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Discussion Paper Details

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Title: On Globalization and the Growth of Governments

Author(s): Paolo Epifani and Gino Gancia

Publication Date: January 2007

Keyword(s): elasticity of substitution between imports and exports, government size, openness and terms of trade externality

Programme Area(s): International Macroeconomics

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.

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Bibliographic Reference

Epifani, P and Gancia, G. 2007. 'On Globalization and the Growth of Governments'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=6065