Do revenues or expenditures respond to budgetary disequilibria?

• Author: Baghestani, Hamid

1. Introduction

   The post-World War II increase in the size of the federal government has led to a number of theoretical and empirical investigations of the sources of this growth. In particular, economists have questioned whether increases in the size of the federal budget tend to be initiated by changes in expenditures followed by revenue adjustments, by the reverse sequence, or both. Friedman, for example, argues that governments adjust expenditures to the level of revenues, so that control of taxation is essential to limit growth in government [13]. Alternatively, the spend-and-tax model posits that revenues will be adjusted to finance any politically chosen level of expenditures. A third perspective, reflecting the institutional separation of allocation and taxation functions of the federal government, hypothesizes the independent determination of revenues and expenditures. The goal of this investigation is to test these three alternative theories of the budgetary process for the United States.

   The tax-and-spend and the spend-and-tax models have been examined in previous studies through causality testing, initially within a conventional vector autoregression (VAR) framework [1; 4; 23; 27; 29]. We follow the more recent studies of Bohn, Jones and Joulfaian and Miller and Russek, who employed the techniques of cointegration and error correction models (ECMs) to examine this same question [5; 21; 25]. In addition, our models include GNP as a control variable. In the cointegration framework this introduces several interesting methodological issues and leads to results that are sharply different than those reported in previous studies. The presence of three variables in the system raises the possibility of more than one cointegrating vector, and we find evidence of two such vectors. We experiment with both maximum likelihood and least squares estimation of these cointegrating vectors, and establish a close correspondence between the two sets of estimates. The cointegrating equations define long run equilibrium relations, one of which is interpreted as a "budgetary equilibrium" relating expenditures and revenues, and the other describing an equilibrium between GNP and either fiscal variable. The departures from both equilibria, represented by the residuals from the cointegrating equations, are included in error correction models, to capture the responses of expenditures and revenues to each of the two disequilibria. We find that neither revenues nor expenditures responds to the budgetary disequilibrium. Instead each budgetary variable adjusts to disequilibrium in the relation between that variable and GNP. We conclude that neither the tax-and-spend nor the spend-and-tax hypotheses account for post-World War II budgetary expansion. Instead these results are consistent with the third model, based on the institutional separation of the allocation and taxation functions of government, with the expansion in revenues and expenditures each determined by long run economic growth.

2. Theoretical and Empirical Background

   Several alternative models of government finance characterize the dynamic relation between expenditures and revenues. The tax-and-spend school, championed by Friedman views expenditures as adjusting, up or down, to whatever level can be supported by revenues [13]. This view implies a causal relation running from revenues to expenditures. The spend-and-tax model posits the reverse relation, with revenues responding to prior spending changes. Peacock and Wiseman see economic or political crises creating increased expenditure programs that are subsequently ratified by tax increases [26]. Barro's tax-smoothing model also implies causation running from expenditures to revenues [3].

   A third model, reflecting the laws and institutions governing the U.S. budgetary process, hypothesizes the independence of revenues and expenditures. Both executive and legislative branches of government participate in the budgetary process, but lack of agreement between these two branches has undermined recent attempts to rationalize the process [30]. Within the Congress there is an institutional separation of allocation and taxation functions of government, for example, into the Appropriations and Ways and Means Committees in the House of Representatives. Despite the reform of the budget process attempted in the Congressional Budget and Impoundment Control Act of 1974, the large deficits of the post-1974 period indicate a continued absence of coordination between expenditure and revenue decisions. The Gramm-Rudman-Hollings Act was another attempt to coordinate the expenditure and taxation decisions of government, which again failed to achieve linkage between the two budget components. Hoover and Sheffrin attribute this failure to the interplay of numerous diverse interests in the context of nonparliamentary U.S. institutions [18].

   In the absence of a balanced budget requirement, there is no legal constraint forcing either budgetary variable to adjust to the other. Buchanan and Wagner argue that government spending grows through deficit financing, which disguises the cost of government programs [8; 9]. Tax rate changes are accompanied by intense political debate and controversy over economic impact and income distributional issues, which politicians would prefer to avoid. To the extent that major tax rate changes are infrequent, year-to-year changes in tax revenues will be dominated by fluctuations in macroeconomic activity. On the expenditures side secular growth in population and incomes increases the demand for public services [6]. Expenditure levels respond to economic growth, rather than taxation decisions. This combination of institutional, political, and economic forces results in levels of expenditures and revenues determined largely by long term growth and macroeconomic fluctuations.

   Previous empirical studies of U.S. expenditures and revenues at the federal level have produced conflicting evidence on the tax-and-spend and spend-and-tax hypotheses. None have explicitly considered the third model of the budgetary process. Conclusions from the empirical studies are sensitive to the sample period under investigation, the degree of temporal aggregation, the inclusion or exclusion of macroeconomic controls, and the choice of econometric methodology. Every VAR model surveyed here employs first differences of relevant variables. Anderson, Wallace and Warner, using a VAR on annual, post-World War II data in real terms, and including macroeconomic controls, find that expenditure changes lead revenue changes [1]. Extending the sample period back to 1929, and using only a dummy variable to capture macroeconomic effects, Manage and Marlow reverse the conclusion of Anderson, Wallace, and Warner, finding either uni-directional causality from revenues to expenditures or bidirectional causality, depending upon the number of lags in the VAR [23]. To reconcile these results, Ram examines both longer period annual (1929-83) and shorter period quarterly (1947-83) data, and produces results largely consistent with Manage and Marlow, with causality running from revenues to expenditures, and some evidence of feedback following World War II [27]. However, Ram's omission of macroeconomic controls prevents a clear rejection of Anderson, Wallace, and Warner's conclusions.

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