Scandinavian Working Papers in Economics

Working Paper Series,
Research Institute of Industrial Economics

No 818: The Futile Quest for a Grand Explanation of Long-Run Government Expenditure

Dick Durevall () and Magnus Henrekson ()
Additional contact information
Dick Durevall: School of Business, Economics and Law, Postal: Department of Economics, University of Gothenburg, P.O. Box 640, SE-405 30 Gothenburg, Sweden
Magnus Henrekson: Research Institute of Industrial Economics (IFN), Postal: P.O. Box 55665, SE-102 15 Stockholm, Sweden

Abstract: This paper carries out a critical reappraisal of the two contending theories purporting to explain long-run government spending: Wagner’s Law and different variants of the ratchet effect. We analyze data spanning from the early 19th century until the present day in Sweden and the United Kingdom. Hence, in contrast to previous studies, we evaluate the validity of Wagner’s Law and the ratchet effect hypothesis over a very long time period, starting at the beginning of industrialization. Cointegration analysis is used to investigate the long-run relationships between government expenditure and GDP, focusing on sub-periods and structural breaks. Moreover, we test the ratchet effect hypothesis by estimating models which allow for asymmetric adjustment. According to our main results, Wagner’s Law does not hold in the long run, although the data are consistent with Wagner’s Law between roughly 1860 and the mid 1970s. This can be traced to the formation of the modern public sector, including the introduction of public education, health care, and so forth. Yet Wagner’s Law did not hold during the initial industrialization phase (before 1860), and in recent periods GDP only affects the government spending share when we control for population age structure. Finally, we find some evidence of asymmetric adjustment in the UK, particularly in the post-WWII period. However, the ratchet effect is not a general cause of the growth of government spending.

Keywords: Displacement effect; Government expenditure; Growth of government; Public sector; Ratchet effect; Wagner’s Law

JEL-codes: H10; H55; I38

41 pages, First version: January 2, 2010. Revised: October 28, 2010. Earlier revisions: October 28, 2010.

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