Estimating the permanent income elasticity of government expenditures: Evidence on Wagner's law based on oil price shocks

This paper provides instrumental variable estimates of the permanent income elasticity of government expenditures. It uses annual variation in the international oil price weighted with countries' average oil net-export GDP shares as a plausibly exogenous source of within-country variation in countries’ permanent income. The short-run estimates of the permanent income elasticity are robust across alternative specifications and are below one: the estimated elasticity coefficients range between 0.3 and 0.6 and have standard errors of 0.1 and 0.4, respectively. Point estimates of long-run elasticities are somewhat larger but still smaller than unity. The investment component of government spending is found to be more elastic than the consumption component, whereas elasticity differences between rich and poor countries are insignificant. ► We provide IV estimates of the permanent income elasticity of government spending. ► Oil price shocks are an exogenous source of within-country variation in national income. ► Short-run estimates of the permanent income elasticity range between 0.3 and 0.6. ► Long-run estimates are somewhat larger but still smaller than unity.