Causality Between Government Revenues and Spending in Europe

Testing for causality between government revenues and spending reveals useful information on the source of budgetary imbalances. This can form the basis for deciding, whether to base fiscal consolidation on spending cuts or on revenue increases. To this end, this paper conducts Granger-causality tests for several European Union (EU) countries, while also paying attention to long-term mechanisms (error-correction). Diverse outcomes for the 12 countries in the sample are found, with mutual causality (synchronization) in place for Austria, Finland, Great Britain, Greece and Portugal, and the evidence of ‘tax-and-spend’ behavior for Germany, Ireland, the Netherlands and Sweden. No evidence of any causality was found for Belgium, Denmark and Italy. Generally, these results are confirmed by an effectiveness analysis, especially when focussing on short-term causality results. Revenue increases appear to be more effective in consolidation of public finances in Austria, Finland, Great Britain, Portugal and Sweden, while for other countries less clear indications can be derived. The diversity of causality results point at national fiscal institutions having to play a key role in reducing budgetary imbalances.