Government size and economic growth in Vietnam:

A panel analysis

Su Dinh Thanh
University of Economics Ho Chi Minh, Vietnam
dinhthanh@ueh.edu.vn
+84918089659

Abstract

This paper investigates the effect of provincial government size on economic growth using the panel
data of 60 provinces over the period of 1997-2012. Empirical estimates are employed by conducting
Difference Generalized Method of Moments (GMM) method proposed by Arellano and Bond
(1991) and Pooled Mean-Group method of Pesaran, Shin et al. (1999). We use respectively various
measures, defining the size of government, namely provincial government expenditure’s share to
gross provincial product (GPP), provincial government revenue’s share to GPP, real provincial
government expenditure per capita, and real provincial government revenue per capita. Our findings
show that the increase in government expenditure’s share and government revenue’s share slow
economic growth, while the real government expenditure per capita and real government revenue
per capita have positive relationship with economic growth. The latter results indicate that provinces
with high economic potential have advantages not only of raising budget revenue per capita but also
providing their people with more and better public services. We also find that the long run and short
run coefficient of government expenditure’s share are negative; the correction mechanism from the
short run disequilibrium to the long run equilibrium is not convergent; and government employment
has negative related to growth of per capita. From a policy perspective, our findings do not advocate
a large government size, which is detrimental to economic growth. A small government size is the
essential issue and could be effective in providing public services for economic growth as well as
for preventing market failures.

Keywords: Government Size, Economic Growth, GMM and PMG Estimations.

Electronic copy available at: http://ssrn.com/abstract=2437242

1. Introduction

Government serves many useful functions in market economy. It is a fact that no society in the
history of mankind has ever obtained a high level of social-economic outcome without a
government (Vedder and Gallaway, 1998). We have seen that the new economic theory that is so-
called endogenous growth theory suggests several mechanisms by which government activity can
affect long run growth (see Romer, 1986; Lucas, 1988; Barro 1990; Rebelo, 1991). In the Barro
model, for example, when government size is relatively small, growth rises with increases in
government services and taxation as the positive effects of more government-provided services
dominate. However, an increase in government services beyond some point requires increase in tax
rate, this reduces the return to investment, and so long-run growth slows. Government growth then
has been the focus of considerable scholarly interest in recent year as many studies have investigate
to explain changes in the scope of public sector activity and government size effects on economic
growth (see Gwartney, Lawson et al., 1998; Vedder and Gallaway, 1998; Dar and AmirKhalkhali,
2002; Chen and Lee, 2005; Afonso and Furceri, 2010; Germmell and Au, 2012; Altunc and Aydın,
2013).

The term “size of government” is still controversy. There are several approaches to measures of
government size (Light, 1999). Government size is represented by various factors, including
government expenditures as a share of gross domestic product and real government expenditures per
capita (Garrett and Rhine, 2006). Most empirical studies in this field have employed the share of
government expenditures and tax revenue to gross domestic product as various determinants of
government size (Berry and Lowery, 1984; Gwartney, Lawson et al., 1998; Vedder and Gallaway,
1998; Dar and AmirKhalkhali, 2002; Chen and Lee, 2005; Afonso and Furceri, 2010; Germmell and
Au, 2012; Altunc and Aydın, 2013). The existing literature also presents mixed results as to the
relationship between government size and economic development. Vedder and Gallaway (1998)
assert that economic progress is limited when government is zero percent of the economy, but also
when it is closer to 100 percent. This idea is related to the so-called “Armey Curve” developed by
Armey (1995), who borrowed a graphical technique popularized by Laffer.

While most of empirical studies on economic growth have been employed across-countries, a few
researchers have applied the framework to a single country analysis. When utilizing the nation as the
unit of analysis for cross-sectonal, one problem lies in structural differences between countries (such
as politics, institutions and culture…). Structural differences are very difficult to quantify, and thus
difficult to incorporate into an econometric test (Auteri and Constantini, 2004; Stansel, 2005). If not
taken into account the problem in the analysis are likely to blur the true empirical results. One way
to solve this problem is to analysis subnational units within a single nation. In this case, empirical
researchers translate the literature on empirical growth to a subnational level.

Public sector reform in Vietnam, which was initiated from the 1990’s, has aimed to improve the
quality of public governance. The main goal of the reform is to build a democratic, strong, clean,
professional, modernized, effective and efficient public administrative system, which contribute to
economic development (Vasakui, Thai et al., 2009; Can, 2013). Vietnam has been transitioning from
a command to market economy orientation, fully integrated into the global economy. Due to
sustained high economic growth rates, Vietnam has escaped from being a low-income country to
become a middle-income country. Nevertheless, there remain challenges that limit the effectiveness
and efficiency of government activities in the process of economic restructuring (Can, 2013). As a

Electronic copy available at: http://ssrn.com/abstract=2437242

result, government size is not well controlled, which is reflected by following aspects. First,
government revenue as a share of GDP is higher than those of countries in the region and it is
difficult to increase further in the context of a persistent economic recession. Budget revenue as a
share of GDP is the highest in Southeast Asia. It averaged 27% of GDP over the period of 2000–
2010. Meanwhile, the level of budget revenue in Malaysia, Thailand and even China is still below
20% of GDP in the same period. Secondary, total government expenditure as a share of GDP across
countries in the region as China, Thailand and Indonesia is at the low end with public spending at
average 18% GDP, while Vietnam is at the high end with average 26% government expenditure as a
share of GDP over the period 2000 – 2010. With the high government spending ratio, Vietnam has
chosen to devote a relatively large share of its national income to public purposes. This reflects a
desire for a larger government role in society and the economy.

Vietnam has significantly decentralized fiscal responsibilities to province governments. The share of
subnational expenditures to total expenditures is approximately 40%. Vietnam is considered as a
high decentralizing country among developing countries (Matinez-Vazquez, 2005). This paper is an
empirical analysis of the relationship between size of government and economic growth for the case
of Vietnam provinces over the period of 1997–2012. Hence we transfer the literature on empirical
growth to a province level. The intent is to determine how the size of subnational governments
impacts the province’s economic growth by examining annual data across provinces. The study is
employed by conducting Difference Generalized Method of Moments (GMM) method proposed by
Arellano and Bond (1991) and Pooled Mean-Group method of Pesaran, Shin et al. (1999).

The paper is organized as follows. Section 2 briefly describes the empirical review existing in this
area. Section 3 presents empirical model employed in this studies. Section 4 describes the data used
in the empirical analysis. In section 5, we explain econometric approach employed to estimate.
Section 6 provides empirical results for the model. Section 7 concludes.

2. Literature Review

There is a vast empirical literature investigating the relationship between government size and
economic growth. Most of empirical studies on government size and economic growth can be
employed on panel data regressions. Previous studies generally have found significant effects, either
positive or negative, of government spending or taxation on economic growth.

Based on recent public policy endogenous growth models, Kneller, Bleaney et al. (1999) examine
the growth effects of fiscal policy for a panel of 22 OECD countries over the 1970–1995 period.
Using two–way fixed effects model and robustness test, the empirical results considerably support
for the predictions of Barro (1990) with respect to the effects of the structure of taxation and
expenditure on growth. Specifically, this study finds that distortionary taxation reduces growth and
productive government expenditure enhances growth. Dar and AmirKhalkhali (2002) use growth –
accounting model to examine the role of government size in explaining economic growth of the 19
OECD countries during 1971–1999. They find that total factor productivity growth and the capital
productivity are weaker in countries that government size is larger. The conclusion is drawn that the
country where a government sector is small has the greater advantage to increase in efficiencies
resulting from reducing tax burden and distortion, and exploits the greater market discipline to
improve efficiency of resource distribution and use. Moreover, a small government could potentially
be effective in providing the legal, administrative, and infrastructure critical for growth, as well as

3
for offsetting market failures. Over-expanding government needs more taxes to finance government
spending, but expanding taxes will be detrimental to economic growth.

Using a model of asymmetric adjustments of output growth to changes in growth of government

spending, Wahab (2011) investigates the effects of aggregate and disaggregate government spending
variables on output growth. The empirical results show that positive growth effects of total
government spending occur primarily when total spending growth is below its trend-growth.
Productivity in public sector for non-OECD countries is higher than productivity in private sector
when spending growth is below-trend growth, but productivity in public sector and private sector is
equal for OECD countries. If considering components of government spending, output growth
effects of government consumption spending has no statistical significance, but positive growth
effects of government investment spending occurs when its growth falls below its trend-growth; and
this effect turns negative when government investment spending growth exceeds its trend-growth.
Afonso and Furceri (2010) investigate the effect of total public revenue and expenditure on growth
using panel data for a set of OECD and a subset of EU countries during 1970- 2004. Each fiscal
variable is measured by size as a percentage of GDP and business-cycle volatility. They come to the
conclusion that total government revenue and spending both size and volatility measures have a
negative effect on growth. By employing the quantile regression to investigate the relationship
between government size and economic growth using a panel data set for 24 OECD countries, Chen,
Chen et al. (2011) show that the effect of government size on economic growth varies through the
quantiles. When the economic growth is low, increasing the size of the government may stimulate
economic growth and have a positive effect. However, as the economic growth rate increases highly,
increasing the size of the government has a negative effect.

What are economic growth effects of government size for developing countries? Vedder and
Gallaway (1998) infer that government services many useful functions and therefore, the growth of
government in emerging economies tends to increase output. Wu, Tang et al. (2010) examine the
causal relationship between government expenditure and economic growth by testing the panel
Granger causality for the panel data of 182 countries (including developing and developed
countries) over the 1950-2004 period, finding strong evidence for supporting both Wagner’s law and
the hypothesis that government spending is helpful to economic growth. However, they also point
out that except that government spending does not Granger cause economic growth for the
developing countries. This may be the fact that the developing countries generally have poor
institutions and corrupt governments, which cause inefficiency of government spending. Recently,
an analysis taking into account the components of government spending is carried out by
Yamamura (2011). He finds that government size has a negative effect on growth due to hampering
capital accumulation. Moreover, when subdividing the sample in OECD and non-OECD, the
negative relationship between government size and capital accumulation is for non-OECD countries
but for OECD countries. The results show that the public sector crowds out private investment for
developing countries, and thereby leading to be detrimental to economic. Altunc and Aydın (2013)
detect the relationship between government expenditure and economic growth for Turkey, Romania
and Bulgaria by using the data for the period 1995-2011. The results show that the share of present
public expenditure in GDP exceeds optimal public expenditure for three countries. They suggest that
these countries should reduce the share of public expenditure in GDP and increase the effectiveness
of public expenditure programs.

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The cross-sectional regression approach implicitly assumes that the economic growth process is
based on similar structural properties cross countries in the sample. On the other hand, when
utilizing the nation as the unit of analysis for cross-sectonal, one problem lies in structural
differences between countries (such as politics, institutions and culture…). Structural differences are
very difficult to quantify, and thus difficult to incorporate into an econometric test (Auteri and
Constantini, 2004; Stansel, 2005). If not taken into account the problem in the analysis are likely to
blur the true empirical results. One way to solve this problem is to analysis subnational units within
a single nation. In this case, empirical researchers translate the literature on empirical growth to a
subnational level. There have some empirical studies employed within a country across state/region
levels.

Based on production function to investigate the effect of government size on economic growth in 48
states during the period 1977–1989, Domazlicky (1996) shows that the growth rate of gross state
product (GSP) has no significance to government size and growth rate of GSP per capita has
negative significance to government size. Estimating the relationship between taxes and income
growth using panel data for the forty–eight states in the United States (US) over the 1977-1999
period, (Reed 2008) finds that taxes are associated with significant, negative effects on income
growth. While Bania, Gray et al. (2007) estimate the model of endogenous growth using a panel
data for 49 US states over the period of 1962-1997. By incorporating non–monotonic effects for
fiscal policy, they find that the rising tax effect is initially positive, but eventually turns negative and
consistent with a growth hill.

The study of Schaltegger and Torgler (2004) concentrates on the relationship between public
expenditure and economic growth using the full sample of state and local governments from
Switzerland over the 1981-2001 period. The empirical results show that the negative relationship
between government size and economic growth is a fairly robust. However, expenditure from capital
budgets is no significant impact on economic growth. Auteri and Constantini (2004) analyze the
relationship between fiscal policy and economic growth using panel data for 20 Italian regions
between 1970 and 1995. They find that government investment has positive influence on economic
growth but transfer payments are insignificant. Martínez-López (2005) investigates the impacts of
fiscal variables on productivity growth for Spanish regions over the period 1965-1997. The results
show that productivity growth effect of government consumption is significantly negative and
productivity growth effect of public investment is not always significant. Public investment in
education has a positive impact on the growth, while public investment in health is insignificant.
Besides, taxes and social benefits are detrimental to growth. Dahlby and Feredeb (2008) detect
economic growth effects of tax rates using panel data from Canadian provinces over the period of
1977-2006. There is strong evidence regarding relationship between higher statutory corporate and
top personal income tax rates with lower private investment and slower economic growth. They
come to a suggestion that if the corporate tax rate is cut by 10 %, the annual growth will increase
from 1 to 2 %.

3. Empirical model

We investigate the relationship between the government size and economic growth rate in a sample
of 60 provinces (cross-sections) in Vietnam over the period of 1997–2012 (times series). For this,
following Mankiw, Romer et al. (1992), Kneller, Bleaney et al. (1999), Schaltegger and Torgler

5
(2004), Auteri and Constantini (2004), and Cooray (2009), we employ empirical equation as
follows:

y it = α it + β1 X it + β 2 Z it + ( μ i + ε it ) (1)

In which, μi ~ i.i.d (0,σ μ i ) ; ε it ~ i.i.d (0, σ ε ) ; E ( μiε it ) = 0 ; i = 1…60; t = 1….16. All variables in Eq.
(1) are transformed into their nature logarithm to ensure the steady state level of gross provincial
product (hereinafter GPP) per capita growth. Variable y is the logarithm of real GPP per capita. A
cross-sectional and time series approach is applied; it is possible to use the growth rate of real GPP
per capita as dependent variable. This allows for a more direct estimate of the impact of government
size on regional economic growth than is possible in cross-section model (see Barro, 1990 and 1991;
Domazlicky, 1996; Kneller, Bleaney et al., 1999).

Therefore, subtracting y it −1 for both sides of Eq. (1), we get the following equation:

yit − yit −1 = α it + β 3 yit −1 + β1 X it + β 2 Z it + ( μ i + ε it ) (2)

Eq. (2) is a dynamic model. In which, dy = y it − y it −1 is first difference of y, proxy for growth rate of
GPP per capita. Variable y it −1 on the right of Eq. (2) is proxy for the initial level in growth to
control for productive capacity in the spirit of the neoclassical growth theory.

The set X indicates various determinants of government size, including the share of provincial
government expenditure to GPP, share of provincial budget revenue to GPP. We use alternative
measures, which reflect the size of government for further assessing the sensitivity of estimation
results, namely real provincial government expenditure per capita and real provincial government
revenue per capita. The lagged value of GPP (i.e. variable yit _ 1 ) is given and per capita budget
expenditures correspondent to the budget planned in year before. An unexpected increase (reduce)
of GPP will reduce (increase) the share of government expenditure and, therefore produce a negative
estimate of government expenditure’s share in Eq. (2).

Besides, we include the level of provincial government employment in the model to analyze
government size. Niskanen 1971’s theory of bureaucracy postulates that government bureaucrats
maximize the size of their agencies budgets in accordance with their own preferences and able to do
so because of the unique monopoly position of the bureaucrat. As a result, government size will
increase and government budget is greater that the efficient level. Some empirical studies use this
variable as the measure of government size (see Durden, Garey et al. 1993; Domazlicky, 1996).

The set Z includes some following determinants, which are involved in growth convergence models:

Population growth: Neoclassical growth models argue that in the steady state, the higher population
growth will reduce income per capita, but will have no impact on per capita income growth.
However, in the transition to the steady state, higher population growth has a negative impact on per
capita growth. The argument for the negative impact of population growth in the transition is

6
essentially the same as in the Harrod-Domar model. Population growth leads economies to use their
scarce savings to undertake capital widening rather than capital deepening.

Unemployment: Total employment equals the labor force minus the unemployed. According to
Okun (1962) law, there is the inverse relationship between the unemployment rate and the economic
growth. The implication of Okun's law is that economic growth depends on the amount of labor
exploited in the production process, so there is a negative relationship between output and
unemployment.

The relationship between government size and unemployment is widely developed in the literature.
A large government sector is likely to increase unemployment rate. First, it crowds out the private
sector investment, leading to reducing technical progress, productivity growth and international
competitiveness. As a result, unemployment rate rises (Alesina and Perotti, 1997). Second, a large
government sector may also result in high government expenditure that requires high taxes. This
reduces the disposable income of households and also the profitability of private investment
(Alesina, Ardagna et al., 2002). With these effects, the unemployment rate tends to increase.

Private investment and human capital accumulation: The importance of private investment has been
widely developed in the literature. OECD (2006) shows by fuelling investment and entrepreneurship,
the private sector contribute to sustained economic growth and create more jobs and increase
incomes of the poor. In turn, this will generate the revenues that governments need to improve
health, education and infrastructure services and so help improve productivity. Endogenous growth
models assume that private investment and accumulation of human capital can generate sustained
economic growth, even in the absence of technological change and population growth (Romer,
1986; Lucas, 1988; Mankiw, Romer et al., 1992).

Infrastructure development: Infrastructure development is involved in both public and private sector.
The important role of infrastructure for social economic development has been well emphasized in
the literature (Sahoo and Dash 2008; Sahoo and Dash, 2009). The empirical literature examines the
impact infrastructure on growth using variety of definitions of infrastructure development. There is
an infrastructure index by taking six major infrastructure indicators (Sahoo, Dash et al., 2010) such
as: (i) per capita electricity power consumption; (ii) per capita energy use; (iii) telephone line (both
fixed and mobiles) per 1000 population; (iv) rail density per 1000 population; (v) air transport,
freight million per kilometer; and (iv) paved road as percentage of total road. In this study, we use
the indicator of telephone line per 1000 population to measure infrastructure development due to
data available.

Terms of trade: Terms of trade trends reflect changes in relative prices of exports to imports.
Changes in terms of trade can have substantial impacts in open economies. Some recent studies have
supported the hypothesis of a positive growth impact of terms of trade (Deaton and Miller, 1996;
Bleaney and Greenaway, 2001). The rise in the relative price of exports creates the feasible set for
purchasing greater amounts of production inputs, and for investing in productivity enhancing
measures. Consequently, an increase in a country’s terms of trade in turn results in economic growth.
An alternate hypothesis is the resource curse. This hypothesis assumes that an improvement in terms
of trade from natural resources would adversely impact on economic growth because such an
improvement would create opportunities for rent seeking (Baland and Francois, 2000). Such rent
seeking actions tend to be non-productive and inefficient, which are detrimental to economic growth.

7
In globalization literature, the relationship between terms of trade and the size of government is
commonly discussed. Epifani and Gancia (2009) theoretically argue that more open economies
increase government size through the channel of terms of trade externality, whereby trade decreases
the domestic cost of taxation. Their theoretical prediction depends on the elasticity of substitution
between domestic and foreign goods. By empirical study, Epifani and Gancia (2009) find that there
exists a low elasticity of substitution between domestic and foreign goods. They recommend that
globalization may have led to inefficiently large governments.

Inflation rate: Inflation can generate a positive effect on growth, this may be the fact that higher
inflation results in investing more in physical capital by private sector. But at the same time,
inflation raises the transaction cost of economic activities and may lower economic growth (Zhang
and Zou, 1998).

4. Data

The government structure in Vietnam is organized into central government and local governments,
with the letter comprising of provincial government, district government, and commune government.
At present, there are 63 provinces. Provinces are divided into approximately 611 districts, which are
divided into around 10.602 communes (Matinez-Vazquez, 2005). The main feature of Vietnam’s
administrative system is in its vertical structure, whereas a hierarchical relationship can be seen in
the accountability and reporting system of local governments. Local governments are accountable to
the upper level government. All local government budgets get consolidated into the provincial
government budget.

Data for Eq. (2) are panel data on 60 provinces for the period of 1997-2012. Cross-sections and time
series are chosen to accommodate data availability from General Statistics Office of Vietnam. There
are three out of 63 provinces eliminated due to data not available. We define and calculate the
variables in our estimations, which are summarized in Table (1):

ƒ Growth rate of real GPP per capita ( grow _ r ) = The first deference of log of real GPP per capita
(lrgdp) in each province.
Gross domestic product by provincial data (i.e. gross provincial product) is in nominal terms
available from General Statistics Office of Vietnam. In fact, each province has its own
individual deflator and cost of living index. However, these are neither readily available nor
comparable; it is not feasible to calculate real GPP by province back past the given data set. We
instead calculate real GPP by deflating nominal GPP in each province using national price
deflator for gross domestic product (GDP) measured by ratio of nominal GDP to the real GDP.
The nominal GDP of a given year is computed using that year's prices, while the real GDP of
that year is computed using the 1994 year's prices. A measure of real GPP per capita is to divide
real GPP by the number of people in a province.
ƒ The size of provincial government is measured: (i) Log of the share of provincial government
expenditure to GPP (lgov_exp). Provincial government expenditures consist of investment
expenditures and current expenditures, and expenditures for targeting programs. We also
estimate an alternative measure of this variable, namely log of real provincial government
expenditure per capita (lexp_per) adjusted for inflation.

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 (ii) Log of the share of provincial government revenue to GPP (lgov_rev). Provincial budget
revenue includes the tax revenues assigned 100 percent to provincial governments, shared taxes
between the central and provincial governments, and transfers/supplementary revenues offered
from central budget to provincial budgets. Two types of transfers, such as equalization and
conditional transfers are established by identifying their different policy strategies under the
State Budget Law. An alternative measure is log of real provincial government revenue per
capita ( lrev _ per ).
ƒ Government employment growth (lgov_emp) = Log of the share of provincial government
employment to total provincial labor force. Provincial government employment consists of
officials, staffs and employees managed by local governments, exclusively employees of state
owned enterprises.
ƒ Population growth rate (pop_r) = First difference of log of total population in each province.
ƒ Private investment growth ( linv _ priv ) = Log of the ratio of private investment to GPP in each
province.
ƒ Capital human accumulation growth (lhum) = Log of share of enrollment numbers in vocational
schools, community colleges and university to total population in each province.
ƒ Unemployment growth ( lunemp ) = Log of unemployment rate in each province.
ƒ Infrastructure development (linfr_dev) = Log of amounts of telephone lines (both fixed and
mobiles) per 1000 population in each province.
ƒ Growth of terms of trade ( ltot ) = Log of ratio of export prices to import prices in each province.
ƒ Inflation ( lcpi ) = Log of consumption price index in each province.

Table 1
Statistical description of variables in our estimations

Variables Obs Mean Std. Dev. Min Max

Log of real GPP per capita (lrgpp) 960 1.199 0.639 -0.721 4.068
Growth rate of real GPP per capita (grow_r) 960 0.070 0.082 -0.894 0.802
Government size
ƒ Log of Share of Provincial Government 960 3.093 0.634 1.023 4.960
Expenditure to GPP (lgov_exp)

ƒ Log of Real Provincial Government 960 -0.312 0.671 -1.873 1.380

Expenditure Per Capita (lexp_per)
ƒ Log of Share of Provincial Government 960 2.502 0.676 0.732 4.291
Revenue to GPP (lgov_rev)

ƒ Log of Real Provincial Government Revenue 960 -0.903 1.044 -3.557 1.919
Per Capita (lrev_per)
Government Employment Growth (lgov_emp) 960 3.454 0.517 1.791 5.437
Population Growth Rate (pop_r) 960 0.009 0.032 -0.667 0.182
Private Investment Growth (linv_pri) 960 6.499 1.081 3.424 10.239
Capital Human Accumulation (lhum) 891 -0.970 1.307 -4.536 2.503
Unemployment Growth (lunemp) 960 1.539 0.397 -1.753 2.35
Infrastructure Development (linfr_dev) 960 4.310 1.290 0.431 7.822
Growth of Terms of Trade (ltot) 960 0.558 1.395 -3.256 6.442
Inflation (lcpi) 960 4.678 0.066 4.508 5.561
Source: General Statistic Office Vietnam.

5. Economic approach

9
5.1. Generalized Method of Moments approach

When estimating Eq. (2), there is a serious difficulty that arises with fixed effects model in the
context of a dynamic panel data model, containing a lagged dependent variable, particularly in the
small time dimension (T=16 years), large cross-sectional (N=60) context of this study. Nickell
(1981) explains that this problem arises because a technical consequence of the within
transformation N, the lagged dependent variable ( yit −1 ), is that it increases standard errors by
exacerbating any measurement errors. The resulting correlation creates a large-sample bias in the
estimates of the coefficient of the lagged dependent variable, which is not mitigated by increasing N
(Nickell, 1981). If the regressors are correlated with the lagged dependent variable to some degree,
their coefficients may be seriously biased as well.

Moreover, there is especially problematic in the case of data with a small time dimension. Cross-
section estimates produce a bias, caused by the correlation between the lagged dependent variable
with the unobserved individual effects, since the current value of the dependent variable would itself
be dependent on the individual effects, which may disappears in samples with large time dimension.
The alternative would be to use any type of fixed effect technique, eliminating time-independent
effects by taking some kind of difference (for example first differences, within group
transformations, etc.). By first differencing the fixed individual effect is removed because it does not
vary with time. From Eq. (2), we get (u i − u i ) + (ε it − ε it −1 ) = ε it − ε it −1 . In this case, however, the
error term would have some lags and therefore will be correlated with the lagged dependent variable,
thus leading to biased estimates. Several methods have been proposed in the literature. The most
popular is to use a Generalized Method of Moments (GMM) method as proposed by Arellano and
Bond (1991).

In the GMM, the most widely used alternative to the within estimation are the methods for dynamic
panel estimation including Arellano-Bond difference and Blundell-Bond system GMM. GMM
methods are considered superior to the alternatives in handling endogneity, heteroscedasticity, serial
correction and identification. They are specifically designed to capture the joint endogeneity of
some explanatory variables through the creation of a weighting matrix of internal instruments,
which accounts for serial correlation and heteroscedasticity. GMM estimator technique requires one
set of instruments to deal with endogeneity and another set to deal with the correlation between
lagged dependent variable and the error term. The instruments include suitable lags of the levels of
the endogenous variables as well as the strictly exogenous regressors. This estimator can easily
generate a great many instruments, since by period T all lags prior to might be individually
considered as instruments.

The GMM estimator requires moment conditions, which are specified on the regression errors.
Moment conditions are assumed that the instruments are exogenous. For this, the moments of the
errors with the instruments equal to zero. In GMM estimator, we should consider to choose
instruments and regressors in each equation. An equation may be under-identified, exactly identified
and over-identified depending on whether the numbers of instruments in that equation are
respectively less than, equal to or greater the regressors to be estimated. Unfortunately, there is no
guidance in the literature to determine how many instruments are too many (Roodman 2009).
Roodman (2009) suggests a rule of thumb that instruments should not outnumber individuals. For

10
this reason, in this study, we decide to use Arellano-Bond difference GMM because system GMM
uses more instruments than the difference GMM.

In GMM, the Sargan test has a null hypothesis of “the instruments are exogenous”. Therefore, the
higher the p-value of the Sargan statistic is the better. The Arellano-Bond test for autocorrelation has
a null hypothesis of no autocorrelation and is applied to differenced residuals. The test for AR(2)
process in the first differences usually rejects the null hypothesis. The test for AR(2) is more
important, since it detect autocorrelation in levels.

5.2. Pooled Mean Group approach

GMM method forces the parameters to be identical across countries and could lead to inconsistent
and misleading long-term coefficients, a possible problem that is exacerbated when the period is
long. Pesaran, Shin et al. (1999) propose an intermediate estimator, which is called Pooled Mean
Group (PMG) estimator because it involves both pooling and averaging. This estimator allows the
intercepts, short-run parameters and error variances to be heterogeneous between groups while
making the long-run coefficients constrained to be homogeneous. The homogeneity of long-run
coefficients across groups may be due to budget constraints, or common technologies affecting all
groups in a similar way. Moreover, the PMG estimator highlights the adjustment dynamic between
the short-run and the long-run because it assumes that short-run dynamics and error variances
should be the same tend to be less compelling. Not imposing homogeneity of short-run slope
coefficients, the PMG estimator allows the dynamic specification (for example, the number of lags)
to differ across groups. The null hypothesis of the homogeneity in the long-run coefficients can be
verified with the Hausman test. In general, the PMG estimator allows to: (i) estimate long-run
coefficients of the panel; (ii) estimate the speed of adjustment back to equilibrium for each group;
(iii) robustness check of GMM main results.

PMG is estimated by the following equation:

n m
Δy it = χ i S it −1 + ∑ λis y it − s + ∑ δ ij Δ X it − j + ( μ i + ε it ) (3)
s =1 j =1

S it −1 = y it −1 − φX it −1 (4)

In which, S it −1 is the deviation from long run equilibrium at any period for group i, and φ is error
correction coefficient. The short run response of X variables are measured by the vector δ it . The
variables in X are the same as in Eq. (2). However, the selection of the variables into those with long
run effects and those with short run short will be guided by the results from GMM estimations, and
cointegration test.

6. Empirical Results

6.1. Difference GMM results

11
We estimate Eq. (2) to analyze the impact of government size in economic growth. Table (1)
presents the results by applying difference GMM for 60 Vietnam provinces over the period of 1997
- 2012. In column 1, the model does not consider any government size variable. In column 2a, two
government size variables, namely growth of government employment and growth of government
expenditure’s share are included. In column 2b, the model is estimated introducing growth of
government expenditure per capita variable instead of growth of government expenditure’s share.
Regression 3a is estimated considering government size measured as growth of government
revenue’s share. In regression 3b, we replace growth of government revenue’s share by growth of
government revenue per capita.

Table 1
Effects of government size on economic growth rate: Difference GMM method
Dependent Variable: Growth rate of real GPP per capita
Variables (1) (2a) (2b) (3a) (3b)
Real GPP Per Capita Growth (-1) -0.396*** -0.509*** -0.354*** -0.473*** -0.318***
(-3.39) (-4.46) (-3.29) (-4.08) (-3.09)
Private Investment Growth 0.039** 0.052*** 0.027** 0.045*** 0.030**
(3.14) (4.30) (2.45) (3.66) (2.59)
Population Growth Rate -0.924*** -0.877*** -0.904*** -0.874*** -0.964***
(-7.71) (-7.55) (-7.35) (-7.37) (-8.26)
Growth of Government Employment 0.009 0.028 -0.004 0.025 -0.009
(0.22) (0.67) (-0.09) (0.58) (-0.21)
Unemployment Growth -0.013 -0.013 -0.013 -0.013 -0.014
(-1.14) (-1.11) (-1.11) (-1.16) (-1.19)
Human Capital Accumulation Growth 0.034*** 0.039*** 0.029*** 0.037*** 0.030***
(4.26) (5.09) (3.75) (4.72) (3.84)
Growth of Terms of Trade 0.0005 0.0004 0.0006 -0.0003 0.0017
(0.13) (0.09) (0.14) (-0.08) (0.42)
Infrastructure Development 0.043** 0.063*** 0.027** 0.053*** 0.030**
(3.14) (4.59) (2.30) (3.79) (2.33)
Inflation -0.011 -0.031 0.002 -0.018 -0.002
(-0.28) (-0.80) (0.06) (-0.48) (-0.05)
Growth of Government Expenditure’s Share -0.088***
(-5.86)
Growth of Government Expenditure Per Capita 0.057**
(2.94)
Growth of Government Revenue’s Share -0.014*
(-1.88)
Growth of Government Revenue Per Capita 0.019**
(2.39)
Obs (N) 788 788 788 788 788
Number of instruments 12 13 13 13 13
AR(2) test 0.783 0.371 0.920 0.301 0.634
Sargen test 0.322 0.403 0.291 0.167 0.454
Note: * p<0.05 ** p<0.01 *** p<0.001; t statistics in parentheses

12
We highlight some preliminary results from Table (1). Growth of government expenditure’s share
and economic growth have negative sign and are statistically significant at the 1% level (see col. 2a).
We also find that growth of government revenue’s share has a negative and statistically significant
impact on economic growth at the 10% level (see col. 3b). These results are in line with findings of
Domazlicky (1996), Schaltegger and Torgler (2004), and Kirchgässner (2006). The results indicate
that increase in various determinants of government size’s share slow provincial economic growth.

An alternative way is to use growth of real government expenditure per capita and real government
revenue per capita instead of growth of government expenditure’s share and growth of government
revenue’s share as explanatory variable. This is done in regression 3a and 3b in Table (1). Our
findings show that real government expenditure per capita as well as real government revenue per
capita has positive and statistically significant impact on economic growth at the 5% level. These
results are similar to findings of Kirchgässner (2006). It is important to note that the coefficient
signs of government expenditure per capita and government revenue per capita are different with
those of government size’s share. Thus, there is the change of the coefficient signs when using
government expenditure per capita and government revenue per capita as explanatory variable.

We explain this mechanism by analyzing provincial government expenditure (G) as an income

function (GPP):

G = αGPP β (5)

with α > 0 and 0 < β < 1 . By taking logarithms Eq. (5), we get

g = α ' + βy (6)

with g = lexp_per, α ' = log(α ) , y = lrgpp. Assuming that there exists a positive relationship
between log of real government expenditure per capita and log of real GPP per capita, it requires:

∂g
=β >0 (7)
∂y

Figure (1) depicts positive linear relationship between log of real government expenditure per capita
and log of real GPP per capita. The correlation coefficient between two variables is 0.553.

If considering log of government expenditure’s share and log of real GPP per capita, we get:

∂⎛⎜ g ⎞⎟
⎝ y ⎠ = − α < 0 with α > 0 (8)
∂y y2

Where g/y = lgov_exp. Figure (2) shows negative relationship between log of government
expenditure’s share and log of real GPP per capita. The correlation coefficient between two
variables is -0.443.

13
 5

4
Log of real GPP per capita

-1
-2 -1 0 1 2

Log of per capita real government expenditure

Figure 1
Linear positive relationship between real government expenditure per capita and real GPP per capita.

4
Log of real GPP per capita

-1
0 1 2 3 4 5

Log of government expenditure' s share

Figure 2
Linear negative relationship between government expenditure’s share and real GPP per capita.

14
In summary, we get for real government expenditure per capita as well as real government revenue
per capita positive effects that are statistically significant at 5%. These findings suggest that
provinces with higher government revenue leading to higher government expenditure per capita, in
general, likely expand the size of economic pie. On the other hand, provinces with high economic
potential do not only have advantages of raising budget revenue per capita but also providing their
people with more and better public services (Kirchgässner, 2006). However, that is not certain.
Growth rate of government expenditure per capita (or government revenue per capita, respectively)
is restrictively bound by per capita output and provincial government budget constraint because the
negative effect of government expenditure’s share (or government revenue’s share, respectively) on
economic growth actually takes place. On the other hand, the incremental effect of provincial
government expenditure’s share (or government revenue’s share, respectively) eventually becomes
negative for economic growth. From a policy perspective, our findings do not advocate a large
provincial government size, which is detrimental to economic growth. A small government size is
the essential issue and could be effective in providing public services for economic growth as well
as for preventing market failures (Dar and AmirKhalkhali, 2002).

In this study, we also find out other interesting findings. First of all, real per capita GPP growth with
lag (-1), which is proxy for initial growth condition has negative and statistically significant effects
on economic growth at the 1% level. This result can be explained that rich provinces grow slowly,
while poor provinces grow quick. Therefore, there will be convergence in the process of economic
development of all provinces in Vietnam. This implies that poor provinces will be able to catch up
with richer countries in long run. Secondly, the private investment coefficient has a positive sign
that is statistically significant at the 1% and 5% level, respectively. Endogenous growth models
predict that private investment has a positive effect on economic growth. This result suggests that
provincial governments should promote economic growth by motivating and mobilizing private
capital investment. Thirdly, coefficient sign of population growth is negative and significant at the
1% level. Therefore, our results show a strong support for the argument that higher population
growth has a negative impact on per capita growth in the transition to the steady state. As such, we
recommend that provincial policy markers tightly control and reduce the growth rate of population
in order to promote economic growth. Fourthly, we find that a positive and significant relationship
exists between human capital accumulation and economic growth. The positive impacts of human
capital accumulation are more consistent than those found in cross-national studies, such as findings
of Auteri and Constantini (2004) and Fleisher, Li et al. (2010). Our finding suggests that policy
makers at national and provincial level should concentrate their efforts on improving the quality of
education in order to enhance the quality of growth. Lastly, infrastructure development measured by
amounts of telephone lines has a positive and significant impact on growth at the 1% level. This
result suggests that an increase in infrastructure investment stimulates growth.
Provincial governments should aim to implement polices that promote infrastructure development
with a maximum impact on economic growth.

6.2. PMG estimation

Harris and Tzavalis (1999) tests for unit root:

Before estimating PMG, we need to verify that all variables are integrated with the same order and
then proceed to determine cointegration among variables. Our panel dataset has a number of time
periods of 16 years and therefore, existence of unit roots in variables could be a real possibility.

15
However, this is a balanced panel data with large N and relatively small T, so tests whose
asymptotic properties are established by assuming that T tends to infinity can lead to incorrect
inference. Harris and Tzavalis (1999) develope unit root tests for the AR(1) panel data model with
individual-specific intercepts and trends, and serially uncorrelated errors, under the assumption that
N → ∞ while T is fixed. Their simulation results suggest that the test has favorable size and
power properties for N greater than 25, and they report that power improves faster as T increases for
a given N than when N increases for a given T.

In this paper, we extend the fixed T approach of Harris and Tzavalis (1999) to the case where the
errors are generated by a stationary AR(1) process, which is based on an unaugmented Dickey-
Fuller regression. The extension of uncorrelated errors to AR(1) errors in a panel data context
corresponds to the extension of the DF test to the ADF test in a single time series context. We
consider two models, having a unit root under the null hypothesis, and AR(1) errors. The first model
has heterogenous intercepts and the second model has heterogenous intercepts and trends. All
variables are included to test unit root, only except for human capita accumulation variable because
its data is unbalanced, which is not appropriate to Harris and Tzavalis test.

Table 2
Results from Panel Unit Root Test of Harris and Tzavalis (1999)

Variables Intercept Intercept and Trend

z p_value z p_value
lrgpp 1.771 0.961 7.783 1.000
Δ lrgpp or (grow_r) -19.787 0.000*** -30.649 0.000***
lgov_exp 1.278 0.899 -3.518 0.0002 ***
Δ lgov_exp -22.245 0.000*** -38.357 0.000***
lgov_rev -3.581 0.0002 *** -8.198 0.000 ***
lgov_emp -1.065 0.143 0.250 0.599
Δ lgov_emp -22.208 0.000*** -38.762 0.000***
pop_r -19.787 0.000 *** -36.971 0.000 ***
linv_pri -4.920 0.000 *** 2.861 0.997
Δ linv_pri -24.134 0.000*** -41.930 0.000***
lunemp -9.838 0.000 *** -1.980 0.023 **
linfr_dev 5.385 1.000 4.021 1.000
Δ linfr_dev -25.028 0.000*** -37.982 0.000***
ltot -5.651 0.000 *** -11.110 0.000 ***
lcpi -23.317 0.000 *** -25.306 0.000 ***
Notes: 1) *** and ** imply levels significance at 1% and 5% respectively. 2) Null hypothesis is that the series contains
unit roots.

Results from this test are given in Table (2), considering two models. The selection of the
appropriate lag length is made using the Schwarz Bayesian Information Criterion. Results from unit
root tests for two models suggest that log of real GPP per capita (lrgpp), government employment
growth (lgov_emp), infrastructure development (linfr_dev) are non-stationary at level and stationary
at first difference; while, log of share of provincial government expenditure (lgov_exp) and private
investment growth (linv_pri) are non-stationary at level for one out of two tests but stationary at first
difference. The null hypothesis of non-stationarity is not rejected by any of the two tests for five

16
variables: provincial government revenue’ share (lgov_rev), population growth rate (pop_r),
unemployment growth (lunemp), growth of terms of trade (ltot) and inflation (lcpi). Therefore, these
variables are not included in the cointegration relation. We then will employ panel cointegration
techniques for variables: log of real GPP per capita, log of provincial government expenditure’s
share, government employment growth, log of private investment, and log of infrastructure
development.

Pedroni (1999) tests for Cointegration:

We apply cointegration test proposed by Pedroni (1999). Pedroni’s cointegration test takes into
account heterogeneity in the intercepts and slopes of the cointegrating equation. Therefore, this
method can be considered as a better technique because it is unrealistic to assume that the vectors of
cointegration are identical among groups on the panel. Moreover, it also overcomes the problem of a
small sample size and more than one cointegrating relationships. This test is based on the estimated
residuals from the following long-run model:

m
y it = α i + ∑ β j X it + ε it (9)
j =1

Where i = 1, …, N and t =1, …, T; ε is residuals; y is log of real GPP per capita (lrgpp); and the set
X includes log of share of provincial government expenditure (lgov_exp), private investment growth
(linv_pri), government employment growth (lgov_emp), and infrastructure development (linfr_dev).
The estimation of residuals is structured as follows:
) ) )
ε it = ρ i ε it −1 + u it (10)

While the null hypothesis is no cointegration, Pedroni (1999) proposes seven alternative statistics to
test panel data: four of them are based on the within-dimension (panel tests) test while the other
three are based on between-dimension (group tests) approach. For the tests based on “within
dimension”, the alternative hypothesis is ρ i = ρ < 1 for all i, while with test statistics based on the
“between dimension”, the alternative hypothesis is ρ i < 1 for all i. (Pedroni 2004) also suggests that
the two statistics tests, which have better small sample properties are panel-ADF test and group-
ADF test. These two statistics tests are more reliable.

Table (3) presents Pedroni’s panel cointegration test results between the log of real GPP per capita
and log of provincial government expenditure’ share in Eq. (9). Except for the p-stat test, results of
the within-group tests and the between-group tests show that the null hypothesis of no cointegartion
cannot be rejected at 1% and 5% significant level. Thus there exists a long run relationship between
between the log of real GPP per capita and log of government expenditure’ share for the panel of 60
provinces over 1997 – 2012 period in Vietnam.

17
Table 3
Pedroni’s panel cointegration test results

Model Within-dimension (panel) Between-dimension (group)

(Weighted)
v − stat. p-stat. PP-stat. ADF-stat. p-stat PP-stat ADF-stat
lrgpp lgov_exp 9.454*** 4.247 -2.634** -3.936*** 5.771 -5.529*** -4.286***
lgov_emp linv_pri
linfr_dev
Notes: Results with deterministic intercept and trend. (**) and (***) indicate 5% significance level and 1% significance
level, respectively.

Pedroni’s cointegration test identifies the existence of long run relationship between variables,
however, does not provide the magnitude of this relationship. Thus, we employ PMG technique to
identify the appropriate sign and the size of the coefficient in the long run equation.

Pooled Mean Group estimation results

The PMG technique allows for only one cointegartion relation. Our main interest in this study is to
test a long run between government size and economic growth. Based on the results of cointegration,
we proceed to PMG estimation of long run relation between log of government expenditure’s share
and log of real GPP per capita. The results of PMG estimation are presented in Table (4). The
estimate provides interesting results. First of all, the error correction term has the positive sign and
significant at the 1% level. This result shows that an adjustment dynamic from short-run to long-run
in between government expenditure’s share and real GPP per capita is explosive. That means that an
adjustment of government expenditure’s share to equilibrium of growth is divergence across
provinces in Vietnam.

Secondly, the long run coefficient of government expenditure’s share is negative and significant at
the 5% level. Hence, our results from estimated panel cointegration and PMG estimator suggest a
negative long run relationship between government expenditure’s share and GPP per capita in all
Vietnam provinces over the period of 1997-2012. Thirdly, the short-run coefficients are statistically
significant at the 1 and 5% level. However, correction mechanism from the short run disequilibrium
to the long run equilibrium is not convergent. A novel finding that is not found by GMM estimation
is negative short run effect of government employment. The result is different from finding of
Durden, Garey et al. (1993) and similar to finding of Domazlicky (1996). Government employment
is not related to growth rate of GPP (in GMM estimation) but is negatively related to growth of per
capita GPP (in PMG estimation).

Lastly, short run outcomes of private investment and infrastructure development are robust
compared to the preceding GMM results. The Hausman test indicates that the null hypothesis of
common coefficients MG and PMG estimators is not rejected. Hence, PMG estimation is
appropriate.

18
Table 4
PMG estimations

Long run cointegration vectors PMG estimation MG estimation

Normalized variable: Real GPP per
capita
Variables (2) (3)
Government expenditure’s share -7.469 0.048
(-3.07)** ( 0.07)
Short run dynamics
Dependent variable: Real GPP per capita
Error correction 0.009 -0.004
(5.11)*** ( -0.34)
Δ Government Expenditure’s Share -0.168 -0.175
(-6.14)*** ( -6.29)***
Δ Private Investment 0.032 -0.039
(2.79)** ( -2.03)**
Δ Government Employment -0.159 -0.178
(-3.15)*** ( -2.97)**
Δ Infrastructure Development 0.026 0.027
(2.56)** ( 1.67)*
Obs 900
Log Likehood 1741.509
Hausman Test χ 2 = 0.27
H0: Difference in coefficients not
Pro> χ : 0.991
2
systematic
Notes: (*), (**) and (***) indicate 10%, 5% and 1% significance level, respectively. Z-values are in parenthesis

7. Conclusion

There are several studies that investigate relationship government size and economic growth.
Previous studies generally have found significant effects, either positive or negative, of government
spending or taxation on economic growth. While most of the studies on economic growth have been
employed across countries, a few researchers have applied the framework to a single country
analysis. This study examines the nexus between provincial government size and economic growth
in Vietnam using the panel data of 60 provinces over the period of 1997-2012. We use the dynamic
panel model, which allows us to include endogenous regressors as proposed by previous studies. We
use respectively various measures, which reflect the size of government: provincial government
expenditure’s share to GPP, provincial government revenue’s share to GPP, real provincial
government expenditure per capita, and real provincial government revenue per capita, and level of
government employment.

By difference GMM estimators, the main results are the following. The coefficients of government
expenditure’s share and government revenue’s share are negative, while the coefficients of real
government expenditure per capita and real government revenue per capita are positive. These
results are similar to findings of Schaltegger and Torgler (2004) and Kirchgässner (2006). Provinces
with high economic potential have advantages not only of raising budget revenue per capita but also
providing their people with more and better public services. However, that is not certain. Growth
rate of government expenditure per capita is restrictively bound by per capita output and

19
government budget constraint. Empirical results show that the negative effects of government
revenue’ share and government expenditure’s on economic growth actually take place.

Results from unit root tests and panel cointegration suggest that there exist long run cointegrating
relationship between government expenditure’s share and economic growth. Additional results from
PMG estimators help to identify the long run and short run relationship between government
expenditure’s share and economic growth. We find that the long run and short run coefficient of
government expenditure’s share are negative. Moreover, the correction mechanism from the short
run disequilibrium to the long run equilibrium is not convergent. A novel finding is negative effect
of government employment. From a policy perspective, our findings do not advocate a large
government size, which is detrimental to economic growth. A small government size is the essential
issue and could be effective in providing public services for economic growth as well as for
preventing market failures. On the other words, in the future Vietnam government should enforce
public sector reforms in order to improve the quality of public administrative service and public
service.

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