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Openness, government size and the terms of trade

Paolo Epifani () and Gino Gancia ()

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: This paper investigates the relationship between trade openness and the size of government, both theoretically and empirically. We show 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. First, we show how their relative strength depends on a key parameter, the elasticity of substitution between domestic and foreign goods. Second, while the terms of trade externality leads to inefficiently large governments, the increase in public spending due to the demand for insurance is optimal. We show that large volumes of trade may result in welfare losses if the terms of trade externality is strong enough while small volumes of trade are always beneficial. Third, we provide new evidence on the positive association between openness and the size of government and test whether it is consistent with the terms of trade externality or the demand for insurance. Our findings suggest that the positive relationship is remarkably robust and that the terms of trade externality may be the driving force behind it, thus raising warnings that globalization may have led to inefficiently large governments.

Keywords: Openness; government size; terms of trade externality; elasticity of substitution between imports and exports (search for similar items in EconPapers)
JEL-codes: F1 H1 (search for similar items in EconPapers)
Date: 2005-11, Revised 2008-01
New Economics Papers: this item is included in nep-int and nep-pbe
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Related works:
Journal Article: Openness, Government Size and the Terms of Trade (2009) Downloads
Working Paper: Openness, Government Size and the Terms of Trade (2008) Downloads
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