Tax and spend, or spend and tax? An inquiry into the Turkish budgetary process.

• Author: Darrat, Ali F.

1. Introduction

   Contemporary economies, perhaps without exception, have been plagued with huge and escalating government budget deficits. These deficits are expected to have adverse economic consequences including high real interest rates, slow capital formation, and high unemployment rates. Moreover, to the extent that the deficit is financed through the issuance of government bonds, the recurrent large deficits have further worsened the public debt problem, which threatens the well-being of numerous countries, both developed and developing.

   Therefore, researchers and policymakers have expended enormous efforts attempting to analyze the deficit problem and to suggest ways to resolve it. Some, for example, advocate cuts in government spending rather than tax increases as the optimal solution to the deficit dilemma. They reason that governments often spend all that they receive in taxes and perhaps much more. Under this line of reasoning, raising taxes would simply induce more spending, leaving the deficit unchanged (or even higher). Others, however, deny this implied tax-and-spend nexus, and argue that it is taxes that adjust gradually to spending. Under this latter scenario, tax increases will not lead to higher spending, and thus, could be used as an effective deficit-cutting measure along with spending cuts. Still, other researchers posit that changes in spending and taxes could occur simultaneously. Therefore, focusing on one component of the government budget while ignoring the interdependence with the other component would have an ambiguous overall effect on the deficit.

   Clearly, then, the optimal approach to solving the problem of government budget deficits depends to a large extent on the intertemporal relationship between government spending and taxation. Indeed, there have been numerous studies that empirically gauge this relationship (e.g., Anderson, Wallace, and Warner 1986; Manage and Marlow 1986; von Furstenberg, Green, and Jeong 1986; Ram 1988; Ahiakpor and Amirkhalkhali 1989; Joulfain and Mookerjee 1990; Miller and Russek 1990; Hoover and Sheffrin 1992; Lee and Vedder 1992; Owoye 1995).

   Interestingly, the bulk of this voluminous empirical literature has focused almost exclusively on the U.S. experience, with few studies examining the case of other large industrialized major OECD countries. By contrast, there has been, thus far, no attempt to study the interrelationship between government spending and taxation for developing countries; yet, the problem may be more acute in these countries with huge and escalating deficits in recent years. Investigating the government spending/taxation nexus in these countries can provide useful information pertaining to the optimal solution to their deficits. Note also that developing countries have often been required to curtail budget deficits as a precondition to receiving financial aid and/or loans from international organizations like the International Monetary fund (IMF) or the World Bank.

   The main purpose of this paper is to fill this gap in the literature and examine the intertemporal relationship between government spending and taxation in the case of Turkey. Since the 1960s, Turkey has had a large and growing government sector. Measured by the share of government expenditures in Gross National Product (GNP), the government sector in Turkey expanded from less than 18% in the 1960s to claim more than 25% of the economy in the 1990s. Taxes have also risen during the last three decades but at a slower pace, resulting in persistent budget deficits. Many analysts and popular commentators (Bugra 1994; Adaman and Sertel 1995; Pope 1996) have warned that such deficits, if they continue, can seriously stifle economic activities and worsen the already bleak international credit-worthiness of the country. So far in the 1990s, inflation in Turkey has been running at about 75% annually, interest rate on three-month government securities is more than 80% and the public debt rose nearly 25% in the first quarter of 1996. Such bad economic conditions have already threatened a new IMF aid package for Turkey and also prompted the Standard & Poor's Ratings Group to rank Turkey's long-term government securities among the lowest of all countries. Although many elements, including perhaps political instability, may be behind Turkey's economic and financial woes, the large budget deficits have undoubtedly been a major contributing factor. Indeed, there is a near consensus among economists and public-policy observers in the region that it is indispensable for Turkey to aggressively resolve the budget deficit dilemma and put the public sector in order.

   Of course, the contrasting viewpoints with respect to government spending and taxation in Turkey presume the endogeneity of the Turkish budgetary process.(1) Budget decisions in an endogenous framework are determined in a large political body whose agents often exhibit conflicting objectives. Despite several military interventions in Turkey since the 1960s, the multiparty political system has remained largely a democratic system with fundamental rights and freedoms guaranteed to all citizens. The 1961 Constitution created a bicameral legislature comprised of a National Assembly and a Senate with an elaborate system of checks and balances on government authority. Among many constitutional responsibilities, the legislators have exclusive powers to make law, and they freely debate and amend the government's proposed budget. The president, who is appointed by the parliament, can veto legislation passed by the parliament. Since 1983, the country has been ruled by a new Constitution, which was approved by a national referendum in 1982. This Constitution established a popularly elected, single-chambered parliament and continued to preserve the civil and political rights of all citizens, but made these rights subordinate to "national security," "national unity," and "public morality."(2) Therefore, it appears that the Turkish budgetary process is sufficiently endogenous without substantial regime shifts, a setting that seems appropriate for the tests I perform in this study.

   The remainder of the paper is organized as follows. Section 2 provides a brief account of the literature on the government spending/taxation nexus with emphasis on four alternative hypotheses pertaining to this relationship. Section 3 describes the data and the empirical methodology of the paper. The methodology is based on the recent cointegration and error correction modeling in bivariate and multivariate contexts. Section 4 reports the empirical results. Section 5 concludes the paper.

2. Alternative Hypotheses

   Researchers have advanced four alternative hypotheses regarding the government spending/taxation nexus. First, some researchers (e.g., Wildavsky 1988) have argued that government's decisions to spend are independent from its decisions to tax. Owing to the institutional separation between spending allocation and taxation in the United States, Hoover and Sheffrin (1992) report empirical results for the U.S. that are consistent with an independent determination of the two sides of the budget, especially since the 1960s.

   Most of the literature, however, suggests that spending and taxes are interrelated, giving rise to three additional possibilities. Several economists, led by Milton Friedman (1982), contend that raising taxes would likely fall to lower budget deficits because they would instead invite more spending. Because of this positive causal impact of taxes on spending, Friedman has long proposed tax cuts as a means to reducing budget deficits. He reasons that the larger budget deficits resulting from tax reductions should exert mounting pressures on the government to curtail its spending. Interestingly, like Friedman, Buchanan and Wagner (1977, 1978) have also suggested that causality runs from taxes to spending. However, unlike him, Buchanan and Wagner hypothesize a negative causal relationship. They argue that reducing taxes would lower the cost of government programs as perceived by the public. Hence, voters tend to accept or even demand further government programs, resulting in higher government spending. The tax cut, in conjunction with the resultant government spending increase, would lead to higher (not lower) budget deficits. Thus, Buchanan and Wagner advocate, instead, tax increases which would raise the cost of government spending as perceived by voters, thus resulting in lower spending. The tax increase, combined with spending cuts, could drastically curtail budget deficits.

   A third group of economists, most notably Barro (1979) and Peacock and Wiseman (1979), has challenged the above views and argues that governments spend first and then tax later. They contend that temporary increases in government spending (perhaps easily justified by natural crises and/or severe humanitarian needs) tend to become enduring and lead to permanent tax increases to finance the excessive spending. Under this causal pattern from spending to taxation, the optimal solution to controlling the budget deficit is clearly spending cuts. Proposals like these will become particularly attractive in the absence of the severe crises that initially justified the spending hikes.

   The fourth and final causative link between government spending and taxation suggests a mutual change. This fiscal synchronization hypothesis of Musgrave (1966) and Meltzer and Richard (1981) contends that the public simultaneously determine the levels of government spending and taxation by contrasting the benefits of government services with their costs. Therefore, these economists maintain that spending and taxes are determined concurrently.

   In summary, there are four alternative hypotheses pertaining to the causal relationship between government spending and taxation. These are (i) taxes and spending are causally independent, (ii) taxes cause spending, (iii) spending causes taxes, and...