1 Prof. George E. Halkos & Epameinondas A. Paizanos The effect of economic growth and government expenditure on the environment: evidence using distributed lag models Prof. George Halkos & Epameinondas Paizanos Lab of Operations Research, Dept of Economics University of Thessaly Οικονομική των Φυσικών Πόρων και του Περιβάλλοντος: Κλιματική Αλλαγή 1 ο Πανελλήνιο Συνέδριο Volos, March 2014 This research has been co-financed by the European Union (European Social Fund – ESF) and Greek national funds through the Operational Program "Education and Lifelong Learning" of the National Strategic Reference Framework (NSRF) - Research Funding Program: Heracleitus II. Investing in knowledge society through the European Social Fund. 1

2 Prof. George E. Halkos & Epameinondas A. Paizanos Introduction The environmental Kuznets curve (EKC) hypothesis posits that in the early stages of economic development environmental degradation will increase until a certain level of income is reached and then environmental improvement will occur. A large fraction of national GDP is spent by governments affecting a variety of economic variables and wealth in general, while a recent strand of literature suggests that government spending is an important determinant of environmental quality (Lopez et al., 2011, Halkos and Paizanos, 2013; Galinato and Islam, 2014). 2

Introduction (cont’d) Four mechanisms by which level and composition of fiscal spending may affect pollution levels: Scale effect (environmental pressures due to economic growth), Composition effect (increased human capital intensive activities instead of physical capital intensive industries that harm environment more), Technique effect (due to higher labor efficiency) Income effect (increased income raises demand for improved environmental quality).

4 Prof. George E. Halkos & Epameinondas A. Paizanos Introduction (cont’d.) It is highly unlikely that the effects of income and government spending occur instantaneously (Halkos, 2003; Lopez et. al., 2011). Dynamics should be taken into account due to: 1) Technological reasons 2) Psychological reasons 3) Institutional reasons 4) Imperfect knowledge Our paper is the first to explicitly study the short-run as well as the long-run effects of both economic development and government expenditure on the environment. 4

5 Prof. George E. Halkos & Epameinondas A. Paizanos Data Panel data for 71 countries with full set of SO 2, CO 2, share of GOVEXP and GDP/c for ( for SO 2 ) observations per variable. The two pollutants vary in geographical range of impact. Since SO 2 moves away from the atmosphere within 10 days after its emission, impact is mainly local or regional, whereas CO 2 emissions, whose atmospheric life is between 50 to 200 years, have a more global impact. Based on sources of pollution, SO 2 pollution characterized as production-generated, while CO 2 emissions are mix between production and consumption–generated pollution. 5

6 Prof. George E. Halkos & Epameinondas A. Paizanos Methodology Box-Cox tests have been performed to test linearity against logarithmic functional forms. Akaike and Bayesian information criteria indicate that a cubic specification is appropriate in our sample. The income variable and its powers control for scale effects. C oefficient of GOVEXP captures the composition, income and technique effect. 6

7 Prof. George E. Halkos & Epameinondas A. Paizanos Methodology (cont’d) To consider correlation between cross-section specific error-component (e.g. country specific climate and geography) and explanatory variables, FE are used instead of RE. To mitigate reverse causality bias occurring from potential endogeneity between GOVEXP and pollution we use the lagged share of government expenditure. Since our panel consists of large N and T dimensions, dynamics and non-stationarity are taken into account by employing the Dynamic Fixed Effects (DFE) estimator proposed by Pesaran and Smith (1995). 7

8 Prof. George E. Halkos & Epameinondas A. Paizanos Methodology (cont’d) For DFE we set up an ADL. If the variables are I(1) and cointegrated then the error term is an I(0) process for all i. Hence we specify an error correction model in which deviations from the long-run equilibrium affect the short-run dynamics of the variables as follows: Nonlinearity in the parameters requires that the model is estimated using maximum likelihood. 8

9 Prof. George E. Halkos & Epameinondas A. Paizanos Methodology (cont’d) Including more than one lags of the government expenditure and income variables in (1) to capture dynamics may result in multicollinearity. Use Koyck transformation of estimating distributed lag models. Assuming that subsequent effects of government expenditure and income decline geometrically each year and similar speed of adjustments we have: 9

10 Prof. George E. Halkos & Epameinondas A. Paizanos In all cases variables are I(1) 10 Fisher-type Philips-Peron tests allowing heterogeneity of autoregressive parameters

11 Prof. George E. Halkos & Epameinondas A. Paizanos We reject Ho: no-cointegration in 6/8 cases for SO 2 and in 5/8 in CO 2. Evidence of cointegration. Application of DFE requires variables cointegrated (LR relationship). DFE is applicable. 11

Dynamic Fixed Effects: DFE estimation assumes intercepts differ across countries but that LR coefficients are equal across countries. Mean Group: Alternative estimation method that fits model for each country individually and calculates arithmetic average of the coefficients is the mean- group estimator (MG). This method is less restrictive than DFE since intercepts, slope coefficients and error variances are all allowed to differ across countries. Pooled Mean Group: PMG estimator combines DFE and MG methods by allowing the intercept, short-run coefficients and error variances to differ across groups while assuming equality of LR coefficients.

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Table 2 provides estimates of pollution/c utilizing FE and DFE. Based on FE estimates GOVEXP has negative and significant direct effect on SO 2 /c and insignificant negative relationship on CO 2 /c. Dynamics in columns 2 and 4 of Table 2. Comparing the MG and PMG estimators, with Hausman test, we see PMG estimator, the efficient estimator under Ho, is preferred and thus, assuming LR coefficients to be equal across panels, more appropriate. Another application of Hausman test suggests that simultaneous equation bias between error term and lagged dependent variable minimal and DFE model is most appropriate. DFE estimates suggest that GOVEXP of income possesses a significant negative relationship with SO 2 /c and insignificant negative relationship with CO 2 /c. Both pollutants have significant cubic relationship with income/c.

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16 Prof. George E. Halkos & Epameinondas A. Paizanos Consistent with the previous results, the estimated effect of government expenditure is negative in all cases but remains significant only for SO 2. Specification of the pollution equation (EKC) depends on the group of countries used. SO2: World  Cubic, OECD  Monotonic, Non-OECD  Quadratic CO2: World  Cubic, OECD  Quadratic, Non-OECD  Cubic 16

17 Prof. George E. Halkos & Epameinondas A. Paizanos Government Expenditure elasticity on SO2 LR elasticity of government expenditure on SO 2 is greater than their SR counterparts in all cases. SR elasticity of government expenditure on SO 2 is of similar magnitude among the different groups, however the same does not hold for the LR elasticity. LR elasticity is much greater, in absolute value, in OECD countries suggesting that a sustained increase of 1% in government share leads to a LR reduction of 5.466% in SO 2 emissions, a result which is more than 10 times greater than for Non-OECD countries. 17

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19 Prof. George E. Halkos & Epameinondas A. Paizanos Income elasticity on SO2 and CO2 The elasticity of income on SO 2 is negative for the World and OECD countries group but positive in the Non-OECD countries. The LR elasticity of income on SO 2 for the median income OECD country implies that following a 1% sustained increase in income there will be a 5.6% reduction in SO 2 emissions. On the contrary, a 1% sustained increase in income is estimated to cause a 0.459% increase in SO 2 emissions in a Non-OECD country. For the CO 2 emissions the income elasticity is positive in all groups. However, both in the short- and long-run the effect is much larger in the Non-OECD countries group. 19

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21 Prof. George E. Halkos & Epameinondas A. Paizanos For the effect of GOVEXP on SO 2 /c to cease being strictly negative the correlation between government expenditure and unobservables would need to be 6.25 times larger than the correlation with the observables. However, for CO 2 /c a relative correlation of only 40% or greater, implies that the point estimate of the effect includes zero and thus is not strictly negative. 21

22 Prof. George E. Halkos & Epameinondas A. Paizanos Policy Implications Policy implications, differ according to level of income in a country. In general, reducing GOVEXP enhances economic performance (Folster and Henrekson, 2001; Bergh and Karlsson, 2010). Important to also take into account the indirect effect of GOVEXP on pollution (Halkos and Paizanos, 2013). Cutting GOVEXP should be undertaken with particular care for some levels of GDP. For SO 2 and CO 2 pollution, results suggest that reducing government size in developing countries leads to deterioration of environmental quality. Therefore, cutting government expenditure in these countries should be accompanied by appropriate environmental regulation along with the establishment of international environmental treaties. 22

23 Prof. George E. Halkos & Epameinondas A. Paizanos Policy Implications (cont’d.) Cutting GOVEXP in countries with higher income levels, leads to improvements in both income and environmental quality, while these effects may also have a greater long-run effect. In particular, countries with income level at the decreasing area of the EKC are more likely to have already established the environmental legislation and to have undertaken public expenditures for improvement of environmental quality, hence they are susceptible to diminishing returns from a further increase in government size. Combining our findings with the results from Lopez et al. (2011), cutting out public spending items that increase market failure will be the most beneficial in high income countries. 23