Pharmaceutical expenditure and gross domestic product: Evidence of simultaneous effects using a two‐step instrumental variables strategy

This paper estimates the income elasticity of government pharmaceutical spending and assesses the simultaneous effect of such spending on gross domestic product (GDP). Using a panel dataset for 136 countries from 1995 to 2006, we employ a two‐step instrumental variable procedure where we first estimate the effect of GDP on public pharmaceutical expenditure using tourist receipts as an instrument for GDP. In the second step, we construct an adjusted pharmaceutical expenditure series where the response of public pharmaceutical expenditure to GDP is partialled out and use this endogeneity adjusted series as an instrument for pharmaceutical expenditure. Our estimations show that GDP has a strong positive impact on pharmaceutical spending with elasticity in excess of unity in countries with low spending on pharmaceuticals and countries with large economic freedom. In the second step, we find that when the quantitatively large reverse effect of GDP is accounted for, public pharmaceutical spending has a negative effect on GDP per capita particularly in countries with limited economic freedom.