Trade Openness and Sustainable Government Size

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This entry is adapted from the peer-reviewed paper 10.3390/su151511836

The ongoing discussion regarding the role of the free market economy and the extent of state intervention is a critical subject in economics. This matter holds special significance for transition economies, as it presents both challenges and opportunities in such contexts. One may perceive the degree of trade openness as a path toward welfare societies. However, the dual impacts of trade openness on an economy, namely, the compensation and efficiency hypotheses, must be considered. The compensation hypothesis proposes that global trade can enhance the economic influence of the state, whereas the efficiency hypothesis advocates for a contraction in the state’s economic undertakings.

government size trade openness compensation hypothesis efficiency hypothesis

1. Introduction

Following the collapse of the Berlin Wall in the 1990s, a myriad of transition economies in Europe embarked on a profound process of transformation. These changes were not restricted to economics but also permeated political, social, cultural, and other sectors. Countries that were previously engaged in a limited global network witnessed remarkable economic transformations. The pace of this shift was amplified with their entry into the European Union (EU), one of the most substantial economic blocks worldwide. The European Union consistently expands its international trade potential every day. As they pursue a growth strategy centered on exports, these countries have indicated levels of exports and imports that exceed the worldwide average. The evolution stages and economic shifts of these nations have continually piqued the interest of economic scholars. The influence of the public sector’s size on openness and other economic activities in transition economies has been explored in various studies. Such research primarily concentrates on macroeconomic variables like economic growth, inflation, financial integration and progress, interest rates, and borrowing. Moreover, the repercussions of political elements such as corruption in these economies have also garnered attention. The research is sparked by the alterations these nations have experienced regarding government size and trade openness. Inevitably, the augmentation of infrastructure by the government during this shift would induce additional influences on the economy. The impact of trade openness on the scope of government essentially materializes in two ways. The first approach is known as the compensation hypothesis. This suggests that the government offsets any escalated costs and risks that arise from an increase in trade openness. As a result, the extent of state intervention in the economy, reflected by public spending, broadens. However, from a liberal point of view, this might result in a long-term economic downturn. The second avenue is referred to as the efficiency hypothesis. According to this theory, greater trade openness prompts a reduction in taxes, thereby boosting the competitiveness of domestic businesses and enticing foreign capital. Consequently, the level of public expenditure contracts along with the reduction in public revenue.

From a liberal perspective, one would expect minimal government intervention. Yet, attaining this completely can be difficult in these nations that are transitioning from socialist and closed economies to more liberal ones. Openness, which underscores the provision of unhindered international trade in goods and services with minimal state intervention, is a significant concept. A nation’s openness level indicates foreign trade’s influence on its economy and its openness to external economies. The European Union Trade Commission posits trade openness as an essential tool that allows European Union firms to achieve global competitiveness. This perspective asserts that maintaining an open trade policy is integral for EU firms to sustain their competitive edge on a worldwide scale. Firms engaged in exporting activities demonstrate higher productivity levels and facilitate the creation of millions of jobs across the EU. Moreover, imports enable the EU to leverage resources from other countries, which include the production of new and cost-efficient intermediate to final goods and services, innovative ideas, advanced technologies, and more. The continuity of these aspects firmly cements the EU’s position in the global economic sphere ^[1]. Particularly after the 1980s, trade openness gained prominence due to liberalization policies, and was regarded as a critical factor for enhancing welfare ^[2]. A prevailing issue in today’s developing nations is the scarcity of resources and savings. As a result, the participation of international corporations and resources is essential in order to produce high-quality goods with remarkable factor productivity. This approach will lead to the advancement and competitiveness of industries. Therefore, in a free market system, a nation’s capability to efficiently produce in the long run hinges on its foreign trade policies. To accomplish absolute trade openness, a country must eliminate all restrictions on imports and exports. However, this cannot be achieved solely based on free market regulations. Hence, the state is anticipated to support the process with policies and practices encouraging trade openness through public expenditures and other guidelines.

Moreover, the extent of governmental intervention in economic affairs has been a topic of contentious debate within economics for several centuries. The classical school of economics perceived the state as a “Leviathan” beast, considering its economic activities as mere instruments. In contrast, Keynesian theory posited fiscal policy instruments as the primary impetus for addressing economic issues and stabilizing macroeconomic factors. Governmental economic activities can influence every variable in the economy, either directly or indirectly. As highlighted by Rodrik ^[3], rising trade openness levels can affect governmental size. The perspectives on international trade and trade openness have evolved since the era of mercantilism. Mercantilist theory underlined that a state would grow wealthier through exporting via international trade, and thus, should implement policies promoting exports. Meanwhile, classical and neoclassical schools of thought advocated that countries could establish firms through foreign trade that would vie with global firms, thereby attaining production efficiency via technological advancements, R&D, and technology transfers. However, the Keynesian perspective asserts that such goals can be realized through fiscal policy tools such as public expenditures, taxes, and public borrowing. Drawing from these perspectives expressed in various economic doctrines, one can infer that the state’s size and trade openness are either directly or indirectly interconnected.

2. Trade Openness and Sustainable Government Size

The correlation between trade openness and government size is illuminated through the compensation and efficiency hypotheses. The seminal study examining the interplay between trade and government size was initiated by Cameron ^[4], and its development was later advanced by Rodrik ^[3]. Cameron ^[4] posits that globalization’s rise engenders an escalation in inter-country trade relations. The hastening of industrial concentration paves the way for workers to form unions and collectively bargain to safeguard their rights. Such robust unions catalyze an elevation in social welfare expenditures such as pensions, employment insurance, social security, and job training, culminating in increased government size. Rodrik ^[3] contributed to the literature with another foundational study in this area, arriving at similar conclusions about the government size and trade openness relationship but from a broader perspective. By underscoring external risks in countries with open trade policies, he highlights the expenditures on social insurance and assistance made to shield society from these risks, thereby exerting pressure to boost public expenditures. In this context, Rodrik ^[3] asserts that compensatory public expenditures are undertaken to mitigate the societal welfare loss stemming from external risks and shocks associated with openness. This relationship, where trade openness drives up government size, is termed the compensation hypothesis in the scholarly literature. A substantial body of research lends support to the compensation hypothesis ^[5]^[6]^[7]^[8]^[9]^[10]^[11]^[12].

The efficiency hypothesis provides another perspective on the connection between trade openness and government size. At the heart of the efficiency hypothesis lies the premise that governments may have to curtail their tax collections in response to amplified capital openness, necessitating cuts in public expenditures to avoid budgetary shortfalls ^[13]. The overarching objective of the efficiency hypothesis is to lessen the tax burden to safeguard the international competitiveness of domestic firms and stave off cost pressures ^[14]. Diminished tax revenues inevitably result in reduced public spending. From the 1980s onward, as the globalization trend gained momentum and public interventions in the economy began to recede, the growth rate of tax revenues saw a downturn. During this era, while the tax base was expanded, statutory corporate tax rates witnessed a decline in OECD and EU member countries, among others ^[15]^[16]^[17]^[18]^[19]. Consequently, there was no decrease in tax revenues. Per the efficiency hypothesis, a key complement to the reduction in capital taxation is that capital openness and trade openness exert a downward effect on the size of the government, as opposed to augmenting it. The literature also corroborates the efficiency hypothesis, with numerous supporting studies ^[13]^[20]^[21]^[22].

The correlation between government size and trade openness, as predicted by the compensation and efficiency hypotheses, is also analyzed in light of aspects such as countries’ political systems and economic structures. Some research indicates that the validity of the compensation hypothesis is contingent upon the degree of democracy in countries ^[12]^[23]^[24]. Assessing the repercussions of trade openness based on countries’ sizes, Mendonça and Oliveira ^[25] argue that trade openness augments the public sector’s size in developing nations, whereas it does not prompt a similar enlargement in affluent nations.

Conversely, Abizadeh ^[26] elucidates that in small, open economies, the government’s economic role contracts as trade openness amplifies. With capital fluidity increasing among countries due to globalization, affecting economic ebbs and flows, the concept of capital openness has been considered. Consequently, a few studies probe the relationship between financial openness, globalization, and government size; Quinn ^[27], for instance, establishes a positive link between financial openness, economic growth, and public expenditures, suggesting that capital openness widens income disparity. Kimakova ^[5], incorporating financial openness into the function of openness and government size, posits that it triggers increased public spending. However, Garrett and Mitchell ^[28] suggest that trade openness and financial openness culminate in reduced total public expenditure, while countries with high Foreign Direct Investment (FDI) tend to impose heavier taxes on substantial capital. Cusack and Garrett ^[29] propose that diminishing barriers to capital flows and increasing financial integration impede the growth of government size. In a subsequent study, Garrett ^[6] asserted that the relationship between trade openness and government size is positive, but capital mobility does not lead to an uptick in government size.

References

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1. Introduction

2. Trade Openness and Sustainable Government Size

References