VITOTANZI
Recent academic studies on the link between globalization and public spending have advanced two hypotheses. The efficiency hypothesis predicts that increased eco- nomic integration is associated with declining public spending. The compensation hypothesis suggests that governments expand as economic openness increases.
While both public spending and economic openness have been rising since the late nineteenth century, the two phenomena are not necessarily associated.
Matters have been more complex. For example, public spending has increased during periods when economies were relatively closed, and factors unrelated to globalization, such as the aging of populations or the availability of convenient
“tax handles,” have contributed to growth in public spending.
There is limited, if any, support for the compensation hypothesis today, but there is some empirical support for the efficiency hypothesis, especially in the more recent era. Growth in public spending appears static and in some instances is on the decline. And public social spending, often a contributor to rising levels of government spending, is being squeezed.
Does this imply, as many globalization critics fear, that social welfare is under pressure? This chapter suggests that this need not be so. Though important, pub- lic social spending is only one of several fiscal tools available to governments to help protect and insure people against such personal risks as ill-health, unem- ployment, and old age. Tax expenditures (credits and exemptions) and regulation are additional instruments that can replace or complement public spending. As the analysis in this chapter shows, different groups of countries are likely to use these measures to different degrees and in varying combinations.
GLO BA L I ZAT I O N A N D P U B L I C S P E N D I N G: T H E O R E T I C A L P R E D I C T I O N S A N D E M P I R I C A L E V I D E N C E
Neither the efficiency hypothesis nor the compensation hypothesis adequately captures the link between globalization and public spending when the timeframe
1 0 9
is extended to include earlier periods of expanding and reversing globalization and when the factors contributing to a rise in public spending are examined more closely.
The hypotheses
According to the efficiency hypothesis, Garrett (2001, pp. 5–6) explains, government spending—beyond minimal market friendly measures such as defense, securing property rights, and other fundamental public goods—
reduces the competitiveness of national producers in international goods and services markets.… Income transfer programs and social services dis- tort labor markets and bias intertemporal investment decisions. Moreover, government spending must be funded, often by borrowing in the short-term, and ultimately by higher taxes. Taxes on income and wealth directly erode the bottom lines of asset holders and distort their investment decisions, and this is exacerbated the more progressive tax systems are. Borrowing results in higher real interest rates, which further depresses investment. If this also leads to an appreciation in the real exchange rate, the competitiveness of national producers is decreased.
Given these relations, the efficiency hypothesis suggests that governments are likely to come under “lowest common denominator pressures” and that increas- ing globalization therefore goes hand in hand with declining public expenditures.
The compensation hypothesis, in contrast, points to the possibility of coun- tervailing political forces that may outweigh downward pressures on public spending and create incentives for an expanded government role. This hypothe- sis was originally put forward by Ruggie (1982), confirming work by Cameron (1978).
More recently, Rodrik (1998, p. 997) argues that there is “a positive correla- tion between an economy’s exposure to international trade and the size of its gov- ernment” measured by the ratio of public spending to gross domestic product (GDP) as government expenditures are used to provide social insurance against external risk. Globalization, defined as increased trade openness, is expected to increase a country’s exposure to external risks (such as instability in the terms of trade), leading to greater volatility in domestic income and consumption. This increased volatility can be reduced by increased government purchases of goods and services as a share of GDP.
Hence, the compensation hypothesis predicts that where democracy is well established and the losers from globalization are well organized, there may be strong public pressure for government spending to function as a shock absorber for the increased risks people face. Also, increased openness requires more pub- lic investment in human capital to retain or strengthen competitiveness in the global economy. Thus, increased public spending can both bolster political
support for globalization and provide market-supporting public goods, such as a qualified and competitive labor force.
Thus, the efficiency and compensation hypotheses are to some extent com- peting predictions. Which appears to have more predictive value?
Some empirical evidence
The point of the discussion here is not to present detailed empirical tests of the two hypotheses but to suggest that a systematic study of the links between glob- alization and public spending requires a more comprehensive approach along three dimensions:
• Lengthening the timeframe and examining earlier periods of globalization and of reversed openness.
• Considering a wider range of factors affecting public spending.
• Assessing public spending against the capacity of governments to raise revenue (not just in terms of whether they were pressured into increasing or decreasing budgets).
The link between economic openness and public spending varies across periods and countries.Economic globalization has been going on for a long time—accelerating in some periods, when, for example, new technologies or a renewed policy empha- sis on economic openness helped it along, and slowing or even reversing itself in periods when wars, plagues, or policy changes obstructed the free movement of goods, services, capital, or people. So, what has happened to public spending dur- ing periods of economic openness, and what when openness was reversed?
Scholars agree that from around 1870 to the beginning of World War I was a period of intense globalization. Technological advances in communications and transport made cross-border economic activity ever easier, and economic policies gave free rein to market forces. Moreover, the gold standard facilitated interna- tional payments, furthering economic globalization.1Many countries became more open to trade and to the movement of capital and even people. Indices of openness to trade and to capital movements for today’s industrial countries were, at that time, broadly similar to those in recent years (Baldwin and Martin 1991).
Yet governments played a limited role in the economy during 1870–1914. The share of public spending in GDP in many of today’s industrial countries was about 10 percent (Tanzi and Schuknecht 2000; Maddison 1997; and Lindert 2004).
Spending on subsidies and transfers, later one of the main drivers of increased pub- lic spending, averaged about 1 percent of GDP (Tanzi and Schuknecht 2000, p.30).
Events after 1914 brought an end to these globalizing trends. World War I, the Great Depression, World War II, and autarkic policies in Germany, Italy, Russia, and other countries all contributed to the closing of economies. Economic policymak- ers lost their enthusiasm for openness, and the world went through a long period when borders were relatively closed to trade and very closed to capital and people.
However, it was in this period that the role of the state in the economy started to change. Welfare states or mixed economies emerged, first slowly and then faster.
For a group of 14 industrial countries, public spending as a share of GDP more than doubled between 1913 and 1960 and grew substantially between 1960 and 1980 (table 1). This phase lasted until the mid-1980s, when the current era of globalization began and the rate of growth in public spending decelerated (table 2). Thus the growth of public spending had little relationship to globalization. It
TABLE 1
General government expenditures for 14 industrial countries, 1870–1980
Yeara Unweighted average (percent of GDP)
1870b 10.8
1913b 13.1
1920 19.6
1937 23.8
1960 28.0
1980 41.9
Note: Unless otherwise indicated, countries include Australia, Austria, Canada, France, Germany, Ireland, Italy, Japan, New Zealand, Norway, Sweden, Switzerland, United Kingdom, and United States. Pre–World War II data are sometimes on the basis of GNP or NNP instead of GDP.
a. Date shown or closest year available. Central government data for Sweden in 1870 and Austria for 1920. For New Zealand 1970 data are provided for 1960.
b. Canada, Ireland, and New Zealand not included in the data.
Source: Tanzi and Schuknecht 2000 (pp. 6–7).
TABLE 2
General government expenditures for OECD countries, 1987–2004
Year Weighted average (percent of GDP)
1987a 40.4
1990b 40.3
1995 42.3
2000 39.2
2003 41.1
2004c 40.6
Note: Unless otherwise indicated, countries include all Organisation for Economic Co-operation and Development (OECD) members:
Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Republic of Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, and the United States.
a. Czech Republic, Hungary, Luxembourg, Poland, Slovak Republic, and Switzerland not included in the data.
b. Czech Republic, Hungary, Poland, and Slovak Republic not included in the data.
c. Estimate.
Source: OECD 2004b (p. 191).
took place before globalization in the contemporary sense and well before much of the recent discussion of globalization.
A similar pattern of events marked the history of some developing countries.
During 1870–1914 Latin American countries had relatively closed economies, with the world’s highest tariffs (Coatsworth and Williamson 2004). On the eve of World War I the unweighted average tariff (import duties as a share of total import values) for eight Latin American countries stood at more than 25 percent, while it was close to 20 percent for the United States, 10 percent for 10 Asian countries, and 5 percent for France, Germany, and the United Kingdom (Coatsworth and Williamson 2004, p. 39). Coatsworth and Williamson (2004) argue that these high tariffs were a result of an exceptionally high level of military conflicts that neces- sitated high public spending—and hence a higher taxation rate. Not globalization but conflicts contributed to increased public revenue collection and spending.
Later, when economic openness increased in developing countries between 1980 and the end of the 1990s, public spending as a share of GDP declined (table 3).
Multiple drivers have contributed to changes in public spending.Studies have found that increased public spending depends on a variety of economic, demographic, social, and political factors, many with no link to economic openness.
One key factor influencing public spending has been income. As predicted by
“Wagner’s Law,” the higher a country’s income, the higher its public spending.
Despite many ups and downs incomes have risen in industrial and developing coun- tries, contributing to growth in public spending. To what extent this law will con- tinue to hold as markets deepen, expand, and integrate, remains to be seen.
Alesina and Wacziarg (1997) point to country size as a determinant of public spending, arguing that smaller countries tend to be more open and to have higher public spending. Smaller countries also tend to be ethnically more homogeneous, which has a positive influence on public spending (Alesina, Glaeser, and Sacerdote 2001; Alesina and La Ferrara 2003). Democracy, political organization, or voice are
TABLE 3
Public expenditure for developing country regions, 1980–97 (percent of GDP)
Region 1980 1990 1997
Sub-Saharan Africaa 25.5 26.3 22.3
North Africa 39.0 29.4 30.4
Latin America — 24.5 23.6
South East Asia 29.4 37.3 26.2b
— is not available.
a. Excludes South Africa.
b. Data are for 1996.
Source: UNRISD 2000 (p. 65).
highlighted by Adserà and Boix (2002), Garrett and Nickerson (2001), and Lindert (2002 and 2004). Schulze and Ursprung (1999) focus on fiscal decentralization and competition among jurisdictions and also on rent-seeking behavior.
Tanzi and Schuknecht (2000) and Tanzi (2002) show that the observed rise in public spending is related largely to the risks associated with becoming old or ill or with being illiterate and untrained. These risks do not derive from economic glob- alization, or only very indirectly. Advances in medical and pharmaceutical technol- ogy certainly generate spillover effects and contribute to rising life expectancy. And other factors, such as consumption habits, may also cross borders and affect peo- ple’s health worldwide. Yet on the whole, people require social protection whether a country is globalized or not. Public spending on pensions in industrial countries rose enormously between 1920 and 1980 and continued to rise, at a slower rate, between 1985 and 2001 (tables 4 and 5). Some analysts forecast that government
TABLE 5
Public expenditure on pensions for OECD countries, 1985–2001
Year Unweighted average (percent of GDP)
1985a 9.7
1990b 9.8
1995c 10.8
2001d 11.2
Note: Unless otherwise indicated, countries include all OECD member states. Pension spending includes old-age, survivor, and incapacity-related benefits.
a. Czech Republic, Hungary, Iceland, Korea, Poland, and Slovak Republic not included in the data.
b. Hungary and Slovak Republic not included in the data.
c. Hungary not included in the data.
d. Turkey not included in the data.
Source: Author’s calculations based on OECD 2004a.
TABLE 4
Public expenditure on pensions for 17 industrial countries, 1920–80
Year Unweighted average (percent of GDP)
1920a, b 1.2
1937a, c 1.9
1960d 4.5
1980 8.4
Note: Unless otherwise indicated, the countries include Australia, Austria, Belgium, Canada, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, United Kingdom, and United States. Pension spending includes old- age cash benefits, disability pensions, and survivor pensions.
a. Central government only.
b. Australia, Canada, Ireland, Netherlands, New Zealand, and Switzerland not included in the data.
c. Canada, France, Germany, Ireland, Italy, Netherlands, Norway, Sweden, Switzerland, and the United States not included in the data.
d. Spain not included in the data.
Source: Tanzi and Schuknecht 2000 (p. 41).
budgets in these countries will remain high because of population aging at least until 2020 or even later (Lindert 2004; Casey and others 2003). Public spending on pen- sions is also expected to rise in developing countries (Lindert 2002), where it now averages 1.4 percent of GDP in Africa, 3.0 percent of GDP in Asia, and 2.1 percent of GDP in Latin America and the Caribbean (table 6).
Changes in the political stance of a country or the international community are also important drivers of change in government spending. The pursuit of more pro-Keynesian policies in the wake of the Great Depression of the 1930s and World War II no doubt had an expansionary effect.2The subsequent shift toward more neoliberal policies and the call for limiting direct government involvement in the economy exerted a dampening effect, at least on the growth of public spending.
Public spending also depends on the availability of “tax handles.”As the case of Latin American countries during 1870–1914 demonstrates, a high level of public spend- ing is often associated with the availability of convenient “tax handles”—readily tapped sources of revenue. Foreign trade was the best tax handle for many coun- tries. The larger the share of imports and exports, the easier it was for a country to raise revenue.3That makes it important to explore the actual scope that gov- ernments have for raising or maintaining revenue and expenditure levels when assessing trends in public spending.
In the 1960s and 1970s foreign trade taxes were an important source of revenue for many developing countries. Zee (1996, p. 1661) estimates that for 1975–79 trade taxes (unweighted) averaged just 4 percent of total tax revenues for Organisation for Economic Co-operation and Development (OECD) countries but 30 percent for non-OECD countries. During this time, increased openness to trade meant increased revenues and improved room for public spending. It was not, as scholars supporting the compensation hypothesis would argue, that spending was high because demands for social protection were high but that spending was high because revenue was high.
Trade liberalization has removed many of these tax handles. As a result, a number of developing countries that failed to build alternative tax bases have faced declining tax revenues (Abed 2000; Khattry and Rao 2002; Tanzi 2003).
TABLE 6
Public expenditure on pensions in developing country regions, 1990–96
Region Public expenditure on pensions (percent of GDP)
Africa 1.4
Asia 3.0
Latin America and the Caribbean 2.1
Note: Pension spending includes old-age, disability, and survivors’ pensions. Regional averages were calculated using 1996 and 1990 data. Averages are weighted by GNP in purchasing power parity dollars.
Source: ILO 2000.
Thus, the earlier positive relation between economic openness and revenue col- lection and public spending has turned negative. Today, for many developing countries more economic openness means (at least for now) lower revenue and curtailed spending possibilities or an increased need to take on debt.
In addition, other aspects of globalization have unleashed a set of “fiscal ter- mites” (Tanzi 2001): forces that are progressively weakening national tax bases, making it more difficult for governments to maintain high tax levels. Among these corrosive forces are electronic commerce and transactions, electronic money, intracompany trade, off-shore financial centers and tax havens, unregulated or barely regulated derivatives and hedge funds, and a growing inability or unwill- ingness of governments to tax financial capital and the incomes of individuals with highly tradable skills.
Therefore, when examining changes in public spending it is important to explore to what extent these changes are due to efficiency pressures and to what extent to an erosion of the tax base. A third hypothesis could thus be added to the compensation and efficiency hypotheses: the fiscal termite hypothesis, which pre- dicts that new global forces are weakening national tax bases, forcing a decline in government spending.
Which hypothesis holds?
There seems to be limited, if any, empirical evidence supporting the compensa- tion hypothesis. As Garrett (2001) points out, scholars like Rodrik (1998) did not really explore how globalization affects public spending. They measured historic levelsof market integration and spending—not how a changein the first variable causes a changein the second.
There is more evidence to support the efficiency hypothesis. The level of pub- lic spending did not grow during 1870–1913, when economies were particularly open. The political and intellectual winds that led to the expansion of government and produced the welfare state have been long in coming and became strong exactly in the years when economies became less open (Tanzi and Schuknecht 2000). The New Deal4and the Keynesian revolution were late products of the Great Depression, a period when economies that had been relatively closed became even more closed. And by the early 1950s, long before the current glob- alization process got under way, there was already support for the creation of wel- fare states in today’s industrial countries (de Jouvenel 1952; Galbraith 1958).
So what findings emerge when changein economic openness is correlated with changein public spending? Garrett (2001, p. 3), who explores this link for more than a hundred industrial and developing countries, finds that “countries in which trade grew more quickly between the 1970–84 and 1985–95 periods witnessed slower growth in government spending between the two periods.”
This suggests that increased openness to trade indeed generates spending constraints.5
A comparison for 13 of the most open industrial countries of public spending at its highest level as a share of GDP and its level in 2002 shows that government expenditures are stagnant or declining, although economic openness clearly con- tinues to be high (table 7). A scatter diagram supports this finding, linking change in openness to trade during 1987–2002 to change in public spending (figure 1). It shows a clear negative relationship (with a correlation coefficient of –0.67): the more open the economies became, the greater the downward pressure on spending.
Thus, there seems to be little if any empirical support for the compensation hypothesis and more for the efficiency hypothesis. The empirical evidence also seems to confirm the fiscal termite hypothesis, considering that public spending is likely to depend not only on political demand for certain expenditures but also on the government’s capacity to collect revenue.
DIRECT PUBLIC SPENDING, TAX EXPENDITURES,AND REGULATION:
PUBLIC POLICY INSTRUMENTS FOR SO CIAL PROTECTION AND INSURANCE
Protection and insurance against personal risks is required no matter how deeply integrated countries are. People grow old, suffer from disabilities and ill-health,
TABLE 7
Highest shares of public expenditures and shares in 2002 in selected economies, ranked by degree of openness in 2002
(percent of GDP)
General government total outlays Open economies Highest level (year) 2002 level
Belgium 57.0 (1987) 50.2
Slovak Republic 65.0 (1997) 51.0
Ireland 52.0 (1987) 33.8
Czech Republic 54.4 (1995) 46.9
Netherlands 58.4 (1987) 47.8
Hungary 63.4 (1994) 52.6
Austria 56.4 (1993) 50.6
Canada 53.3 (1992) 40.9
Korea, Rep. of 25.0 (2001) 24.8
Switzerland 36.1 (1998) 35.4
Denmark 61.7 (1993) 55.8
Sweden 72.9 (1993) 58.2
Finland 64.2 (1993) 50.1
Note: Openness is defined as exports plus imports divided by GDP in 2002. Peak figures for public spending are based on data for 1987–2002.
Source: Openness figures are from World Bank 2004 (pp. 306–09) and government spending figures are from OECD 2004b (p.191).