Causality between Government Expenditure and Revenue in Malaysia: A Seasonal Cointegration Test

Abstract

The objective of this article is to empirically incorporate the effect of seasonality in examining the causal relationship between quarterly government revenue and government expenditure in Malaysia for the period 1970.1-1994.4. The seasonal integration and cointegration tests developed by Hylleberg, Engle, Granger and Yoo (1990) and extended by Engle, Granger, Hylleberg and Lee (1993) are applied prior to determination of causality. Evidence of seasonal cointegration of biannual frequency is found. The seasonal error correction model results indicate a unidirectional causal influence from government expenditure to government revenue, supporting the spend-and-tax hypothesis in the short run, i.e. higher government spending leads to higher taxes. The implication of this result is that the size and growth of the public sector and consequential tax burden as well as fiscal deficit in Malaysia are largely determined by the spending decision. I. Introduction In the contemporary era, after World War II, the rapidly increasing size of the public sector in most economies inspired a number of theoretical and empirical studies in explaining the causes of such growth through quantitative analysis. Basically, this type of research was prompted by the need to devise appropriate measures in order to reduce the U.S. federal budget deficit (Manzini and Nejadan 1995). Besides, causality links between government expenditure and revenue have unique significance for developing countries in making budgetary decisions. Governments in developing countries often face greater budgetary constraints. Usually, the government has to make a choice between two possibilities: either to raise taxes or to reduce expenditure in order to contain the fiscal deficit through necessary adjustments in its fiscal operations. This linkage issue is crucial in understanding the causes and consequences of budgetary deficit, which is commonly observed in most countries. On a theoretical plane, there is no consensus among the economists on the issue of causal relations between government expenditure and tax revenue. Three alternative hypotheses have been advanced in perceiving the intertemporal budgetary links between taxation and government spending: (1) Spend-and-tax hypothesis (2) Taxand-spend hypothesis, and (3) Fiscal synchronization hypothesis. According to the spend-and-tax hypothesis, government starts spending first, and then determines how to finance the expenditure through additional taxes at a later date, so that causation runs from expenditure to revenue. Such a view is explored by Peacock and Wiseman (1967) who argue that external shocks (such as the Great Depression, World War II, oil shocks) which require temporary increases in government spending can lead to a permanent increase in taxes. The proposition that taxes adjust to changes in government expenditure is also substantiated in a study by Barro (1974), a supporter of the Ricardian Equivalence proposition, who argues that increases in taxes are the results of higher levels of fiscal expenditure; hence:, causality runs from expenditure to revenue with no feedback. The tax-and-spend hypothesis, contrary to the previous hypothesis, posits the reverse relationship. It is argued that changes in taxes lead to changes in government spending. This hypothesis earned its popularity with the supply-side economists. Economists, such as Friedman (1982), argued that increases in taxes only result in increased expenditure, and not in deficit reduction. This view suggests a causal relationship from revenue to expenditure. The fiscal synchronization hypothesis, on the other hand, postulates that governments change expenditure and revenue simultaneously. According to this hypothesis, governments decide on the desired expenditure and taxes, by comparing the marginal benefits and costs of any balanced budget change. …