Wagner's law, fiscal discipline, and intergovernmental transfer: Empirical evidence at the U.S. and German state levels

Does fiscal discipline restrain government from increasing its budget size? To answer this question, this paper investigates whether Wagner's law is satisfied for two types of states: U.S. states, in which fiscal sovereignty is established, and German states, in which fiscal transfer dependence is high and budget constraints are softened. In U.S. states, we demonstrate that Wagner's law is validated, while some of the balanced budget requirements weaken the validity of the law. In German states, we find an “inverse” law, especially after the bailouts of Bremen and Saarland. The “inverse” law is a new channel of growth in government size, and means that soft budget constraints cause significant negative correlation between government size and output. These results are robust regardless of whether intergovernmental fiscal transfers are taken into account, while they quantitatively change the validity of the law. Our findings imply that the characteristics of fiscal discipline are prime determinants of the channel and degree of growth in government size.