Working Paper: CEPR ID: DP6065
Authors: Paolo Epifani; Gino Gancia
Abstract: This paper investigates the relationship between trade openness and the size of governments, both theoretically and empirically. We argue that openness can increase the size of governments through two channels: (1) a terms of trade externality, whereby trade lowers the domestic cost of taxation, and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a unified framework for studying and testing these two mechanisms. Our main theoretical prediction is that the relative strength of the two explanations depends on a key parameter, namely, the elasticity of substitution between domestic and foreign goods. Moreover, while the first mechanism is inefficient from the standpoint of world welfare, the second is instead optimal. In the empirical part of the paper, we provide new evidence on the positive association between openness and government size and we explore its determinants. Consistently with the terms of trade externality channel, we show that the correlation is contingent on a low elasticity of substitution between domestic and foreign goods. Our findings raise warnings that globalization may have led to inefficiently large governments.
Keywords: elasticity of substitution between imports and exports; government size; openness; terms of trade externality
JEL Codes: F1; H1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trade openness (F43) | domestic cost of taxation (H29) |
| trade openness (F43) | government size (H11) |
| trade openness (F43) | demand for public insurance (G52) |
| elasticity of substitution (D11) | domestic cost of taxation (H29) |
| demand for public insurance (G52) | government size (H11) |