Abstract
This note describes how research on the link between economic openness and government size has changed over time. Early interpretations suggested that countries develop welfare states to compensate for volatility caused by economic openness (the compensation hypothesis). Recent findings have cast doubts on this interpretation. For example, more open economies are on average not more volatile, and economic openness does not unambiguously increase the social security demands from voters. Some recent studies suggest that economic openness is particularly beneficial for countries with high taxes and high‐income equality. A re‐interpretation of the compensation hypothesis is thus possible: Through trade, the citizens in large welfare states enjoy some of the benefits associated with cheap labour and high wage dispersion despite their domestic economy being characterized by high real wages, high taxes and a compressed wage distribution.
Highlights
The idea that open economies develop large welfare states or corporatist institutions as a response to the volatility caused by economic openness and international markets is known as the compensation hypothesis
Down presents similar findings for a smaller set of countries and goes further by noting that trade integration may have eased rather than accentuated domestic economic volatility.2. Another link in the compensation hypothesis is examined by Shelton (2007) who showed that the expenditure associated with increased trade openness is largely not in categories that insure for risk, suggesting that even in samples where the expected correlation between government size and openness is found, the explanation provided by the compensation hypothesis is not the correct one
In addition to the evidence regarding the openness-government size link cited above, see the survey by Potrafke (2015) suggesting that globalization is not associated with lower overall tax revenue, and the study of developed welfare states by Brady, SeeleibKaiser, and Beckfield (2005) that concluded that globalization effects are far smaller than the effects of domestic political and economic factors and that globalization does not clearly cause welfare state expansion, reduction or convergence
Summary
Background The idea that open economies develop large welfare states or corporatist institutions as a response to the volatility caused by economic openness and international markets is known as the compensation hypothesis. Another link in the compensation hypothesis is examined by Shelton (2007) who showed that the expenditure associated with increased trade openness is largely not in categories that insure for risk, suggesting that even in samples where the expected correlation between government size and openness is found, the explanation provided by the compensation hypothesis is not the correct one.3 This finding rules out the possibility that policy makers or voters perceive economic openness to be associated with volatility, and that such perceptions (regardless of whether they are correct or not) are sufficient to explain political choices.
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