Wednesday, June 16, 2010


Ever since the original proposition by a 19th century German economist Adolph Wagner, Wagner's law has undergone significant theoretical and empirical discussion on its long-run validity. In the most basic and rudimentary version, the law states that alongside the economic development of industrial societies, there is a persistent tendency of an increasing share of government spending in the GDP. Since the beginning of the 20th century course, the growth in government expenditures has escalated in all major industrial countries. The economic literature has centered the discussion on two elementary versions of Wagner's law. The first version of Wagner's law attributes the growing share of government spending to the ever expanding power of interest groups.

The concept of interest groups has been thoroughly developed by a rigorous theoretical analysis by Mancur Olson's The Logic of Collective Action. There is a remarkably positive correlation between the growth of government spending and the political power of interest groups. Back in 1954, Milton Friedman and Simon Kuznets have analyzed the income dynamics in independent professions (link). Although there has not been much discussion in the economic literature, the Friedman-Kuznets analysis is an important milestone in the explanation of the evolution of interest groups. Friedman and Kuznets examined five independent professions. Using a comprehensive statistical analysis, they showed how income growth in five profession has exerted an upward trend without significant gains in productivity. The five independent professions analyzed by Friedman and Kuznets emerged as pure interest groups. These groups have imposed a regulated labor market structure marred by occupational licencing and aimed at gaining an insider's earnings rent at the expense of entry restriction. Occupational licensing is one of the most powerful explanatory features of low coefficient of price and income elasticity of labor supply of physicians, dentists, legal consultants and medical practitioners. In most of the industrial countries, these groups have emerged as powerful interest groups and triggered an unbreakable increase on the growth of government spending. The evolution of interest groups in fields such as agriculture, social security and trade has resulted in the intensive pressure on the growth of government spending. The interest group perspective on Wagner's law emphasizes the state capture created by the democratic system and an irreversible pattern of increases in government spending centered on small and powerful interest groups. If interest group's representative utility function can be described as a relationship between the group's size and its price elasticity of labor supply: U(f,e)=f(1-|e|), then the effect of a unit change in price elasticity of labor supply dU/de=-f indicates that greater price elasticity of labor supply will reduce the size (f) of the interest group as a result of pure substitution effect at work. On the other hand, if price elasticity of labor supply of the particular interest group will decrease, causing more price inelastic labor supply, the size of the interest group will increase since most of the excess wage increases will spill into physician's pocket.

The second version of Wagner's law states that an increase in government spending in time is a result of a high income elasticity of demand for public goods. Rati Ram (1986) has tested this hypothesis on the sample of 115 countries between 1950 and 1980. His conclusions suggest that income elasticity of demand for public goods is very elastice (exceeding 1) in 60 percent of all countries in the sample. A comprehensive development of econometric methodology has enabled a more rigorous and empirical evaluation of Wagner's law on the basis of long-run simulation using time-series data. For example Sidelis (2006) has applied cointegration analysis and Granger casuality tests to determine whether long-run changes in income account for the growth of government spending in Greece between 1833 and 1938 (link). The author concludes that income elastic demand for public goods caused a growth in government expenditures. A recent study by Lamartina and Zaghini (2008) indicates (link) a negative relationship between government spending and economic growth in a sample of 23 OECD countries. The study further suggests that the correlation between income growth and government expenditure is stronger in countries with low initial levels of GDP per capita. Neck and Getzner (2007) collected data on government expenditure in Austria between 1870 and 2002 and examined whether the surge of government expenditure is attributed to either Wagner's law or Baumol's cost disease. The authors applied Phillipe-Perron and Augmented Dickey-Fuller stationarity tests, concluding that government spending time series more likely represents a stationary time series. In concluding remarks, the authors note that much of the increase in government expenditure is a problem of increasing prices in public sector, relating the growth in public expenditures to Baumol's cost disease where output reduction in public sector is a result of net decrease in productivity growth which yields a significant pressure from public sector interest groups on expenditure increases.

Wagner's law is an intriguing theoretical and empirical issue. In spite of the numerous empirical evaluation and theoretical design, the issue will probably remain an intensive course of the academic debate.

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