Testing For Government Intertemporal Solvency: A Smooth Transition Error Correction Model Approach

Abstract

Applied macroeconomists have tested for the government intertemporal solvency condition by either testing for linear stationarity in the total government deficit series or testing for linear cointegration between total government spending and total tax revenues. A number of authors have focused, in particular, on structural breaks in the government deficit process. In this paper, we use a smooth transition error correction model to test and estimate a shift in the adjustment toward a linear cointegration relationship between the government spending to output ratio and the total tax revenues to output ratio. Estimation results show that government authorities react only to large (in absolute value) changes in the government spending to output ratio. Residual diagnostic tests are provided and they show that the model is not misspecified.