GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 1

Government Expenditure and Economic Growth Relationship:

Co-integration and Causality tests for Pakistan
Abdul Karim
Ayesha Riaz
Iqra Kabir
Abstract
This study examines the Wagner’s and Keynesians Law to state the causal relationship between
economic growth and government expenditure. Annual time series data is used over the period
1976-2013. Augmented Dickey-Fuller (ADF) and Phillip-Perron (PP) used to find the order of
integration. Long run relationship is detected by Autoregressive Distributed Lag (ARDL)
Bounds Test techniques and Granger Causality tests are used to see causality flow. The estimated
results suggest that there is a long run relationship between economic growth and government
expenditure. And the study provides support for the Wagner’s Law that economic growth
granger-cause the government expenditure.
Keywords: Government expenditure, economic growth

Government Expenditure and Economic Growth Relationship:

Co-integration and Causality tests for Pakistan

Pakistan’s economy is facing challenges like energy shortages, poor law and order
conditions, floods and rains and structural impediments that are giant obstacles in the growth of
the country. During this outgoing year the economy of Pakistan has shown many signs of growth
in the economy. The economy of Pakistan is growing on average at the rate of 2.9% per annum
since last five years. In 2014-15 GDP growth has accelerated to 4.24%. Per capita income in
Pakistan has shown a significant increase of 9.25% in 2014-15. Investment is very important
factor for the growth but it has been facing challenges since last five years and now the situation
is improving. Total investment is recorded at 15.12% of the GDP. On the other side, fiscal deficit
was recorded at 3.8% of the GDP during the fiscal year 2014-15 (Economic Survey of Pakistan
2014-15)
Pakistan’s economy has experienced many fiscal imbalances since its existence. Fiscal
policy of the Pakistan has always been weak. Fiscal policy consists of taxes and government
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 2

expenditures which effects the growth of the country. It includes the policies used for meeting all
kind of expenditures using revenues. In fiscal structure of Pakistan there are current and
development expenditures, and to fulfill these non-tax and tax revenue are used. Tax revenue is
generated from direct and indirect taxes. Adjustments in the policy are made by the governments
to achieve macroeconomic goals, like full employment level, consistent economic growth and
stable economy. Development expenditures have always been neglected in Pakistan whereas
current expenditures had the biggest share. Current expenditures were always above 12 percent
as a percentage of GDP and it prominently increased during 1980’s and was almost 20 percent. It
started to decline after 1999. Development expenditures as a percentage of GDP declines sharply
in 1990’s and in 2001 it was just 2 percent. After 2001 it started to increase. On the revenue
side, non-tax revenue showed increasing trend after 1997 earlier in 1972 it started from 2.6
percent of GDP and then reached 5.5 percent in 1992 and again declined till 1997. Tax revenue
was below 11 percent after 2000 but in 1990’s it was about 12 to 14 percent. Pakistan has a weak
and an unfair tax system.
Wagner’s and Keynes Law explain the correlation between economic growth and
government expenditure in contrast. In 1893 Adolph Wagner formulated the law of increasing
government expenditure and named it as Wagner’s Law. This law proposes that if economic
growth proceeds it would give rise to high government expenditure. The main reason behind this
relationship is that government expenditure is a habitual outcome of economic growth. In the
same way, government expenditure is an endogenous factor that is operated by the economic
growth. On the other side Keynes Law suggests that raise in government expenditure would lead
to growth. So the government expenditure is an exogenous variable to effect economic growth.
So in Wagner’s Law growth causes government expenditure an in Keynes Law government
expenditure causes growth.
After introduction, next section is the brief review of the literature regarding this topic for
Pakistan and few other countries. Those studies investigated the Wagner’s and Keynesian Law
using different set of variables and methodologies, and investigated the outcomes of fiscal policy
on the growth. This provides a brief theoretical lens to our study and then literature review is
followed up by the research questions which will be answered in this paper. And the next section
describes the methodology, firstly model of the study and then brief introduction to the following
methodologies: ADF Unit Root Test, ARDL Bounds Test and Granger Causality Test. After
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 3

methodology, results and analysis are given for the period 1976-2013 using time series data. All
the above sections are then concluded into one section named conclusions. On the base of this
study few recommendations are made. And the paper ends up with references.

Research Questions
 Whether there exists a long run relationship between government expenditure and
economic growth or not?
 Whether economic growth causes government expenditure or vice versa?

Theoretical framework

Leads to

Industrialization & Cultural & Welfare

Modernization Monopolies Laws etc

WAGNER’S
LAW
Government
Economic Expenditure
Growth
KEYNESIAN VIEW

Investment in
Outcome Human capital,
infrastructure
s
others
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 4

Literature Review

Many researches have been done to investigate the effects of economic growth (GDP)
and government expenditure (G) their causality and co-integration. Many studies found the
causal relationship between G and GDP to examine whether Wagner’s or Keynesian Law is true
in the case of Pakistan. All the different researches ended up with different results.
Shaheen and Turner analyzed the effects of fiscal policy shocks in Pakistan. It was done
for the period 1973-2008. GDP, inflation, interest rate, net taxes and government expenditure
were used to estimate the results. Structural Vector Auto Regression model was used to see the
effects of these variables. The result suggests that government spending positively affects the
output and inflation.
Ahmad (2011) worked on the fiscal policy and growth in Pakistan. OLS procedure was
used. It covers data for the period 1982 to 2010. The variables were government expenditure and
government revenues divided into further sections. It is found that federal tax revenue
contributed negatively to the economic growth. Development expenditures have positive impact
on growth whereas current expenditure plays no role in increasing the growth in Pakistan.
Fatima et al. (2011) researched the fiscal deficit and growth of Pakistan. Time series data
was used from 1980 to 2009. The variables were real GDP per capita, investment, imports,
exports, fiscal deficit, real interest rate, and population growth and inflation rate. The 2-stage
least square method was used to find the results. They concluded that fiscal deficit has adverse
effects on the economic growth of a country.
Ogbole et al. (2011) analyzed the influence of fiscal policy on the economic growth in
Nigeria from 1970 to 2006. The variables of the study were government expenditure, inflation
rate, private investment, exports and capital inflow. The research involved the stationarity test,
co-integration test and OLS regression. The results suggest that economic growth was at
different levels during and after the regulation periods and significant during deregulation.
Zagler and Durnecker (2003) investigated the fiscal policy and the economic growth.
Government expenditures and taxes were divided into further sections for analysis in the
research. The result suggests that several taxes and expenditures have direct impact on the
growth of the country because they are significant.
Kneller et al. (1999) worked on the alliance between economic growth and fiscal policy.
Their research found that, distortionary taxation negatively effects the growth, whereas non-
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 5

distortionary taxation has a constructive impact on growth. And productive expenditure increases
growth, whereas non-productive don’t.
Cashin (1995) analyzed the relationship between government spending, taxes and growth.
He took cross sectional data from 23 developed countries for the period 1971-1988. Endogenous
growth model was developed in this paper to see the impact of public transfers, public
investment and distortionary taxes on growth. The results propose that increasing the level of
government spending on public investment and transfer payments will increase the economic
growth and private investment.
Landau (1983) analyzed government expenditure and economic growth. His study reviews the
interrelation between the government consumption expenditure and the growth rate of real GDP
per capita. The data was from 1961 to 1976. Cross country study was done on 96 countries. He
developed that there is an anti-relationship between government consumption expenditure and
the growth rate of real GDP per capita.
Ali and Ahmad (2010) studied the effects of fiscal policy on the economic growth of
Pakistan. The variables included in the study were growth rate of GDP per capita, inflation,
account deficit, private investment current and fiscal policy variables. They took data from 1972
to 2008. This study used ADF, PP and Ng-Perron unit root tests, and used robust econometric
technique and ARDL model to review the long-run equilibrium.
Lamartina and Zaghini analyzed the expanding public expenditure and Wagner’s Law in
OECD countries. They used ARDL model for this research using pooled mean group (PMG)
methodology. They took data from 1989 to 2006. The result suggests the public spending and
GDP growth rate have positive long-run correlation.
Henrekson (1993) studied the Wagner’s Law. He analyzed the data for the period 1861-
1990. He did this research on Swedish data. The variables were real income and government
expenditure. The results conclude that these two variables have no long-run relationship.
Katrakilidis and Tsaliki (2009) analyzed the relationship between government spending
and growth. It covers the period 1958-2004 using the data for the Greek economy. They found
long-run equilibrium between economic output and government expenditure. They are causative
both in long and short run.
Malik et al. (2006) worked on fiscal decentralization and growth in Pakistan. The
variables were real GDP, openness to GDP ratio, inflation rate, total government expenditures
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 6

and total government revenue along with few decentralization variables. They took data for the
period 1971-2005. They used ADF test to check the stationarity of the variables. Then they
estimated the model using simple OLS method. They found mixed results few variables were
significant and other insignificant.
Aisha and Khatoon (2009) investigated the causality and co-integration between tax
revenue and government expenditure. They did this research in the case of Pakistan for the
period 1972-2007. Unit root test and Engle Granger co-integration test were used in this
research. The result defined the relationship that government expenditure causes tax revenues.
Samudram et al. (2009) analyzed the Keynes and Wagner law for the developing country.
They took data from 1970 to 2004 for Malaysia. The variables were GNP and sector wise
government expenditures. They used Philip-Perron unit root test, Gregory-Hansen structural
break test and ARDL model. The empirical results showed that there exists long-run correlation
between Gross National Product and total expenditures.
Antonis et al. (2013) investigated the Wagner’s and Keynesian Law. They took data for
over a century, 1833-1938 for Greek economy. ARDL test and co-integration methods were
used. The results were in the support of Wagner’s law in Greece; it shows positive and
significant causal effect from income to government spending.
Angelopoulos and Philippopoulos studied the effects of fiscal policy in Greece. They
analyzed the data for several kinds of government expenditures and taxes and real GDP per
capita for the period 1960-2000. They used ADF, Durbin-Watson and Ramsey RESET tests.
Results show that a small public sector is enough for growth and government should look
beyond efficiency, formation and size of the public sector.
Kumar et al. analyzed the Wagner’s Law, co-integration and causality for New Zealand.
Data from 1960 to 2007 was used for this research. They used output measures of GDP and GNP
and compared their results. The methodologies which were followed in this research include
ARDL, Engle and Granger, Phillip Hansen’s modified OLS and Johansen’s time series
techniques. The result observes the existence Wagner’s Law.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 7

Methodology

Model
lnGDP t=α 0 +lnG t +ε t 1 (1)

lnGt =β 0 +lnGDP t +ε t 2 (2)

Where:
GDP = Gross Domestic Product
G = Government Expenditure
α 0 , β 0 = Constant
ε = Error Term

The data for GDP and G is in constant 2005 US $. Annual time series data for the period 1976 –
2013 is used. Logs of both variables have been taken to estimate the results in this research. The
main data source is The World Bank. The methodology which we applied in this study is from
the research paper of Kumar et al. who analyzed the Wagner’s Law, co-integration and causality
for New Zealand.
Level of Integration. We used Unit Root Test to check the stationary of the variables. As
we know these macroeconomic variables continue to change over time and it makes them non-
stationary. If the research is done using non-stationary variables, it will show unreliable causal
relationships between variables which will lead to spurious research. Mostly variables are not
stationary and to make them stationary /we can subtract a trend or taking one or more difference.
ADF unit root test is used. It is valid for the large samples of the data. Null and alternative
hypothesis are stated below:

H 0 = Series is non-stationary
H a = Series is stationary
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 8

ARDL Approach. Autoregressive- Distributed Lag is used for checking long run
equilibrium between time series variables. As order of integration is different so we can use the
ARDL approach. As well as this technique is suitable for the small set of data.
ARDL Bounds Test technique used to find out the long run correlation between GDP and G and
there co-movement. Null and alternative hypothesis are stated below:

H 0 = No long-run relationship exist

H a = Long-run relationship exist

Value of F-statistic in bounds tests informs about the existence of long run relationship. The
estimated models for the ARDL Bounds Test are following:

p 1−1 q 1−1
∆ lnG t=∝0 G + ∑ b iG ∆lnG t−i + ∑ c jG ∆ lnGDP t− j+ σ 1 G lnGt −1+ σ 2 G lnGDP t −1+ ε 1 t
i=1 j=0

(3)

p 2−1 q 2−1
∆ lnGDP t =∝0Y + ∑ biY ∆ lnGDPt −i+ ∑ c jY ∆ lnG t− j + σ 1 Y lnGDPt −1+ σ 2 Y lnG t−1 +ε 2 t
i =1 j=0

(4)
Granger Causality. This test is used for time series variables to see whether A causes B
or vice versa. It not only explains causality between the variables but also identifies one variable
precedes the second or the other way. The model should be fully specified for checking
Granger’s causality otherwise it may give spurious results.
If there exists co-integration it means there can be causality between the variables, which we will
be detected using Granger Causality Wald Test. Following models will be estimated:

n n
∆ lnG t=α 1 + ∑ θi ∆ lnG t−i + ∑ k j ∆ lnGDPt − j + ε 1t (5)
i=1 j=1
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 9

n n
∆ lnGDP t =α 2+ ∑ k i ∆ lnGDPt −i+ ∑ δ j ∆ lnGt − j +ε 2 t (6)
i=1 j=1

There will be null hypothesis that A does not Granger-causes B and its alternative hypothesis. In
this study we will reject or accept the hypothesis based on the value of ‘Chi-Squared’ obtained
by Wald Test. Direction of the causality will also be found through this.
Results and Analysis
First of all we have conducted the ADF unit root test for Gross Domestic Product (LNGDP) and
Government Expenditure (LNG) to check stationary. Table 1 shows the results for the given test.
Table 1

ADF Unit Root Test

Variables At Level At First Difference

Intercept Intercept and Intercept Intercept and
Trend Trend
LNG -0.713 -1.953 -7.403** -7.316**
(0.831) (0.607) (0.000) (0.000)
LNGDP -3.049 -2.119 -3.835** -4.979**
(0.039)* (0.5180) (0.006) (0.001)

**Significant at 1% level
*Significant at 5% level

The result of unit root test suggests that government expenditure (LNG) is not significant at level
but it is significant at first difference. It is significant with both intercept and intercept and trend.
It shows significance at 1% level. Null hypothesis is rejected because the variable is stationary at
first difference.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 10

Whereas the unit root test for LNGDP suggests that it is significant at level with intercept only at
5% level. Null hypothesis is rejected because the variable is stationary at level. Whereas at first
difference it is again significant with both intercept and intercept and trend.
Phillip-Perron Unit Root Test was also applied to check the stationarity of the variables but it
also shown the same results as that of ADF test.
As ADF suggests the different order of integration, we can apply the Autoregressive Distributed
Lag (ARDL) approach. Both short and long run coefficient would be estimated using ARDL.
When the dependent variable is LNGDP, ARDL (1,0) model is selected using Akaike
Information Criterion.
ARDL Co-integrating and Long Run Form
Table 2
Short-Run Coefficients
Variable Coefficient Std. Error t-Statistic Probability
D(LNG) 0.013994 0.025327 0.552531 0.5842
Co-intEq (-1) -0.035239 0.026492 -1.330173 0.1923
Long-run Coefficients
LNG 0.397111 0.432922 0.917281 0.3655
C 17.271188 10.736593 1.608628 0.1169

The short run coefficient is 0.013994 and insignificant (p-value>0.01). Long-Run coefficient is
also insignificant with 0.397111(p-value>0.01). We can see insignificant short run and long run
relationship between GDP and G when dependent variable is LNGDP.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 11

Graphical representation for the Lag Selection of the ARDL

This Akaike Information Criteria shows the different sets of lags from which the best one is
selected i.e. ARDL (1,0).
When the dependent variable is LNG, ARDL (2,3) model is selected using Akaike Information
Criterion.
ARDL Co-integrating and Long Run Form
Table 3
Short-Run Coefficients
Variable Coefficient Std. Error t-Statistic Probability
D(LNG(-1)) -0.327329 0.173884 -1.882454 0.0702
D(LNGDP) 0.653472 0.832422 0.785025 0.4390
D(LNGDP(-1)) 0.074762 1.234772 0.060547 0.9521
D(LNGDP(-2)) 1.580315 0.813356 1.942956 0.0621
Co-intEq (-1) -0.193793 0.129511 -1.496347 0.1458
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 12

Long-Run Coefficients
LNGDP 1.415655 0.349608 4.049265 0.0004
C -13.311308 9.186628 -1.448987 0.1584

The short run coefficient is insignificant (p-value>0.01). It shows insignificant short run
relationship between GDP and G. Long-Run coefficient is 1.415655 and significant (p-
value>0.01). It shows there exists a long run relationship between GDP and G and 1 % change in
LNGDP will increase the government expenditure by 1.415655%.
Graphical representation for the Lag Selection of the ARDL

This Akaike Information Criteria shows the different sets of lags from which the best one is
selected i.e. ARDL (2, 3).
Table 6 shows the results for the Autoregressive Distributed Lag (ARDL) Bounds Test.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 13

Table 6
Dependent variable
Government Expenditure Gross Domestic Product
Test Statistic Value K Value K
F-statistic 6.331078 1 3.032681 1

Critical Values for Bounds Test

Significance I0 Bound I1 Bound
10% 4.04 4.78
5% 4.94 5.73
2.5% 5.77 6.68
1% 6.84 7.84

ARDL Bounds Test estimated the long run relationship between GDP and G. When the
dependent variable is G, F-statistic is 6.331078 that is greater than bounds critical value at 2.5%
level and is significant. This will result in the rejection of null hypothesis as there exists a long
run relationship between GDP and G. With GDP as a dependent variable, F-statistic is 3.032681
which is less than bounds critical values. So it is insignificant and we are unable to reject the null
hypothesis. GDP and G shows no long run relationship.

The estimated results of ARDL Bounds Test found the long run relationship between GDP and
G. To find the direction of the causality, we will apply Granger Causality Walt Test. Table 7
shows the results for the given test:

Table 7
Dependent Variable: D(LNG)
Independent
Variable χ 2 –Statistic Df Probability
D(LNGDP) 13.16085 2 0.0014
All 13.16085 2 0.0014
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 14

When the dependent variable is LNG, the value of chi-square is 13.16085 (p-value=0.0014)
which is significant. And GDP granger causes G. We will reject the null hypothesis because
there is bidirectional causality from GDP to G. The result supports Wagner’s Law.

Table 8
Dependent variable: D(LNGDP)
Independent
2
Variable χ –Statistic Df Probability
D(LNG) 0.004159 2 0.9979
All 0.004159 2 0.9979

When the dependent variable is LNGDP, the results are insignificant the value of chi-square is
0.004159 (p-value=0.9979). G does not granger cause GDP. So the null hypothesis is accepted
that G does not Granger causes GDP.
Conclusion
As in this research we investigated the causality and co-integration between G and GDP.
Time series data was used for both variables from 1976 to 2013 to find out whether the Wagner’s
or Keynesians Law holds in the case of Pakistan. First of all we have done ADF Unit Root Test
to check the level of integration. We found LNG (Log of Government Expenditure) was
stationary at first difference, whereas LNGDP (Log of Gross Domestic Product) was stationary
at level. ARDL test was used to check the long and short run coefficients. With LNGDP as a
dependent variable both short and long run coefficients are insignificant and on the other side
with LNG as a dependent variable short run coefficient is insignificant whereas long run
coefficient is significant. It shows that 1 % change in LNGDP will increase the government
expenditure by 1.415655%. Then ARDL Bounds Test was conducted with the null hypothesis of
no long run relationship. F-statistic is significant at 2.5% level with LNG as a dependent variable
so it shows that there exists a long run correlation between them. With LNGDP as a dependent
variable, F-statistic is insignificant and we are unable to reject the null hypothesis.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 15

Granger Causality test was then used to check the causality between these both variables. With
LNG as a dependent variable, the results are significant and show that GDP granger causes G.
When the dependent variable is LNGDP, result shows that G does not granger cause GDP. So
the result of Granger Causality Test provides evidence of Wagner’s Law in Pakistan. As this law
proposes if economic growth increases it would give rise to high government expenditure.

In sum our results show long run relationship between GDP and G and it is consistent with the
Wagner’s Law. No evidence found for the existence of Keynesian Law in Pakistan.

Limitations of the study

To some extent this research tried to achieve its objectives in analyzing the relationship between
G and GDP, their causality and co-integration. But still there are few limitations of the study.
Firstly time period was very short to conduct the research due to which confined set of
methodologies was used on only two macroeconomic variables that are Gross Domestic Product
(GDP) and Government Expenditure (G). Secondly, the data collected for the research was from
1976 to 2013 which is very limited and to get better results the research must be done with a
large data set.

Recommendations
As fiscal policy plays around Government Expenditure and Gross Domestic Product so it should
be modified in such a way that it can achieve macroeconomic goals, like full employment level,
consistent economic growth and stable economy. The expenditures should be divided evenly
between development and non-development expenditures. As in our country the development
expenditures have always been neglected so government needs to pay attention towards them. It
plays a positive role in the economic growth. There is little unnecessary expenditure which is
playing no role in the growth. So it is required to cut down those expenditures and utilize those
resources in a productive manner. There is also a need to improve the tax collection system of
the country, as a large portion of revenue is generated from taxes. So a strong system of tax
collection will generate a good stream of revenues, and then expenditures and that will to lead to
economic growth.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 16

As this study found evidence for the Wagner’s Law in Pakistan. It means growth in the economy
leads to more expenditures. So as the economy grows then it is more willing to increase the
expenditures. Policies should be designed to productively use the expenditures for the
development projects. Growth policies should also be introduced by the government to achieve
high economic growth. They help to boost the economy in many ways and provide a pave to
achieve the future goals of development.
GOVERNMENT EXPENDITURE AND ECONOMIC GROWTH RELATIONSHIP 17

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