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Government Size, Trade Openness, and Output Volatility: A Case of fully Integrated Economies

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Abstract

Government is often considered the safe sector of an open economy that provides households with insurance against external risk exposure. Among highly integrated economies, however, households should be able to exploit common financial markets to insure themselves. In this paper we examine the relationship between government size, trade openness, and output volatility across fully integrated economies using Japan’s regional income accounting and public finance data. The contributions of the government- and market-based insurances to inter-regional risk sharing are also estimated. The empirical results reveal some unique aspects of the state-market interactions under full economic integration with vertical fiscal imbalance.

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Notes

  1. Rodrik (2011) highlights the complementarity between market and state as an essential feature of the process of economic globalization.

  2. See Svaleryd and Vlachos (2002) for evidence on positive interdependence between trade liberalization and financial market development.

  3. An implicit assumption is that governments at the local level can function similarly to governments at the national level in provision of insurance and risk-sharing means. Nonetheless, we also note that the findings of this study may not be readily generalizable at the international level because the unique features of Japan’s fiscal system may not be shared by a fiscal union of sovereign states.

  4. It should be noted that, as Alesina and Wacziarg (1998) acknowledges, their account and Rodrik’s are not necessarily mutually exclusive.

  5. For evidence on Wagner’s law, see Abizadeh and Gray (1985), Ram (1987), and Brückner et al. (2012) among others.

  6. Differences in political accountability and electoral system can also generate variation in government size across countries (Persson and Tabellini 1999). However, for the intra-Japan investigation, they are unlikely to play a chief role.

  7. A recent study by Collard et al. (2017) uses a standard New-Keynesian model with multiple shocks to find that the relationship between volatility and government size can be non-monotonic, and hence, it may not be restricted to be negative. Specifically, the relationship can turn positive when government size exceeds a threshold so that the volatility amplification emanating from expenditure shocks dominates the volatility mitigation on other shocks.

  8. An important exception is the intra-US investigation of Fatás and Mihov (2001).

  9. See, for instance, Bordo et al. (2013).

  10. The prefectures are listed in Table 7 in the data Appendix. Within a prefecture there are municipalities (i.e. cities, towns, and villages) as smaller administrative units. For the remainder of this paper, the prefectural and municipal governments combined are referred to as the local government.

  11. See Ministry of Internal Affairs and Communications (2014) for details.

  12. Specifically, 32% of the income and alcohol tax revenue, 34% of the corporate tax revenues, 29% of the consumption tax revenue, and 25% of the tobacco tax revenue are used as a fund.

  13. The main usages of the NTD include social welfare payment, compulsory educational expenses, child-rearing support, recovery and reconstruction from earthquakes, and ordinary construction work expenses. The allocative decisions are made by the corresponding ministries within the central government.

  14. Consequently, both the local government consumption and investment expenditures contain the transfer payment as a financial source.

  15. Brückner and Tuladhar (2013) provides an empirical assessment of the spillover effects of local government spending in Japan.

  16. See Ministry of Internal Affairs and Communications (2014) for details.

  17. See Persson and Tabellini (1996) for more general analyses of moral hazard in a fiscal federation with two levels of government.

  18. While the Annual Report contains both nominal and real data, the real series have an advantage of being free from possible cross-prefectural difference in relative price of government purchases. We thus use the real data.

  19. The independent local revenue consists mostly of the prefectural and municipal tax revenues including those on the inhabitant tax, enterprise tax, local consumption tax, real estate acquisition tax, automobile tax, and fixed asset tax.

  20. We additionally run panel regressions to provide the estimates in the Appendix.

  21. The following prefectural GDP accounting identities hold: GDP ≡ private final consumption + government final consumption + gross capital formation (GCF) + export − import; GCF ≡ gross fixed capital formation (GFCF) + inventory changes; GFCF ≡ Gross fixed (GF) private capital formation + GF public capital formation (GFPCF); and GFPCF ≡ GF residential capital formation + GF business equipment capital formation + GF government capital formation.

  22. It is not possible to measure the extent of openness to international trade by prefecture because no data are available. Japan is among the countries that are least open to international trade with the trade-to-GDP ratio of only 24% on average for 1996–2009. The openness for inter-prefectural trade is far greater at approximately 133%. These suggest that trade vis-à-vis other prefectures has more significant implications for the prefectural economies and governments.

  23. For robustness, we also used the 2006–2007 averages for the dependent variable to remove possible effects of the 2008 world financial crisis. The results turn out to be qualitatively very similar, and hence, they are not reported to conserve space.

  24. Specifically, we divide the data into three sub-periods of 1996–2000, 2001–2005, and 2006–2009. The independent and dependent variables are measured, respectively, by the averages of the first three years and the following years of each sub-period to avoid endogeneity. The resulting panel (of three periods by forty-seven prefectures) is used for the estimations.

  25. The idea of the specialization index comes initially from Krugman (1991). The index he proposed uses the sectoral shares in employment rather than output and the absolute values instead of squares. We rely on the output data because the corresponding data on sectoral employment are not available. Kalemli-Ozcan et al. (2003) uses (2) to assess the extents of specialization within manufactures by limiting k to be manufacturing sub-sectors and defining y i to be total manufacturing output. In our intra-Japan context, products and services other than manufactures can also be tradable. Thus, we consider all sectors for k.

  26. In particular, access to integrated financial markets can have significant implications. In the international context, Kimakova (2009) finds that richer financially open economies tend to have smaller governments. Thus, our results are in part consistent with and complementary to the findings of the previous international studies, despite the apparent differences in the trade openness effect estimates.

  27. These component figures are available only in nominal series. Therefore, we take their ratios to the nominal GDP and deflate them by the prefectural GDP deflators.

  28. For implications of fiscal spending shocks in a monetary union, see Bénétrix and Lane (2010).

  29. The intra-US investigation of Fatás and Mihov (2001) avoids this endogeneity problem because their measure of the state government size is determined federally without endogenous responses to the state output fluctuations.

  30. The exercises conducted in section 5 do not require the sectoral output data. Thus, we report the estimates on the full sample including Okinawa prefecture.

  31. In addition to those cited in the main text, see Atkeson and Bayoumi (1993), von Hagen (1993), Bayoumi and Masson (1995), and Sørensen and Yosha (1998). von Hagen (2000) provides an excellent review of the literature.

  32. The European commission (1977) reports equally high or even higher estimates for France, Germany, and Italy.

  33. Kalemli-Ozcan et al. (2003) also estimates for 1975–1993 that about 97% of the idiosyncratic shocks in Japan are insured. While the contribution of capital market is estimated 21.6%, the breakdown between the fiscal and credit channels are not specified. Also, van Wincoop (1995) compares the risk sharing in Japan to that across the OECD countries via the metric of consumption correlations.

  34. The year specific constant term in (5) absorbs the effects that are common to all prefectures but vary by year.

  35. It is interesting to observe that our estimate also closely matches the share of debt in Japan’s total international assets estimated by Rogoff and Tashiro (2014).

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Acknowledgements

The author thanks three anonymous referees of this journal for helpful comments. All remaining errors are solely of the author’s. This research was supported by JSPS KAKENHI Grant Number 25285087.

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Authors and Affiliations

  1. School of Economics, Kwansei Gakuin University, 1-155 Uegahara Ichiban-cho, Nishinomiya, Hyogo, 662-8501, Japan

    Eiji Fujii

  2. Center for Economic Studies & Ifo Institute, Munich, Germany

    Eiji Fujii

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  1. Eiji Fujii
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Correspondence to Eiji Fujii.

Appendix

Appendix

1.1 Data sources

The data used in this study are obtained from the following two sources:

  • Annual Report on Prefectural Accounts 2012 CD-ROM, Department of National Accounts, Economic and Social Research Institute, Cabinet Office, Government of Japan.

  • Regional Statistics Database, Official Statistics of Japan.

Notes

Data on the disposable income (DI) are available only in nominal figures. We convert them into real series using the prefectural GDP deflators. Also, there are a couple of prefecture-specific incidents of missing observations. First, the observations on Tokyo’s DI are missing altogether. We obtain the 2001–2009 nominal figures from Tokyo Metropolitan Government’s site (http://www.toukei.metro.tokyo.jp). These figures are then converted into real terms using Tokyo’s GDP deflator. Secondly, Aichi prefecture’s export and import are available only in nominal figures. They are also converted into real series using Aichi’s prefectural GDP deflator.

1.2 Sectors for the specialization index

The specialization index in sub-section 4.2 is constructed by using the output data on the following sectors:

  1. A.

    Industries

  1. 1.

    Agriculture, forestry and fishing

1) Agriculture, 2) Forestry, 3) Fishing

  1. 2.

    Mining

  2. 3.

    Manufacturing

1) Food products and beverages, 2) Textiles, 3) Pulp, paper and paper products, 4) Chemicals, 5) Petroleum and coal products, 6) Non-metallic mineral products, 7) Primary metal, 8) Fabricated metal products, 9) Machinery, 10) Electrical machinery, equipment and supplies, 11) Transport equipment, 12) Precision instruments, 13) Others

  1. 4.

    Construction

  2. 5.

    Electricity, gas and water supply

1) Electricity supply, 2) Gas and water supply

  1. 6.

    Wholesale and retail trade

  2. 7.

    Finance and insurance

  3. 8.

    Real estate

  4. 9.

    Transport and communications

  5. 10.

    Service activities

  1. B.

    Producers of government services

  1. 1.

    Electricity, gas and water supply

  2. 2.

    Service activities

  3. 3.

    Public administration

  1. C.

    Producers of private non-profit services to households

  1. 1.

    Service activities

1.3 Inter-prefectural distance

The inter-prefectural distance is measured by the geographical distance between the prefectural capitals using the program provided by the Geospatial Information Authority of Japan, Ministry of Land, Infrastructure, Transport and Tourism.

Table 7

Table 7 List of the prefectures
Full size table

Table 8

Table 8 Determinants of government size – Panel estimates
Full size table

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Fujii, E. Government Size, Trade Openness, and Output Volatility: A Case of fully Integrated Economies. Open Econ Rev 28, 661–684 (2017). https://doi.org/10.1007/s11079-017-9433-4

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