Asymmetries in the conditional relation of government expenditure and economic growth

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Previous studies on the relationship between government expenditure and economic growth have, invariably, aggregated periods of strong and weak GDP growth and reported a single government expenditure response coefficient estimate. We argue that traditional test specifications of this relationship suffer from aggregation (or omitted variables) biases by failing to distinguish between diverse economic growth experiences and their impact on government expenditure. We reexamine the evidence concerning Wagner's Law using a proposed conditional test specification that is capable of: (a) separating periods of strong and weak economic growth, (b) accommodating possible asymmetries in the marginal responses of government expenditure to variations in economic growth and (c) distinguishing between positive and negative asymmetries in such responses. We present evidence showing that: (a) the majority of government expenditure responses tend to occur during periods of an economic slowdown characterized by GDP growth that is below trend-growth; and (b) there is little evidence suggesting that government expenditure increases markedly during periods of an economic expansion when GDP growth is at/above trend-growth. Results from several tests of hypotheses also corroborate these findings. When we aggregate response coefficients across periods of above trend-growth and below trend-growth, we obtain an elastic aggregate response coefficient for OECD countries in line with Wagner's proposition. However, the evidence seems less forthcoming for EU economies. Nonetheless, the estimated cumulative response coefficient from our conditional asymmetric specification exceeds the estimated response coefficient from a traditional symmetric test specification which appears biased against finding support for Wagner's proposition due to omission of important directional asymmetry variables from the estimating equation.