Estimating Income Elasticity of Government Expenditures: Evidence from Oil Price Shocks

We estimate the income elasticity of government expenditures using variation in the international oil price as a plausibly exogenous source of within-country variation of countries’ permanent income. Our short run elasticity estimates, between 0.25-0.50, are generally somewhat smaller than the previously obtained ones, and they, in particular, indicate that Wagner’s law does not hold; long run elasticities are larger, but still smaller than unity. We also explore the correlates of the income elasticity of government spending and find no support for views that either democracy, inequality, or openness are associated with a larger elasticity. However, we find evidence consistent with “voracity” theories: cross-country differences in ethnic polarization are associated with a significantly higher oil price driven income elasticity of government spending.