Testing Wagner’s Law Based on Government Functions: Is There Evidence of Quality of Public Finances Regarding Sustainability?

Abstract

The issue of the quality of public finances is gaining importance in light of long-term fiscal sustainability challenges. The Recovery and Resilience Facility (RRF) can play a role in improving the quality of public finances by reshaping the composition of general government expenditure by function and supporting the economy’s long-term growth potential. This paper analyses the validity of Wagner’s law for Euro area countries and examines the evidence on the quality of public finances based on productive government expenditure. The quantitative approach is based on panel data approaches. The results do not confirm the validity of Wagner’s law. However, they indicate that the RRF, as an instrument of exogeneous fiscal intervention, has contributed to a shift in the composition of government expenditure, thereby providing some evidence of an improvement in the quality of public finances. Given that the RRF is a temporary, performance-based programme, it represents—at best—a temporary form of exogeneous fiscal intervention on the quality of public finances, which, upon its completion and ceteris paribus, will remain within the domain of the Member States.

1. Introduction

In 1883, Wagner [1,2,3] coined the “Law of Increasing State Activity”. Its tenet is that economic development leads to increased demand for public goods and services. Enhancing such services necessitates higher levels of government expenditure. As government functions expand, so does the government sector’s size relative to the rest of the economy. Such dual growth of the economy and the size of government within that economy is, according to Wagner, accompanied by rises in state intervention upon private economic activity. He further contends that the Law prevails as long as economic progress continues and that the only limit to the law is the tolerance of taxpayers to infringements on their consumption baskets. Wagner thus anticipates causality running from economic activity to government expenditure. This contrasts with a Keynesian perspective, see, for example, ref. [4].

According to Wagner [2,3], the relative role of the state in the economy increases for three main reasons: first, because state intervention substitutes for private initiative to reduce the potential for market failures and enhance the protection of property rights; second, economic growth triggers increased demand for income-elastic goods, particularly education and cultural amenities, which may be government-subsidised; and third, as its role becomes more engrained in the economy, government invests in infrastructure that can improve economy-wide efficiencies. Such infrastructure is typically unattractive to private investors because the required scale of investment is simply too large for them to undertake with sufficient effectiveness.

The role of the public sector in the economy, within the context of modern public finance, is multifaceted. It encompasses the provision of public goods and services, market regulation, and social protection, thereby contributing to societal welfare and economic stability (see, for example, ref. [5]). Public sector activities affect both the revenue and expenditure sides of the budget, while persistent fiscal deficits lead to the accumulation of public debt, which may become unsustainable. Fiscal sustainability thus represents a key prerequisite for the sound and effective performance of fiscal policy functions [6].

Prolonged and excessive borrowing can have adverse effects on the economy, as in an unstable macroeconomic environment, sustainable economic growth becomes unattainable. High levels of public debt reduce the government’s capacity to provide essential public services to its citizens. Empirical research [7,8] indicates that when public debt exceeds a certain threshold or share of GDP, it begins to hinder economic growth. However, the exact turning point depends on the specific characteristics of each country. Although borrowing can serve as an effective instrument for promoting economic growth and prosperity, and it tends to have a positive effect on real economic growth in countries with a low public debt-to-GDP ratio, high levels of debt require lower future consumption and higher taxes [9,10]. The measures undertaken by governments to service their debt may lead to higher required yields when taking on new debts. In an environment of higher interest rates, the debt servicing risk increases, complicating public debt management and undermining the country’s credibility and financial stability. The optimal level of public debt is difficult to determine precisely. It depends on a range of factors, including the initial level of debt, expenditure needs related to social protection, healthcare, and the green transition, as well as the political power of various interest groups, sovereign credit risk, and the political feasibility of fiscal measures. Ensuring fiscal sustainability is of crucial importance and given the adverse consequences of high public debt, governments must adhere to fiscal rules within the new economic and fiscal governance framework to maintain fiscal sustainability. However, under conditions of political uncertainty and increasing pressure to raise defence spending, medium-term fiscal sustainability may be jeopardised. This representing a step away from the developmental role of public finances by diverting government expenditure away from productive uses.

Fiscal policy plays an important role not only in ensuring macroeconomic stability but also in supporting structural reforms (see, for example, ref. [11,12]). Through an appropriate structure of the tax burden and government expenditure, as well as their targeted efficiency, fiscal policy must support the achievement of the country’s development priorities. The quality of public finances is thus a multidimensional concept that fundamentally encompasses policies aimed at enhancing the long-term potential for economic growth and resilience to shocks, while also ensuring long-term fiscal sustainability. In this context, the quality of public finances is measured by changes in the composition of government expenditure.

Changes in the composition of government expenditure towards enhancing productivity and economic growth and the quality of government expenditure contribute to the developmental role of public finances [13]. The Recovery and Resilience Facility (hereinafter RRF) seen as an exogeneous fiscal intervention aimed at enhancing the resilience, crisis preparedness, adaptability, and development potential of EU Member States in the aftermath of the COVID-19 pandemic, has the potential to contribute to the improvement of the quality of public finances in Member States. In particular, the RRF is a performance-based programme that provides grants and loans to support reforms and investments in the EU Member States.

The RRF pursues objectives aimed at mitigating the economic and social impact of the pandemic, ensuring that Member States become more resilient, sustainable, and better prepared for the challenges and opportunities of the green and digital transitions. Furthermore, the RRF also aims at achieving climate neutrality by 2050; advancing the digital transition; and fostering job creation and growth. RRF funds are allocated, among other things, to the following: (i) The green transition (e.g., sustainable mobility, energy efficiency and renewables, climate change adaptation, circular economy, biodiversity). (ii) The digital transformation (e.g., promoting the roll-out of very high capacity networks, the digitalisation of public services, government processes and businesses, in particular SMEs, developing basic and advanced digital skills, supporting digital-related R&D and the deployment of advanced technologies). (iii) Smart, sustainable, and inclusive growth (e.g., promoting entrepreneurship, competitiveness, industrialisation, improving the business environment, fostering research, development and innovation, and supporting small and medium-sized enterprises), as well as in the area of health [14]. Therefore, the RRF, as an exogeneous fiscal intervention, is viewed in this paper as a catalyst for changes in the composition of the general government expenditure, with the potential to sustain the developmental role of public finances and long-term growth.

Changes in the composition of government expenditure are a key instrument for achieving the economic, social, and environmental objectives of sustainable development. From the economic dimension perspective, government expenditure promotes economic growth through investments in research, education, and infrastructure, thereby enhancing productivity and the competitiveness of the economy. Through public investments in services such as healthcare, education, and green infrastructure, employment opportunities are created, while macroeconomic stability is maintained through balanced spending and efficient allocation of resources, thereby reducing the risk of inflation and excessive public debt. From the social dimension perspective, government expenditure ensures access to basic services (such as healthcare and social security), thereby reducing inequalities and improving quality of life. By fostering social cohesion, it reduces poverty and promotes the inclusion of vulnerable groups as well as intergenerational fairness. Changes in the composition of government expenditure contribute to environmental sustainability objectives by promoting the sustainable use of resources, mitigating negative environmental impacts, and supporting climate change adaptation. Through balanced government expenditure, the state can simultaneously foster economic growth, reduce social disparities, and protect the environment.

The aim of this paper is threefold: to test the validity of Wagner’s law for Euro area countries; to examine how the Recovery and Resilience Facility (RRF), as an exogenous fiscal intervention instrument, affects the structure of general government expenditure; and to assess its implications for sustainable fiscal governance.

The research contributes to the literature in a following ways: (1) It highlights the issue of the quality of public finances, which has so far received limited attention but is gaining renewed relevance in view of the medium- and long-term challenges to fiscal sustainability. The crises experienced over the past decade have generally coincided with expansionary monetary policy and, as a result, with favourable conditions for financing public debt. The increase in non-crisis-related government expenditure has raised expectations regarding the role of the state and the availability of public resources. (2) On the other hand, there is limited empirical evidence of analysing the developmental role of public finances. This research seeks to fill this research gap. In this context, the RRF was introduced into the analysis as an exogenous fiscal intervention. The RRF is considered an important source of funding in support of the green and digital transitions, while also contributing to making economies more sustainable and resilient. In addition, it addresses the challenges identified in the country-specific recommendations (CSRs) under the European Semester framework for economic, fiscal, and social policy coordination. Accordingly, in this paper, the RRF is viewed as a catalyst for changes in the composition of general government expenditure. Since the RRF is a temporary instrument (set to conclude in 2026), the responsibility for maintaining the quality of public finances will increasingly rest with the Member States. This entails the risk that fiscal policy decisions may become more influenced by prevailing political cycles. (3) Furthermore, several economists have criticised Wagner’s law for its conceptual ambiguity in defining and measuring government expenditure. This paper adopts a more granular approach and takes into account general government expenditure by function, in line with the classification of the functions of government (COFOG), which allows for a broader and more substantive perspective than total government expenditure alone. (4) Finally, this paper contributes to advancing the debate on government expenditure review. Given the limited fiscal space and the medium- and long-term challenges of fiscal policy sustainability, there have been renewed calls for a comprehensive review of government expenditure. Such a review would contribute to greater efficiency in the use of public resources, improve the quality of public services, and redirect government expenditure towards more productive purposes. At the same time, it is essential to take into account the associated risks and costs of population ageing, which will affect the long-term sustainability of public finances (see, for example, ref. [15,16,17]).

2. Literature Review

The literature includes numerous studies testing the validity of Wagner’s law. For instance, Lamartina and Zaghini [18], using a panel cointegration analysis on a sample of 23 OECD countries, found a positive correlation between government expenditure and per capita GDP. The authors also observed that the correlation tended to be stronger in countries with lower per capita GDP. The assessment of the Wagner’s law is conducted using the panel estimation technique of pooled mean group (PMG) regressions. The authors highlight that a major advantage of PMG estimation methodology over the standard dynamic fixed-effects modelling is that it allows the short-run dynamic specification to vary across countries. Considering that certain parameters may be identical across groups, the PMG approach exploits the cross-sectional dimension of the dataset. The authors also emphasise that the PMG approach is methodologically appropriate for testing the validity of Wagner’s law, as it enables the identification of a verifiable long-term relationship across countries. Furthermore, the baseline modelling with the autoregressive distributed lag model allows for some degree of endogeneity in the variables. Adequately selecting the lag length of both government expenditures and GDP in the specified model is sufficient for correcting the problem of endogenous regressors and maintain the asymptotic distribution of the estimators.

Kolluri, Panik, and Wahab [19] report the short and long-term effects of national income on government expenditure for G7 countries, whereas Hsieh and Lai [20] attempt—on the basis of Barro’s endogenous growth model—to investigate the relationship between government expenditure and economic growth, taking into account intertemporal interactions between the growth rate of real GDP per capita, the share of government expenditure, and the share of private investment in GDP for the G7 countries. The authors employed a multivariate time series analysis, in which, within the framework of a vector autoregression (VAR), they specifically addressed causal relationships and the form of the impulse–response function. The results of the study indicate that government expenditure does not contribute to an increase in the growth rate of real GDP per capita, nor is there any evidence to suggest that the reverse holds true. For most of the countries included in the study, government expenditure contributes, at best, only marginally to GDP growth.

Murphy [21] argues that the smaller the government expenditure, the weaker the state. The study is based on an analysis of the Economic Freedom of the World index, specifically on the subindex scoring the size of government, which includes government spending, the top marginal tax rate, and government ownership of the economy. The results confirm the validity of Wagner’s law, namely, that countries with higher GDP also have higher consumption. Afxentiou and Serletis [22] tested Wagner’s law for EU countries and, overall, found no evidence of a long-term relationship between categories of government spending and GDP. The authors examined the causality between GDP growth and the growth of government expenditure, also including transfers and subsidies. They examined the integration and cointegration properties of the data and found that all series are non-stationary over time and not cointegrated; therefore, they applied Granger causality tests. In doing so, they considered the growth rates of the variables under study within bivariate vector autoregression models. The results show that causality cannot be confirmed for aggregate expenditure in any of the countries in the sample, while Wagner’s hypothesis of causality running from GDP to government expenditure was confirmed only for Germany (for government final consumption expenditure), for Spain (for transfer payments, as well as for transfer payments and subsidies combined), and for the United Kingdom (for subsidies). The authors also examined the validity of reverse causality, which was confirmed only for Italy, but not for the other European countries included in the sample.

Wahab [23] formulated a new test specification of Wagner’s Law with the aim of disentangling the effects of accelerating and decelerating economic growth on growth in government expenditure. Two alternative proxies for the state of the economy were experimented with. The first defines the current state of the economy by relating it to its historical mean growth rate, while the second defines it relative to a pooled time-series/cross-sectional mean growth rate. This distinction was then incorporated into an error correction model that parameterizes the bivariate relation between government expenditure and economic growth for alternative OECD country groupings. The authors find that when economic growth increases, government expenditure rises less than proportionately, whereas during periods of declining economic growth, government expenditure decreases more than proportionately. There is limited support for Wagner’s law. Paparas, Richter, and Kostakis [24] examined Wagner’s law validity in the United Kingdom using data spanning more than 100 years. The results indicated the presence of a long run relationship between national income and government spending, and based on the Granger causality test, they found that the causality is bi-directional, thus providing support for Wagner’s and Keynesian hypotheses, while only the former was confirmed by Chang, Liu, and Caudill [25] and by Leshoro [26].

Liu, Hsu, and Younis [27] report mixed results when examining different subcategories of government spending. The paper focuses on the relationship between government expenditure and economic growth in the United States, using a time series of data for the period 1947–2002. The authors investigate the causal relationship between economic growth and government expenditure based on the Granger causality test. Government expenditure is further divided into the following subcategories: national defence, human resources expenditure, physical resources expenditure, net interest payment, and other expenditure. When testing for causality between economic growth and government expenditure, the authors find that government expenditure does not cause economic growth, nor does economic growth cause an increase in government expenditure (which is contrary to Wagner’s law). The authors report mixed results when examining different subcategories of government spending. When testing for causality between economic growth and individual subcategories of government expenditure, the authors find no causality between government expenditure on national defence and economic growth. In addition, there is bidirectional causality between economic growth and government expenditure on physical resources and net interest payments, as well as unidirectional causality between economic growth and government expenditure on human resources and other government expenditure.

Moreover, Klonowska and Pawełek [28] reported, based on the Granger causality test, that GDP changes may affect social security expenditures, and not vice versa. The analysis was conducted for the EU countries for the period 2003–2019. The authors find that the Granger burdens of causation were not equally distributed and that revenue redistribution plays a greater role than allocation. This is because, in countries that were members of the community before 2004, expenditures and revenues were characterised by bidirectional Granger causality. In turn, in countries that joined the community in 2004 and later, expenditure and balance were characterised by bidirectional Granger causality.

Jalles [29] used panel data and seemingly unrelated regressions approach to test Wagner’s law on a sample of 61 advanced and emerging market economies for the period 1995–2015. Jalles [29] included data for different government spending categories, see also ref. [30] and highlights that granularity matters when testing Wagner’s law. A similar approach can be found in Afonso and Alves [31] testing Wagner’s law for 14 EU Member States over the period 1996–2013.

Based on the literature review, it can be observed that research focuses on testing the validity of Wagner’s law per se and on examining the causal relationship between economic growth and general government expenditure. On the other hand, there is little evidence of going beyond that causal relationship taking into account the quality of public finances and their developmental role. Our research complements this research gap by incorporating the RRF as an exogenous fiscal intervention with the potential to redirect general government expenditure towards more productive and development-oriented purposes.

3. Methodology

The empirical analysis includes the Euro area countries, specifically Austria, Belgium, Croatia, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The data for the Euro area countries were obtained from the Eurostat database [32] and Ameco database [33]. Based on data availability, two datasets were constructed: one covering the period 1997–2023 and the other covering the period 2021–2023. The latter covers the available period of RRF implementation, which entered into force in 2021, and includes all data available to date (which is also seen as a limitation of the research). The data used in the empirical analysis have the structure of panel data, incorporating both dimensions: the cross-section dimension, denoted by i, and time series dimension, denoted by t.

We used data on the real gross domestic product per capita (RBDP) and data on the annual general government expenditure by function (ISD), which, according to the classification of the functions of government (COFOG), are categorised into ten areas: general public services (JU); defence (OB); public order and safety (JRV); economic affairs (ED); environmental protection (VO); housing and community amenities (SD); health (ZDR); recreation, culture, and religion (RKR); education (IZO); and social protection (SZ). The data on the annual general government expenditure by function (ISD) are expressed as a ratio of annual general government expenditure by function to gross domestic product. In line with the methodology of Bańkowski et al. [34], productive government expenditure (PROD) includes expenditure on transport (TR) and communication (KOM), health (ZDR), education (IZOB), and research and development (RR) across all categories of the classification of the functions of government (COFOG). The quality of public finances, and thus, the developmental role of public finances, is measured by changes in the composition of productive general government expenditure. The list of variables used with their description and data source is presented in Appendix A,

Table A1. Description of variables and data source.

Variable	Description	Data Source
JU	Annual general government expenditure for general public services in mio EUR	Eurostat
OB	Annual general government expenditure for defence in mio EUR	Eurostat
JRV	Annual general government expenditure for public order and safety in mio EUR	Eurostat
ED	Annual general government expenditure for economic affairs in mio EUR	Eurostat
VO	Annual general government expenditure for environmental protection in mio EUR	Eurostat
SD	Annual general government expenditure for housing and community amenities in mio EUR	Eurostat
ZDR	Annual general government expenditure for health in mio EUR	Eurostat
RKR	Annual general government expenditure for recreation, culture and religion in mio EUR	Eurostat
IZO	Annual general government expenditure for education in mio EUR	Eurostat
SZ	Annual general government expenditure for social protection in mio EUR	Eurostat
RBDP	Real gross domestic product per capita in EUR	Eurostat
JD	Government consolidated gross debt, percentage of gross domestic product	Eurostat
IN	Inflation, annual average rate of change	Eurostat
BRE	Unemployment rate, percentage of active population	Ameco

Source: Eurostat and Ameco data.

.

To test the validity of Wagner’s law, the ratio of general government expenditure by function to GDP was considered as the dependent variable, and real GDP per capita as the independent variable (see, for example, ref. [6,35]). For the validation of the Wagner’s law, the estimated regression coefficient associated with real GDP per capita must be greater than or equal to zero. To control for macroeconomic environment, the following variables were included: public debt, inflation, and unemployment. According to the literature and theoretical expectations, the control variables mentioned above are expected to have a positive effect on government expenditure. However, as already mentioned in the introduction, there is a longstanding debate regarding the optimal level of public debt and its associated effects (see, for example, [36]). All data expressed in nominal terms were price deflated by harmonised consumer price index (annual average index). Descriptive statistics for the period 1997–2023 are presented in

Table 1. Summary statistics for the panel 1997–2023.

Variable	Obs	Mean	Std.Dev.	Min	Max
JU	539	0.0733382	0.0310275	0.0177497	0.2755488
OB	539	0.0141526	0.0071801	0.0015861	0.0504534
JRV	539	0.0202195	0.0088523	0.0064098	0.0928565
ED	539	0.0618128	0.0235660	0.0168958	0.2608319
VO	539	0.0088201	0.0039933	−0.0029383	0.0279985
SD	539	0.0088542	0.0064915	0.0001833	0.0395305
ZDR	539	0.0683019	0.0164618	0.0250635	0.1327801
RKR	539	0.0136168	0.0054611	0.0037611	0.0422936
IZO	539	0.0582505	0.0169689	0.0225823	0.1304421
SZ	539	0.1829073	0.0477320	0.0652647	0.3526573
RBDP	537	28,608.4	19,188.44	4790	10,1170
JD	540	64.99574	37.82183	3.9	209.4
BRE	537	9.913408	4.386683	2.3	27.8
IN	538	2.689033	2.721281	−1.7	19.4

Source: Authors’ calculations based on Eurostat and Ameco data.

, while descriptive statistics for the period 2021–2023 are presented in

Table 2. Summary statistics for the panel 2021–2023.

Variable	Obs	Mean	Std. Dev.	Min	Max
RR	60	0.0051256	0.0032644	0.0005747	0.0149331
TR	60	0.0211603	0.0066785	0.0069643	0.038715
KOM	60	0.0004575	0.0003855	0.0000076	0.0021745
ZDR	60	0.0581958	0.0123225	0.035031	0.0859226
IZOB	60	0.0411613	0.0071597	0.0225713	0.0557979
PROD	60	0.1083094	0.0245188	0.0543472	0.1579403
JD	60	76.55333	39.60023	18.4	197.3
BRE	60	6.551667	2.641616	3.1	14.9
IN	60	6.268333	4.135645	0.6	19.4

Source: Authors’ calculations based on Eurostat and Ameco data.

.

In the empirical analysis, we followed Afonso and Alves [31] and applied panel data methodology [37,38,39] to compute relevant coefficients for Wagner’s law. To address possible issues of omitted variables, cross-country heterogeneity, and potential endogeneity and to include control variables, we performed fixed effects panel data regression (FE) and instrumental variables two-stage least squares for panel data models (IV-2SLS) using fixed effects estimator. According to Baltagi [38], the fixed effects specification is appropriate when the analysis focuses on a specific set of n cross-section units—in our case, Euro area countries. Fixed effects regression is a method used to control for omitted variables in panel data when these variables vary across entities (cross-sections) but do not change over time [40]. In the fixed effects model, the intercepts are different for different cross-sectional individuals, whereas the slope coefficients are assumed to be constant for all individuals. Individual heterogeneity, which relates to all behavioural differences between individuals, is assumed to be captured by the intercept term. Individual intercepts are included to control for individual-specific, time-invariant characteristics that do not change over time [41,42,43].

On the other hand, to adequately address the endogeneity concern (in our case GDP can influence government expenditure and vice versa), we implemented instrumental variables two-stage least squares for panel data models (IV-2SLS). Let us assume that we aim to estimate the following model: $Y={\beta }_0+{\beta }_1{X}_1+{\beta }_2{X}_2+\epsilon$. Further, we assume that X₁ is endogenous (correlated with the error term ε) and that X₂ is exogenous (uncorrelated with the error term ε). In the first stage, we regress the endogenous regressor X₁ on all exogeneous regressors (in our case only X₂) and all instrumental variables (assuming we have a single instrument, Z₁). We would estimate the following model: $X_1={\gamma }_0+{\gamma }_1{X}_2+{\gamma }_2{Z}_1+\vartheta$. Based on this, we then calculate a predicted version of X₁, denoted by $\widehat{X_1}$. In the next step, we estimate the model we are interested in (Stata 13.0 was used), replacing X₁ with its predicted version: $Y={\beta }_0+{\beta }_1\widehat{X_1}+{\beta }_2{X}_2+\epsilon$. For an instrument to be valid, it should satisfy the requirement of relevance and exogeneity [40], as discussed in the following section. The basic regression function for each category of general government expenditure by function, classified according to COFOG (ISD), for both approaches and for country i (i = 1, …, N) at time t (t = 1, …, T), is specified as follows: ${ISD}_{it}={\alpha }_i+{\beta }_1{RBDP}_{it}+{\beta }_2{JD}_{it}+{\beta }_3{BRE}_{it}+{\beta }_4{IN}_{it}+{\epsilon }_{it}$. To address the issue of heteroskedasticity and ensure more reliable estimates, robust standard errors are used.

4. Results

The relationship between general government expenditure—disaggregated into ten functional categories in accordance with the COFOG classification—and GDP (including control variables) were estimated using both fixed effects panel data regression (FE) and instrumental variables two-stage least squares for panel data models (IV-2SLS) using fixed effects estimator. The analysis was conducted for twenty Euro area countries over the period 1997–2023, while in the case of estimating productive government expenditure, the assessment covered the period 2021–2023, taking into account the duration of the RRF and data availability.

The estimation results are presented in the Appendix A,

Table A2. Coefficients estimates for Wagner’s law, 1997–2023.

	JU		OB		JRV		ED		VO
	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS
RBDP	−0.00000210 *** (0.00000019)	−0.000002 ** (0.000000853)	−0.000000268 *** (0.00000031)	−0.00000235 ** (0.0000012)	−0.00000488 *** (0.00000522)	−0.00000494 ** (0.00000186)	−0.00000137 *** (0.00000176)	−0.00000135 ** (0.00000443)	−0.00000221 *** (0.00000231)	−0.00000224 *** (0.00000633)
JD	−0.0004908 *** (0.0000523)	−0.0004433 ** (0.0001413)	−0.000114 *** (0.00000855)	−0.0001109 *** (0.000021)	−0.0001351 *** (0.0000144)	−0.0001306 *** (0.0000295)	−0.0002259 *** (0.0000486)	−0.0002135 *** (0.0000602)	−0.0000103 (0.00000637)	−0.0000114 (0.0000181)
BRE	0.0017355 *** (0.000324)	0.0013397 * (0.000727)	0.000026 (0.000053)	0.0000123 (0.0001354	0.0007735 *** (0.0000893)	0.000718 *** (0.000187)	0.001813 *** (0.0003008)	0.0017762 ** (0.0005301)	0.0000884 ** (0.0000395)	0.0000927 (0.000108)
IN	0.0006091 * (0.0003471)	0.000011 (0.0006998)	0.0000316 (0.0000568)	0.000012 (0.0000827)	0.0003619 *** (0.0000956)	0.0002626 (0.0002035)	0.0008094 ** (0.0003222)	0.0006704 (0.0004332)	0.0001176 ** (0.0000423)	0.0001271 (0.0000887)
R2	0.0002	0.002	0.1205	0.1007	0.4123	0.4287	0.0781	0.0701	0.0016	0.0016
F-stat	78.76 ***	206.48 ***	86.16 ***	81.09 ***	81.26 ***	105.02 ***	40.70 ***	557.70 ***	33.57 ***	115.39 ***
N	534	515	534	515	534	515	534	515	534	515
	SD		ZDR		RKR		IZO		SZ
	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS
RBDP	−0.00000303 *** (0.00000287)	−0.0000031 *** (0.0000081)	−0.00000952 *** (0.00000823)	−0.00000928 *** (0.00000246)	−0.00000214 *** (0.00000263)	−0.00000219 * (0.00000112)	−0.00000128 *** (0.00000833)	−0.00000172 ** (0.00000495)	−0.00000332 *** (0.0000021)	−0.00000138 ** (0.00000439)
JD	−0.000088 *** (0.00000792)	−0.0000877 ** (0.0000253)	−0.0002573 *** (0.0000227)	−0.0002488 *** (0.00004)	−0.0000798 *** (0.00000725)	−0.0000773 *** (0.0000187)	−0.0004115 *** (0.000023)	−0.0003985 *** (0.000064)	−0.0004257 *** (0.0000577)	−0.0003985 *** (0.000064)
BRE	0.0001369 ** (0.0000491)	0.0001338 (0.0001123)	0.0006978 *** (0.0001406)	0.0006526 (0.0003483)	0.000236 *** (0.0000449)	0.0002086 ** (0.0000978)	0.0013124 *** (0.0001423)	0.0011949 ** (0.0003879)	0.0038151 *** (0.0003573)	0.0011949 ** (0.0003879)
IN	0.0001548 ** (0.0000526)	0.00016 (0.0001084)	0.0001908 (0.0001506)	0.0000689 (0.0002551)	0.00001111 (0.0000481)	−0.0000316 (0.000059)	0.0000252 (0.0001524)	−0.0001459 (0.0001875)	0.0001416 (0.0003828)	−0.0001479 (0.0001875)
R2	0.0693	0.0670	0.0003	0.0004	0.2683	0.2554	0.2339	0.2243	0.103	0.2243
F-stat	82.73 ***	106.74 ***	93.31 ***	327.96 ***	66.46 ***	75.10 ***	202.16 ***	137.52 ***	150.72 ***	137.52 ***
N	534	515	534	515	534	515	534	515	534	515

Notes: *, ** and *** represent statistical significance at levels 10%, 5% and 1%, respectively. Standard errors are reported in parenthesis.

and

Table A3. Assessment of productive government expenditure, 2021–2023.

	RR		TR		KOM		ZDR		IZOB		PROD
	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS	FE	IV-2SLS
RBDP	−0.00000963 (0.00000868)	−0.00000113 (0.00000947)	0.0000035 (0.0000038)	0.00000277 (0.00000436)	0.00000987 (0.00000355)	−0.00000164 (0.00000223)	−0.00000659 (0.00000966)	0.00000943 (0.00000246)	−0.00000124 (0.00000461)	0.00000273 (0.00000732)	0.00000948 (0.00000255)	0.00000318 (0.00000536)
JD	0.00000419 (0.0000185)	0.0000215 (0.0000127)	0.0001091 (0.0000812)	0.0003253 ** (0.0001155)	0.00000755 (0.00000758)	−0.00000744 (0.0000143)	0.0003363 (0.0002063)	0.0004811 ** (0.0001992)	0.0001652 (0.0000986)	0.0002728 (0.0000848)	0.0009354 (0.000545)	0.0014122 ** (0.0004493)
BRE	0.0001829 (0.0001739)	−0.000017 (0.0001021)	−0.0000876 (0.0007613)	−0.0015293 * (0.0007767)	−0.000092 (0.0000711)	0.0002422 (0.0001405)	0.003253 (0.0019356)	0.0003095 (0.0014317)	0.0011826 (0.0009249)	0.0000933 (0.0004978)	0.0081314 (0.0051123)	−0.0003411 (0.0031496)
IN	−0.0000306 (0.0000205)	0.0000053 (0.0000109)	−0.0002915 (0.0156787)	−0.0000659 (0.0001017)	−0.00000224 (0.00000839)	0.0000196 (0.0000192)	−0.0005927 (0.0002283)	0.0002567 (0.0002188)	−0.0003737 ** (0.0001091)	0.0000238 (0.0000627)	−0.0017828 (0.0006029)	0.0006511 80.000456)
R2	0.0007	0.0296	0.0075	0.0067	0.0265	0.0125	0.1301	0.0916	0.0173	0.0059	0.1135	0.0885
F-stat	4.82 **	10.55 **	6.17 **	14.94 **	2.57 *	7.46	13.94 ***	26.38 ***	15.38 ***	26.91 ***	14.03 ***	42.94 ***
N	60	40	60	40	60	40	60	40	60	40	60	40

Notes: *, ** and *** represent statistical significance at levels 10%, 5% and 1%, respectively. Standard errors are reported in parenthesis.

. The results indicate similar results across fixed effects panel data regression and instrumental variables two-stage least squares for the 1997–2023 sample, confirming the robustness of results and, and in most cases, also for the 2021–2023 sample.

According to the Wagner approach, GDP influences general government expenditure, and the causality running from GDP to general government expenditure confirms the validity of the Wagner’s law. In such a relationship, there can be a problem of reverse causality, as higher GDP can lead to higher government expenditure, while higher government expenditure can, in turn, influence GDP.

To identify the causal relationship between an endogenous variable of interest x and a dependent variable y in such a setup, one uses an instrument z, on which x is conditioned before y is regressed on $\widehat{x}$, the predicted value of x when conditioned on z [44]. In accordance with the relevant literature [45,46], we decided to use lagged GDP as an instrument. The instrument should satisfy the requirement of relevance and exogeneity [47,48]. Since GDP_it-1 precedes GDP_it in time, the causality runs entirely from GDP_it-1 to GDP_it, and since there is presumably a high degree of autocorrelation in GDP, we may therefore infer that GDP_it-1 constitutes a valid instrumental variable for GDP_it. Graf-Vlachy and Wagner [47] pointed out that the instrument should be a statistically significant predictor in the first-stage model and that F or suitable F-statistics in the case of robust standard errors should be large enough or as high as possible. As a rule of thumb, it is suggested that the F-statistic is greater than ten. In the sample covering the period 1997–2023, lagged GDP proved to be positive and statistically significant, whereas in the 2021–2023 sample, it remained positive but was not statistically significant. For both samples, the values of F-statistics were in most cases greater than ten (see Appendix A, Table A2 and Table A3). We therefore concluded that lagged GDP was suitable enough to be included as instrumental variable.

For all areas of the functional classification of general government expenditure, the results for the 1997–2023 sample suggest a negative and significant association with GDP. This implies that based on the sample data, Wagner’s law cannot be confirmed. As noted in the literature review, empirical findings on the validity of Wagner’s law are mixed. Regarding the control variables, the variable public debt was found to be negative and statistically significant in most cases for the 1997–2023 sample, whereas when focusing on productive government expenditure, the sign is mostly positive but not significant. This may indicate that borrowing in the case of productive government expenditure is more efficient and contributes to higher economic growth. On the other hand, the results for the 1997–2023 sample suggest a positive and statistically significant impact of unemployment on government expenditure, whereas in the case of productive government expenditure, the impact is estimated to be negative in some instances but not statistically significant. The impact of inflation on government expenditure is positive but not statistically significant in the 1997–2023 sample, while the results for productive government expenditure are mixed.

The analysis also incorporates the RRF, which came into effect in 2021 and may contribute to improving the quality of public finances in the Member States. We are interested in whether the RRF, as an exogenous fiscal intervention, has an impact on the composition of general government expenditure by function—that is, whether we can confirm any shifts in general government expenditure towards more productive government expenditure with more pronounced effects on economic growth, thereby reinforcing the developmental role of public finances.

Based on the data in the Appendix A, Table A3, we can see that the coefficient for productive government expenditure is positive; however, it is not statistically significant. In addition to productive government expenditure, the results are also robust for expenditure in the area of transport, while the estimated coefficient is likewise positive for expenditure on education and health. These are key developmental areas that are also crucial for achieving the Sustainable Development Goals, not only for advancing fiscal quality. The transport sector accounts for one quarter of greenhouse gas emissions in the EU, and its sustainable development is a key step towards achieving the EU’s climate and environmental objectives. Given the sector’s high dependence on imported fossil fuels, the decarbonisation of transport requires expanding the use of alternative fuels, promoting zero-emission vehicles, and increasing the share of clean public mobility in people’s daily lives (through the development of urban public transport and the modernisation of railway infrastructure). Expenditure on education encompasses improving access to general, vocational, and higher education, enhancing its quality, promoting digital education, expanding early childhood education and care, and supporting youth employment. Expenditure on health, among other aspects, includes measures to enhance the resilience, accessibility, and quality of healthcare and long-term care, as well as initiatives to accelerate their digitalisation [14].

The results of the research indicate a shift in the composition of government expenditure towards more productive, development-oriented government expenditure, driven by the implementation of the RRF. At the same time, we should be aware of the limitations associated with the inclusion of the RRF as an exogenous fiscal intervention in the analysis. Due to data availability and the fact that the RRF was launched in 2021 (and is set to end in 2026), the period covered by our analysis involves the years 2021–2023, which is a relatively short period.

5. Discussion

Based on the results of the empirical analysis for the Euro area countries, the validity of Wagner’s law cannot be confirmed. The results show that as economic activity increases, government expenditure decreases, which may indicate the presence of other trends within the public sector, as well as the reform of the economic and fiscal governance framework that upholds fiscal discipline to enhance the resilience of European economies and ensure long-term fiscal sustainability.

The recovery from the COVID-19 pandemic and the consequences of Russia’s aggression against Ukraine, coupled with higher levels of public debt and interest rates, as well as reform and investment objectives, are creating new challenges for the European economy. At the same time, it has become apparent that the current economic and fiscal governance framework lacks sufficient flexibility to respond effectively to diverse economic shocks, leading to uneven compliance between Member States. The reform of the EU’s economic and fiscal governance framework aims to ensure sustainable public finances while promoting growth through reforms and investments. The new rules are expected to enhance the efficient governance and use of public resources, support the digital and green transitions, and strengthen the competitiveness and innovativeness of the European economy.

The European Commission sends a differentiated, risk-based reference trajectory for multiannual net expenditure growth to Member States whose debt ratio exceeds 60% or whose deficit exceeds 3% of GDP. The trajectory ensures that following the fiscal adjustment period, Member States’ public debt will likely decline or remain at a prudent level below 60% of GDP in the medium term. In addition, it ensures that the fiscal deficit is reduced to below 3% of GDP and maintained at that level. The standard fiscal adjustment period is four years; however, Member States may request an extension of up to seven years. Such an extension is permitted if the Member State concerned implements reforms and investments that enhance resilience and growth potential, support the sustainability of public finances, and address common EU priorities, such as the green and digital transitions, energy security, or the strengthening of defence capabilities.

Within the new economic and fiscal governance framework, Member States prepare a medium-term fiscal-structural plan for the period of for four or five years. This plan sets out the Member State’s fiscal, reform, and investment commitments, obliging it to ensure a consistent and gradual reduction in public debt while promoting sustainable and inclusive growth [49,50].

In addition, the non-confirmation of Wagner’s law may indicate certain other contemporary trends present in the public sector, such as rapid technological progress and demands for efficiency and innovation, which contribute to more effective and sustainable public finances. Digital transformation is undoubtedly an important trend that contributes to improving the provision of public services, enhancing efficiency, and increasing transparency. The implementation of artificial intelligence and data analytics enables better decision-making and predictive capabilities. Public–private partnerships, on the other hand, foster synergies between the public and private sectors regarding the use of expertise and resources, thereby contributing to improved public services and lower costs. They are particularly important in areas such as infrastructure, transport, healthcare, and education [51]. In light of the challenges of ensuring fiscal sustainability and meeting fiscal commitments regarding public debt and the budget deficit, there is a clear tendency to apply private-sector management practices in the public sector. The objective is to reduce government expenditure and increase the competitiveness of the economy. The efficiency and effectiveness of government expenditure, as core principles of new public management, are primarily grounded in ensuring accountability (legal, targeted, and efficient use of public funds), while fulfilling the commitments and objectives of the public sector (measuring efficiency and effectiveness as a factor in improving public services), and monitoring the intangibles (objectives and motivations as factors contributing to improved performance) [51]. Finally, the adoption of the United Nations Sustainable Development Goals has established a comprehensive framework for economies to integrate sustainability into their policies and operations, thereby supporting sustainable, resilient, balanced, and inclusive economic development through a range of measures and initiatives.

On the other hand, the research results indicate the developmental role of public finances, which can be achieved through an exogenous fiscal intervention such as the RRF. The developmental role of public finances, or the quality of public finances, is, in line with Larch et al. [52], defined primarily by the composition of government expenditure. The research results indicate a shift in the composition of government expenditure towards more productive, development-oriented government expenditure, stimulated by the implementation of the RRF. One of the central developmental roles of public finances is to promote economic growth. Through various measures, higher government expenditure can mitigate the negative effects of a recession, stimulate consumption, and preserve jobs. On the other hand, during periods of economic expansion, surpluses are used to reduce public debt and finance strategic investments. The developmental role of public finances is also evident in their contribution to promoting social justice and reducing inequality, as well as in advancing environmental protection and sustainable development. Within the economic and fiscal governance framework, the country-specific recommendations (CSRs) issued under the annual European Semester are regarded as the most important instrument for influencing the quality of public finances and, consequently, their developmental role.

In this context, each Member State receives guidance on its economic, budgetary, employment and structural policies from the Council every year, with the aim of ensuring sound public finances, avoiding excessive government deficits, and preventing or reducing general government debt. Other developmental objectives of public finances being pursued include ensuring convergence and stability within the EU, fostering economic growth, preventing excessive macroeconomic imbalances in the EU, monitoring the implementation of national recovery and resilience plans, and coordinating and monitoring employment and social policies. The European Court of Auditors [53] finds that compliance with the CSRs is insufficient across EU Member States. This suggests that improving the quality of public finances remains a major challenge for Member States in the future—an observation also confirmed by the results of our analysis.

It should be noted that in this respect, the RRF is an exogenous fiscal intervention and a temporary instrument with a limited duration. The RRF was launched in 2021 and is set to conclude in 2026. It is therefore a temporary and performance-based programme, and from this perspective it has important implications for the quality of public finances in the Member States, as the disbursement of funds is conditional upon the fulfilment of milestones and targets. At best, the RRF represents only a temporary form of external influence on the quality of public finances in the Member States. Once the RRF concludes, ceteris paribus, the quality of public finances will, to a greater extent, remain in the domain of the Member States themselves.

In addition, this paper has the following implications for sustainable fiscal governance. Independent fiscal institutions are the final link in the fiscal governance chain, capable of strengthening the medium-term budgetary framework and the developmental role of public finances. Procyclical behaviour in favourable economic conditions, the slowdown of reforms prior to the crisis, and public finance challenges have undermined the credibility of economic policymakers’ commitment to ensure sustainable public finances. The aforementioned factors increase uncertainty regarding future economic and financial developments, requiring economic policymakers to provide clear guidance on the future course of fiscal policy. Efforts to respect the commitments made represent a persistent challenge in the fiscal domain; therefore, the key issue is what measures can effectively constrain fiscal discretion to achieve stable and development-oriented public finances as well as sustainable economic growth. In this context, independent fiscal institutions play a crucial role. An independent fiscal institution is an entity that issues independent opinions on fiscal policy orientations, monitors compliance with fiscal rules, and analyses the medium- and long-term consequences of non-compliance. The core values of independent fiscal institutions are independence, non-partisanship, accountability, and transparency, and their operations are based on clear principles and recommendations [54]. The role of independent fiscal institutions is important in ensuring fiscally sustainable and development-oriented public finances over the long term, as it is not dependent on the prevailing political cycle.

On the other hand, achieving the ambitions set out in the European Green Deal will require substantial investments; therefore, the inclusion of national budgets is essential. The concept of green budgetary planning is a step in this direction, as it enables the identification and classification of favourable and unfavourable budgetary expenditures, revenues, and tax expenditures, and as such can contribute to the quality of public finances.

Green budgetary planning is a concept that integrates environmental objectives into the budgetary process. It ensures that climate and environmental impacts are duly taken into account in the formulation of budgetary and fiscal policy, encompassing budgetary expenditures, revenues, and tax expenditures. Green budgetary planning is an approach to the design of budgetary policies and processes that integrates environmental objectives such as climate change mitigation, climate change adaptation, the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and the protection and conservation of biodiversity and ecosystems. The purpose of green budgetary planning is to ensure that public funds are directed towards projects, measures, and programmes that promote environmentally friendly solutions; are implemented in an environmentally sustainable manner; reduce greenhouse gas emissions; and improve the efficiency of natural resource use. Tax policy can also contribute to this objective by discouraging economic entities from engaging in environmentally harmful activities or by providing incentives that support the achievement of environmental objectives.

Green budgetary planning also emphasises transparency, traceability, and the assessment of the impact of budgetary expenditures, revenues and tax expenditures on environmental objectives. This approach promotes the transition to a low-carbon and sustainable society and creates opportunities for green and innovative projects that can contribute to the long-term preservation of natural resources, to environmental protection, and to mitigating and adapting to climate change. Green budgetary planning practices continue to evolve and adapt [55]. This approach, which systematically integrates environmental objectives into the budgetary process, will ensure that public resources are allocated to projects and measures that, through environmentally sustainable solutions and the reduction in adverse environmental impacts, contribute to meeting environmental commitments and enhancing the long-term well-being of citizens. Green budget tagging, as a process of identifying, measuring, and monitoring “green” budgetary expenditures, revenues, and tax expenditures, also constitutes an important step in raising awareness of the importance of redirecting public investments towards sustainable and environmentally sound projects, thereby fostering the sustainable use of public resources, including tax expenditures [55].

Last but not least, given the limited fiscal space and the medium- to long-term challenges related to fiscal policy sustainability, there have been renewed calls for a comprehensive review of government expenditure. Hoogeland, Dimitriadis, and Mandl [56] define government expenditure reviews as the process of identifying and weighing saving options, based on the systematic scrutiny of baseline expenditure. This process checks if baseline expenditure items are still a policy priority, whether they are effective in reaching their goals, and whether they are cost-efficient. It is a budgetary instrument that allows national authorities to improve the quality of public finances by re-prioritising government expenditure and assessing whether existing expenditure items are still efficient and in line with new policy priorities. Tryggvadottir [57] highlights that the nature of spending reviews has evolved over time. Many countries adopted spending reviews in the wake of the 2008 financial crisis primarily as a means of identifying savings. Subsequently, the focus shifted more towards efficiency and effectiveness. Today, strengthening spending review practices primarily means building on existing practices and ensuring the reviews play an integral role in budgetary decision-making. In this context, the OECD [58] has developed best practices, which include, among other things, formulating clear objectives and specifying the scope of spending reviews; assuming political accountability; setting up clear governance arrangements throughout the review process; ensuring integration with the budget process; ensuring the full transparency of spending review reports; and updating the spending review framework periodically, see, also ref. [59,60]. The government expenditure review has been recognised by the European Commission [61] as a useful tool for enhancing the quality of public finances, as it contributes to the efficiency of public resources; improves the quality of public services; and enables the reallocation of government expenditure towards other, more productive purposes.

6. Conclusions

Our study investigated the validity of Wagner’s law for the Euro area countries. Based on the results of the empirical analysis, the validity of Wagner’s law cannot be confirmed. The results show that as economic activity increases, government expenditure decreases. On the other hand, the research results indicate the developmental role of public finances, which can be achieved through an exogenous fiscal intervention such as the RRF. The developmental role of public finances is reflected in the administering of economic and social processes towards sustainable, inclusive, and resilient economic growth. It should be emphasised that the RRF is a temporary instrument and, as such, represents a temporary exogenous fiscal intervention. After 2026, when the RRF ends, the quality of public finances and thus their developmental role will remain to a greater extent in the domain of the Member States.

Strengthening the developmental role of public finances continues to be shaped by prevailing challenges and priorities. Empirical research suggests that the main constraints to enhancing the developmental role of public finances are not so much fiscal rules, but rather market pressures, political cycles, rising public debt, and population ageing. To effectively address current economic and social challenges, including the digital and green transitions as well as geopolitical issues, it is crucial to improve the quality of public finances. Sound public finances ensure that budgetary spending supports smart, sustainable, and inclusive economic growth, thereby enhancing quality of life and overall well-being.

While this study contributes to the existing body of literature, it also has certain limitations that can be addressed in future studies. Future research could consider a longer time horizon and a broader sample of countries. It might also employ or develop alternative indicators to measure the developmental role of public finances, thereby mitigating the limitation posed by the temporary nature of the RRF. In addition, researchers could apply other methodological approaches, such as Granger causality tests or cointegration analysis.