Openness, government size and the terms of trade

Paolo Epifani, Gino Gancia

Research output: Journal PublicationArticlepeer-review

78 Citations (Scopus)

Abstract

This paper investigates the relationship between trade openness and the size of governments, both theoretically and empirically. We argue that openness can increase the size of governments through two channels: (1) a terms-of-trade externality, whereby trade lowers the domestic cost of taxation, and (2) the demand for insurance, whereby trade raises risk and public transfers. We provide a unified framework for studying and testing these two mechanisms. Our main theoretical prediction is that the relative strength of the two explanations depends on a key parameter, namely, the elasticity of substitution between domestic and foreign goods. Moreover, while the first mechanism is inefficient from the standpoint of world welfare, the second, instead, is optimal. In the empirical part of the paper, we provide new evidence on the positive association between openness and government size and we explore its determinants. Consistent with the terms-of-trade externality channel, we show that the correlation is contingent on a low elasticity of substitution between domestic and foreign goods. Our findings raise warnings that globalization may have led to inefficiently large governments.

Original languageEnglish
Pages (from-to)629-668
Number of pages40
JournalReview of Economic Studies
Volume76
Issue number2
DOIs
Publication statusPublished - 2009
Externally publishedYes

ASJC Scopus subject areas

  • Economics and Econometrics

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