Government Expenditures and Revenues: Evidence from Asymmetric Modeling

Abstract

1. IntroductionExamining the empirical relationship between government revenues and expenditures is a crucial step in understanding the future path of the budget deficit. Four alternative explanations have been used to describe the relationship between these variables in the budgetary process: (i) the tax-and-spend hypothesis, (ii) the spend-and-tax hypothesis, (iii) the fiscal synchronization hypothesis, and (iv) the institutional separation hypothesis. The issue of which hypothesis best describes the nature of the budgetary process has yet to be resolved in the literature. However, existing research has implicitly assumed that the state of the budget and whether or not the budget deficit (or surplus) is worsening or improving does not matter. We argue that government decision-makers may take these factors into account when determining expenditures and tax policy. As such, this article reexamines the tax-spend debate by using a more robust econometric technique that allows for asymmetry in the relationship between revenues and expenditures.Until now, the empirical evidence on the tax-spend debate has focused almost exclusively on two conventional econometric techniques. Depending on the cointegrating properties between revenues and expenditures, these techniques are based on either variations of the unrestricted vector autoregression (UVAR) or the vector autoregression error correction model (ECM).1 If, for example, the two budgetary variables are not cointegrated, then the application of causality2 tests requires the use of stationary variables in the UVAR model.3 On the other hand, if the two budgetary variables are cointegrated, then the application of causality tests requires an ECM specification.It is important to note that the ECM specification implicitly assumes that the adjustment process of expenditures and revenues due to disequilibrium between the variables is strictly symmetric. Indeed, if the adjustment is asymmetric, then the symmetric adjustment implicitly assumed in the conventional techniques to ascertain causality implies model misspecification. This specification error may lead to misguided and perhaps inappropriate fiscal policy decisions. Accurate estimation of the revenue and expenditure process is especially important as changes in taxes and spending alter incentives for work, investment, and productive activity (CEA 2004). Thus, the anticipated behavioral responses of households and businesses may be better captured by more general models that allow for asymmetry in the tax-spend relationship. To this end, this article examines the existence of cointegration between revenues and expenditures and the corresponding ECM specification by using the recently developed techniques of asymmetric modeling. In particular, we employ the threshold autoregression (TAR) and momentum threshold autoregression (M-TAR) models developed by Enders and Granger (1998) and Enders and Siklos (2001). Within the context of these models, we shed new light on whether budget surpluses versus budget deficits (or an improving budget versus a worsening budget) have asymmetric effects on the dynamic behavior of expenditures and revenues.There is an a priori rationale for modeling asymmetry in the budget and for the response of its components to disequilibrium. This rationale can be categorized into four factors. First, the fiscal policymakers may respond differently to a deviation of the deficit or surplus from its long-run trend. One would expect, for example, that the response would be more aggressive if the deficit was greater than its long-run trend than if it was less than its trend.Second, it is widely acknowledged that there is a very close connection between the budget and the business cycle through automatic fiscal stabilizers and discretionary fiscal measures. To the extent that the business cycle is asymmetric, the associated change in the budget may also be asymmetric. …