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Applied Economics
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Government revenue and government expenditure

nexus: evidence from developing countries
a a
Paresh Kumar Narayan & Seema Narayan
a
Department of Accounting , Finance and Economics , Griffith University , PMB 50, Gold
Coast MC, Queensland, 9726, Australia
Published online: 19 Aug 2006.

To cite this article: Paresh Kumar Narayan & Seema Narayan (2006) Government revenue and government expenditure nexus:
evidence from developing countries, Applied Economics, 38:3, 285-291, DOI: 10.1080/00036840500369209

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 Applied Economics, 2006, 38, 285–291

Government revenue and

government expenditure nexus:
evidence from developing countries
Paresh Kumar Narayan* and Seema Narayan
Department of Accounting, Finance and Economics, Griffith University,
PMB 50, Gold Coast MC, Queensland 9726, Australia
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The relationship between government revenue and government expendi-

ture has attracted a lot of interest given its policy relevance, particularly
with respect to budget deficits. The goal of this paper is to investigate
evidence for causality between government revenue and government
expenditure within a multivariate framework by modelling them together
with gross domestic product for 12 developing countries. Our application
of the Toda and Yamamoto (1995) test for Granger causality reveals
support for the tax-and-spend hypothesis for Mauritius, El Salvador,
Haiti, Chile and Venezuela. For Haiti, there is evidence for the spend-and-
tax hypothesis, while for Peru, South Africa, Guatemala, Uruguay and
Ecuador there is evidence of neutrality.

I. Introduction Wiseman (1961, 1979), who argued that a

There is a large literature (see, inter alia, Owoye,
1995; Miller and Russek, 1990; Li, 2001; Baghestani
and McNown, 1994; Baffes and Shah, 1994; Fasano
and Wang, 2002; Hondroyiannis and Papapetrou,
1996; Hatemi-J and Shukur, 1999; Katrakilidis, 1997;
Chang et al., 2002; Hasan and Lincoln, 1997; Kollias
and Makrydakis, 2000) that examines the relation-
ship between government revenue and government
expenditure. The empirical findings have both theo-
retical and policy relevance. On the theoretical front,
three outcomes are possible:
(1) revenue causing expenditure, that is, raising
taxes leading to more spending. This is known
as the tax-and-spend hypothesis advocated by
Friedman (1978);
(2) expenditure causing revenue: the spend-and-
tax hypothesis advanced by Peacock and
severe crisis that initially forces up government
expenditure more than taxes has the potential
to change public attitudes about the proper size
of government. The upshot is that some of the
tax increases originally justified by the crisis
situation become permanent tax policies; and
(3) the ‘fiscal synchronization hypothesis’, which
is based on the tenet that governments may
change expenditure and taxes concurrently
(Musgrave, 1966; Meltzer and Richard, 1981).
On the policy side, the nature of the relationship
between government expenditure and government
revenue is essential for three reasons. First, if
government revenue causes government expenditure,
budget deficits can be eliminated by policies aimed
at stimulating government revenues. Second, if
the ‘fiscal synchronization hypothesis’ does not
hold, it implies that expenditure decisions are made

*Corresponding author. E-mail: p.narayan@griffith.edu.au

Applied Economics ISSN 0003–6846 print/ISSN 1466–4283 online ß 2006 Taylor & Francis 285
http://www.tandf.co.uk/journals
DOI: 10.1080/00036840500369209
 286
in isolation from revenue decisions, which can lead
to serious budget deficits should government expen-
ditures increase more rapidly than government
revenues (Narayan, 2005). Third, if government
expenditure causes government revenue, it implies
government behaviour as one where it spends first,
and later, to pay for this spending, it raises taxes.
Such a situation can induce capital outflow due to
the fear of paying higher taxes in future.
A tour of the empirical literature suggests that
there are mixed findings on the relationship between
government revenue and government expenditure.
For instance, while Von Furstenberg et al. (1986)
and Anderson et al. (1986) found expenditure
Granger causing revenue in the case of the USA,
Manage and Marlow (1986) found some evidence of
causality running from revenue to expenditure.
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Moreover, using more recent developments in applied
time series econometric techniques, Baghestani and
McNown (1994) found no evidence of any causality
between revenue and expenditure. Joulfaian and
Mookerjee (1991) studied a group of industrialized
countries and found that revenue Granger caused
expenditure in most of the countries except for
Canada, Iceland and Japan, and expenditure caused
revenue for all countries except for France, Greece
and Ireland. In the case of studies on developing
countries, Baffes and Shah (1994) found bidirectional
causality between government revenue and govern-
ment expenditure for Argentina and Mexico, while
for Brazil they found unidirectional causality. In a
more recent study, Fasano and Wang (2002) inves-
tigated the relationship for oil-dependent Gulf
Cooperation Council countries and found bidirec-
tional causality for Kuwait, Qatar and Saudi Arabia
and unidirectional causality running from revenue
to expenditure in Bahrain, the United Arab Emirates
and Oman.
Given the theoretical and policy implications
of studying the relationship between government
revenue and government expenditure, we were
encouraged to launch an investigation of this
relationship for 12 developing countries. However,
we do not do this in a bivariate framework as is the
fashion; rather, given the limitations of modelling
bivariate relationships, we model the relationship
within a multivariate framework by including the
real gross domestic product (GDP) variable. GDP
is an important variable, for government’s revenue
and expenditure are both contingent on the level of
economic activity. A growing economy, for instance,
will both demand increased spending on
1
Payne (1997), to the best of our knowledge, is the only study that models government revenue and government expenditure
together with GDP.
P. K. Narayan and S. Narayan
infrastructure and provide additional revenues for
the government. In this light, GDP is likely to
positively impact on both government expenditures
and government revenues. It follows that our multi-
variate approach in modelling government revenue
and government expenditure represents an advance
over existing studies.1
The goal of this paper is achieved through two
steps. In the first step, we use the augmented Dickey
and Fuller (ADF, 1979, 1981) and the Kwiatkowski–
Phillips–Schmidt–Shin (KPSS) (Kwiatkowski et al.,
1992) test for unit roots. In the second step, we use
the Toda and Yamamoto (1995) procedure to test for
Granger causality. The balance of the paper is
organized as follows. In the next section, we briefly
discuss the econometric methodology. In the penulti-
mate section, we present the empirical results, while
in the final section we conclude with some policy
implications.
II. Methodology
KPSS unit root test
The KPSS test for unit root differs from the ADF
and the Phillip and Perron test in that the series Yt
is assumed to be (trend-) stationary under the null.
Put differently, the KPSS test reverses the null and
the alternative hypothesis. The KPSS statistic is based
on the residuals from the OLS regression, which takes
the following form:
Yt ¼
t þ bt þ "t ð1Þ
where t is a linear deterministic trend, "t is a station-
ary error, and bt is a random walk; bt ¼ bt
1 þ t ,
where t are i.i.d. ð0, 2 Þ. The initial value of bo is
treated as fixed and is interpreted as an intercept.
The test is conducted by first regressing Yt on a
constant and a trend (t), allowing one to obtain the
residuals. The KPSS statistic is defined as:
X
ðuÞ ¼ T2 S2t =S2 ðkÞ, ð2Þ
Pt
where St ¼ ei ði ¼ 1, 2, . . . , tÞ, ei is the partial sum
of the residuals, S2 ðkÞ is a consistent non-parametric
estimate of the disturbance variance and T is the
sample size. Kwiatkowski et al. (1992) show that
the statistic ðuÞ has a nonstandard distribution, and
critical values are provided therein. If the calcu-
lated value of ðuÞ is larger than the critical value,
then the null of stationarity for the KPSS test is
rejected.
 Government revenue and government expenditure nexus
Granger causality
The Granger causality test is based on the procedure
suggested by Toda and Yamamoto (1995), which
allows for causal inference based on an augmented
level vector autoregressive (VAR) model with inte-
grated and cointegrated processes. The method is
useful because it does not require the practitioner
to conduct tests for cointegration. The Toda and
Yamamoto (1995) procedure uses a modified Wald
test to conduct restrictions on the parameters of
the VAR(k) model. The test has an asymptotic
chi-squared distribution with k degrees of freedom
in the limit when a VAR[k þ d(max)] is estimated
(where, d(max) is the optimal order of integration
for the series in the system). The test essentially
involves two stages. The first stage is where we need
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287
III. Empirical Results
Data
All data are from the World Bank World Tables and
the IMF publication International Financial Statistics
CD-ROM, and the sample period differs country by
country and is contingent on data availability.
For instance, for Mauritius data is for the period
1966–2000, for South Africa data is for the period
1960–2000, for Peru data is for the period 1970–2000,
for Guyana data is for the 1961–1966, for Haiti
data is for the period 1967–1997, for Chile data is for
the period 1973–1996, for Uruguay data is for
the period 1969–1996, for Venezuela and Ecuador
data is for the period 1950–1996, for El Salvador data
is for the period 1954–1996, for Guatemala data is

to determine the optimal lag length k and the
maximum order of integration d of the variables
in the system. To achieve the optimal lag length, we
use the Schwarz Bayesian Criterion (SBC) and to
establish the order of integration, we use the ADF
and the KPSS tests. Once a VAR(k) is selected and
the order of integration d(max) obtained, a VAR in
levels is then estimated with the optimal lag length
of p ¼ [k þ d(max)]. The second stage is where we
apply the Wald test to the first k VAR coefficient
matrix to test for Granger causality. These discus-
sions can be represented arithmetically as follows:
X
kþdmax
kþdmax
ln GRt ¼
0 þ
i ln GRt
i þ
i¼1
X
kþd max
for the period 1958–1996, and for Paraguay data
is for the period 1958–1993.
Unit root tests
The starting point for our empirical analysis is an
investigation of the unit root property of the three
variables in our proposed model (see Equations 3–5).
We find that for the natural logs of government
revenue, government expenditure and real GDP, the
null hypothesis of a unit root cannot be rejected
at conventional levels of significance. However, when
we apply the ADF test to the first difference of these
X
three series, we are able to reject the null hypothesis
i ln GEt
i
i¼1
of a unit root at the 5% level of significance or better.
These results imply that government revenue, govern-

þ i ln Yt
i þ "1t ð3Þ ment expenditure and the GDP series, for all the
i¼1 12 countries in our sample, are integrated of order
X
kþdmax X
kþd max one, Ið1Þ. The results are not reported here to
ln GEt ¼ 0 þ i ln GEt
i þ i ln GRt
i conserve space but are available from the authors
i¼1 i¼1 upon request. However, given the generally low
X
kþd max power of the ADF test, we also examine the unit
þ i ln Yt
i þ "2t ð4Þ root property using the KPSS test. We report the
i¼1 results in Table 1. The results generally suggest
X
kþd max X
kþd max that government revenue, government expenditure
ln Yt ¼ 0 þ i ln Yt
i þ i ln GEt
i and real GDP are non-stationary in their levels.
i¼1 i¼1
These findings corroborate those obtained from the
X
kþd max
ADF test.2
þ $i ln GRt
i þ "1t ð5Þ
i¼1
Granger causality results
Here, ln GR is the natural log of the government
revenue, ln GE is the natural log of the government The Granger causality test results are presented in
expenditure, ln Y is the natural log of the real gross Table 2. We find that there is unidirectional causality
domestic product, and "1t , "2t and "3t are serially running from revenue to expenditure for Mauritius,
independent random errors with a mean of zero and El Salvador, Haiti, Chile and Venezuela; hence,
a finite covariance matrix. there is support for the tax-and-spend hypothesis.
2
The Im et al. (2003) panel unit root test was also undertaken for the 3 series. We found that all the three variables were
non-stationary at the 10 per cent level or better. Detailed results are available from the authors upon request.
 288
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Table 1. KPSS unit root test

Variables Mauritius Peru South Africa Guyana El Salvador Guatemala Haiti Chile Uruguay Venezuela Ecuador Paraguay

ln GRt 0.4709 [3] 0.3528 [4] 0.7649 [5] 0.5864 [5] 0.3725 [3] 0.3550 [2] 0.3830 [4] 0.5612 [3] 0.5853 [4] 0.3758 [4] 0.6442 [5] 0.3976 [4]
ln GEt 0.3562 [4] 0.6002 [4] 0.7215 [5] 0.4761 [5] 0.3609 [4] 0.3579 [4] 0.3863 [4] 0.6256 [3] 0.5767 [3] 0.3635 [4] 0.5533 [3] 0.3941 [3]
ln Yt 0.6879 [5] 0.6208 [4] 0.7446 [5] 0.3665 [4] 0.6212 [4] 0.7010 [5] 0.4276 [4] 0.6742 [3] 0.5995 [4] 0.6946 [4] 0.6970 [5] 0.6656 [5]
Notes: Critical values at the 1%, 5%, and 10% levels are 0.7390, 0.4630, and 0.3470, respectively.

P. K. Narayan and S. Narayan

 Government revenue and government expenditure nexus
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Table 2. Granger causality tests

Mauritius Peru South Africa Guyana El Salvador Guatemala Haiti Chile Uruguay Venezuela Ecuador Paraguay

Y ) GR 5.2509 1.8311 3.2035 9.1674** 1.9133 5.9274** 16.0101*** 4.7203 8.6832** 2.2862 7.6236** 1.8624
[0.1543] [0.6082] [0.3613] [0.0271] [0.5906] [0.0516] [0.0011] [0.1935] [0.0338] [0.5152] [0.0545] [0.3941]
Y ) GE 5.6313 8.8094** 3.3776 9.0880** 11.5467*** 0.0676 8.3956** 5.6201 2.4675 1.7087 5.6393 6.8830**
[0.1310] [0.0319] [0.3370] [0.0281] [0.0091] [0.9668] [0.0385] [0.1316] [0.4812] [0.6350] [0.1305] [0.0320]
GR ) GE 15.0536*** 0.7001 0.1481 1.9034 6.2983* 4.4276 10.3919** 11.1197** 1.9494 11.5857** 1.6631 15.4327***
[0.0018] [0.8732] [0.9855] [0.5927] [0.0980] [0.1093] [0.0155] [0.0111] [0.5830] [0.0089] [0.6452] [0.0004]
GE ) GR 2.6683 0.8501 3.2035 3.7455 4.9781 2.3063 14.9415*** 4.7968 2.4093 1.8642 14.5969 3.3147
[0.4456] [0.8374] [0.4836] [0.2903] [0.1734] [0.3156] [0.0019] [0.1873] [0.4919] [0.6011] [0.0022] [0.1906]
GE ) Y 3.5246 5.8894 11.1942** 12.1765*** 1.3746 14.0482*** 3.2627 1.4101 6.1838* 11.6684 2.4614 2.0336
[0.1376] [0.1171] [0.0107] [0.0068] [0.7115] [0.0009] [0.3527] [0.7031] [0.1030] [0.0086] [0.4823] [0.3618]
GR ) Y 5.3144 13.7302*** 5.8346 8.2734** 12.1325*** 9.2267*** 0.9912 5.6486 6.8355* 7.5098 2.8490 3.8294
[0.1502] [0.0033] [0.1199] [0.0407] [0.0069] [0.0099] [0.8034] [0.1300] [0.0773] [0.0573] [0.4823] [0.1474]
Notes: ***, **, * denote statistical significance at the 1%, 5%, and 10% levels, respectively.

289
 290
Meanwhile, for Haiti causality runs from government
expenditure to government revenue, supporting
the spend-and-tax hypothesis. For the remaining
countries, namely Peru, South Africa, Guatemala,
Uruguay and Ecuador, there is neutrality between
revenue and expenditure, inconsistent with the
‘fiscal synchronization hypothesis’. This implies that
revenue and expenditure decisions are made
independently.
In terms of the causal relationship between GDP
and government’s revenue and expenditure, we find
some interesting results. First, we find that there is
bidirectional causality between GDP and government
expenditure in the case of Guyana, and unidirectional
causality running from GDP to government expen-
diture in the case of Peru, El Salvador, Haiti and
Paraguay. Second, we find that there is bidirectional
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causality between GDP and government revenue in
the case of Guyana, Guatemala and Uruguay, while
causality runs from GDP to government revenue
for Haiti and Ecuador.
IV. Conclusions
Given the policy relevance of the relationship between
government expenditure and government revenue, we
investigate this issue for a group of 12 developing
nations. Among our key results, we find that:
(1) for Haiti, government expenditure Granger
causes government revenue, consistent with
the spend-and-tax hypothesis;
(2) for Mauritius, El Salvador, Haiti, Chile and
Venezuela government revenue Granger causes
government expenditure, consistent with the
tax-and-spend hypothesis; and
(3) for Peru, South Africa, Guatemala, Uruguay
and Ecuador there is neutrality between gov-
ernment revenue and government expenditure,
inconsistent with the ‘fiscal synchronization
hypothesis’.
Our empirical findings lead to two important policy
implications. First, because there is no causality
between government revenue and government expen-
diture for Peru, South Africa, Guatemala, Uruguay
and Ecuador, the fiscal synchronization hypothesis
is rejected. This implies that in these countries revenue
decisions are made independent of expenditure
decisions. A likely implication, in the face of rapid
growth in expenditures relative to revenues, is one
of serious budget deficits. Second, because in Haiti,
government expenditure causes government revenue,
P. K. Narayan and S. Narayan
the signal is that government first spends and then,
later, to pay for this expenditure, it raises taxes.
Potential investors may construe this government
behaviour negatively – that is, investment decisions
may take into account the possibilities of paying
higher taxes in future. In the light of this, it is safe
to conclude that in countries where government
expenditure causes government revenues, private
investments may be hampered.
Acknowledgements
We would like to thank Professor Mark Taylor and a
referee of this journal for helpful comments and
suggestions on earlier versions of this paper.
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