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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
Source: Author’s Eviews Computation
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]
Source: Author’s Eviews Computation
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
Source: Author’s Eviews Computation
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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
Source: Author’s Eviews Computation
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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