Abstract
This paper analyzes the impact of financial openness on the size of the government in a stochastically growing small open economy when public spending is productive and volatility-reducing using a portfolio approach. The main result of the model is that economies that are more open are associated with a smaller productive public sector. The lower risk associated with more open economies due to risk diversification implies that the government is less inclined to increase the scale of its activity to maximize welfare when productive spending is also volatility-reducing. The empirical evidence based on a sample of 16 OECD countries for the period 1970–2004 broadly supports the main results of the model, even though some results are mixed.
Highlights
IntroductionThe relationship between openness and the size of the public sector has received much attention since Rodrik (1998) asked in his seminal work, “Why do more open economies have bigger governments?.” His main result was that trade openness is positively related to the size of government since “government expenditures are used to provide social insurance against external risk” (Rodrik 1998, p. 997). While many other studies have followed suit and other studies have cast doubts on the robustness of this result, recent evidence shows that the positive association between trade openness and government size is robust across countries and over time for a large dataset of 143 countries during the period 1950–2000 (Epifani and Gancia 2009). Most research has naturally been focused on the impact of increasing trade openness on the size of government, usually measured as government consumption expenditure. other variants of the relationship between openness and the size of the public sector have not been widely analyzed in the literature
The main result of our model is that more open economies are associated with a smaller productive public sector
This paper is centered on three crucial aspects of this relationship: financial openness, the importance of productive public spending, and the stabilizing role of government size
Summary
The relationship between openness and the size of the public sector has received much attention since Rodrik (1998) asked in his seminal work, “Why do more open economies have bigger governments?.” His main result was that trade openness is positively related to the size of government since “government expenditures are used to provide social insurance against external risk” (Rodrik 1998, p. 997). While many other studies have followed suit and other studies have cast doubts on the robustness of this result, recent evidence shows that the positive association between trade openness and government size is robust across countries and over time for a large dataset of 143 countries during the period 1950–2000 (Epifani and Gancia 2009). Most research has naturally been focused on the impact of increasing trade openness on the size of government, usually measured as government consumption expenditure. other variants of the relationship between openness and the size of the public sector have not been widely analyzed in the literature. Higher tax rates on mobile inputs, such as capital for instance, in the domestic economy would make capital outflow enormously to other countries (or regions) when international capital mobility is high, as the tax rates would be too low for investors seeking the highest return This literature suggests that more open economies that suffer more tax competition would be associated with a smaller public sector. We find that the empirical evidence based on a sample of 16 OECD countries for the period 1970–2004 broadly supports the result that more open economies are associated with a lower size of the productive public sector, even though some results are mixed.
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