europe: Evidence from a

panel data analysis
Diego Romero-vila a , Rolf Strauch b,
a
Department of Economics, Pablo de Olavide University, Carretera Utrera, Km. 1, Sevilla, 41013, Spain
b
European Central Bank, Kaiserstr. 29, 60311 Frankfurt am Main, Germany
Received 29 November 2005; received in revised form 23 January 2007; accepted 11 June 2007
Available online 13 August 2007
Abstract
This paper addresses the question whether public finance reform can affect trend growth in the EU-15. Focusing on time series
patterns, we investigate whether there have been persistent trends in economic growth and fiscal variables over the last 40 years. In
addition, we estimate a distributed lag model, which 1) indicates that government size measured either with total expenditure or
revenue shares, government consumption and direct taxation negatively affect growth rates of GDP per capita, while public
investment has a positive impact, and 2) provides robust evidence that distortionary taxation affects growth in the medium-term
through its impact on the accumulation of private capital.
2007 Published by Elsevier B.V.
JEL classification: C22; C23; H11; O11
Keywords: Panel cointegration; Public finances; Economic growth
1. Introduction
The European Council set forth the Lisbon Process in order to raise growth rates of output in EU countries. The
Council considers an average economic growth rate of around 3% [as] a realistic prospect for the coming years.1 For
this purpose economic policy should be geared to foster a knowledge-driven economic expansion through the spread of
new technologies and higher human capital, more perfect goods and financial markets in Europe, a more employmentfriendly active labour market policy and a modernisation of the welfare state as well as an investment-friendly climate
brought about by regulatory changes. Many of the measures envisaged by the heads of states affect not only the
regulatory setting but also public finances. In a follow-up to the process initiated in Lisbon, the Commission and
ECOFIN Council underscored that the quality of public finances plays a crucial role for growth and employment.
More specifically, they outlined the necessity to lower the tax burden and particularly the tax wedge for low-skilled
Corresponding author. Tel.: +49 69 1344 7376; fax: +49 69 1344 6320.
E-mail address: [email protected] (R. Strauch).
1
See Conclusions of the Presidency, page 2.
0176-2680/$ - see front matter 2007 Published by Elsevier B.V.
doi:10.1016/j.ejpoleco.2007.06.008
D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191
173
workers, make benefit systems more supportive to employment, shift resources towards productive expenditures in
health, education and physical infrastructure, and to ensure the sustainability of public finances.
The conclusions of the European Council on the European economic performance in the future leave open which
growth model actually best reflects the intentions of the heads of state. If they implicitly assume an exogenous growth
framework, then we could expect output to speed up in the short and medium run but then level off again. Conversely,
the structural changes which they envisage to make Europe a more integrated, competitive and productive economy
may also imply that trend growth rises permanently from currently 22.5% to 3% per year.
In this paper we will investigate which growth pattern would be the outcome of policy reforms in the future course
of the Lisbon process. Analysing past experiences in European countries should indicate whether public finances have
the potential to raise growth rates permanently, i.e. affecting trend growth, or whether one could at best expect a
transitory improvement.
Numerous Barro-type regression studies have claimed to find evidence for endogenous growth if diverse policy
and institutional variables included in the regressions affect long-term performance. However, these studies mainly
exploit the cross sectional variation of very large samples and are not very informative if we want to focus on the
European context. Using the standard set-up of these studies, relying on long-term averages of output growth, we
would quickly exhaust the degrees of freedom for European countries. Moreover, this approach would not be
appropriate since the European sample is rather homogeneous in several of these explanatory characteristics.2
As an alternative, a small literature has emerged with a main focus on the time series implications of the two strands
of theory. If the policy variable follows a specific time series pattern, economic growth should exhibit the same
behaviour under endogenous growth theory. Conversely, the time series properties of the policy-variable do not
necessarily have to coincide with output growth according to exogenous growth models. Fiscal variables are a good
testing ground for these hypotheses, since distortionary taxation and productive expenditures are assumed to have a
permanent effect on economic growth according to endogenous growth theory, whereas they should have only level
effects from a neoclassical perspective. We will use these predictions as a basis to interpret the observable pattern of
economic growth and public finance developments, which has not systematically been done for Europe. This is the gap
in the empirical literature that our study wants to close. In first place, we will analyse the time series properties of output
growth and fiscal policy variables in order to determine their degree of persistence. In second place, we will estimate
the impact of fiscal policies on trend growth by employing the distributed lag approach.
The paper is organised as follows. Section 2 briefly describes the theoretical background and the shortcomings of
the empirical evidence existing in this area. Section 3 describes the data used in the empirical exercise. In Section 4 we
analyse the time series properties of real per-capita output growth and public finance variables. This analysis will show
that there are persistent developments in per-capita GDP growth and fiscal variables, which are broadly in line with
some theoretical predictions on long-term growth. In Section 5 we conduct distributed lag estimations as a more
systematic check of the long-term impact of public finances and Section 6 concludes.
2. Theory and existing empirical evidence
Since the mid-1980s the theoretical growth literature has above all tried to endogenise the growth rate of output in
the long-run. Earlier growth models, formulated by Solow (1956) and Cass (1965) among others, conceived trend
growth largely as a function of factors exogenous to public policy such as technological progress and population
growth. Endogenous growth theory pioneered by the work of Romer (1986, 1990), Lucas (1988), Barro (1990) and
Rebelo (1991) among others, points out mechanisms by which policy variables cannot only affect the level of output,
but also steady-state growth rates. Barro (1990) constitutes one of the first attempts at endogenising the relationship
between growth and fiscal policies. He distinguishes four categories of public finances: productive vs. non-productive
expenditures and distortionary vs. non-distortionary taxation. We present a simple sketch of the Barro model in order to
show that both productive public expenditure and distortionary taxation can affect long-run output growth. We assume
that the population of consumers is normalised to one. Consumers both consume and produce final output according to
the following production function:
y Ak 1g gg
2
For a meta-analysis of studies on the effect of fiscal policies on long-run growth see Nijkamp and Poot (2004).
174
where k stands for privately accumulated physical capital and g is productive government expenditure that directly
enters the production process. It is assumed that the government budget constraint is balanced in every period and is
given by:
g G sd y T
where G represents other government expenditure that does not directly enter the production function as an input, T
represents lump-sum taxation and is the proportional tax rate on output which
distorts the investment decision.
R
c1r 1
Consumers maximise their intertemporal utility function that is given by 0l eqt
dt subject to the standard budget
1r
constraint. represents the time preference rate and is the elasticity of intertemporal substitution of consumption.
The growth rate of consumption and output in steady state takes the form:
"
#
g
:
:
1
c y 1
g 1g
1g
1 s1 gA

q
3
y
c y r
Eq. (3) shows that productive government expenditure as a share of output positively affects long-run growth while
distortionary taxation has a negative impact on growth. Neither unproductive expenditure nor lump-sum taxation affect
output growth in steady state. From this model, we see that fiscal variables from both sides of the budget constraint
matter for growth, and the failure to include both productive government expenditures and distortionary taxation in
growth regressions would lead to mis-specified models.
Jones (1995) constitutes the first attempt at exploiting time series properties to test exogenous vs. endogenous
growth theory. He starts with the simple argument that according to endogenous growth theory, permanent shifts in
certain policy variables should have a permanent effect on the growth rate of output. Hence, if growth rates in the US
and other OECD countries exhibit no large persistent changes, the underlying policy variables should also either not
show large persistent changes or the persistent movements in these variables must be off-setting. Using the
conventional augmented Dickey and Fuller (1979, ADF) test, he finds considerable evidence for a stochastic trend in
the data-generating process for total investment, producer durables investment and R&D expenditure in a large share of
countries. The estimation of distributed lag models showed that shifts in investment and R&D expenditures did not
exert any permanent effect on growth, thereby rejecting the predictions of endogenous growth theory.
Karras (1999) largely follows the approach of Jones (1995), focusing on the effect of taxation on per capita GDP
growth. He analyses a panel of 11 OECD countries, finding that the real GDP growth rate is generally stationary, while
the null of a unit root cannot be rejected for the total and direct tax rates in most of the countries. He concludes that
adjustments of tax rates cannot be associated with permanent changes of real GDP growth, unless permanent changes
in taxes are cancelled out by permanent changes in other policy variables. But he does not investigate this final
possibility by including the expenditure side of the budget in his analysis. Evans (1997) attains similar results by
analysing the impact of government consumption on growth for a sample of 92 countries.
Kocherlakota and Yi (1997) test whether taxes or public investment have any permanent effect on output growth,
based on time series for up to 100 years for the US and 160 years for the UK. Thus, they incorporate both sides of the
budget into their analysis and find that predictions of exogenous growth theory are usually rejected when taxes and
public investment are included in the econometric model. However, they do not formally test for the co-movement of
policy variables. This also holds true for Kneller et al. (1999) and Bleaney et al. (2001) who estimate the long-run effect
of public finances on growth for the OECD countries, finding a significant growth impact of productive expenditures
and distortionary taxation.
The main contributions of the present paper are as follows. Our analysis constitutes the first attempt at investigating
the possibility that two countervailing forces may impart an opposite (and possibly offsetting) effect on growth
following the logic of Jones' analysis. This is done by putting together two main theories. On the one hand, we take the
endogenous growth model of Barro (1990) which predicts that productive government expenditure and distortionary
taxation exert a growth effect of opposite sign. On the other, we consider the theory of intertemporal sustainability of
fiscal policies, which predicts that government expenditure and revenues are cointegrated in order to ensure that the
intertemporal government budget constraint in present value terms holds. Therefore, even if we find that individual
fiscal variables exhibit non-stationarity while output growth appears mean-stationary, this diverging pattern could still
be reconciled with endogenous growth predictions if another policy variable with an offsetting persistent effect on
175
Fig. 1. Growth rates in European countries, 19612001.
growth existed. Thus, unlike the studies of Evans (1997) and Karras (1999) and based on the theory of fiscal
sustainability, we look at the opposite side of the government budget constraint since any additional expenditure needs
to be financed, thus leading to a higher excess burden of taxation.
3. Data
As the previous short review of the literature has shown, the existing evidence clearly supports endogenous growth
predictions of a long-term growth impact when both sides of the budget are taken into account, but evidence is still
incomplete. Except for the study of Bleaney et al. (2001) the sample of countries and the budgetary categories used have
been very selective. Bleaney et al. (2001) incorporate most European economies in their sample and include all budget
items, but they focus on central government data only. The drawback of this approach is, of course, that ideally one would
look at general government figures. First, overall government activity and not only central government activity should
count from an economic point of view. Second, general government provides a more homogeneous data set than central
government, which may vary strongly according to the organisation of national and subnational authorities.
Therefore, we use data for general government outlays and revenues in all EU member states from 1960 to 2001
(Commission AMECO data set, Autumn 2002). All time series are computed in logs and fiscal variables are measured
as shares of GDP. Budgetary aggregates are classified according to an economic criterion rather than functionally. This
is fairly unproblematic with respect to taxation, because the classification of direct taxation on property and income, on
the one hand, and indirect taxation on imports and production on the other, largely reflects the theoretical distortionary/
non-distortionary classification. For public expenditures the link is less immediate. Evidently, public capital formation
could be counted as productive expenditures. Government consumption comprises wage payments going to teachers
176
Table 1
Deterministic time series patterns of growth and selected fiscal variables
Deterministic trend (common coefficient and intercept)

Deterministic trend (fixed effects, common coefficient)
Deterministic trend (mean group estimate)
DLYPC
LTEXP
LTR
LG
LPI
LTREV
LTDIST
0.0005
(0.00013)
0.0005
(0.0001)
0.0005
(0.0002)
0.015
(0.0015)
0.015
(0.001)
0.015
(0.0019)
0.018
(0.003)
0.015
(0.002)
0.015
(0.003)
0.010
(0.002)
0.010
(0.0009)
0.011
(0.001)
0.014
(0.003)
0.013
(0.002)
0.014
(0.005)
0.014
(0.001)
0.013
(0.0008)
0.014
(0.002)
0.017
(0.003)
0.015
(0.001)
0.015
(0.002)
Note: The deterministic trend pattern is estimated using yit = + Ti + eit for different assumptions about the heterogeneity of and , where y is the
variable under consideration for country i at time t and T represents the time trend. The table reports the estimates of and the NeweyWest standard
errors allowing for serial correlation in parenthesis. Three asterisks indicate statistical significance at the 1% level.
and professors, i.e. they are investments in human capital, as well as salaries and purchases for the social security
system, which Bleaney et al. (2001) assume to be unproductive. In addition, it also comprises expenditures on health
and education, which are clearly of productive use. In other words, empirical evidence on the impact of these spending
categories jointly evaluates the validity of the theoretical predictions and assesses the productive vs. non-productive
content of the expenditure flow under consideration. Data to compute the level and growth rate of real GDP per capita
as well as the private investment share of GDP are obtained from the OECD Economic Outlook. 3
4. The time series properties of growth and public finances
To assess the potential impact of fiscal policies on growth we take a look at the time series properties of the data. The
conjecture that permanent shifts in policy variables should be associated with a permanent shift in the growth pattern, if
endogenous growth theory holds, is compatible with different time series patterns. Therefore, we first search for
deterministic long-run movements and then for possible persistent stochastic processes.
4.1. Deterministic trends
Fig. 1 presents the growth rates of real GDP per capita in EU member states from 1961 to 2001. From the charts there is
not a clear time series pattern which holds for all countries. Growth rates in several countries, such as France, Spain,
Germany, Greece, Italy and Sweden, have slowed down over the last few decades. In Ireland and Luxembourg mediumterm growth has however picked up over this time period, while it has remained fairly stable in Austria and Belgium.
More formal evidence for these patterns is presented in Table 1 where we show different estimates for deterministic
trends existing in EU countries. The first row shows a trend estimate imposing a common mean and trend coefficient
for all countries. The second row shows the within estimate of the trend coefficient (i.e. allowing the intercept to vary)
and the third row a mean-group estimate of the trend coefficient which is computed as the average of individual
estimates.4 The estimated coefficient for a deterministic trend in per-capita GDP growth carries a negative sign and is
highly statistically significant. Turning to public finances, Fig. 2 shows that there has been a clear increase in public
spending up to the early 1980s in all countries. This trend flattens thereafter or is even reversed. In Belgium, Ireland,
Luxembourg and the Netherlands, the reversal sets in the 1980s, while it is of a more recent nature in most other
countries. Overall public revenues show a similar but often less pronounced increase in the 1960s and 1970s. This trend
then also flattens in most cases, but is not reversed.
Since aggregate spending and revenues are inaccurate measures of productive expenditures and distortionary
taxation, Table 1 presents the trend estimates for different spending and revenues categories which might have a growth
impact according to Barro's model. The second column confirms the long run upward trend in government spending,
which appears mainly driven by transfers and to a somewhat lesser extent by government consumption. Interestingly,
public investment shows the opposite development, as indicated by the negative and statistically significant coefficient
3
See Table A1 for the notation of the variables employed in the analysis and data sources. Descriptive statistics and the correlation matrix are
provided in Tables A2 and A3, respectively. These three tables are provided in Appendix A.
4
Pesaran et al. (1996) showed the asymptotic consistency of the mean-group estimator.
177
Fig. 2. Public expenditures in European countries, 19612001.
for the whole panel. In parallel, distortionary taxation which is computed as the sum of total direct taxation and social
security contributions increased steadily over the last decades. The long-term decline of public investment and rising
distortionary taxation are both compatible with the lower trend growth apparent in our estimates.
4.2. Stochastic trends
Given the observable patterns in Figs. 2 and 3, our policy variables may not only exhibit deterministic but also
persistent stochastic trends. To test this hypothesis we carry out panel unit root tests which overcome the low power
associated with individual unit root tests. We employ the Im et al. (2003) (henceforth, IPS) and the Breitung (2000)
tests. Our panel specification will be of the form:
Dyit ai di t ht gi yit1
pi
X
bij Dyitj eit
j1
where pi is the required country-specific degree of lag augmentation to make the residuals white noise,5 and N and T
are the number of cross-section units and time observations, respectively. i and it represent the country-specific fixed
effects and deterministic trends respectively, and t stands for the time dummies used to account for cross-sectional
correlation which could result from common shocks affecting all panel members in a given period. The null hypothesis
5
The degree of augmentation of individual ADF t-statistics was computed following the general-to-specific procedure of removing insignificant
lag-differenced terms until the last term is significant at conventional significance levels. For the panel as a whole, we use a degree of lag-truncation
of 2 and 4, since 4 was in general the longest degree of augmentation required to whiten the residuals of individual ADF specifications.
178
Fig. 3. Public revenues in European countries, 19612001.
H0 of the IPS test implies that i = 0, for all i, i.e. all series have a unit root, which is tested against the alternative H1 that
i b 0 for i = 1,2,, N1 and i = 0, for i = N1 + 1, N1 + 2,, N. Assuming that the N cross-section units are independently
distributed, the t-statistic can be computed as an average of the individual ADF t-statistics such that:
N
X
t NT p; q
tiT pi ; qi
i1
where tiT(pi,i) is the t-statistic for testing i = 0 in each individual ADF specification. Assuming that the second-order
moments of tiT(pi,i) exist, the t NT p; q statistic is corrected for small sample size as follows:

N
p
P
1
N
t NT p; q N
EtiT pi ; 0=gi 0
d
P
i1
s
Zt
6
Y N 0; 1
N
P
1
VartiT pi ; 0=gi 0
N
i1
where E[tiT( pi,0) / i = 0] and Var[tiT( pi,0) / i = 0] are the adjustment factors obtained via stochastic simulation. The
standardised statistic weakly converges to a one-sided standard normal distribution under the null and diverges under
P
the alternative. Therefore, we need to compare the value of Zt to the critical values from a lower-tailed standard normal
distribution.
The main strength of the IPS test compared to the Levin and Lin (1992) test is that the autoregressive coefficient is
allowed to differ across countries and only a fraction of units is required to be stationary under the alternative. However, the
179
Table 2
Panel unit root tests for growth and fiscal variables
Variables
LYPC
LTREV
LTDIR
LSSC
LTDIST
LTIND
LTEXP
LPI
LTR
LG
DLYPC
DLTREV
DLTDIR
DLSSC
DLTDIST
DLTIND
DLTEXP
DLPI
DLTR
DLG
IPS test 2 lags
IPS test 4 lags
Breitung test
No trend
Trend
No trend
Trend
4.30
1.97
1.75
1.49
0.48
2.23
1.26
1.45
0.68
1.02
5.28
9.50
8.93
8.77
9.70
8.24
6.96
6.80
6.96
8.33
3.14
0.73
2.04
2.60
0.31
0.43
1.38
2.61
0.06
0.38
5.54
8.26
8.41
6.94
8.69
6.91
5.40
5.28
5.46
6.72
3.87
0.06
0.43
1.60
1.94
2.67
1.51
0.80
1.16
1.60
2.27
5.64
3.63
5.90
5.96
5.52
3.18
2.12
4.57
4.67
2.32
1.01
2.47
2.77
0.16
1.44
1.00
2.85
0.12
2.24
2.19
3.96
3.50
3.06
5.02
5.15
1.96
0.15
2.84
3.64
Trend
2.33
0.40
0.62
0.69
1.17
1.57
3.03
0.54
4.38
1.37
11.27
12.79
13.71
13.13
12.93
12.69
10.63
16.60
10.97
13.11
Note: Time dummies were included in all ADF specifications. The value of the IPS and Breitung tests must be compared to the critical values from a lower-tailed
standard normal distribution. , and imply rejection of the null of a unit root at the 10%, 5% and 1% level of significance respectively.
IPS test suffers from a substantial decrease in power when heterogeneous trends are included in the specification as a result
of the small-sample bias correction applied to the t-statistics (Baltagi and Kao, 2000a,b; Breitung, 2000).6 To address this
issue, Breitung (2000) proposes a panel unit root test which employs unbiased t-statistics. By allowing for heterogeneous
deterministic trends and short-run dynamics across countries without the need of bias adjustment, the Breitung test has
more power to reject a false null and is not sensitive to the degree of augmentation of the ADF specifications.7
Table 2 presents the results for real per-capita growth, current revenues and aggregate expenditures along with their
economic subcategories (i.e. direct taxation, social security contributions, indirect taxation, government consumption,
transfers and public investment).8 The results of the tests show that per-capita GDP follows an I(1) pattern, while real
GDP per-capita growth is stationary for the sample of the EU-15. The results for fiscal variables are also clear. As
regards the revenue side of the budget, the IPS and Breitung tests indicate a unit root in all specifications for total
revenues and distortionary taxation (LTDIST). This result seems to be mainly driven by the direct tax component which
clearly contains a unit root, since the results for social security contributions are rather mixed. While the IPS test rejects
the null of a unit root in social security contributions at the 1% level when trends are included and at 10% in the
specifications without trends, the Breitung test does not reject it. With regard to the expenditure side of the budget, total
expenditure and its sub-categories appear to be driven by a stochastic trend. The unit root statistics for the variables in
first-differences indicate that no fiscal variable is integrated of second order.
Taken as a whole, output growth is found to be stationary while fiscal policy variables are in general non-stationary.
Given that public investment is generally considered as productive expenditure and direct taxation as distortionary
taxes, this result could be considered as a challenge to endogenous growth theory. Since persistent changes in fiscal
categories do not appear to be accompanied by persistent changes in GDP per capita growth rates, there is no support
for endogenous growth predictions according to the logic expressed by Jones (1995) and Karras (1999).
6
We present the IPS results of the specifications with and without heterogeneous deterministic trends. We include time dummies so as to control
for common shocks affecting all EU Member States in a given period.
7
As with the IPS test, the Breitung test converges to a one-sided standard normal distribution under the null, so we need to compare the value of the statistic to
the critical values from a lower-tailed standard normal distribution. Large negative values would reject the null of joint non-stationarity.
8
We include all economic categories for the sake of completeness, although only some results will be discussed in this section.
180
4.3. Cointegration of expenditures and revenues

The diverging time series pattern of per-capita GDP growth and the fiscal policy variables could still be reconciled if
another policy variable with an offsetting persistent effect on growth existed. In other words, two conditions have to be
met: first, the variable has to co-move with the policy instrument under consideration and, second, it should exhibit a
persistent growth effect according to endogenous growth theory. The obvious candidate here is to look at the opposite
side of the budget, since any expenditure increase has to be financed, and this may lead to a higher excess burden of
taxation.
It can be shown that the intertemporal budget constraint does indeed imply a cointegrating relationship between
revenues and expenditures (see Afonso, 2005; Santos Bravo and Silvestre, 2002; Trehan and Walsh, 1988; Bohn,
1991). However, whether this relationship exists for our sample and whether it could explain the observable pattern of
economic growth is still an empirical question. First, growth theory focuses on productive expenditures and
distortionary taxation. Thus, it is empirically unclear whether the cointegrating relationship holds for relevant spending
and revenue items. For example, higher public investment could be financed through non-distortionary consumption
taxes. Second, the intertemporal budget constraint has to hold over an infinite horizon and binds under the assumption
that the economy operates efficiently. The implications over a finite horizon are not clear ex ante, particularly if the
economy operates inefficiently and growth rates exceed interest rates. Under these circumstances, countries can engage
in a deficit gamble even for an extended period of time (Ball et al., 1998; O'Connell and Zeldes, 1988).
Therefore, we conduct panel cointegration tests for different combinations of spending and revenue aggregates or
sub-categories. The panel cointegration tests of Pedroni (1999) make use of estimated residuals from the hypothesised
long run regression of the form:
yit ai di t gt b1i x1it b2i x2it N bmi xmit eit
where M is the number of regressors. This can be seen as a fixed effects model, where i and it are country-specific
intercepts and deterministic trends respectively, and t represents a set of time dummies common to all members of the
panel. The coefficients, mi(m = 1,2,...M), are allowed to differ across individuals. Evidence in favour of cointegration
is provided when eit in Eq. (7) is found stationary. This is done by rejecting the null that i =1 in eit qi ei;t1
uit .
In order to identify long-run relationships, we present the results of the pooled and mean-group ADF t-statistics
developed by Pedroni (1999) for the specifications with and without heterogeneous deterministic trends.9 Pedroni
(1999) rescales the mean-group ADF t-statistic with N1/2 so that it is distributed as a standard normal distribution. The
standardisation of the cointegration statistics can be expressed as:
p
jNT l N
p
Z N 0; 1
m
where NT is the standardised form of the test statistic with respect to N and T. The values of the mean () and the
variance () are tabulated in Pedroni (1999). The values of the normalised statistics are to be compared to the critical
values implied by a lower-tailed standard normal distribution. We opt for normalising on the variable standing for the
revenue side of the government budget constraint, without implying that the direction of causality is running from the
spending to the revenue side.10
Results in Table 3 support the existence of a long-run relationship between revenues and expenditures. First, total
spending as a share of GDP appears to clearly cointegrate with total current revenues when deterministic trends are
included in the cointegrating vector. Similar cointegrating patterns are found for the long-run relationship between total
expenditures and revenue subcategories in the specification with deterministic trends. Given this result we would expect
big ticket items to co-move with the other side of the budget. Indeed, we find clear indications that total transfers
9
The pooling of information is done along the within dimension of the data for the pooled version of the test and along the between dimension for
the mean-group ADF t-statistic. The latter, thus, allows for an additional source of cross-country heterogeneity under the alternative. The panel unit
root and cointegration analyses were carried out with routines kindly provided by Peter Pedroni.
10
Empirical evidence on Granger-causality for expenditures and revenues indicates different patterns running unidirectional from expenditures to
revenues or vice versa, or being bi-directional in some countries (Belessiotis, 1995).
181
Table 3
Panel cointegration results for public finances
Country
dummies
Country
dummies
and trend
Country
dummies
Country
dummies
and trend
Country
dummies
Dep. variable
Indep. variable
Indep. variable
Indep. variable
LTREV
Panel adf-stat
Group adf-stat
LTDIR
Panel adf-stat
Group adf-stat
LSSC
Panel adf-stat
Group adf-stat
LTDIST
Panel adf-stat
Group adf-stat
LTIND
Panel adf-stat
Group adf-stat
LTEXP
0.398
1.269
LTEXP
2.239
3.954
LTEXP
0.309
4.673
LTEXP
1.985
4.994
LTEXP
1.605
1.351
LPI
1.493
2.479
LPI
2.261
3.633
LPI
2.745
2.885
LPI
2.603
2.638
LPI
2.381
7.803
LTR
0.328
0.363
LTR
0.289
0.688
LTR
0.947
3.340
LTR
0.417
1.181
LTR
0.177
0.273
5.750
7.121
6.573
11.657
3.235
7.101
8.215
11.341
5.815
10.883
0.049
1.903
1.409
3.372
0.530
0.157
1.300
1.750
5.786
12.426
Country
dummies
and trend
Country
dummies
Country
dummies
and trend
Indep. variable
3.359
6.489
5.104
10.979
3.859
5.713
4.752
7.637
6.381
18.580
LG
1.898
1.661
LG
2.871
3.966
LG
0.398
1.049
LG
1.769
2.304
LG
0.388
0.231
0.315
1.509
2.119
4.519
0.967
4.903
1.298
5.280
2.659
6.006
Note: The cointegrating vector is normalised on the revenue category. The normalised panel cointegration statistics must be compared to the critical
values of a lower-tailed standard normal distribution. , and imply rejection of the null of non-cointegration at the 10%, 5% and 1% level of
significance, respectively.
cointegrate with all revenue subcategories, in particular with distortionary taxation. Government consumption cointegrates
with direct and distortionary taxation. Finally, there is firm evidence that public investment cointegrates with total revenue
as well as with distortionary taxation and its components, especially in the specification without trends.
Table 4 presents the estimates of the long-run coefficient for the variables entering the cointegrating vector. The
long-run estimates should provide evidence for the co-movement between fiscal categories from both sides of the
budget. We base our inferences on the mean-group Fully Modified OLS estimator (FMOLS) proposed by Pedroni
(2000), which corrects the standard OLS for the bias induced by the endogeneity and serial correlation of the
regressors. It also allows for heterogeneous cointegrating elasticities and more flexible hypotheses testing than the
pooled FMOLS estimator. The cointegrating vector is again normalised on the revenue category.
Looking at these relationships from the expenditure side, we find that the long-run coefficient of the relationship of
aggregate revenues with total expenditures is around 0.7 and is robust to the inclusion of time effects. This implies that
an increase in total government spending is under-compensated by an increase in total revenues.11 We tested for a oneto-one relationship between total revenues and total expenditures, rejecting the existence of a proportional relation at
the 1% significance level.12 This finding can be partly explained by the deficit bias leading to a continuous debt buildup during the 1970s and 1980s in many European countries.13 Furthermore, the coefficient of the relationship of
government transfers and consumption with total revenues and their sub-categories falls significantly when time
dummies are included, though remaining positive and significant. This indicates that part of the co-movement between
these budget categories is accounted for by factors which are invariant across EU countries, such as common supply or
demand shocks. The long-run elasticity of public investment to total revenues and distortionary taxation equals 0.15,
and 0.32 for direct taxation in the specification with time dummies.
11
Again, when we talk about undercompensating movements in revenues as a result of expenditure changes, we do not mean causality going from
expenditures to revenues.
12
Quintos (1995) showed that a cointegrating slope lower than one may still be compatible with public deficit sustainability, provided the debt
ratio grows at a lower rate than that of mean interest rates. Santos Bravo and Silvestre (2002) note that such condition holds for most EU countries
over the period 19602001.
13
This appears in line with the findings in Afonso (2005) and Santos Bravo and Silvestre (2002) who conduct cointegration tests for individual EU
member states.
182
Table 4
Panel cointegrating vectors for public finance (aggregates and economic sub-categories)
Dep. variable
Indep. variable
Country
dummies
Country
dummies and
time dummies
LTEXP
LTREV
1-to-1 rel test
LTDIR
LSSC
LTDIST
LTIND
0.66
(31.25)
( 13.52)
0.74
(17.82)
0.87
(26.23)
0.76
(32.64)
0.16
(2.43)
Indep. variable
Indep. variable
Indep. variable
Country
dummies
Country
dummies
Country
dummies
Country
dummies and
time dummies
LTR
0.71
(26.6)
( 13.84)
1.27
(15.89)
0.52
(13.06)
0.74
(18.06)
0.15
(4.12)
Country
dummies and
time dummies
LG
Country
dummies and
time dummies
LPI
0.46
(15.88)
0.37
(11.26)
0.75
(20.6)
0.26
(10.48)
0.01
( 8.45)
0.15
( 57.42)
0.61
(10.99)
0.65
(24.35)
0.60
(20.54)
0.12
(1.85)
0.46
(6.3)
0.39
(11.73)
0.38
(12.27)
0.70
(3.6)
0.92
(14.2)
0.81
(14.95)
0.80
(17.1)
0.41
(4.41)
0.35
(7.42)
0.01
(1.22)
0.20
(4.58)
0.10
(1.17)
0.10
( 3.5)
0.13
( 7.62)
0.03
( 6.61)
0.12
( 1.1)
0.32
(7.96)
0.02
(2.6)
0.15
(7.08)
0.02
(5.18)
Note: The cointegrating vector is normalised on the revenue category. The row labelled by 1-to-1 rel test relates to testing the existence of long-run
proportionality between total government revenues and aggregate expenditure. T-statistics are given in parenthesis below the estimates. , and
imply rejection of a zero long-run elasticity at the 10%, 5% and 1% level of significance, respectively.
In short, this exercise has shown a strong cointegrating relationship between public revenues and expenditures. This
holds particularly true for budget aggregates, but also applies to sub-categories. Moreover, the cointegrating vectors
generally have the expected sign, showing that expenditures and revenues co-move in the same direction. To the extent
that their persistent component may have opposite effects on growth, they would therefore cancel each other out. That
would be particularly true for the cointegrating relationship between direct taxation and public investment. An
interesting case is the cointegrating relationship found between government consumption and indirect taxation. Thus, if
government consumption exerts a persistent growth-enhancing effect, this would not be fully offset by distortionary tax
developments.
5. The impact of public finances on long-term growth A distributed lag test
The previous exercise searching for deterministic processes has shown that per-capita GDP growth rates and fiscal
policy variables are marked by persistent, long-run developments. Real per-capita GDP shows a declining trend in the
growth rate and public finance variables follow some persistent upward or downward trends which could be compatible
with this growth pattern. When we look at stochastic processes, fiscal variables also reveal a persistent component,
while GDP growth is mean-reverting. This pattern is still compatible with the assumption that the persistent impacts of
productive expenditures and distortionary taxation cancel each other out. But even under the condition that both effects
offset each other, fiscal policies may have a short or medium term impact on the growth rates of the economies. In this
section we will therefore analyse more systematically whether fiscal variables affect economic performance over the
business cycle.
5.1. Estimation procedure
The long-term effect of fiscal policy on growth can be estimated using a distributed lag approach, controlling for
both sides of the government budget. Thus a simple model of the following form will be estimated:
Dyit
I
X
j0
bgj gitj
I
X
bsj sitj ai eit
j0
where y indicates the log of per capita output, g and represent the log of government expenditures and revenues
categories expressed as shares of GDP, i is a set of country dummies and I represents a finite number of lags. This
183
equation can theoretically be used to test exogenous vs. endogenous growth theories. As Evans (1997) and
Kocherlakota and Yi (1997) show, exogenous growth theory implies
I
X
bgj
j0
I
X
bsj 0
j0
as the lag order goes to infinity. Conversely, endogenous growth theory implies for productive expenditures
I
X
bgj N0
j0
and for distortionary taxation

I
X
bsj b0
j0
In other words, the sum of coefficients has to be different from zero for a sufficiently large lag order if endogenous
growth predictions are to be valid. It is not clear ex ante what constitutes the right lag order in this context. Even transitory
changes to the new equilibrium state after a fiscal reform can expand over several years. Thus, we may not be able to
sensibly discriminate between the two growth theories, but only confirm whether public finances have a consistent impact
on growth over the cycle and possibly affect trend growth. Therefore, we use a lag-length equal to eight since spectral
analysis tends to indicate a business cycle of six to eight years for European countries (see Bouthevillain et al., 2001).
Moreover, this specification is in line with the literature in the public finance field (e.g. Bleaney et al., 2001).
Eq. (9) can be rewritten as a function of the lag operator as follows:
Dyit ALgit BLsit ai eit
10
where A(L) and B(L) represent two lag polynomials with a unit root outside the unit circle. We re-parameterise Eq. (10)
in line with Jones (1995) in order to separate long-run from short-run effects as follows:
Dyit A1git CLDgit B1sit DLDsit ai eit
11
where C(L) and D(L) are (p 1)th-order lag-polynomials such that:

p
X
cis
aij
js1
p
X
dis
bij
js1
where s = 1,, p 1.
In sum, the coefficients for A(1) and B(1) capture the long-run effect of government spending and revenue categories
on growth, while the first-difference terms will capture short-run interactions between fiscal policies and growth.
The baseline estimation approach is amplified in two respects. First, a set of other standard variables is added to
control for further growth factors. Second, we use variables for short-term domestic and international shocks
affecting growth performance below business cycle frequency to ensure that our results are not distorted by
shorter-term correlations. Therefore the estimation specification takes the following form:
Dyit A1git CLDgit B1sit DLDsit Kwit ai eit
12
where K is a vector of parameters and it represents a set of control variables which are commonplace in the
empirical growth literature.14 This includes the private investment rate, the average years of schooling in the
14
The data set used for the empirical analysis is available from the authors upon request.
184
Table 5
Public finances and long-term growth
Private investment
Human capital
Openness
Inflation
US GDP growth
Total revenues
(1)
(2)
(3)
(4)
(5)
0.015
(0.006)
0.03
(0.02)
0.10
(0.03)
0.29
(0.03)
0.002
(0.001)
0.06
(0.01)
0.01
(0.006)
0.04
(0.02)
0.01
(0.02)
0.20
(0.04)
0.001
(0.000)
0.01
(0.006)
0.04
(0.02)
0.01
(0.02)
0.25
(0.03)
0.001
(0.001)
0.07
(0.03)
0.006
(0.007)
0.03
(0.02)
0.02
(0.03)
0.21
(0.04)
0.001
(0.001)
0.004
(0.007)
0.02
(0.02)
0.003
(0.03)
0.25
(0.04)
0.001
(0.001)
0.006
(0.01)
0.01
(0.01)
0.02
(0.01)
0.05
(0.02)
0.02
(0.01)
0.03
(0.02)
0.02
(0.02)
Direct taxes
Social security contributions
Indirect taxes
0.05
(0.009)
Total expenditures
Government consumption
Government transfers
Government investment
R square (within)
Wald test
Usable observations
0.44
1071.8
468
0.56
1478.22
468
0.06
(0.02)
0.006
(0.01)
0.03
(0.005)
0.67
1621.83
407
0.59
1288.5
416
0.08
(0.02)
0.04
(0.02)
0.03
(0.007)
0.67
1571.2
407
Note: The dependent variable is the growth rate of per-capita GDP. The estimates shown represent long-term coefficients. Standard errors are given in
parenthesis. , and imply the rejection of the null of insignificant parameter estimates at the 10%, 5% and 1% levels, respectively.
working age population,15 changes in the trade openness ratio computed as exports plus imports over GDP,16 the
inflation rate and US GDP growth. Our coefficient estimates for the fiscal variables will thus measure the influence
that individual fiscal policies have on growth beyond their effect on the decision to invest in physical and human
capital. Inflation is used as domestic conjunctural indicator assuming that short to medium-term fluctuations of
output are mainly demand-driven, i.e. inflation and output move in the same direction. Private investment and
inflation are instrumented using two lags to cope with the endogeneity problem affecting these two variables. US
GDP growth is employed as a variable to control for the international environment.17 In addition, we allow for
country effects, which should capture all time invariant sources of growth, such as persistent features of the
political system and initial conditions. Finally, time dummies for the years 1990 to 1992 are incorporated to correct
for the impact of German reunification.18
15
Though not entering directly in the model sketched in Section 2, direct taxation on personal income, due to its progressivity, can reduce the
formation of human capital. Higher tax rates levied on higher incomes reduce the return to investment in human capital, thus leading to less
education and lower growth.
16
The IPS test consistently showed for the specifications analysed in Section 4.2 that the trade openness ratio follows an I(1) process. Therefore,
the variable enters the model in first differences.
17
See Gali and Perotti (2003), who also employ this variable. In addition, we used real oil price growth as a measure for the international
environment. It did however not yield any significant estimates and was therefore dropped.
18
These are the only years for which we could find robust and significant estimates when all time effects are included in the model.
185
5.2. Estimation results

5.2.1. Public finances and growth
Table 5 reports the estimates of the growth effects from aggregate revenues and expenditures as well as from different
subcategories. Model 1 controls for the conditioning information set in addition to total revenues which measure the overall
effect that government size has on growth.19 The coefficient on total revenues carries a negative sign and is statistically
significant at the 1% level. Likewise, model 2 renders a comparable coefficient on total expenditures (as an alternative
measure of government size) equal to 0.05, which should capture the benefits of spending minus the cost of taxation in
addition to the reduction of growth due to deficit financing. When we try to include both total revenues and aggregate
expenditures in the same (unreported) specification, only the latter remains significant. The fact that one variable loses
statistical significance should not be surprising given the high correlation between both aggregates with a correlation
coefficient larger than 0.9. In order to disentangle whether the balance of benefits and costs looks different for individual
spending categories, model 3 analyses the sign and size of the growth effects due to government spending categories while
controlling for total revenues. Government consumption and public investment are significant at the 1% levels with a
negative and positive parameter estimate, respectively. Government transfers enter insignificantly with a negative coefficient.
When we control for different revenue categories in model 5, the results for public investment and government consumption
remain robust, while the negative coefficient estimate for government transfers becomes statistically significant.
According to the simple theoretical model presented earlier, productive spending items should have a positive growth
effect, while non-productive spending would be at worst neutral. The empirical results support the notion that public
investment can be considered productive spending contributing to long-term growth. The negative estimates for the two
other major spending items cannot reflect the tax financing costs since this is properly accounted for in the model.
Therefore it should either relate to the deficit financing costs in terms of growth performance or a growth-reducing effect
which is not apparent in our model, where among others labour supply is inelastic. In a more complete theoretical model,
social benefits or government wages may reduce labour supply in the private sector and thereby undermine growth.20
As stressed by Widmalm (2001), not all taxes are expected to have the same impact on growth.21 It is, thus, necessary to
investigate the growth effects of the tax mix. As regards capital taxation, which includes personal and corporate income
taxes, it is clear that it reduces growth by decreasing the accumulation of capital. In a growth model like the one sketched
above, the assumption of an inelastic labour supply makes a consumption tax or a flat tax on labour income useless to
influence growth. It would not affect intertemporal decisions on consumption and capital accumulation. On these grounds,
one may expect direct taxation and, to a lower extent, social security contributions to be growth inhibiting, while indirect
taxation would be neutral. Models 4 and 5 can help us shed some light on this issue. The former controls for aggregate
government expenditures as well as for the tax categories. Total expenditures enter significantly with a negative coefficient,
while all tax coefficients are negative though none is statistically significant at conventional levels. However, when the
growth effect associated with different spending categories is captured in model 5, the coefficient for direct taxation
remains negative and becomes statistically significant at the 5% level. Thus in the most complete model, we find on the
expenditures and on the revenue side growth effects which stand much in line with theoretical predictions.
For the regression results reported above to be valid, one has to assume that the fiscal variables on the right hand side are
exogenous. However, this can be questioned due to the existence of automatic stabilizers, i.e. mechanisms built into fiscal
regulations that lead to counter-cyclical fluctuations of transfers and taxation over the business cycle. Spending items such
as public investment or government consumption are generally not affected by automatic stabilisers. Under the assumption
that this is the source of endogeneity, parameter estimates for social transfers would be downward biased because the social
transfers to GDP ratio should decline in high growth periods and vice versa. The parameter estimated for social transfers
may therefore be the result of this source of endogeneity. The estimates for taxes would be upward biased since the tax to
19
We also report the t-statistics and the significance level of the estimates, although these do not allow proper inference since the GDP growth rate
is stationary and the policy variables are I(1). However, it should be noted that the results are largely in line with those reported later on, where we
control properly for both sides of the budget. To the extent that spending and revenue items are in general cointegrated, the t-statistics can be used
for statistical inference.
20
These negative coefficients are much in line with the results reported in De la Fuente (1997) for industrialised countries. De la Fuente also
discusses the productivity and investment channels through which government expenditures could have a negative externality for growth. These are
however partly captured by our tax controls.
21
Widmalm (2001) find that the proportion of tax revenue raised through taxes on personal income negatively affects growth in 23 OECD
countries over the period 19651990.
186
Table 6
Public finances and private investment
(6)
Total expenditures
(7)
(8)
0.12
(0.15)
0.13
(0.16)
0.53
(0.19)
0.24
(0.11)
0.28
(0.11)
0.45
(0.13)
0.15
(0.11)
0.35
(0.13)
0.85
(0.14)
0.53
(0.17)
1.26
(0.13)
0.18
(0.07)
0.23
(0.09)
0.83
(0.19)
1.15
(0.12)
0.44
3.54
416
0.57
4.35
407
Social transfers
Public investment
Direct taxes
Indirect taxes
(9)
Average effective tax on labour

Average effective tax on capital
Average effective tax on consumption
R2 (within)
F-test
Usable observations
0.33
3.35
416
0.36
3.11
416
(10)
(11)
0.77
(0.19)
1.22
(0.16)
0.09
(0.11)
1.20
(0.15)
0.47
4.81
345
0.68
(0.20)
0.18
(0.11)
1.16
(0.15)
0.53
4.96
345
Note: The dependent variable is the private investment share of GDP. The estimates shown represent long-term coefficients. Standard errors are given
in parenthesis. The sample period for models including average effective tax rates from 19702001. , and imply the rejection of the null of
insignificant parameter estimates at the 10%, 5% and 1% levels, respectively.
GDP ratio should increase in high growth periods. On this account, the negative parameter estimate for direct taxation
would be the upper bound of plausible estimates, while the lack of statistical significant results mainly for social security
contributions could be driven by this source of endogeneity. Indirect taxation generally tends to show an output gap
elasticity close to one, which holds the tax to GDP ratio constant over the cycle and should therefore not produce a
significant bias. In order to control for this problem, we estimate a set of specifications using leads, cyclically adjusted
fiscal data (either produced by the European Commission (various years) or trends derived by HP-filtering) as well as
instrumental variables GMM estimates. Details are reported in Appendix B. None of these methods suggests that the
results reported above are driven by an endogeneity problem caused by the functioning of automatic stabilisers.22
5.2.2. Taxation and private investment
Endogenous growth theory suggests that distortionary taxation affects the investment decision, and provided private
investment exerts a positive impact on growth, distortionary taxation in turn affects growth. In order to check for this
transmission channel of physical capital accumulation, we run distributed lag regressions with private investment as the
dependent variable on different revenue categories, also controlling for aggregate government outlays. The control
variables often employed in the growth literature are dropped from Eq. (12) since one cannot presume ex ante that they
have a direct impact on private investment.23 The investment model includes fixed time and country effects in addition
to the set of fiscal variables.
Table 6 reports the results when using revenues to GDP ratios as proxies for tax effects. Models (6) to (8) combine
total expenditures with different revenue categories. Model (9) then combines the three main expenditure and tax
categories. In all specifications direct taxation carries a negative coefficient which is mostly statistically significant at
standard levels. Indirect taxation yields a positive and highly statistically significant parameter estimate. A possible
22
The fact that the cyclically adjusted and the GMM estimates do not corroborate the result reported in model 5 for direct taxation could be seen as
lag of robustness. However, as also noticed in the annex, it should be taken into account that the cyclical adjustment is subject to substantial
methodological problems and GMM estimates may suffer from efficiency losses and finite sample bias given the relatively restricted time and crosssectional dimension of our data set.
23
Moreover, these variables became statistically insignificant when we experimented with variations of Eq. (12) as a robustness check.
187
explanation for this result would be the systematic substitution from direct to indirect taxes pursued by several
European countries in the 1980s and 1990s as part of their reform strategy. Finally, the coefficient estimate for social
security contributions as a share of GDP is negative when total expenditures is included but becomes positive when all
spending categories are incorporated in the model. The estimate is statistically significant in all specifications, which
complicates the interpretation since multicollinearity would not only be associated with parameter instability, but also
with lack of statistical significance. Arguably, the change in the sign of the coefficient is thus related to the fact that
social security contributions capture an effect attached to a specific spending category in model (9). The most robust
result from this exercise is therefore that direct taxes have a negative impact on private investment.
Since direct taxation is a broad revenue category, we further investigate the link between investment and taxation by
using an updated version of a more differentiated data set of the effective tax rates on labour, capital and consumption goods
from Martnez-Mongay (2000).24 The effective tax rates should capture the average negative effect that taxation exerts on
growth, thereby constituting a better proxy than the revenue shares of GDP. Models (10) and (11) give a clear message.
Labour taxation consistently affects investment. The coefficient takes on a negative value of around0.7, implying that a
1% increase in capital taxation would cause a fall in the private investment rate by 0.7%. We could, however, not find any
significant effect from the effective tax rate on capital on private investment.25 While this result may look surprising at first
sight, one has to notice that the bulk of direct taxation comes from labour income. Moreover, as Alesina et al. (2002) and
Ardagna (2006) show, increases in direct taxation put pressure on unions wage claims, leading to higher private sector
wages and lower profit margins and investment in unionized labour markets in industrialized countries. The coefficient for
consumption taxes is consistently positive in line with the earlier results reported for indirect taxes.
Overall, our results point to the existence of a significant impact from aggregate government expenditure and its
main subcategories on growth. The size of the public sector and the government consumption negatively affect longrun growth. This may reflect the fact that the average size of the public sector in the EU is above its optimal level.
Conversely, public investment has a positive impact on growth which indicates the likely gains in economic
performance from shifting welfare expenditure to productive investment. Furthermore, we find that above all direct
taxation negatively affects growth through its impact on private capital accumulation.
6. Conclusions
The Lisbon Process assigns a prominent role to public finance reform in order to foster economic growth. The main
purpose of our analysis is therefore to shed some light on the relation between public finances and growth in the EU-15.
Most importantly, this requires determining whether public finances provide policy instruments contributing to higher
trend growth, or whether they can at best be expected to have a short-run impact on economic performance. Following the
approach of some studies in this field that exploit the time series properties of the data, we find some persistent deterministic
changes in per-capita GDP growth rates and public finances. Nevertheless, when we look at stochastic trends, it appears
that public finance variables have generally shown persistence over time while growth rates of output have remained fairly
stable. This pattern does not exclude a long-term effect of fiscal variables per se, if expenditures and revenues have opposite
long-term effects and co-move. Using recently developed panel cointegration techniques, we have indeed found
overwhelming evidence of cointegration between both sides of the budget, as would be expected on theoretical grounds.
We then estimate the long-run effect of fiscal policies on growth using a distributed lag approach. We improve on
previous studies on the nexus of fiscal policies and growth by better controlling for real business cycle effects and
reverse causality as well as by using better proxies for taxation. The main findings are that the expenditure side of the
budget appears to consistently affect long-run growth over the business cycle. Specifically, government size and
government consumption are found to have a clear negative effect on growth, while public investment positively
24
For a discussion on different measures of the tax burden on labour see de Haan et al. (2004). Although there are substantial differences, the authors
find that this does not affect strongly conclusions regarding the economic impact found in several well-known empirical studies using these measures.
25
This finding is not in line with Mendoza et al. (1997). The reason for the discrepancy of the results cannot easily be explained since Mendoza
et al. (1997) use a different methodology and data sample. As a robustness check, Portugal has been dropped from the sample, since it shows fairly
large swings in capital tax revenues in the 1970s and therefore could present an outlier. For the reduced sample, the capital taxation coefficient
becomes indeed negative ( 0.17), but does not attain standard significance levels, while the coefficients for labour and consumption taxes remain
stable and statistically significant. Amplifying the model by including our human capital variable and changes in trade openness, to use a model
more closely reflecting the specification chosen by Mendoza et al., also yields a negative coefficient when Portugal is omitted, which is however not
statistical significant at the 10% level.
188
affects growth. On the revenue side, evidence exists for a negative effect of direct taxation on growth in our preferred
specification. Moreover, a robust negative impact of direct taxation on physical capital accumulation is confirmed by
our data. This impact seems to work primarily through the taxation of labour income which may lead to wage pressure,
thus lowering profits and investment in unionized European labour markets. Taken as a whole, our results stand in
contrast to previous studies on this issue (e.g. Evans, 1997; Karras, 1999) which did not appropriately take into account
the financing relations implied by the intertemporal budget constraint.
Before concluding the paper, it is important to point out some limitations of the present analysis. First, the growth effects
estimated represent reduced-form partial correlation coefficients, which do not necessarily imply causation. Second, the
fact that the panel unit root tests employed in the analysis fail to allow for structural breaks may bias the results towards the
non-rejection of the joint non-stationarity null, which was required for the conduct of the cointegration analysis. Third,
given the limited length of the data series available, it may be impossible to know with certainty whether the growth impact
estimated is the result of a continuum of level shifts along the transitional path as held by neoclassical growth theory or
represents a genuine growth effect as advocated by endogenous growth defenders.26 Finally, according to the endogenous
growth models being tested, it would be desirable to use marginal tax rates rather than average or effective tax rates.
However, we have refrained from employing marginal tax rates due to the difficulties in consistently computing them for
the EU-15 countries. This is because the system of exemptions and scales used to tax different types of income vary widely
across countries. Future research should be conducted in the direction of providing reliable estimates of marginal tax rates
so that new results can be confronted with the ones obtained in the present paper.
Acknowledgements
We would like to thank Jrg Breitung, Antonio Fats, Manfred Kremer, Chiara Osbat, Jonathan Temple, Jrgen von
Hagen, Simon Wren-Lewis, and two anonymous referees for very helpful comments and discussion. Pedro Pedroni kindly
made his RATS codes for the panel cointegration analysis available to us. All remaining errors are ours. The opinions
expressed herein are those of the authors and do not necessarily represent those of the European Central Bank.
Appendix A. Data sources and descriptive statistics
Table A1
Notation of variables
Variable
Definition
Source
LYPC
Gross domestic product in per capita terms nominated

in constant dollars
Private physical investment share of GDP
Average years of education of working age population
Ratio of exports plus imports to GDP
Inflation rates computed with consumer price index data
Growth rate of real GDP per-capita
Total current revenues as a share of GDP
Total expenditures as a share of GDP
Total public investment as a share of GDP
Total transfers as a share of GDP
Government consumption spending as a share of GDP
Total direct taxation as a share of GDP
Social security contributions as a share of GDP
Total distortionary taxation as a share of GDP computed as
the sum of direct taxation and social security contributions
Total indirect taxation as a share of GDP
Effective labour tax rate
Effective capital tax rate
Effective consumption tax rate
Economic outlook N.74, OECD.
LPRINV
LHK
LOPEN
INF
DLYPC
LTREV
LTEXP
LPI
LTR
LG
LTDIR
LSSC
LTDIST
LTIND
LTL
LTK
LTC
Economic outlook N.74, OECD.

Bassanini and Scarpetta, 2002; De la Fuente and Domnech, 2006.
Penn World Table 6.1.
International Financial Statistics (IMF).
Economic Outlook N.74, OECD.
Ameco StatisticsAutumn 2003, European Commission.
Martnez-Mongay (2000).
Note: All variables except for DLYPC and the inflation rate are expressed in log-levels.
26
See Temple (2003) for a more extended discussion of this issue.
189
Table A2
Descriptive statistics, European countries 19612001
LYPC
LHK
LOPEN
INF
LINV
LTREV
LTDIR
LSSC
LTDIST
LTIND
LTEXP
LG
LTR
LPI
DLYPC
LTL
LTK
LTC
Obs.
Mean
S.D.
Min
Max
630
615
615
615
600
597
544
544
544
544
597
536
544
544
615
465
465
465
16,145.601
9.240
59.808
0.060
20.415
40.628
12.925
11.398
24.323
13.601
42.818
17.323
15.284
3.287
2.835
32.503
20.009
20.263
7507.463
1.836
44.077
0.049
4.644
9.711
5.763
4.924
7.227
3.274
10.277
4.313
5.057
1.053
2.683
9.381
6.451
4.463
3619.817
4.370
8.985
0.007
5.013
17.438
2.369
1.463
7.692
5.875
17.385
7.845
3.029
1.034
11.049
11.100
6.800
9.100
66,398.890
13.600
276.545
0.255
35.411
62.859
30.644
21.056
39.626
30.644
70.075
28.858
28.473
6.468
11.552
54.100
38.000
31.400
Notes: All variables except growth rates of per capita GDP and inflation rate are expressed in levels.
Table A3
Correlation matrix of main variables, European countries 19612001
LYPC LINV
LYPC
LINV
LHK2
LOPEN
INF
LTREV
LSSC
LTIND
LTDIR
LTDIST
LTEXP
LG
LTR
LPI
DLYPC
1.00
0.47
0.80
0.70
0.39
0.78
0.33
0.42
0.68
0.80
0.70
0.53
0.67
0.14
0.17
0.47
1.00
0.41
0.43
0.39
0.45
0.12
0.29
0.41
0.39
0.47
0.37
0.39
0.25
0.12
LHK
LOPEN INF
0.80
0.41
1.00
0.53
0.41
0.84
0.23
0.62
0.73
0.78
0.75
0.70
0.68
0.17
0.26
0.70
0.43
0.53
1.00
0.42
0.57
0.17
0.35
0.60
0.56
0.51
0.25
0.48
0.09
0.02
0.39
0.39
0.41
0.42
1.00
0.41
0.17
0.27
0.35
0.38
0.24
0.23
0.29
0.22
0.25
LTREV LSSC
LTIND LTDIR LTDIST LTEXP LG
LTR
LPI
DLYPC
0.78
0.45
0.84
0.57
0.41
1.00
0.30
0.57
0.87
0.95
0.92
0.79
0.82
0.06
0.31
0.42
0.29
0.62
0.35
0.27
0.57
0.25
1.00
0.59
0.39
0.49
0.59
0.33
0.04
0.07
0.67
0.39
0.68
0.48
0.29
0.82
0.54
0.33
0.58
0.86
0.89
0.47
1.00
0.11
0.36
0.14
0.25
0.17
0.09
0.22
0.06
0.05
0.04
0.05
0.08
0.06
0.11
0.11
1.00
0.08
0.17
0.12
0.26
0.02
0.25
0.31
0.17
0.07
0.22
0.33
0.42
0.35
0.36
0.08
1.00
0.33
0.12
0.23
0.17
0.17
0.30
1.00
0.25
0.07
0.46
0.34
0.02
0.54
0.05
0.17
0.68
0.41
0.73
0.60
0.35
0.87
0.07
0.59
1.00
0.82
0.76
0.76
0.58
0.05
0.22
0.80
0.39
0.78
0.56
0.38
0.95
0.46
0.39
0.82
1.00
0.89
0.68
0.86
0.08
0.33
0.70
0.47
0.75
0.51
0.24
0.92
0.34
0.49
0.76
0.89
1.00
0.75
0.89
0.06
0.42
0.53
0.37
0.70
0.25
0.23
0.79
0.02
0.59
0.76
0.68
0.75
1.00
0.47
0.11
0.35
Note: The matrix shows the correlations of relevant variables.
Appendix B. Public finances and growth: Robustness results

This appendix reports the results of various specifications controlling for the possible endogeneity of fiscal variables
in Eq. (12) due to the existence of automatic stabilisers. Three different approaches are used for this purpose. First, Eq.
(12) is augmented with leads of fiscal variables. Eight lags and five leads are included in our specification.27 Second,
regressions are run with cyclically adjusted budgetary aggregates as provided by the European Commission. Since
these are not available for different spending and revenue categories, we also compute cyclically adjusted spending and
revenues as shares of trend GDP using a HP-filter.28 Third, we use a GMM instrumental variables estimator to check
27
The results appear fairly robust to different lag and lead-lengths. In order to keep a reasonable number of usable observations we set to eight and
five the number of lags and leads included in the regressions respectively. Panel studies often average the data over five-year periods to cancel out
cyclical fluctuations, so we use a number of leads equal to five.
28
The smoothing coefficient is set to = 100.
190
for endogeneity.29 Considering that our regressions already include lagged values of the fiscal regressors up to 8 years,
we employ as instruments for the fiscal policy variables their values lagged 9 and 10 periods.30
In interpreting the results it should be kept in mind that the operation of automatic stabilizers would induce a
downward bias for social transfers and an upward bias for taxes, in particular if taxes have an output elasticity larger
than one. For the sake of brevity, Table A1 reports only the results for the coefficient estimates for fiscal variables.
Model (13) is based on the cyclically adjusted budgetary aggregates as derived by the European Commission. The
estimated coefficients do not provide a clear picture. The coefficient for aggregate spending increases slightly as one
might expect, but the coefficient for total revenues, contrary to what one would expect, increases even more. For social
transfers, the coefficient estimate is even lower than the one found in the comparable specification (model 5) in Table 5.
For direct taxation, the result varies considerably across specifications. The specification including leads (model 12)
yields a somewhat lower coefficient than the one reported in Table 5. The estimate is significant at the 10% level. HPfiltered direct taxation as a share of trend GDP yields a statistically significant positive coefficient. Parameter estimates
vary again considerably and no statistically significant coefficient is found for social security contributions and indirect
taxation. Overall, based on these results there is no evidence for a systematic bias in parameter estimates induced by the
operation of automatic stabilizers. The results reported in Table A4 may rather point to some problematic aspects of
these specifications, in particular the reduction of the sample size and degrees of freedom through the inclusion of
leads, measurement issues for the cyclical adjustment of fiscal data and the possible inefficiency of IV-estimates.
Table A4
Public finances and growth: Robustness checks
(12)
(13)
(14)
(15)
Leads
Cyclically adj. (EC)

0.04
(0.03)
Cyclically adj. (HP-filter)
GMM
0.02
(0.06)
0.05
(0.02)
0.00
(0.02)
0.06
(0.02)
0.05
(0.02)
0.02
(0.007)
0.05
(0.02)
0.03
(0.03)
0.05
(0.03)
0.01
(0.01)
0.02
(0.02)
0.02
(0.02)
Total primary expenditures

Social transfers
Public investment
0.06
(0.04)
0.05
(0.04)
0.03
(0.01)
Total revenues
Direct taxes
Indirect taxes
0.04
(0.02)
0.04
(0.04)
0.05
(0.04)
0.01
(0.05)
Note: The dependent variable is per-capita GDP growth. The estimates shown represent long-term coefficients. Standard errors are given in
parenthesis. The sample period for models including average effective tax rates is 19702001. , and imply the rejection of the null of
insignificant parameter estimates at the 10%, 5% and 1% levels, respectively.
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European Journal of Political Economy 24 (2008) 172 191

Public finances and long-term growth in Europe: Evidence from a

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Fig. 1. Growth rates in European countries, 19612001.

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Deterministic trend (common coefficient and intercept)

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Fig. 2. Public expenditures in European countries, 19612001.

bij Dyitj eit

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Fig. 3. Public revenues in European countries, 19612001.

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

IPS test 2 lags

IPS test 4 lags

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

4.3. Cointegration of expenditures and revenues

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

bsj sitj ai eit

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

and for distortionary taxation

where C(L) and D(L) are (p 1)th-order lag-polynomials such that:

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

5.2. Estimation results

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Average effective tax on labour

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Gross domestic product in per capita terms nominated

Economic outlook N.74, OECD.

Economic outlook N.74, OECD.

See Temple (2003) for a more extended discussion of this issue.

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

LTIND LTDIR LTDIST LTEXP LG

Note: The matrix shows the correlations of relevant variables.

Appendix B. Public finances and growth: Robustness results

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

Cyclically adj. (EC)

Cyclically adj. (HP-filter)

Total primary expenditures

D. Romero-vila, R. Strauch / European Journal of Political Economy 24 (2008) 172191

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