International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 16 (2008)

© EuroJournals Publishing, Inc. 2008
http://www.eurojournals.com/finance.htm

An Empirical Investigation on the Nexus between

Tax Revenue and Government Spending: The Case of Turkey

Abu N.M. Wahid

Department of Economics and Finance, Tennessee State University
330 10th. Ave North, Nashville, TN 37203-3401
E-mail: wahid0019@gmail.com
Tel: 615-963-7149(off); Fax: 615-963-7139

Abstract

In order to meet several social, political and military objectives, government

spending often exceeds its tax revenue giving rise to budgetary deficit. There has been an
intense ongoing debate in the macro economics literature as to whether or not this budget
deficit is bad and if so, it is also controversial as to how bad it is. The present paper
hypothesizes that increased government spending can cause tax revenue to rise. In order to
test this hypothesis, this study uses Turkish data and the Granger-causality testing
procedure. The results support the hypothesis that government expenditure causes tax
revenues to increase in Turkey.

Keywords: Turkey, Government Expenditure, Economic Reforms, Tax Revenue.

JEL Classifications Codes: F30, F31

Introduction
The economy of Turkey is dynamic but dualistic. It has very modern industrial and commercial sectors
along with a traditional agricultural sector. Although the industrial and commercial sectors are
growing, still agricultural sector provides employment opportunity to nearly 40% of the total Turkish
labor force. (according to 2001 data: source: www.classbrain.com/art_cr/publish/turkey_
economy.shtml).
In the Turkish economy, private sector is expanding very fast, yet the public sector plays a
dominant role in basic industry, banking, transportation and communication. The most vibrant and
foreign exchange earning sector of the economy is textile and garments which is largely in the hands of
the private entrepreneurs. Lately the Turkish economy performed quite erratically causing serious
macro economic imbalances. In some years, real GDP growth exceeded 6% while in other years such
as 1994, 1999, and 2001, this growth was interrupted by sharp declines in aggregate output and
income.
During the recent past the rate of inflation in Turkey was hovering around 20%. In 2003, it
declined to 18.4%. Due to the problem of double digit inflation and erratic GDP growth, inflow of
foreign direct investment in Turkey remained as low as only S1 billion per annum. During 2000-02
period, mounting trade deficit and liquidity problem in the banking sector caused the economy to slip
into serious crisis. As a result, government was forced to float lira which led to a mild recession in the
economy. Subsequently, substantial financial support from IMF brought back the economy on
International Research Journal of Finance and Economics - Issue 16 (2008) 47

sustainable non-inflationary growth path. Thus the economy is now poised to grow at a rate of 5% or
more in the near future.
However, the government budget deficit is still a problem in Turkey. The public sector fiscal
deficit has regularly exceeded 10% of GDP due in large part to the huge burden of interest payments,
which accounted for more than 40% of central government spending in 2003. Tax revenues, on the
other hand are deficient due to a tax system that has been designed to extract quite heavy taxes from a
paucity of taxpayers. All segments of the Turkish public that are liable to pay tax do not participate in
the tax system. Hence, the state has politically found it convenient to heap it on the backs of those from
whom it can milk more. Thus, there is need for a radical structural reform. The tax reform presently in
dispute is taken to be one of the hottest issues in Turkey. This study uses the Granger-causality testing
procedure to study the causal relationship between government spending and tax revenues in Turkey.

Data and Methodology

In this paper we use the Granger test of causality (1969) to study the causal relationship between
Government Spending and Tax Revenues for Turkey. It states that a variable TR Granger-cause GE if
the prediction of GE is improved solely by the past values of TR and not by other series included in the
analysis. Vice versa is true for GE Granger-causing TR. In this connection, it is necessary to estimate
these two regressions:
n n
GE t = a0 + ∑
i =1
α i TRt − i + ∑
i =1
β i GE t − j + u1t (1)
n n
TRt = a1 + ∑
i =1
λ i TRt − i + ∑
i =1
δ i GE t − j + u 2t (2)

Where GE is Total Government Expenditures, TR is Tax Revenue and u1 and u2 are white-
noise residuals. We will test the hypotheses Ho: ∑αi = 0 and Ho: ∑ δi = 0 respectively for both the
equations. If both the hypotheses are subject to rejection, then we can conclude the presence of
feedback effect between GE and TR. And if only one of the hypotheses is subject to rejection, we can
construe the unidirectional causality from that variable to the independent variable of the equation.
Furthermore, we also anticipate that ∑αi<1, ∑ β i<1, ∑λi<1 and ∑ δ i<1. In addition, the Granger
Causality test is very sensitive to the selection of lags of independent and dependent variables. Some
previous studies like Anderson et. al., (1986); Manage and Marlow (1986); Joulfaian and Mookerjee
(1990); Baghestani and McNown (1994) arbitrarily choose the lag lengths. This arbitrary choice can
not be justified a priori and could generate biased results. As Lee (1997) points out the practice of
choosing similar lag length could be a potential model misspecification. One may argue that the
political and economic history of a country would appropriately elucidate at what year one variable is
causing the other. However, to keep oneself from model misspecification in a situation where one is
not sure as to what lag to use, some alternative measures would have to be acquired. Therefore, a more
proper technique of best-lag selection is adopted using the modus operandi defined here: In our
approach, we use the Akaike Information Criterion (1969) and Schwarz Criterion (1978) to determine
the appropriate lag lengths for GE and TR. Both these tests suggest that a model with the least value of
AIC and/or SC should be chosen. This selection process follows this way: first we regress GE on the
lags of GE excluding TR from where the best lag(s) is determined. Second, using these lags for GE, we
start including lags of TR in the regression so that the suitable lag(s) for TR would be determined. It is
the procedure for selecting appropriate lag lengths for both variables in equation (1) and the same
methodology is adopted for equation (2). We use Normal, First-differenced and Log series for our
analysis. First-differenced series is a good instrument to get rid of any nonstationarity problem and Log
series is used to minimize the variance. It is also worthwhile notifying that Schwarz Criterion is a
better measure of choosing lag lengths since it imposes a harsher penalty of adding more restrictions;
{see Gujarati (2003) for details}. In our analysis, both AIC and SC depict the same conclusion for most
of the cases. Otherwise we use SC for the reason defined above. We use the data for these two
48 International Research Journal of Finance and Economics - Issue 16 (2008)

variables in real terms. We use GDP deflator as the general price level from 1975 to 2003. GDP
deflator is the ratio of GDP in current local currency to GDP in constant local currency. Total
Government Expenditures constitute Current Expenditures. Similarly, Total Tax Revenue constitutes
Direct & Indirect Taxes. Tax revenue comprises compulsory transfers to the government for public
purposes. Compulsory transfers such as fines, penalties, and most social security contributions are
excluded. Refunds and corrections of erroneously collected tax revenue are treated as negative revenue.
All data is obtained from the World Development Indicators CD-ROM. Evidence indicate that we
essentially face unidirectional causality running from Government Expenditure to Tax Revenues.
Moreover, Tax Revenue responds quickly to the changes in Government Expenditure. This would
fundamentally be the case where government expenditures are determined through political
manipulation and then the financial sources are searched to finance these expenditures.

Table 1: Tests for Lag Selection using AIC & SC Normal Series
⎛ GE ⎞ ⎛ TR ⎞
⎜ ⎟, ⎜ ⎟
⎝ P ⎠ ⎝ P ⎠

Dependent Variable Lag of GE Lag of TR AIC SC

1 - 12.7983 12.9093
2 - 12.7317 12.8871
3 - 12.7428 12.9537
4 - 12.8094 13.0758
GE
2 1 12.7872 12.9981
2 2 12.8649 13.1202
2 3 12.987 13.3089
2 4 12.9537 13.3311
- 1 10.5117 10.6116
- 2 10.4673 10.6227
- 3 10.545 10.7559
- 4 10.6338 10.9002
TR
1 1 10.3896 10.545
2 1 10.4451 10.656
3 1 10.545 10.8114
4 1 10.6338 10.9557

Table 2: Granger Causality Test Results between Total Expenditures (GE) and Tax Revenues (TR)

TR ===> GE GE ===> TR
Dependent Variable Lag of GE Lag of TR Final Inference
F-Stats Sig. Level F-Stats Sig. Level
GE 2 1 0.5223 0.4127 - - Unidirectional
Causality from
TR 1 1 - - 5.2327 0.0219
GE to TR
International Research Journal of Finance and Economics - Issue 16 (2008) 49
Table 3: Tests for Lag Selection using AIC & SC First Differenced Series
⎛ GE ⎞ ⎛ TR ⎞
∆⎜ ⎟ , ∆⎜ ⎟
⎝ P ⎠ ⎝ P ⎠

Dependent Variable Lag of GE Lag of TR AIC SC

1 - 12.654 12.7539
2 - 12.6651 12.8205
3 - 12.7206 12.9426
4 - 12.6651 12.9426
GE
1 1 12.7317 12.8871
1 2 12.8538 13.0647
1 3 12.7983 13.0647
1 4 12.654 12.9759
- 1 12.7317 12.8871
- 2 10.4784 10.6338
- 3 10.5561 10.767
- 4 10.6116 10.8891
TR
1 1 10.4895 10.6449
2 1 10.545 10.7559
3 1 10.3452 10.6116
4 1 10.3896 10.7115

Table 4: Granger Causality Test Results between Total Expenditures (GE) and Tax Revenues (TR)

Dependent Variable Lag of GE Lag of TR TR ===> GE GE ===> TR Final Inference

F-Stats Sig. Level F-Stats Sig. Level
GE 1 1 0.0000 0.9999 - - Unidirectional
Causality from
TR 3 1 - - 3.7225 0.0242
GEs to TR

Table 5: Tests for Lag Selection using AIC & SC Log Series
⎛ GE ⎞ ⎛ TR ⎞
LOG ⎜ ⎟ , LOG ⎜ ⎟
⎝ P ⎠ ⎝ P ⎠

Dependent Variable Lag of GE Lag of TR AIC SC

1 - -3.2079 -3.0969
2 - -3.108 -2.9526
3 - -3.1302 -2.9193
4 - -3.0747 -2.8083
GE
1 1 -3.2079 -3.0525
1 2 -3.1413 -2.9304
1 3 -3.1413 -2.8749
1 4 -3.0525 -2.7306
- 1 -3.6408 -3.5298
- 2 -3.5631 -3.4077
- 3 -3.5631 -3.3522
- 4 -3.4854 -3.219
TR
1 1 -3.6852 -3.5298
2 1 -3.5964 -3.3855
3 1 -3.5631 -3.2967
4 1 -3.4743 -3.1524
50 International Research Journal of Finance and Economics - Issue 16 (2008)
Table 6: Granger Causality Test Results between Total Expenditures (GE) and Tax Revenues (TR)

TR ===> GE GE ===> TR Final Inference

Dependent Variable Lag of GE Lag of TR
F-Stats Sig. Level F-Stats Sig. Level
GE 1 1 1.9081 0.1622 - - Unidirectional
Causality from
TR 1 1 - - 3.3213 0.0928 GEs to TR

Conclusion
In this study, the causal relationship between Total Expenditures(GE) and Tax Revenue(TR) has been
analyzed. In general, our results support the hypothesis that government expenditure causes revenues.
The result that TR does not cause GE can best and only be explained by the political economy of
Turkey where the main expenditures are the outlays chiefly determined politically by bureaucratic
influence.
The policy implications of the findings of this study can be better understood in light of the
reform initiative that Turkey undertook in the 1980s. Under this initiative, Turkey wanted to shift her
economy from insulated command system to private sector and market driven model. Reforms
stimulated growth but it was not sustained due to weak banking sector and financial crisis. “Turkey’s
failure to pursue additional reforms, combined with large and growing public sector deficits, resulted in
high inflation, increasing macroeconomic valatility, and a weak banking sector.”
(www.answers.com/topic/economy-of-turkey)
Under the supervision of the IMF, the then Turkish government during 1999-2002, embarked
upon a very ambitious reform plan in the areas of social security, public finance, public and private
banks, financial transparency of the public sector, liberalization of telecommunications and energy
sectors etc. It also tried to control inflation using exchange rate policies. Nothing produced expected
results.
In light of the findings of this study, Turkey now “seeks to improve its investment climate
through administrative streamlining, an end to foreign investment screening, and strengthened
intellectual property legislation. However, a number of disputes involving foreign investors in Turkey
and certain policies, such as high taxation of cola products and continuing gaps in the intellectual
property regime, inhibit investment. The Turkish privatization board is in the process of privatizing a
series of state-owned companies, including the state alcohol and tobacco company and the oil refining
parastatal. In 2004, the Privatization Board privatized the telephone company and some of the state-
owned banks. The government also committed in the World Trade Organization to liberalize the
telecommunications sector at the beginning of 2004.
International Research Journal of Finance and Economics - Issue 16 (2008) 51

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[3] Baghestani,, H., and R. McNown. 1994 “Do Revenue or Expenditures Respond to Budgetary
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