The effect of economic growth and
government expenditure on the
environment: evidence using distributed
lag models
Prof. George Halkos & Epameinondas Paizanos
Lab of Operations Research, Dept of Economics University of Thessaly
Οικονομική των Φυσικών Πόρων και του Περιβάλλοντος: Κλιματική Αλλαγή
1ο Πανελλήνιο Συνέδριο
Volos, 26-27 March 2014
This research has been co-financed by the European Union (European Social Fund – ESF) and Greek national funds through the
Operational Program "Education and Lifelong Learning" of the National Strategic Reference Framework (NSRF) - Research Funding
Program: Heracleitus II. Investing in knowledge society through the European Social Fund.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Introduction
• The environmental Kuznets curve (EKC) hypothesis posits
that in the early stages of economic development
environmental degradation will increase until a certain level
of income is reached and then environmental improvement
will occur.
• A large fraction of national GDP is spent by governments
affecting a variety of economic variables and wealth in
general, while a recent strand of literature suggests that
government spending is an important determinant of
environmental quality (Lopez et al., 2011, Halkos and
Paizanos, 2013; Galinato and Islam, 2014).
Prof. George E. Halkos & Epameinondas A. Paizanos
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Introduction (cont’d)
• Four mechanisms by which level and composition of
fiscal spending may affect pollution levels:
• Scale effect (environmental pressures due to
economic growth),
• Composition effect (increased human capital
intensive activities instead of physical capital
intensive industries that harm environment more),
• Technique effect (due to higher labor efficiency)
• Income effect (increased income raises demand for
improved environmental quality).
Introduction (cont’d.)
• It is highly unlikely that the effects of income and government
spending occur instantaneously (Halkos, 2003; Lopez et. al., 2011).
• Dynamics should be taken into account due to:
1) Technological reasons
2) Psychological reasons
3) Institutional reasons
4) Imperfect knowledge
• Our paper is the first to explicitly study the short-run as well as the
long-run effects of both economic development and government
expenditure on the environment.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Data
• Panel data for 71 countries with full set of SO2, CO2,
share of GOVEXP and GDP/c for 1970-2008 (- 2003 for
SO2). 2698 observations per variable.
• The two pollutants vary in geographical range of impact.
Since SO2 moves away from the atmosphere within 10
days after its emission, impact is mainly local or regional,
whereas CO2 emissions, whose atmospheric life is
between 50 to 200 years, have a more global impact.
• Based on sources of pollution, SO2 pollution characterized
as production-generated, while CO2 emissions are mix
between
production
and
consumption–generated
pollution.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Methodology
• Box-Cox tests have been performed to test linearity
against logarithmic functional forms.
• Akaike and Bayesian information criteria indicate that a
cubic specification is appropriate in our sample.
• The income variable and its powers control for scale
effects.
• Coefficient of GOVEXP captures the composition, income
and technique effect.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Methodology (cont’d)
• To consider correlation between cross-section specific
error-component (e.g. country specific climate and
geography) and explanatory variables, FE are used
instead of RE.
• To mitigate reverse causality bias occurring from potential
endogeneity between GOVEXP and pollution we use the
lagged share of government expenditure.
• Since our panel consists of large N and T dimensions,
dynamics and non-stationarity are taken into account by
employing the Dynamic Fixed Effects (DFE) estimator
proposed by Pesaran and Smith (1995).
Prof. George E. Halkos & Epameinondas A. Paizanos
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Methodology (cont’d)
• For DFE we set up an ADL.
• If the variables are I(1) and cointegrated then the error term is an I(0)
process for all i. Hence we specify an error correction model in
which deviations from the long-run equilibrium affect the short-run
dynamics of the variables as follows:
• Nonlinearity in the parameters requires that the model is estimated
using maximum likelihood.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Methodology (cont’d)
• Including more than one lags of the government
expenditure and income variables in (1) to capture
dynamics may result in multicollinearity.
• Use Koyck transformation of estimating distributed lag
models.
• Assuming that subsequent effects of government
expenditure and income decline geometrically each year
and similar speed of adjustments we have:
Prof. George E. Halkos & Epameinondas A. Paizanos
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Fisher-type Philips-Peron tests allowing heterogeneity of autoregressive parameters
In all cases variables are I(1)
Prof. George E. Halkos & Epameinondas A. Paizanos
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• We reject Ho: no-cointegration in 6/8 cases for SO2 and in 5/8 in CO2.
Evidence of cointegration.
• Application of DFE requires variables cointegrated (LR relationship).
DFE is applicable.
Prof. George E. Halkos & Epameinondas A. Paizanos
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• Dynamic Fixed Effects: DFE estimation assumes intercepts differ across
countries but that LR coefficients are equal across countries.
• Mean Group: Alternative estimation method that fits model for each country
individually and calculates arithmetic average of the coefficients is the meangroup estimator (MG). This method is less restrictive than DFE since
intercepts, slope coefficients and error variances are all allowed to differ
across countries.
• Pooled Mean Group: PMG estimator combines DFE and MG methods by
allowing the intercept, short-run coefficients and error variances to differ
across groups while assuming equality of LR coefficients.
Prof. George E. Halkos & Epameinondas A. Paizanos
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• Table 2 provides estimates of pollution/c utilizing FE and DFE.
• Based on FE estimates GOVEXP has negative and significant direct
effect on SO2/c and insignificant negative relationship on CO2/c.
• Dynamics in columns 2 and 4 of Table 2. Comparing the MG and
PMG estimators, with Hausman test, we see PMG estimator, the
efficient estimator under Ho, is preferred and thus, assuming LR
coefficients to be equal across panels, more appropriate.
• Another application of Hausman test suggests that simultaneous
equation bias between error term and lagged dependent variable
minimal and DFE model is most appropriate.
• DFE estimates suggest that GOVEXP of income possesses a
significant negative relationship with SO2/c and insignificant negative
relationship with CO2/c.
• Both pollutants have significant cubic relationship with income/c.
Prof. George E. Halkos & Epameinondas A. Paizanos
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• Consistent with the previous results, the estimated effect of
government expenditure is negative in all cases but remains
significant only for SO2.
• Specification of the pollution equation (EKC) depends on the
group of countries used.
SO2: World  Cubic, OECD  Monotonic, Non-OECD 
Quadratic
CO2: World  Cubic, OECD  Quadratic, Non-OECD 
Cubic
Prof. George E. Halkos & Epameinondas A. Paizanos
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Government Expenditure elasticity on SO2
• LR elasticity of government expenditure on SO2 is greater
than their SR counterparts in all cases.
• SR elasticity of government expenditure on SO2 is of similar
magnitude among the different groups, however the same
does not hold for the LR elasticity.
• LR elasticity is much greater, in absolute value, in OECD
countries suggesting that a sustained increase of 1% in
government share leads to a LR reduction of 5.466% in SO2
emissions, a result which is more than 10 times greater than
for Non-OECD countries.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Prof. George E. Halkos & Epameinondas A. Paizanos
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Income elasticity on SO2 and CO2
• The elasticity of income on SO2 is negative for the World and
OECD countries group but positive in the Non-OECD countries.
• The LR elasticity of income on SO2 for the median income OECD
country implies that following a 1% sustained increase in income
there will be a 5.6% reduction in SO2 emissions.
• On the contrary, a 1% sustained increase in income is estimated
to cause a 0.459% increase in SO2 emissions in a Non-OECD
country.
• For the CO2 emissions the income elasticity is positive in all
groups.
• However, both in the short- and long-run the effect is much larger
in the Non-OECD countries group.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Prof. George E. Halkos & Epameinondas A. Paizanos
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• For the effect of GOVEXP on SO2/c to cease being strictly
negative the correlation between government expenditure
and unobservables would need to be 6.25 times larger
than the correlation with the observables. However, for
CO2/c a relative correlation of only 40% or greater, implies
that the point estimate of the effect includes zero and thus
is not strictly negative.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Policy Implications
• Policy implications, differ according to level of income in a country.
• In general, reducing GOVEXP enhances economic performance
(Folster and Henrekson, 2001; Bergh and Karlsson, 2010).
• Important to also take into account the indirect effect of GOVEXP on
pollution (Halkos and Paizanos, 2013).
• Cutting GOVEXP should be undertaken with particular care for some
levels of GDP. For SO2 and CO2 pollution, results suggest that
reducing government size in developing countries leads to
deterioration of environmental quality.
• Therefore, cutting government expenditure in these countries should
be accompanied by appropriate environmental regulation along with
the establishment of international environmental treaties.
Prof. George E. Halkos & Epameinondas A. Paizanos
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Policy Implications (cont’d.)
• Cutting GOVEXP in countries with higher income levels, leads to
improvements in both income and environmental quality, while these
effects may also have a greater long-run effect.
• In particular, countries with income level at the decreasing area of the
EKC are more likely to have already established the environmental
legislation and to have undertaken public expenditures for
improvement of environmental quality, hence they are susceptible to
diminishing returns from a further increase in government size.
• Combining our findings with the results from Lopez et al. (2011),
cutting out public spending items that increase market failure will be
the most beneficial in high income countries.
Prof. George E. Halkos & Epameinondas A. Paizanos
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