Abstract:The empirical and theoretical literature on long-term relationships in public finance is dominated by two approaches: Fiscal sustainability and Wagner's law of an increasing state activity. In this paper, we argue that these two relationships should be analyzed simultaneously and not separately. We show how Wagner's law might influence fiscal sustainability and how the interaction of the two can be modelled using vector error correction models that include public expenditures, revenues and GDP. For Germany, we find strong evidence for Wagner's law throughout the whole period analyzed , while our results indicate sustainability of public finances only until 1973. We show that, for the period after 1973, it is the interaction of permanent expenditure increases and revenue reductions resulting from fiscal policy reactions to the oil crisis and Wagner's law that ruins the sustainability of public finances in Germany. Our findings underline the importance of the German debt brake for re-establishing sustainable public finances even under Wagner's law.

It is argued that fiscal policy can play a part in preventing a possible downward spiral or be instrumental in achieving a higher long-term path of growth. Never before has this argument been advanced as frequently as in the current economic crisis. However, the economic literature -an overview of which is given here -does not provide an unambiguous answer, either theoretically or empirically, to the question of the relationship between (the smoothing of) cyclical fluctuations and long-term growth. In this context, two main contrasting explanatory paradigms can be identified: Schumpeter's concept of creative destruction and the learning by doing hypothesis. Even if it were possible to identify the relationship more clearly on this basis, it is important not to lose sight of the problems associated with the real-time assessment of the current economic situation, time lags and political economic incentives even in difficult times.

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