The Incidental Parameters Problem in Testing for Remaining Cross-Section Correlation

Artūras Juodis and Simon Reese

Journal of Business & Economic Statistics, 2022, vol. 40, issue 3, 1191-1203

Abstract: In this article, we consider the properties of the Pesaran CD test for cross-section correlation when applied to residuals obtained from panel data models with many estimated parameters. We show that the presence of period-specific parameters leads the CD test statistic to diverge as the time dimension of the sample grows. This result holds even if cross-section dependence is correctly accounted for and hence constitutes an example of the incidental parameters problem. The relevance of this problem is investigated for both the classical two-way fixed-effects estimator and the Common Correlated Effects estimator of Pesaran. We suggest a weighted CD test statistic which re-establishes standard normal inference under the null hypothesis. Given the widespread use of the CD test statistic to test for remaining cross-section correlation, our results have far reaching implications for empirical researchers.

Date: 2022
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Citations: View citations in EconPapers (30)

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DOI: 10.1080/07350015.2021.1906687

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