Pertanika J. Soc. Sci. & Hum. 8(1): 45 - 50 (2000) ISSN: 0128-7702© Universiti Putra Malaysia Press

Testing for Causality Between Taxation and Government Spending:An Application of Toda-Yamamoto Approach

MARIAM ABDUL AZIZ, MUZAFAR SHAH HABIBULLAH,W.N.w. AZMAN-SAINI & M. AZALI

Department of EconomicsFaculty of Economics & Management, Universiti Putra Malaysia

43400 UPM Serdang, Selangor, Malaysia

ABSTRAK

Kajian ini bertujuan menyelidik hubungan penyebab antara hasil cukai kerajaan denganperbelanjaan kerajaan. Kaedahjangka panjang bukan penyebab Granger yang dicadangkan olehToda dan Yamamoto (1995) digunakan untuk menguji hubungan penyebab tersebut untuktempoh masa 1960 hingga 1997. Hasil kajian menunjukkan kewujudan hubungan penyebab duahala di antara perbelanjaan kerajaan dengan hasil cukai kerajaan.

ABSTRACT

The purpose of the present study is to investigate the causal relationship between the governmenttax revenues and government expenditures in Malaysia. We employ the Granger long run non­causality test as proposed by Toda and Yamamoto (1995) to test the causal relationships betweengovernment spending and tax revenues for the period 1960 to 1997. The evidence generallysupports the existence of bi-directional casuality between government spending and tax revenues.

INTRODUCTION

Governmen t expenditures in Malaysia havealmost consistently exceeded governmentrevenues throughout most of the past decadessince 1959 except for the 1959-61 and 1993-97periods. The government's commitment inpursuing rapid economic developmentprogrammes as embodied in the various fiveyear Malaysian develoment plans largely accountsfor the fiscal deficits incurred. The expandedrole of the public sector resulted in rapid growthof government expenditures.

Government budget deficits have significantimpact on the economy. Such fiscal imbalancetends to reduce national savings which in turnhas the effect of impeding rapid economicgrowth. The options available to stimulateeconomic growth in a budget deficit economyinclude reducing government expenditures and/or raising tax revenues. Both options serve theobjective of reducing the fiscal deficit.

One of the most researched topics inmacroeconomics is the empirical testing of therelationship between government expendituresand tax revenues. Establishing the direction ofinterdependence between the two macro-

economic variables, namely, governmentexpenditures and tax revenues would assist policymakers in identifying the source of any fiscalimbalances that might exist. Consequently thiswould facilitate efforts to develop a suitablefiscal reform strategy.

The purpose of this study is to investigatethe causal relationship between the governmenttax revenues and government expenditures forthe period 1959 to 1997. We have utilised themore recent technique proposed by Toda andYamamoto (1995) in the attempt to determinethe interdependence between the two variablesmentioned. According to Toda and Yamamoto,their Granger long-run non-causality analysis,provide a simplistic approach in determiningthe association between integrated variableswithout having to worry about the order ofintegration and/or the cointegrating rank in aVector Autoregression (VAR) system.

UTERATURE REVIEW

The relationship between government revenueand expenditure can be categorized into threemain competing hypotheses. First, the fiscalsynchronization hypothesis implies that taxation

Mariam Abdul Aziz, Muzafar Shah Habibullah, W.N.W. Azman-Saini & M. Azali

and spending decisionS-are simultaneously madeby the fiscal authorities. In the Granger sense,this is known as a bi-directional relationshipbetween tax revenue and government spending.Second, a unidirectional causality that runs fromrevenue to expenditure supports the so-calledtax-and-spend hypothesis. The hypothesisindicates that, since government revenue causeschanges in government expenditure, the controlof tax revenue should represent a good policy toreduce the size of the government expenditure.On the other hand, the spend-and-tax hypothesisimplies that government expenditure leads tochanges in tax revenue. In other words, thechain of causality is running from governmentspending to tax revenue.

Empirical evidences with respect to the abovethree competing hypotheses are at best mixed.Musgrave (1966), Meltzer and Richard (1981),Miller and Russek (1990), Bohn (1991) andBhat et at. (1993) supported the fiscalsynchronization hypothesis. Studies by Friedman(1972, 1978), Buchanan and Wagner (1977,1978), Darrat (1998), Blackley (1986), Marlowand Manage (1987) andJoulfaian and Mookerjee(1990); all indicated that govern men t taxrevenues lead expenditures. On the other hand,the spend-and-tax hypothesis is supported bystudies done by Peacock and Wiseman (1961,1979), Jones and Joulfaian (1991), Anderson etat. (1986), von Furstenberg et at. (1986) andProvopoulos and Zambaras (1991). Conversely,apart from those studies, Baghestani andMcNown (1994) found that governmentexpenditure and revenue are notin terdependen t.

Other studies on the government revenue­expenditure nexus found a diversity of results,depending on the time period used, lag lengthand also between different levels of government.For instance, Manage and Marlow (1986) foundout that using different lag lengths gave differentsets of results. Varying the lag length betweentwo and five, the result indicates that in all casesthe lower and most upper lag lengths suggestunidirectional relationship; a causal relation thatruns from expenditures to revenues. On theother hand, the intermediate lag length providessupport for bi-directional causal relationshipbetween the two variables. Ram (1988) usedboth annual and quarterly data to examine theexpenditures-revenues nexus for both Federalgovernment and State and Local government.

The study arrived at conflicting results too. Forexample, using annual data, the results supportthe fiscal synchronization hypothesis at thefederal government level. However, whenquarterly data was used, the results suggest thatcausality runs from revenues to expenditures,thus, supporting the tax-and-spend hypothesis.But, at the state and local level, both annual andquarterly data indicate results that support thespend-and-tax hypothesis. In another study,Owoye (1995) studied the causal relationshipbetween taxes and expenditures in the G7countries. Despite the similarities in terms of theeconomic settings of the sample countries, Owoyefound that the results of the causalityrelationships are not similar. The empiricalresults obtained from the error-eorrection modelssupport the fiscal synchronization hypothesis forthe U.S, Germany, U.K, France and Canada.This implies that the fiscal authorities in thesecountries make tax and spending decisionsjointly. On the other hand, causality runs fromrevenues to expenditures in Japan and Italy,thus, supporting the tax-and-spend hypothesis.

METHOD OF ESTIMATIONS

It has been noted that the traditional Granger(1969) causality test for inferring leads and lagsamong integrated variables will end up inspurious regression results, and the F-test is notvalid unless the variables in levels arecointegrated. New development in econometricoffers the error-correction model (Engle andGranger 1987) and the vector autoregressionerror-correction model (Johansen and Juselius1990) as alternatives for testing of non-causalitybetween economic time series. Unfortunately,these tests are cumbersome and sensitive to thevalues of the parameters in finite samples andtherefore their results are unreliable (Toda andYamamoto 1995; Zapata and Rambaldi 1997).Furthermore, pretests are necessary to determinethe number of unit roots and the cointegratingranks before proceeding to estimate the VectorError-Correction Model (VECM).

Toda and Yamamoto (1995) propose asimple procedure requiring the estimation of an'augmented' VAR, which guarantees theasymptotic distribution of the MWald statisticeven when there is cointegration. The Toda­Yamamoto causality procedure has been labelledas the long-run causality tests. One needs todetermine the maximal order of in tegration d

max

46 PertanikaJ. Soc. Sci. & Hum. Vol. 8 No.1 2000

Testing for Causality Between Taxation and Government Spending: An Application of Toda-Yamamoto Approach

which is expected in the model and construct aVAR in their levels with a total of p = (k + d ma)lags. Toda and Yamamoto point out that for d=1the lag selection procedure is always valid sincek(l=d. If d=2, then the procedure is also validunless k=1. Moreover, according to Toda andYamamoto, the MWald statistic is valid regardlesswhether a series is 1(0), 1(1) or 1(2), non­cointegrated or cointegrated of any arbitraryorder.

To examine the causality betweengovernment expenditure and governmentrevenue our structural VAR model consist ofthree (p=3) variables; government revenues(GR), government expenditures (GE) andnational output (Q).l Using Akaike's InformationCriteria (AlC) as the lag selection criteria, say,the lag length chosen k=2. If d max=l, then wemust estimate a VAR(3). Suppose we want to testthat GE does not Granger cause GR, we thentest that GE'_I and GE

t_ 2 do not appear in the

GR, equation. The estimated system is:

(1.1)

where A's are three by three matrices ofcoefficients with Ao as an identity matrix. The

null hypothesis is H o : aW =a~~ =0, where a~~are

the coefficients of GEt_i' i=l, 2, in the firstequation of the system. The existence of acausality from government expenditure togovernment revenue can be established throughrejecting the above null hypothesis whichrequires finding the significance of the MWaldstatistic2 for the group of the lagged independentvariables identified above. A similar testingprocedure can be applied to the alternativehypothesis that government revenue does not

Granger cause government expenditure, is totest H o : aW = a~;) =0, where a~~ are thecoefficients of CRt-i, i=I,2, in the second equationof system equation (1.1) where the system isbeing estimated as a VAR(3).

Sources and Description of Data Used

The study utilised annual data series for allthree variables, namely government revenues,government expenditures and output for theperiod 1960 to 1990. The real GDP series wereutilised to proxy for national real output. Allvariables were compiled from various issues ofthe Quarterly Bulletin published by Bank NegaraMalaysia.

THE EMPIRICAL RESULTS

The application of the Toda-Yamamoto approachrequires information about the lag length (k)and the maximum order of integration (d) ofthe variables. The order of integration of eachvariable is not examined as a pretest. This isbecause in most cases, the order of theintegration of macroeconomic variables are atmost two. The causality test for both d =1 andd max=2 is done after selecting the lag l~;gth.

In this study, the optimal lag length wasdetermined using the AlC. Although the AlCchose k=l as the optimal lag, we have presentedk=2 and k=3 to show the robustness of theresults at various lag lengths. We thereforeestimated a system of VARs (p) where(p=dm~+k=2,p=dm~+k=3,p=dm~+k=4;p=dm~+k=3,

p=dmax+k=4, p=dmax+k=5) and then calibrated theMWaid test statistics The result for d =1 andmaxd max=2 are presented in Tables 1 and 2respectively. In each table we have also presentedthe respective p-values.

The test results in Table 1 clearly suggestthat government revenue and governmentexpenditure are bi-directional in nature. Theresults are robust irrespective of the number oflag length estimated. For all lag length chosen,lag 1, 2 and 3, indicate that the null hypothesisof Granger non-causality from governmentrevenues to government expenditures is rejected

1. Output is included in the analysis as a third variable because both government expenditures and governmentrevenues are related to the overall conditions in the economy (see Payne, 1997). Furthermore, the inclusion ofoutput is to alleviate the problem of spurious causal effects due to omitted important variable from the investigatedrelationship.

2. With the degree of freedom equal to the number of restriction imposed.

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Mariam Abdul Aziz, Muzafar Shah Habibullah, W.N.W. Azman-Saini & M. Azali

at the five percent significance level. At the sametime, the null hypothesis of Granger non-causalityfrom government expenditures to governmentrevenues can be rejected at the five percentsignificance level for all lag length. These resultssupport the fiscal synchronization hypothesis for

Malaysia.Our results in Table 2 suggest similar bi­

directional causality that runs from governmentexpenditures to government revenues and fromgovernment revenues to governmentexpenditures in the case of d max=2. The nullhypothesis of Granger non-causality running fromgovernment revenues to governmentexpenditures and from government expendituresto government revenues is rejected at the five

percent significance level. The robustness of theresults of both the dmax=l and d max=2 supportsthe existence of a two-way causal relationshipbetween government expenditure and taxrevenues in Malaysia.

CONCLUSION

Most of the empirical studies addressing thedebate about the causal relationships betweengovernment expenditures and revenues havefocused on developed nations. In addition, theprocedures employed were based on the testingfor unit root, cointegration, error-correctionmodeling and the vector error-correctionmodeling and Granger causality.

This study, however, adopts the methodology

TABLE 1Results of long-run non-causality test due to Tocla-Yamamoto (1995) for dmax =1

Null hypothesis Test statisticsMWaid statistics p-values

k=l:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

18.4848.161

0.000**0.004**

k=2:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

33.11018.453

0.000**0.000**

k=3:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

36.66313.312

0.000**0.004**

Notes: Asterisk (**) denotes statistically significant at one and five percent level respectively.

TABLE 2Results of long-run non-causality test due to Toda-Yamamoto (1995) for dmax=2

Null hypothesis Test statisticsMWald statistics p-values

18.960 0.000**18.430 0.000**

31.962 0.000**13.264 0.001 **

53.645 0.000**18.093 0.000**

k=3:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

k=l:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

k=2:Government revenue does not Granger cause government expenditureGovernment expenditure does not Granger cause government revenue

Notes: Asterisk (**) denotes statistically significant at one and five percent level respectively.

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Testing for Causality Between Taxation and Government Spending: An Application of Toda-Yamamoto Approach

of Granger non-causality recently proposed byToda and Yamamoto (1995) to test the causalrelationship between government expendituresand government revenues for Malaysia. Theevidence, based on MWald-tests, generallysupports the existence of the bi-directionalcausality between government spending andgovernment revenues. The results are robustwith respect to our assumption that the variablesare 1(1) and 1(2).

The empirical evidence of bi-directionalcausal relationship implies fiscal synchronizationin Malaysia. This suggests that the governmentcompares the marginal benefits and marginalcosts of any balanced budget change whenformulating a decision in terms of theappropriate levels of government revenues andexpenditures.

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