On the relationship between trade openness and government size

Abstract

Does trade openness systematically imply bigger governments, as proposed by Rodrik (1998)? This paper presents a novel and more refined explanation for when and why international trade may enlarge the public sector. We propose that trade openness is associated with bigger governments if (i) the price volatility of a country's export basket is substantial and (ii) the country is democratic. The first condition satisfies the prior that open trade barriers indeed introduce uncertainty and external risk -something that is not necessarily the case for all trade. The second condition ensures that the people's desire for greater economic security can be realized through government spending. Empirical evidence for 143 countries (accounting for approximately 96 percent of world population) from 2000-2016 is consistent with this hypothesis. Exploring areas of public spending, we find intuitive patterns: Consistent with the compensation hypothesis, government spending on economic affairs and housing increases significantly with trade openness, whereas public spending on education, health care, and the military are not immediately concerned. As with our general result, this is only the case in democracies that are subject to high price volatility on the global market.

Trade Openness and Sustainable Government Size: Evidence from Central and Eastern European Countries

“…Based on panel data for 126 countries from 1980 to 2018, the relationship between trade openness and government size was negative in high-income countries but positive in low-income ones. Bharati et al [41] also found results endorsing the compensation hypothesis in their study of 137 countries. In a long-term analysis of Spain, Espuelas [42] found that trade openness positively affects social spending when fiscal capacity is high, but negatively when it is low, over the period 1850-2000.…”

“…Their findings highlighted a causal relationship between openness and education expenditures, but only in low-income countries, providing no support for the compensation hypothesis. A variety of empirical studies have been conducted in recent years to elucidate the relationship between trade openness and government size [34][35][36][37][38][39][40][41][42][43]. For example, Lin et al [34] discovered that heightened trade openness enlarges the government size in small developing countries from 1985 to 2010.…”