Revenue and Expenditure Nexus: A Case Study of Nigeriaijrbem.com/doc/127.pdfThe second school known as the spend-and-tax school has been proposed by Peacock and Wiseman (1961). The

International Journal of Research in Business, Economics and Management

Vol.3 Issue 2 March-April 2019

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Revenue and Expenditure Nexus: A Case Study of Nigeria

Olatunji D. Adekoya University of Wales Trinity Saint David, United Kingdom

Telephone: +44 74 4864 7131

ABSTRACT

Recent concerns on the effect of increasing budget deficits in many countries particularly the

developing nations have necessitated for establishing a relationship between government revenue

and government expenditure. The study examines the relationship between federal government

revenue and expenditure in Nigeria, from 1970 – 2014. Using a Granger causality test, the study

investigates the causal relationship between government revenue and government expenditure,

via a vector error correction mechanism (VECM) aimed at determining which of the four-way

revenue-expenditure hypothesis is inherent in Nigeria. The four-way hypothesis includes the tax-

spend hypothesis, spend-tax hypothesis, fiscal synchronization hypothesis, and the fiscal

neutrality hypothesis. The result indicates that there is no causality either uni-directional or bi-

directional between government revenue and expenditure but rather, a fiscal neutrality

hypothesis is found existent for Nigeria. Recommendations were provided suggesting that the

federal government should consider both the spend-tax decisions and tax-spend decisions to

avoid excessive deficits. This is because the joint determination of revenues and expenditures is

appealing as long as it effectively restrains the budget deficit. Also, reducing government

spending is beneficial to achieving resource allocation and even distribution of wealth.

Keyword: Budget Deficit, Revenue, Expenditure, Four-way Hypothesis, Government, Nigeria.

INTRODUCTION

The issue of the relationship between government revenue and government expenditure has been

a significant concern in various economies. Government revenues are majorly received from

sources such as taxes levied on the incomes and wealth accumulation of individuals and

corporations on the goods and services produced, exported and imported. Non-taxable sources

also form part of government revenue. On the other hand, government expenditures are financed

by the revenue collected.

Essentially, fiscal policy is a deliberate attempt to synchronise expenditure with revenue towards

the desired fiscal targets. Amongst these fiscal targets been pursued by the government is the

ability to reduce the ratio of fiscal deficits to GDP; this results from the fact that budget deficit is

influenced by the relationship between government revenue and expenditure, that is, when the

government spends (expenditure) more than it receives (income).

Fiscal policy has to support price stability and economic growth, provide employment, and

stimulate capital formation (Narayan & Narayan, 2006). It is, therefore, necessary that

policymakers understand the relationship between government revenue and government

expenditure in order to prevent deficits. As government increases her spending which leads to

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higher taxation, the size of the public sector has continued to increase also, without leaving

behind permanent increases in fiscal deficits. Different economists have argued that tax increases

are not an appropriate tool to improve the budget balances and reduce budget deficits,

particularly, if investments in infrastructure caused the deficit, for example (Richter & Dimitrios,

2013). Also, it was viewed that to reduce the debt burden, the solution is to reduce government

spending instead of increased taxation, because an increase in taxes will have an adverse effect

on consumption spending, which goes along to reduce aggregate demand in the economy.

Despite the debt relief given to Nigeria by the Paris club, its debt has continued to increase over

the years. One would imagine what causes what? Is the nation's expenditure pattern the cause of

its revenue or her revenue been the cause of her expenditure?

In a bid to implement a policy that will reduce the budget deficit, the relationship between the

revenue and expenditure of the government needs to be examined. It is therefore essential to

understand what causes what. As such, from the preceding analysis, it has become necessary to

ascertain the relationships existing between government's financing capability and her

expenditure profile. The relationship, therefore, has been analysed by many with the aid of the

four revenue - expenditure hypotheses which are; Tax and Spend (Milton Friedman; Buchanan

and Wagner), Spend and Tax (Peacock and Wiseman; Barro), Fiscal Synchronization

(Musgrave; Meltzer and Richard) and Fiscal Neutrality School or Institutional Separation

Hypothesis (Baghestani and McNown).

An essential issue in this regard is the causality between taxes and spending. Notably, in order to

decide which variable should be given temporal priority, it should be known (for policy

decisions) whether changes in spending lead, follow, coincide, or are independent of the changes

in taxes.

This study will, therefore, review the finances of the federal government of Nigeria with respect

to the four-way hypothesis between 1970 and 2014. It will further seek to determine the direction

of causality between tax and spending components, test the validity of the four-way hypothesis

to ascertain which is particular to Nigeria and determine the relative effect of tax policy and

spending on fiscal performance.

The Concept of Taxation and Expenditure

Definitions of Tax

According to Taylor, P. (cited by Edge and Rudd, 2002), taxes are compulsory payment to the

government without expectation of direct return in benefit to the taxpayer. Seligman (1928 cited

by Mehrotra, 2005) defines a tax as a payment levied by the government on those liable to be

taxed to settle a specific percentage of expenditure or spending on a particular activity or

infrastructure undertaken in the public interest. Similarly, Dalton (1920) asserts that “a tax is a

compulsory contribution imposed by a public authority, irrespective of the exact amount of

service rendered to the taxpayer in return, and not imposed as a penalty for any legal offence.”

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Taxation, in a simple language, is a compulsory non-quid-pro-quo withdrawal of resources from

the private sector of the economy (Nwosu, 2000).

Purpose of Taxation

The primary purpose of collecting taxes is to provide funds or property with which the

government discharges its responsibilities for the protection and general welfare of its citizens.

Moreover, besides tax being a source of finance for funding government operations and public

expenditure, it is also a tool for achieving the main national objective, that is, economic

development, welfare and socio-cultural fulfilment (Asian Development Bank, 2018).

Additionally, a much broader objective of collecting taxes include; to improve the livid or weak

businesses by providing incentives for growth through reducing taxes via tax exemptions or tax

holiday; providing some protection for local businesses against foreign competition; acting as a

tool for negotiations or bargains with foreign countries; to mitigate the adverse effects of

inflation or recession; and to propagate an even distribution of wealth thereby reducing income

inequalities (Angerer, 2018).

Definitions and Concept of Government Expenditure

Government expenditure is spending made by the government of a country on collective needs

and wants such as pension, provision, infrastructure, etc. Public expenditure or spending is the

money expended by a government to pay for defence, development projects, education, health,

infrastructure, law and order maintenance, etc.

According to Barua (2005), government expenditure can be financed by borrowing (domestic or

international) or taxes. The changes that occur in government spending is a significant

component of fiscal policy used to stabilise the macroeconomic business cycle; this means that

government spending is geared towards achieving a purpose or specific goal(s). Besides, public

expenditure is generally grouped into recurrent and capital expenditure. On the one hand,

recurrent expenditure comprises administration or defence, general administration, internal

security, economic services (agriculture, construction, transportation and communication, etc.)

social and community services such as education, health and others. On the other hand, capital

expenditure comprises, internal security, agriculture, quarrying and mining, defence, special

projects, manufacturing is composed of general administration, defence, internal security,

agriculture and natural resources, manufacturing, etc. (Olugbenga and Owoye, 2007; Ezirim and

Ofurum, 2003).

THEORETICAL REVIEW

Tax and Spend Hypothesis

The first school known as tax-and-spend school was proposed by Friedman (1978) and

Buchanan and Wagner (1978). It was argued that there exists a positive causal relationship

between government revenue and expenditure (Friedman, 1978). It was argued that increasing

taxes affords the government the avenue to offset deficits in the budget. However, Payne (2003)

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alluded that since government revenue is expected to affect its expenditures positively, therefore,

government expenditure can be reduced when government revenue falls.

Furthermore, Buchanan and Wagner (1978) stated that the causal relationship is negative.

Buchanan and Wagner propose an increase in taxes revenue as a remedy for deficit budgets.

They opined that given a fall in taxes or tax cut, the public would perceive that the cost of

government programs has fallen. The tenet of the Buchanan and Wagner version of the tax-and-

spend hypothesis is that taxpayers suffer from fiscal illusion. According to them, the price of

goods provided by the government is perceived to be low when a tax cut is implemented;

however, it often translates to an increase in aggregate demand. It was further posited that in

some cases, higher costs could be incurred by the public because, it will reach a certain point

where inflation sets in and continues to increase until producers increase the prices of the goods;

also, interest rates could be increased which would have an effect on borrowing businesses called

the ‘crowding-out effect' which limits the level of private investment. However, both scholars are

in support of creating limitations to increasing or resorting to deficit financing.

Spend and Tax Hypothesis

The second school known as the spend-and-tax school has been proposed by Peacock and

Wiseman (1961). The "displacement effect hypothesis" expounded by Peacock and Wiseman in

their well-known 1961 monograph “The Growth of Public Expenditure” in the United Kingdom

remains one of the most reliable explanations. This school advocated that expenditure cause

revenue, suggesting that first governments spend and then increase tax revenues as necessary to

finance expenditures. The spend-and-tax hypothesis is valid when there is a hike in spending

activities created by some special events such as critical situations, which necessitates the

government to resort to increasing taxes. Hence, increasing public spending temporarily in the

advent of war or crisis may result in a permanently fixed amount of tax. Therefore, the spend-tax

perspective presumes that the government can reduce the deficit by reducing its spending.

Fiscal Synchronization Hypothesis

The third school, fiscal synchronization hypothesis builds its argument on the premise that

governments may concurrently change expenditure and taxes, (Meltzer & Richard, 1981;

Musgrave, 1966). Typically, government, as a rational agent, equates the marginal cost of

taxation with the marginal benefit of government spending. This implies a bidirectional causality

between government expenditure and revenue (governments take decisions about revenues and

expenditures simultaneously). It was also opined that voters do not suffer from fiscal illusion and

are not myopic. It was further stated that the voters are aware that the government must extract

resources to pay for redistribution. It was opined that the size of the government depends on the

relation of mean income to the income of the decisive voter and therefore, increase in the relative

size of government appears to be independent of budget and tax systems, federal or national

governments, the size of the bureaucracy, and other institutional arrangements often mentioned,

although the relative rates of change in different countries may depend on these arrangements.

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The size of the government emphasises voters' demand for redistribution that is, the government

size is determined by the welfare maximising choice of a decisive individual.

Fiscal Neutrality Hypothesis

A fourth hypothesis introduced by Baghestani and McNown (1994) relates to the institutional

separation of the expenditure and taxing decisions of the government. In this perspective, it is

suggested that revenues and expenditures are independent of each other. Fiscal neutrality

requires that government do not use tax incentives to encourage or discourage the behaviour. It is

referred to as a state of balanced budget. Here, expenditure would be defined on the basis of the

requirements expressed by the citizenry and revenue would depend on the maximum tax burden

tolerated by the population. As a result, the achievement of fiscal equilibrium was merely a

matter of coincidence. This school is known fiscal neutrality school or institutional separation

hypothesis.

RESEARCH METHODOLOGY

The empirical relationship between government revenue and government expenditure has been

investigated through many approaches for a long time. Some of the essential methodological

techniques that are used in estimating such relationships are Vector Error Correction Mechanism

(VECM) based causality test, Toda Yamamoto Granger Causality test and Vector Auto-

Regressive (VAR) approach. Studies like Rahman and Wadud (2014) amongst others employed

the use of Vector Error Correction Mechanism in their analysis. Other techniques used are

cointegration tests and unit root tests.

Since the main focus of this study is to determine the causal relationship between government

revenues and expenditures, an economic technique of Vector Error Correction Model Granger

Causality test shall be used. Other techniques include cointegration tests (Johansen cointegration

approach) and unit root tests (Augmented Dickey-Fuller test and Philips – Perron test).

This study considers the annual time series data on government revenue and government

expenditure covering the period 1970 – 2014. This period is selected because time series data is

only available for this period. The variables of interest are government revenues, government

expenditure, inflation rate, exchange rate and gross domestic product. The data for this study

were obtained from a secondary source notably the Central Bank of Nigeria's Statistical Bulletin,

for the period 1970 – 2014 and the World Bank (World Development Indicators).

Model specification

A causality model is specified to enable us to analyse the relationship between government

revenue and expenditure.

Model 1

n1 n2

∆TGEt = α0+ Σα1i∆TGEt-1 + Σα2i∆TGRt-1 + δμt-1 + ε1t… (1)

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i=1 i=1

T1 T2

∆TGRt = β0+ Σ β1i∆TGRt-1 + Σ β2i∆TGEt-1 + λξt-1 + ε2t… (2)

i=1 i=1

Model 2

n1 n2 n3

∆TGEt = α0+ Σα1i∆TGEt-1 + Σα2i∆TGRt-1 + Σα3i GDP+ δμt-1 + ε1t… (3)

i=1 i=1 i=1

T1 T2 T3

∆TGRt = β0+ Σ β1i∆TGRt-1 + Σ β2i∆TGEt-1 + Σβ3iGDP + λξt-1 + ε2t… (4)

i=1 i=1 i=1

Where;

TGEt= total government expenditure

TGRt= total government revenue

GDP= gross domestic product

n and T= optimal lag length

μt-1 and ξt-1= error correction terms

ε1t and ε2t= white noise error terms

δ and λ= error correction coefficients

ε1 andε2= normally distributed error terms

To determine the direction of causality between tax and spending components and also test for

the validity of tax and spend, spend and tax, fiscal synchronisation and fiscal neutrality in

Nigeria, model 1 will be implored.

To determine the relative effect of tax policy and spending on fiscal performance, model 2 will

be implored.

Data Analysis and Result

In this study, both descriptive and trend analysis were employed. The study also made use of

econometric analysis in order to achieve the objectives of the research. The unit root test was

used to detect the stationarity of the variables in the model, co-integration test was used to detect

equations that are moving together in the long run, and the Granger causality test shows the

direction of causality.

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Fig. 1: Source: Author’s Eviews Computation

The graphical presentation above reveals a positive trend in all three variables –government

expenditure, government revenue and gross domestic product. Government expenditure was

relatively low in the 1970s to mid-1980s until 1989 when it rose up and then again in 2001 when

the increase became more evident after which it continued to increase at a more steady rate until

a great hike occurred in 2013.

Also for government revenue, early years until 1995 experienced a steady low rate in revenue

then increased much more in 2000 and 2005 until it got to a high peak in 2011 after which it

experienced a steadily low downfall. Unlike other variables, the gross domestic product

experienced an increasing trend almost throughout the years.

Unit Root Test

0

2,000

4,000

6,000

8,000

10,000

12,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

GEXP

0

2,000

4,000

6,000

8,000

10,000

12,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

GREV

10,000

20,000

30,000

40,000

50,000

60,000

70,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

GDP

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

GDP GREV GEXP

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The table above shows the unit root of each variable at level and first difference. Two methods of

the test of stationarity are used that is, the Augmented Dickey-Fuller test and Phillip-Perron test.

Both tests give the same result about the stationarity of the variables. All variables are found to

be non-stationary at levels but stationary at first difference in both the Augmented Dickey-Fuller

and Philip-Perron tests. Since all the variables are stationary at first difference, we apply the

cointegration and vector autoregressive based modelling techniques. If any cointegrated

relationship exists in the set of variables given, we would be able to consider the use of the

vector error correction model, and should it be that there is no cointegrating relationship, we will

make use of the autoregressive vector modelling as it enables us to extract all the possible

autoregressive relationships that exist in the set of variables.

Cointegration Test

Johansen’s Cointegration Test

Unrestricted Cointegration Rank Test (Trace)

Hypothesised Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.471565 32.30756 29.79707 0.0252

At most 1 0.093680 5.518502 15.49471 0.7516

At most 2 0.032491 1.387272 3.841466 0.2389

Trace test indicates 1 cointegrating eqn(s) at the 0.05 level

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

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Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.471565 26.78906 21.13162 0.0072

At most 1 0.093680 4.131230 14.26460 0.8453

At most 2 0.032491 1.387272 3.841466 0.2389

Max-eigenvalue test indicates 1 cointegratingeqn(s) at the 0.05 level

Source: Author’s Eviews Computation

The table above gives the cointegration test of the variables in the model. Two methods are

displayed in the table above that is the Trace statistic and Max Eigen-statistic. Both tests agree

that there is only 1 cointegrating relation. In the Johansen Trace test, we see that the null

hypothesis that there is at most 1 cointegration is failed to be rejected at the 5% level as shown

by the p-value of 0.0252. In the case of the Johansen Max-Eigen value test, we see also that the

null hypothesis that there is at most 1 cointegration is failed to be rejected at the 5% level as

shown by the p-value of 0.0072. From the above findings, it is noticed that both findings agree

that there is 1 cointegrating equation.

Vector Error Correction Model: The Long-run Model

Cointegrating Eq: CointEq1

LGDP(-1) 1.000000

LGREV(-1) 1.973336

(0.50063)

[ 3.94167]

LGEXP(-1) -2.185465

(0.55007)

[-3.97305]

C -9.809688


The long-run co-integrated model reveals that only government expenditure has a positive

impact on the gross domestic product by 218.5% while government revenue has a negative

impact on the gross domestic product by 197.3%.

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Error Correction Model

Error Correction: D(LPCI)

CointEq1 0.034480

(0.02602)

[ 1.32522]

D(LGDP(-1)) 0.045915

(0.19319)

[ 0.23766]

D(LGREV(-1)) -0.023527

(0.04427)

[-0.53147]

D(LGEXP(-1)) 0.041364

(0.06151)

[ 0.67251]

C 0.031411

(0.01964)

[ 1.59914]


Short-Run Model

The vector error correction results reveal that the degree of adjustment of the GDP to the

equilibrium level in the event of a short run of gross domestic product (GDP) is about 3.44% in a

year. However, the degree of adjustment is statistically significant at the 5% level.

The net log of government revenue (GREV) has a negative impact on the gross domestic product

(GDP) by 2.35% in the short run, while government expenditure (GEXP) has a positive impact

on the gross domestic product (GDP) by 4.13%.

Model Summary

R-squared 0.116991

Adj. R-squared -0.064805

Sum sq. resids 0.179420

S.E. equation 0.072643

F-statistic 0.643528

Log likelihood 54.97413

Akaike AIC -2.236864

Schwarz SC -1.905879

Mean dependent 0.034504

S.D. dependent 0.070398


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The above summary measures reveal a coefficient of determination of 17.5% for the error

correction model and an F-statistic of 0.45 which is statistically insignificant and this suggests

that the different independent variables combined do not have a satisfactory explanatory power

over the dependent variable gross domestic product (GDP) revealing that the short run impacts

are practically irrelevant.

Granger Causality Test

The Granger Causality test below shows that none of the variables granger causes each other.

That is, government expenditure does not Granger cause government revenue (the null

hypothesis is thereby accepted), nor does government revenue granger cause government

expenditure (the null hypothesis is thereby accepted). This result indicates that there is no case of

causality either uni-directional or bi-directional between government revenue and expenditure

but rather, a fiscal neutrality hypothesis is found.

Also from the result, the gross domestic product does not Granger cause government revenue nor

does government revenue granger cause gross domestic product. Likewise, government

expenditure does not Granger cause gross domestic product nor does gross domestic product

granger cause government expenditure. This shows that the variables act independently.

NULL HYPOTHESIS OBS F-STATISTICS PROB

LGEXP does not Granger Cause LGREV 43 2.37390 0.1068

LGREV does not Granger Cause LGEXP 1.74321 0.1887

LGDP does not Granger Cause LGREV 43 1.40972 0.2567

LGREV does not Granger Cause LGDP 1.38933 0.2616

LGEXP does not Granger Cause LGDP 43 1.26871 0.2928

LGDP does not Granger Cause LGEXP 0.88978 0.4191


Discussion of Results

After the various tests have been conducted on the variables making sure that the variables are

stationary and cointegrated, the Granger causality test also revealed that there exists no

relationship between government revenue and government expenditure that is, both variables act

independently of the other. It was also established from the results of the Granger causality test

that the gross domestic product also has no relationship with either government revenue or

government expenditure. The results for the Granger causality test, therefore, reveals that the null

hypothesis that there is no causality between tax and spending profiles in Nigeria is hereby

accepted. Likewise, the null hypothesis that there is no effect of tax policy and spending on the

fiscal performance of Nigeria is also accepted. This shows that the fiscal neutrality hypothesis

exists for Nigeria.

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The long-run co-integrated model reveals that only government expenditure has a positive

impact on the gross domestic product by 218.5% while government revenue has a negative

impact on the gross domestic product by 197.3%.

The vector error correction results reveal that the degree of adjustment of the GDP to the

equilibrium level in the event of a short run of gross domestic product (GDP) is about 3.44% in a

year. However, the degree of adjustment is statistically significant at the 5% level.

The net log of government revenue (GREV) has a negative impact on the gross domestic product

(GDP) by 2.35% in the short run, while government expenditure (GEXP) has a positive impact

on the gross domestic product (GDP) by 4.13%.

CONCLUSION AND RECOMMENDATIONS

This study has shown that there is a long-run or equilibrium relationship between GDP and

government expenditure but no long-run relationship between GDP and government revenue.

There is no direction of causality between government revenue, government expenditure and

GDP in Nigeria. The results, therefore, support the fiscal neutrality hypothesis for Nigeria

thereby validating the null hypothesis. The findings indicate that changes in government revenue

do not induce changes in government expenditure either does changes in both government

revenue and expenditure induce fiscal performance (GDP) of the economy.

Some important recommendations for policy can be drawn from the analysis:

Controlling the change in government revenue, mainly the oil revenue which constitutes over 80

per cent of government revenue, is very necessary for controlling government expenditure and

avoiding unsustainable fiscal imbalances in Nigeria.

Since the revenue and expenditure patterns of the government could not positively affect the

fiscal performance of the country, proper policies should be made to facilitate the growth of the

economy. Proper institutions should ensure effective coordination of budgeting decisions. The

stabilisation of public expenditure and the need to pursue productive spending is strongly

recommended.

The fiscal neutrality hypothesis indicates that there exists an act of isolation between government

revenue and expenditure, which could be said to be not a good pattern for the country. Therefore,

it is recommended that the government of Nigeria integrates both its revenue and expenditure

patterns for better policy and decision making to ensure proper growth and sustainability of the

economy.

The government should act effectively by blocking all loopholes in the various sectors of the

economy which would also reduce the rate of corruption in the country. This will enable proper

interactions of the macroeconomic variables therefore enhancing growth.

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Revenue and Expenditure Nexus: A Case Study of Nigeriaijrbem.com/doc/127.pdfThe second school known as the spend-and-tax school has been proposed by Peacock and Wiseman (1961). The