Government expenditures and revenues: evidence from asymmetric modeling.

• Author: Ewing, Bradley T.

In this article, we examine the relationship between U.S. federal revenues and expenditures while relaxing the assumption of a symmetric adjustment process underlying the conventional cointegration and error correction model. Threshold autoregression and momentum threshold autoregression models are used to ascertain the empirical link between the two variables of the budgetary process. Our results suggest that revenues and expenditures are cointegrated and that the adjustment process of the budgetary disequilibrium is asymmetric. The application of the asymmetric error correction model indicates that revenues and expenditures respond to the long-run requirements of the budgetary balance only when the budget is worsening.

JEL Classification: E600, H600, H500, H300

1. Introduction

   Examining 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).l if, for example, the two budgetary variables are not cointegrated, then the application of causality (2) 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. (4) Some elements of tax revenues are especially sensitive to cyclical movements in the macroeconomy. (5) Sichel (1993) makes a distinction between sharp versus deep cycles because he found that many important macroeconomic variables display asymmetric adjustment paths. Thus, one cannot rule out the possibility that aggregate federal revenues and expenditures may also exhibit asymmetries. Third, taxpayers' behavioral responses to changes in either the effective tax rate or the effective tax base may produce asymmetric variations in the budget. Examples of such responses include changes in portfolio investments or changes in the related tax elasticities. These behavioral responses will probably manifest as large swings in tax revenues.

   Fourth, some elements of tax revenues are highly responsive to certain internal and external developments. Trade tax revenues, for example, are sensitive to the international economy, including any asymmetric variations in interest rates or exchange rates. Profit tax revenues, as another example, are sensitive to internal and external demand and supply shocks. Finally, expenditures on defense are sensitive to political developments, especially when we compare wartime spending with peacetime expenditures.

   Within the public finance literature, it is often assumed that a government determines both revenues and expenditures in ways that maximize the social welfare of the society. However, four alternative hypotheses have been advanced to ascertain the nature of the causality between these variables in the budgetary process. The tax-and-spend argument proposes that changes in government revenues lead to changes in government expenditures. Friedman (1978) and Buchanan and Wagner (1978) were early proponents of this view but differed in their perspectives. Friedman argued that increasing the resources available to government by increasing tax revenues will only lead to increases in government expenditures. The Friedman version of the tax-spend hypothesis suggests that government revenues have a positive effect on government expenditures. Alternatively, Buchanan and Wagner argued that increases in government revenues may lead to decreases in government expenditures through fiscal illusion. In particular, if the government is financing expenditures by means other than direct taxation, the fiscal illusion occurs because the public pays less in direct taxation but more in the form of indirect taxation (e.g., crowding-out effects and bracket creep caused by inflation). If indirect taxation declines while direct taxation increases, this trend could reduce government expenditures.

   The spend-and-tax hypothesis suggests that a government first makes expenditure decisions and then adjusts tax policy and revenues as necessary to accommodate expenditures. From a Ricardian equivalence perspective, Barro (1979) argued that increased government expenditures financed by borrowing will translate into higher future tax liability for the public. In the context of fiscal policy response to "crisis" situations, Peacock and Wiseman (1979) argued that temporary increases in government expenditures in response to such crises will lead to higher permanent taxes. Under either perspective, higher expenditures would lead to higher taxes.

   Many recent studies have found that revenues and expenditures are cointegrated. The finding of cointegration implies that the standard UVAR specification is incorrectly...