The Effects of Fiscal Policy on the Environment

1. The Effects of Fiscal Policy on the Environment • Thesis Defence • by • Epameinondas Paizanos • Department of Economics, University of Thessaly • Supervisor • Professor George E. Halkos • Volos, 30 October 2015 • This research has been co-financed by the European Union (European Social Fund – ESF) and Greek national funds through the Operational Program "Education and Lifelong Learning" of the National Strategic Reference Framework (NSRF) - Research Funding Program: Heracleitus II. Investing in knowledge society through the European Social Fund. 1

2. Introduction • Despite the immense importance of government expenditure and government revenues in many economies worldwide, little effort has been so far devoted to the study of the impact of fiscal policy on environmental quality. • Focus on the effect of government expenditure, but also considers impact of government revenues. 2

3. Contribution Objective is to examine dimensions of this relationship that have not been sufficiently considered in previous work. • Few studies, but growing body of literature. • Estimate both the direct and indirect effects of government expenditure on environmental degradation and thus, report the total effect. • Examine how the magnitude of the direct effect of government expenditure on environmental quality may differ conditional on the level of economic development and the quality of institutions in a country. 3

4. Contribution (cont’d.) • Provide estimates of the effect of fiscal policy on different indicators of environmental pollution, which can be directly compared. • Offer insights concerning the short-term interrelationships between government expenditure and government revenues with air pollution. • The importance of employing appropriate dynamic econometric techniques in this framework is emphasized and the dynamic nature of the examined relationships is explicitly taken into consideration throughout the empirical analysis. 4

5. Fiscal Policy - Environment • Mechanism and effect may differ according to whether pollution is production- or consumption-generated (McAusland, 2008). Production-generated pollution (Lopez et al., 2011) • Scale effect (change in environmental pressures due to the effect of government expenditure on economic growth), • Composition effect (increased human capital activities instead of physical capital intensive industries that harm environment more), • Technique effect (due to higher labor efficiency) • Income effect (increased income raises demand for improved environmental quality). 5

6. Fiscal Policy – Environment (cont’d.) Consumption-generated pollution(Galinato and Islam, 2014) • Scale (Income) effect (spending on health and education increases the current and future income of households and leads to an increase of consumption pollution) • Regulation effect (government expenditure encourages the development of institutions and therefore the establishment and enforcement of environmental regulations which enhance environmental quality) - Fullerton and Kim, 2008. 6

7. Fiscal Policy – Environment (cont’d.) Other related channels • Governance quality (enhanced institutional quality reinforces the alleviating effect of government expenditure on pollution) – Galinato and Islam 2014; Bernauer and Koubi, 2009. • Special interest groups (influence the strictness of environmental regulation the government imposes) - Mueller and Murrell 1986; Bernauer and Koubi, 2013; Galinato and Islam, 2014; Sobel, 2001. 7

8. Fiscal Policy – Environment (cont’d.) Empirical evidence • Ambiguous effect on environmental degradation. • Positive effect (KoubiBernauer, 2013) • Mixed evidence (Frederik and Lundstrom, 2001) • Negative effect (Lopez et al., 2011; Lopez and Palacios, 2014; Galinato and Islam, 2014) 8

9. Estimating the total effect of government spending • Government size has been found to influence prosperity (Ghali, 1998; Bajo-Rubio, 2000; Folster and Henrekson, 2001; Bergh and Karlsson, 2010) • Thisin turn may impose an indirect effect on pollution, depending on the shape of the Environmental Kuznets Curve (Grossman and Krueger, 1995). • This study is the first to distinguish and empirically estimate both direct and indirect effects of fiscal spending on the environment. Prof. George E. Halkos & Epameinondas A. Paizanos 9

10. Data • Panel data for 77 countries with full set of SO2, CO2, share of Govshare, GDP/c and other explanatory variables for 1980-2000. 1617 observations per variable. • SO2 emissions production-generated with local impact. • CO2 emissions mix with global impact. 10

11. Methodology Model • Control variables in Eq. (1) include GDP/c (scale effect), household final consumption (income effect) and democracy level (proxy for environmental regulation). • Thus, coefficient of GOVSHARE (i.e. direct effect) mainly captures composition effect and part of technique effect. • Equation 2 is augmented Solow model. 11

12. Estimating the total effect of government spending • The total effect of government spending on pollution can be expressed as: 12

13. Methodology • FE are used instead of RE (Hausman test). • Since our panel consists of large N and T dimensions, dynamics and non-stationarity are taken into account by employing the Dynamic Fixed Effects (DFE) estimator proposed by Pesaran and Smith. • To address bias occurring from potential endogeneity between GOVSHARE with pollution and income respectively, we apply A-B GMM. 13

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15. Fisher-type Philips-Peron tests allowing heterogeneity of autoregressive parameters In all cases variables are I(1) 15

16. Application of DFE requires variables cointegrated (LR relationship).DFE is applicable. • We reject Ho: no-cointegration in 5/8 cases for SO2 and in 6/8 in CO2. Evidence of cointegration. 16

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19. The negative sign of indirect effect occurs from the positive relationship between income and pollution at the median income level (upward section of EKC). 19

20. The total effect of government share on SO2/c is negative for low levels of per capita income and then turns to positive (above $10,809), while the total effect on CO2/c is also negative but becomes positive only for very high income levels (above $16,438). 20

21. Sensitivity analysis Relative tests indicate that the results are robust to : • Inclusion of a GOVEXP composition variable. • Omission of time-variant variables. • Use of different model specifications. • Inclusion/exclusion of extreme observations. 21

22. Magnitude of the direct effect • Environmental quality is influenced by various other factors, apart from fiscal policy and economic growth, including political institutions, population, trade and capital stock (Grossman and Krueger, 1995; Halkos, 2013a; Bernauer and Koubi, 2009; Zhu and Peng, 2012; Cole and Elliott, 2003). • Some of these characteristics may interact with government expenditure and influence its effect on environmental quality. • It is highly unlikely that the direct effect of government spending on pollution is independent from country specific characteristics. 22

23. Magnitude of the direct effect (cont’d.) Institutional quality • Small elites in autocratic regimes oppose the establishment of environmental regulations (Bernauerand Koubi, 2009; Lake and Baum, 2001; Niskanen, 1997; Farzin and Bond, 2006). • Corruptionreduces the stringency of environmental regulations (Fredriksson and Svensson, 2003; Fredriksson et al., 2003; Cole, 2007; Halkos and Tzeremes, 2013). • The median voter, in democracies, faces a relatively lower burden from environmental policies. 23

24. Magnitude of the direct effect (cont’d.) Level of economic development In developed countries: • the income effect exceeds the scale effect (Islam and Lopez, 2015). • more demand for environmental quality since the demand for other public goods has already been satisfied (Frederik and Lundström, 2001; Martinez-Mongay, 2002). • government expenditure more likely to be targeted at education and R&D spending. 24

25. Data & Methodology • Panel data for 94 countries. SO2, N2O, CO2, NOx,Govshare, GDP/c and other explanatory variables for 1970-2008. 3.525 observations per variable. • Use of dynamic estimation methods (slow adjustment) – Perman and Stern, 1999 • Partial Adjustment Model. • Dynamic Fixed Effects. 25

26. Partial effects 26

27. Magnitude of the indirect effect 27

28. Magnitude of the direct effect (cont’d.) 28

29. Magnitude of the direct effect (cont’d.) 29

30. Magnitude of the direct effect (cont’d.) 30

31. Magnitude of the direct effect (cont’d.) 31

32. Short-run effects • The empirical studies use reduced-form models and estimate the long-term effect of government spending. • This section draws structural conclusions using Vector Autoregression methods based on minimal hypotheses about the signs of the impacts of certain shocks (Mountford and Uhlig, 2009). • Examines for the first time how different realistic policy implementation scenarios, that aim to stimulate the economy, may also impact environmental quality. • Quarterly data for 10 macroeconomic and 2 environmental variables for the U.S. economy, for the period 1973-2013. 164 observations per variable. 32

33. Short-run effects • Following Mountford and Uhlig (2009) the computations are performed using a Bayesian approach. • The sign identification procedure starts with a reduced form VAR as: • The VAR system has two lags (based in AIC and SC criteria). • No constant term or a time trend included. • Logarithm for all variables is used, except for interest rate. 33

34. Short-run effects • The business cycle and monetary policy shocks are identified first. • The basic fiscal policy shocks are then identified by requiring that they are orthogonal to both business cycle and monetary policy shocks. • No sign restrictions imposed on the reaction of the environmental and macroeconomic variables of interest to fiscal policy shocks. 34

35. Short-run effects • This identification strategy, combined with the measure of government expenditure used, serves the separation of changes in the variables of interest that are the result of actual fiscal policy shocks, rather than capturing their variation in response to the business cycle shocks. • To enhance the identifying power of the model, the responses of the fiscal variables are restricted for four quarters after the initial shock 35

36. Short-run effects 36

37. Short-run effects 37

38. Short-run effects 38

39. Short-run effects 39

40. Conclusions • Government expenditure has a negative or non-positive direct effect on the different indicators of environmental degradation. • The alleviating direct effect of government spending on pollution is significantly reinforced in developed countries and democratic regimes. • The direct effect is greater in significance and in magnitude on pollutants that are characterized by shorter atmospheric life times, local geographical range and therefore more immediate impact on human health. • The estimated direct effect is larger in significance and magnitude on production-generated pollution compared to consumption-related pollution. 40

41. Conclusions (cont’d.) • The alleviating direct effect of government expenditure on environmental degradation can be considerably enhanced by targeting spending on specific functional categories, such as spending on public goods and environmental protection. • The total effect of government expenditure on environmental quality depends on thegovernment spending-growth and growth-environment relationships (i.e. the indirect effect). • An attempt to stimulate the economy through tax-cuts is associated with an increase in consumption-related CO2 emissions in the short-run, while there is little evidence of an effect on production-generated CO2 emissions. 41

42. Policy implications • Fiscal spending may be used to complement the efforts to improve environmental quality, rendering these efforts easier and more cost efficient. • The weak direct effect of government spending on environmental quality in developing countries and autocratic regimes can be enhanced by enforcing property rights on natural resources which may promote the internalization of environmental externalities. • There is a need for technological and knowledge diffusion to developing countries in order to advance the abatement methods used and encourage the use of environmental cleaner production methods. • The mitigation of pollutants with more global impact, requires the adoption of international environmental treaties which will internalize such externalities. 42

43. Policy implications (cont’d.) • Provides reassurance to macroeconomic policy makers that increasing government expenditure does not deteriorate CO2 related air pollution and in fact is associated with improvements of environmental quality. • Governments in developed countries should restructure government expenditure composition and reform tax systems in order to ensure that these are not linked with a slowdown of economic growth. This can be achieved by promoting spending in categories that alleviate market failures such as investments in human capital, R&D and health (Lopez et al., 2011; Fakin, 1995; Lee, 1996). • A fiscal expansion based on tax-cuts increases consumption-generated CO2 emissions in the short-run and should be accompanied by stricter environmental regulations. 43

44. Limitations and future research directions • Lack of data on the composition of government expenditure for a large sample of countries and for a long period of time. • Analysis of the short-run link between fiscal policy and environmental degradation is also limited by data unavailability in most countries and thus prevents a more representative study on this relationship. 44

45. Limitations and future research directions (cont’d.) • The analysis should be conducted in a joint framework with two other bodies of literature. • Lack of theoretical models that examine the relationship between fiscal policy, output and environmental quality. • For the establishment of such models, the empirical finds occurring from this thesis can provide a useful starting point. 45

46. Thank you for your attention! 46