The Causal Nexus between Government Expenditure and Economic Growth: Wagner versus Keynes Hypothesis

Abstract

The causality between economic growth and government expenditure has long been a topic of interest among economists. Theoretically, Wagner’s law claimed that economic growth (EG) contributes to government expenditure (GE), while the opposite causal nexus was claimed by Keynes. This study seeks to test the validity of these two theories by examining four versions of functional hypotheses and their reverse functions: Gupta, Peacock and Wiseman, Musgrave, and Mann. The main objectives include examining the nexus by comparing the developed versus developing countries, short-run versus long-run estimates, and the results between three estimators. The panel data regression applies the three estimators, which include pooled mean group (PMG), mean group (MG), and dynamic fixed effect (DFE). The datasets are collected from 1970 to 2018. The results detect both long-run and short-run relationships in the Gupta version and the Peacock and Wiseman version of Wagner’s law, and also the reverse Gupta version and the reverse Peacock and Wiseman version of Keynes’ theory. To sum up, the two-way relationship between GE and EG exists in developing countries. On the other hand,Wagner’s law and Keynes’ theory are not valid in developed countries. The results imply that economic level matters, which leads to different linkages between EG-GE across groups of countries. Since the nexus exists in developing countries, policymakers should adopt fiscal policies to stimulate economic growth. With no GE and EG relationship found in developed countries, policymakers should focus on other economic indicators other than government expenditure to foster economic growth.