Economic Openness and Government Size

A body of influential research has argued that there may be a positive relationship between openness and government size, motivated by the need to compensate the additional risk that national economies bear when facing increasing exposure to foreign trade (the compensation hypothesis). On the other hand, it has been suggested that more economic openness may de facto reduce the autonomy of national tax and spending policies through capital mobility (the efficiency hypothesis). This paper provides additional insights on this topic. In particular, it shows that:

1. the empirical evidence in favour of the compensation hypothesis may to some extent be driven by specific geographical areas, which means that the hypothesis cannot be safely generalised;
2. the efficiency hypothesis is more easily verified when both within-country and between-country variability are considered;
3. the introduction of a measure of capital openness would strengthen the efficiency hypothesis;
4. the concepts of natural openness and residual openness may help explain the different impacts of trade and capital openness on the government consumption of low-income and high-income countries.