Are Consumption and Government Expenditures Substitutes or Complements? Morishima Elasticity Estimates from the Fourier Flexible Form

1. INTRODUCTION Macroeconomists paid relatively little attention to the economic effects of government expenditures and to alternative methods of financing those expenditures until Barro (1974, 1979, 1981) challenged conventional views on the economic impact of government activity. Much of the literature stimulated by these studies addressed the effects of alternative financing methods for a given path of government expenditures. But Barro (1981) also stressed the fact that government expenditures can provide direct welfare to economic agents and that variations in the level of government expenditures may have an impact on the consumption decisions of households. As a result, many studies estimate the extent to which economic agents treat government expenditures as substitutes to or complements with private consumption expenditures (e.g., Kormendi, 1983; Aschauer, 1985; Graham and Himarios, 1991; Ni, 1995). The degree of substitution or complementarity between private consumption and government expenditures is of crucial importance in assessing the impact of fiscal policies on economic welfare. Thus it is important to establish the extent to which federal expenditures and private consumption are substitutes or complements as a guide to the design of fiscal policies. There is much disagreement about the extent to which consumption and government expenditures are substitutes or complements in use for economic agents. (1) Studies differ in their details, so it is difficult to know what might account for such diverse results. But it seems fair to say that the relationship between government expenditures and consumption is largely an open question. The diversity of the results, however, may be a consequence of a number of restrictive assumptions that have been used in various studies. Many of these assumptions appear hard to justify a priori. Studies typically estimate the parameters of an equation containing private consumption and government expenditures, often assuming that the relevant choice variable for the representative household is an aggregate consumption measure given by the sum of nondurables and services consumption (e.g., Aschauer, 1985; Reid, 1985; Bean, 1986; Campbell and Mankiw, 1990) or the sum of nondurables, services, and the service flow from durable goods (e.g., Kormendi, 1983; Graham and Himarios, 1991). This implies that each component of private consumption expenditures is a perfect substitute for the household, an assumption for which there is no compelling theoretical basis. Similarly, government expenditures (defense, nondefense, and state and local) are typically aggregated (e.g., Feldstein, 1982; Aschauer, 1985; Reid, 1985; Graham, 1993), with various studies excluding either federal or state and local expenditures. Just as for private consumption expenditures, these aggregation assumptions should be tested, rather t han simply imposed in applied work. In addition, although substitution elasticities are generally not constant in an optimizing framework, they are often assumed to be constant in applications by using a single aggregate of consumption or a utility function that imposes a constant elasticity of substitution (e.g., Aschauer, 1985; and Ni, 1995). Finally, none of the above-mentioned studies computes elasticities of substitution in a manner consistent with microeconomic utility maximization principles. (2) In this article we provide estimates of elasticities of substitution between consumption and government expenditures based on the demand-systems approach that has been widely used in testing the neoclassical theory of household behavior (see, eg., Deaton and Muellbauer, 1980, and the survey of Barnett et al. 1992). This approach has a number of attractive features, making it a substantial improvement over the applied studies available in the macroeconomics literature. The estimates in this article are based on an optimizing framework where both government and consumption expenditures are treated as choice variables by the representative household. …