Wagner's Law in Sri Lanka: An Econometric Analysis

This study examines whether there is empirical evidence that Wagner's law holds in the Sri Lankan economy using time series annual data over the period from 1960 to 2010 for Sri Lanka, applying cointegration and error correction modeling (ECM) techniques. In particular, this study keeps a special focus to examine the validity of six versions of Wagner's hypothesis, which support the existence of long-run relationship between public expenditure and economic growth. The empirical evidence of this study indicates that while there prevail is a short-run relationship between public expenditure and economic growth, the long-run results showed no strong evidence in support of the validity of the Wagner’s law for Sri Lankan economy. Granger causality analysis also confirms this result. Therefore, the findings of this study pave to broaden this study further for a deeper understanding about the relationship between public expenditure and economic growth by giving more attention on individual items of public expenditure and by including more macroeconomic variables in the econometric model using different methodology in future. 1. Introduction Fiscal policy is a fundamental instrument that can be used to lessen short-run fluctuations in output and employment. Meanwhile, in macroeconomic issues such as high unemployment, inadequate national savings, excessive budget deficits, and large public debt burdens, fiscal policy has been acknowledged to hold center stage in policy debate in both developed and developing economies. During the global economic recession of the 1930s, the government sectors of both developed and developing economies played a vital role in stimulating economic growth and development, as advocated by Keynes. In such situations every economy attempted to promote its economic growth through increasing government expenditures and reducing taxes. These empirical achievements and the Keynesian theoretical outpourings generated considerable interest among economists and policy makers to the issues of fiscal policy as a stabilising force. Public expenditure is a fundamental instrument that influences the sustainability of public finances via effects on fiscal balances and government debt. Moreover, public expenditure can also pursue other objectives, including output, employment, and redistribution, which can contribute to economic welfare. On the other hand, tax policy can also be used to achieve the fiscal policy goals of fair distribution of income and wealth, efficient resource allocation, economic stabilization, and so on, [1]. Taxes affect