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Wagner’s Law in Malaysia: A New Empirical Evidence

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 Wagner’s Law in Malaysia:
A New Empirical Evidence
Fumitaka Furuoka *

Despite the availability of extensive research on Wagner’s Law, a systematic empirical

testing of the hypothesis in the context of developing countries, especially South-
East Asian nations, is still lacking. Thus, the current paper attempts to reduce this
gap and chooses Malaysia as a case study to test the existence of Wagner’s Law.
The Malaysian Government has been playing an increasingly important role in the
country’s industrialization process as Malaysia is pursuing the target of becoming
a fully-industrialized nation by the year 2020. This suggests that Malaysia could be
an example of a developing nation where government expenditure grows as the
country becomes wealthier. The first to notice such a tendency was a German
economist, Adolph Wagner, the author of the so-called ‘Wagner’s Law’. The most
important empirical finding of the present study is that there exists a long-run
cointegrating relationship and a short-run—but not long-run—causality between
economic development and government expenditure in Malaysia. This provides an
additional empirical evidence to support the existence of Wagner's Law in the context
of an Asian developing country, such as Malaysia.

Introduction
In the process of transforming Malaysia into a fully-industrialized nation by the year 2020, the
government has been playing an increasingly important role in the country’s industrialization
drive. The Malaysian Government has launched various grand-scale development projects.
Among them are, setting up the national car maker Proton (Perusahaan Otomobil Nasional),
establishing the Multimedia Super Corridor (MSC), building the North-South highway, the
Kuala Lumpur International Airport (KLIA), and the new administrative capital Putrajaya.
The planning, implementation and overseeing of these government initiated development
projects could have resulted in setting up new government agencies and offices, and the
expansion of bureaucracy. In other words, Malaysia may be one of the developing countries
where government expenditure grows as the country becomes wealthier.

Generally, in the early stages of the industrialization process, the governments may attempt
to diversify their activities by substituting private sector activities and services. As a result, the
size of government expenditure tends to expand. This inevitable increase of government
expenditure during the industrialization process is known as ‘Wagner’s Law’. According to
Adolph Wagner, the public sector expenditure grows as a country develops economically and
its national income increases.

* Lecturer, School of Business and Economics, Universiti Malaysia Sabah, Sabah, Malaysia.
E-mail: fumitakamy@gmail.com

Wagner
© 2008 ’sThe
L aw
IcfaiinUniversity
Malaysia: A New
Press. Empirical
All Rights Evidence
Reserved. 33
 Wagner’s Law is a much discussed topic in the field of applied economics. However,
the majority of previous research studies have tested the existence of Wagner’s Law in the
context of developed countries. There is still a lack of systematic research involving the
developing countries, such as Malaysia, Thailand and Indonesia. Empirical testing of Wagner’s
Law in the former could offer interesting insights, as economic reality in developing countries
nowadays closely resemble the situation in European countries and Germany, when those
nations were rapidly industrializing their economies at the end of the 19 th century. At that
time, the German Government had also implemented various development projects in order
to catch up with its more economically advanced European neighbors and to promote
industrialization.

This paper chooses Malaysia as a case study to test Wagner’s Law. To analyze the hypothesis,
it employs a three-stage procedure proposed by Oxley (1994). Firstly, unit root test is used to
examine the stationarity of the datasets. Secondly, cointegration test is done to examine the
long-run movement of variables. Finally, the paper runs the Granger causality test based on
the Vector Error Correction Model (VECM).

Next, the paper briefly reviews important literature on Wagner hypothesis. Then, it discusses
the research methodology employed in this study, and reports the results of the empirical
tests. Finally, it offers concluding remarks.

Literature Review
‘Wagner’s Law’ has been attracting the attention of researchers, economists and applied
econometricians, since the end of the 19 th century. Wagner (1883) proposed the existence of
an inevitable increase in public expenditure as a country’s national income increases.
He predicted that as a country becomes wealthier, the size of the government and its expenditure
would tend to increase as well.

Wagner gave the following three reasons as to why public expenditure tends to expand
when a country undergoes the industrialization process (Bird, 1971). Firstly, the administrative
and protective functions of the state would substitute public for private activities. Secondly,
economic development would lead to an increase in ‘culture and welfare’ expenditure.
Finally, intervention from the government would be required to manage and finance natural
monopolies.

Numerous academic inquiries employed various approaches to test the hypothesis.

However, empirical findings of the previous research studies are contradictory and
inconclusive. As Kolluri et al. (2000, p. 1059) put it, “A number of authors have tested
so-called Wagner’s Law of public expenditure and, surprisingly, report a set of highly
diverse and conflicting results”. Some of these inquiries provided evidence in support of
the existence of Wagner’s Law (Krzyzaniak, 1974; Vatter and Walker, 1986; Ram, 1987;
Nagarajan and Spears, 1990; Lin, 1995; Ahsan et al. , 1996; and Kolluri et al. , 2000). For
example, Lin (1995) tested the hypothesis adopting Mexico as a case study. Kolluri et al.
(2000) chose to study seven industrialized nations (i.e., Canada, France, Italy, Japan, United
Kingdom, United States, and Germany) over the period 1960-1993. These researchers

34 The Icfai University Journal of Applied Economics, Vo l. VII, No. 4, 2008

employed cointegration test and Error Correction Model (ECM). Results obtained in the
course of their study supported the hypothesis that government expenditure escalates with
increase in national income.
On the other hand, some inquiries disputed the existence of Wagner’s Law as their empirical
findings did not support the hypothesis (e.g., Diamond, 1977; Wagner and Weber, 1977;
Afxentiou and Serletis, 1991; Ashworth, 1994; and Hondroyiannis and Papapetrou, 1995).
Wagner and Weber (1977) analyzed data for 34 countries over the period 1950-1977. Findings
of their research did not support the existence of Wagner’s Law. A case study of Greece done
by Hondroyiannis and Papapetrou (1995) used cointegration analysis and provided additional
empirical evidence against the existence of Wagner’s Law.
The majority of research studies on Wagner’s Law have focused on the developed countries.
A systematic research on the topic involving developing countries, especially Asian countries,
is still lacking. Among a few available studies, Ram’s (1986) research tested the existence of
Wagner’s Law in Thailand; the findings of the study supported the hypothesis. On the other
hand, a study by Chang et al. (2004) disputed the proposition that Wagner’s Law applied to
Thailand.
Very few studies have tested the existence of Wagner’s Law in the Malaysian context.
Sinha’s (1998) inquiry tested Wagner’s Law in Malaysia over the period 1950-1992. It employed
the Johansen cointegration test and the Granger causality test. Sinha detected the existence of
long-run relationship, but no causality between economic development and government
expenditure in Malaysia.

Research Methodology
In the current paper, several econometric analyses are done to examine the relationship between
public expenditure and economic growth in Malaysia. This study uses time series datasets for
the period 1970-2005. The main source of the data is Malaysia Economic Statistics – Time
Series published by the Department of Statistics, Malaysia (2006). Wagner’s hypothesis could
be estimated using the following equation (Thornton, 1999):

ln GE t   α  β ln GDPt   1 β  ln POPt   μ ...(1)

where ln is natural log, GDPt is real Gross Domestic Product (GDP) in year t , GE t, is real
government expenditure in year t , POPt is population size in year t, and μ is a random
disturbance term. Real government expenditure could be estimated using the GDP deflator
(Thornton, 1999). Support for Wagner’s Law would require that the elasticity of government
expenditure with respect to domestic product exceeds unity, i.e., β  0 (Oxley, 1994).
The presence of Wagner’s Law can be examined in three stages. In the first stage, unit root
test is used to examine the stationarity of datasets (Oxley, 1994). This paper uses the augmented
Dickey-Fuller (ADF) unit root test to investigate the stationarity (Dickey and Fuller, 1979 and
1981). The ADF test is based on the following regression,
n
 y t  μ  βt 1t  γ  y
i 1
i t i  εt ...(2)

Wagner ’s L aw in Malaysia: A New Empirical Evidence 35

where t is a linear time trend,  is the difference operator, and t is the error term. The ADF
tests tend to be sensitive to the choice of lag length, n which is determined by minimizing the
Akaike Information Criterion (AIC) (Akaike, 1974). The AIC is defined as:

 RRS 
AIC q   T ln    2q
 n q 
where T is the sample size, RRS is the residual sum of squares, n is lag length, and q is the
total number of parameters estimated.

In the second stage, this study would employ the Ordinary Least Squares (OLS) regression
model, if the variables are integrated of order zero. On the other hand, if the variables are
integrated of order one, the Johansen cointegration test would be employed to check the
long-run movement of the variables (Johansen, 1988 and 1991). The Johansen cointegration
test is based on maximum likelihood estimation of the K-dimensional Vector Autoregressive
(VAR) model of order p,

Z t  μ  A 1  Z t 1  A 2  Z t  2   A K 1  Z t  p 1  εt

where Zt is a k x 1 vector of stochastic variables, μ is a k x 1 vector of constants, At is k x k

matrices of parameters, and t is a k x 1 vector of error terms. The model could be transformed
into an error correction form:

 Z t  μ  1  Z t 1   2  Z t  2   k 1  Z t  p 1  π Z t 1  εt

where π and 1 , …,  k 1 are k x k matrices of parameters. On the other hand, if the

coefficient matrix π has reduced rank, r < k, then the matrix can be decomposed into
π  α β . The Johansen cointegration test involves testing for rank of π matrix by examining
whether the eigenvalues of π are significantly different from zero. There could be three
conditions: 1) r = k, which implies that Zt is stationary at levels, 2) r = 0, which implies that
Zt is the first differenced VAR, and 3) 0 < r < k, which implies that there exists r linear
combinations of Zt that are stationary or cointegrated.

For example, if r =1, then the relationship between the variables could be written as:

 ln GE t   μ1  k 1
  i ,11  i ,12  i ,13   ln GE t  i 
    

 ln GDPt    μ 2     i , 21  i , 22  i , 23 

 ln GDPt  i 

 ln POPt   μ 3  i 1 
 i , 33   ln POPt  i 
   i , 31  i , 32

 α1   ln GE t 1   ε1 
 

 α 2  β1 β 2 β 3     
 ln GDPt 1   ε 2 
α 3   ln POPt 1   ε 3 
   
The vector β represents r linear cointegrating relationship between the variables. This paper
uses the Trace (Tr ) eigenvalue statistics and Maximum (L-max) eigenvalue statistics (Johansen,
1988; and Johansen and Juselius, 1990). The likelihood ratio statistic for the trace test is:

36 The Icfai University Journal of Applied Economics, Vo l. VII, No. 4, 2008

  ln 1 λ̂ 
p 2
Tr  T i
i  r 1

where λˆr 1, , λˆp are the smallest eigenvalues of estimated p – r. The null hypothesis for the
trace eigenvalue test is that there are at most r cointegrating vectors. On the other hand, the
L-max could be calculated as:


L  max  T ln 1  ˆr 1 
The null hypothesis for the maximum eigenvalue test is that r cointegrating vectors are
tested against the alternative hypothesis of r + 1 cointegrating vectors. If trace eigenvalue test
and maximum eigenvalue test yield different results, the results of maximum eigenvalue test
should be used, because the power of maximum eigenvalue test is considered greater than
the one of trace eigenvalue test (Johansen and Juselius, 1990).

The major problem of the Johansen cointegration test is that the test statistics are highly
sensitive to the choice of model specification and lag length. As shown in Table 1, five
different model specifications are used for the Johansen cointegration test.

Table 1: Model Specifications for Johansen Cointegration Test

Model 1 Model 2 Model 3 Model 4 Model 5

Intercept in CE No Yes Yes Yes Yes
Intercept in VAR No No Yes Yes Yes
Linear Trend in CE No No No Yes Yes
Linear Trend in VAR No No No No Yes
Note: CE denotes Cointegrating Equation; and VAR denotes Vector Autoregression.

The optimal model specification and lag length are determined by minimizing the AIC.
In the third stage, this paper runs the Granger causality test based on the following VECM:
n n n
 ln GE t  b 1  
i 1
b 2i  ln GDPt i   
i 1
b 3i  ln POPt i   b
i 1
4i  ln GE t i   b 5 u t 1  εt

where u t –1 is the lagged error correction term.

The current study is different from Sinha’s (1998) research, as it uses the Granger causality
test based on the VECM instead of the standard Granger causality test employed by Sinha.
There are two advantages of using this method rather than the standard Granger causality
test: 1) The F -test of the independent variables indicates short-run causal effect, and
2) Significant and negative error correction term indicates long-run causal effects.

Empirical Results
In the first stage, the ADF unit root test was done to examine the stationarity of the variables.
The results from the ADF unit root test are shown in Table 2. Despite minor differences in the

Wagner ’s L aw in Malaysia: A New Empirical Evidence 37

 Table 2: ADF Unit Root Test
Levels First Difference
C on st an t C on st an t C on st an t C on st an t
wi thout Tr end with Trend without Tr end with Trend
ln(GDP ) –1.291(9) –0.539(9) –5.639 (0)** –5.920(0)**
ln(GE ) –1.213(0) –1.687(2) –6.677 (0)** –6.801(0)**
ln(POP ) –1.043(0) –0.261(0) –3.816 (0)** –3.873(3)**
N o t e : Figures in parentheses indicate number of lag structures; and ** indicates significance at
1% level.

findings as reported in the table, the obtained results indicate that the three variables—lnGDP,
lnPOP and lnGE—are integrated of order one, I(1).

In the second stage, the Johansen

cointegration test was used to test the
long-run movement of the variables. As
Engle and Granger (1987) pointed out,
only variables with the same order of
integration could be tested for
cointegration. As such, in the present
study, all three variables could be
examined for cointegration.
First of all, the AIC was used to
determine optimal lag length, while the
maximum lag length was set at six.
Table 3 shows that optimal lag length
for the Johansen cointegration test is one,
which minimizes the AIC.
Table 3: Optimal L ag Length Selection
for the Johansen Test
(Maximum Lag Length = 6)
Lag Length AI C
0 –2.599
1 –12.553*
2 –12.247
3 –12.119
4 –11.964
5 –11.961
6 –12.412
N o t e : AIC denotes the Akaike Information Criterion; and *
indicates optimal lag length selected by AIC.

Secondly, the AIC was used again to determine the most appropriate model specification
for the Johansen cointegration test. As Table 4 shows, the best model specification is Model
2 and the number of cointegrating equation is one.

Table 4: Optimal Model Specification Selected

by the Akaike Information Criterion

Model 1 Model 2 Model 3 Model 4 Model 5

Number of CEs = 0 –12.083 –12.083 –12.269 –12.269 –12.201
Number of CEs = 1 –12.069 –12.331* –12.243 –12.295 –12.272
Number of CEs = 2 –11.865 –12.073 –12.043 –12.154 –12.187
Number of CEs = 3 –11.613 –11.791 –11.791 –11.843 –11.843
Note: CE denotes cointegrating equation; and * indicates optimal model selection by AIC.

38 The Icfai University Journal of Applied Economics, Vo l. VII, No. 4, 2008

 Results of the cointegration tests are reported in Tables 5 and 6. Trace eigenvalue test
indicates that there is no cointegrating equation, while maximum eigenvalue statistic indicates
one cointegrating equation. Following Johansen and Juselius’s (1990) suggestion, this paper
uses empirical results obtained from maximum eigenvalue statistic.

Table 5: The Johansen Cointegration Test (Trace Eigenvalue Statistic)

Number of
5% Critical 1% Critical
Eigenvalue Trace Statistic C oi nt eg r at in g
Val u e Val u e
Equations

0.482 32.08 34.91 41.01 None

0.142 9.66 19.96 24.60 At Most 1
Note: The results are based on a VAR with one lag.

Table 6: The Johansen Cointegration Test (Maximum Eigenvalue Statistic)

Number of
M a xi m u m 5% Critical 1% Critical
Eigenvalue C oi nt eg r at in g
St ati st ic Val u e Val u e
Equations

0.482 22.42 22.00 26.81 None*

0.142 5.24 15.67 20.20 At Most 1
Note: The results are based on a VAR with one lag; and * indicates significance at 5% level.

The findings indicate that there exists long-run relationship between the three variables
(i.e., lnGDP , lnPOP and lnGE ), which means that these variables are cointegrated. In other
words, although the variables are not stationary at levels, in the long run, they move closely
with each other. Long-run cointegration when the variables are normalized by cointegrating
coefficients could be expressed as:

lnGER = 2.845 lnGDPR – 7.723 lnPOP + 57.950

This cointegrating vector equation indicates that there exists positive long-run relationship
between population growth and government expenditure. On the other hand, there is
long-run relationship between economic development and government expenditure. This implies
that in Malaysia, government expenditure increases as the size of national income grows. In
other words, Malaysia represents a typical developing country, where the size of government
expands as the country pursues economic development and industrialization.

Finally, the Granger causality method based on the VECM was employed to examine the
long-run and short-run casual relationships between the three variables.

Firstly, the AIC was used to determine the optimal length for the causality test. As Table 7
shows, the optimal lag length for causality test is six which minimizes the AIC.

Next, results of F-test and t-tests are reported in Table 8. The findings show that the error
correction term is statistically significant, but positive. This means that there is no long-run Granger

Wagner ’s L aw in Malaysia: A New Empirical Evidence 39

causality between the three variables. In
Table 7: Optimal L ag Length Selection
other words, the long-run Granger for Causality Test
causality could not be confirmed, despite (Maximum Lag Length = 6)
the existence of the long-run equilibrium
Lag Length AI C
relationship between Malaysia’s GDP and
public expenditure as indicated by the 0 –1.286
results of the Johansen cointegration test. 1 –1.158

As the results of F-tests indicate, the 2 –1.085

Granger causality between the variables
has been detected in the short run. This
means that in Malaysia, the size of GDP
influences the size of public expenditure
over a short period of time. In other
words, Malaysia’s economic
performance does ‘Granger cause’ the
size of public spending in the short run.
3 –0.997
4 –0.833
5 –0.888
6 –1.976*
N o t e : AIC denotes the Akaike Information Criterion;
and * indicates optimal lag length selected
by AIC.

Table 8: Granger Causality Test Based on VECM

Dependent Variable: ln GE

Var i a bl e F - st at i st ic s p-value
lnGDP 3.845 0.029
Coefficient t - s ta t i st i c
u t –1 0.133 4.854**

N o t e : To test for causality when variables are cointegrated, the following Granger causality test
based on the VECM could be used:
n n n
 ln GE t  b1  
i 1
b 2i  ln GDPt i   
i 1
b 3i  ln POPt i   b
i 1
4i  ln GE t i   b 5 u t 1  εt

Short-run causality: The joint significance of the coefficients is determined by the F-test;
Long-run causality: The level of significance for error correction term is determined by the
t-statistics; The results are based on a VECM with six lags; and ** indicates significance
at 1% level.

In a nutshell, empirical findings of the present study imply that there is a long-run
relationship—but no causality—between Malaysia’s GDP and public expenditure. These findings
partially confirm the results of the previous research on Wagner’s Law in Malaysia, done by
Sinha (1998). On the other hand, in the present inquiry, short-run causality has been detected
between Malaysia’s GDP and the public expenditure, which contradicts Sinha’s findings. This
difference in results could stem from the differences in methodology adopted by the two
studies. While Sinha employed the standard Granger causality test, the present study used the
Granger causality test based on the VECM.

40 The Icfai University Journal of Applied Economics, Vo l. VII, No. 4, 2008

Conclusion
This paper used the VECM to analyze the relationship between Malaysia’s economic
development and government expenditure. The findings of the current study offer some
interesting insights. The results of the Johansen cointegration test indicate that, there exists a
long-run relationship between Malaysia’s economic development and government expenditure.
In other words, the size of the Malaysian Government expands as the country becomes
wealthier. This is the most important finding of this paper.

Despite the existence of cointegrating relationship between economic development and

public expenditure in Malaysia, long-run causality between the variables could not be established.
On the other hand, the empirical findings of the current research provide an additional evidence
in support of the proposition that economic development in Malaysia ‘Granger causes’ expansion
of government expenditure in the short run.

To conclude, empirical findings of the present study indicate that there is long-run
relationship and short-run causality between Malaysia’s GDP and public expenditure. These
findings confirm that Wagner’s hypothesis may be valid in the context of an Asian developing
country, such as Malaysia. In other words, the current study provides an additional empirical
evidence to support the existence of Wagner’s Law.

There have transpired some contradictions in the course of the current research, such as
the absence of long-run causal relationship between national income and government
expenditure despite the existence of cointegrating relationship between the two. To address
this issue, future research studies may choose to employ different model specifications
which would incorporate variables such as per capita GDP or government expenditure per
person. 

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26. Wagner A (1883), Finanzwissenschaft, 3rd Edition, Leipzig, C F Winter.

27. Wagner R E and Weber W E (1977), “Wagner’s Law: Fiscal Institution and the Growth of
Government”, National Tax Journal, Vol. 30, pp. 59-68.

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