Firm Profits and Government Activity: An Empirical Investigation

Abstract

Recent studies suggest that firm profits have risen to a level far above than what would have been earned in a competitive economy. It has been hypothesized that these profits, generated by market power, allow firms to influence the activity of the government. However, despite an abundance of theoretical investigations, the empirical examinations for the validity of this hypothesis have been largely neglected. Against this background, here we perform a detailed empirical study on the potential effects of firm profits and markups on government size and effectiveness. Using data on 30 European countries for a period of 17 years and an Instrumental Variables approach, we find that there exists a robust and stable negative relationship between firm gains and the activity of the state. Our results indicate that, even in such a homogeneous group of countries, firm power may dictate the decline in state activity and, successively, lead to emergence and persistence of inefficient states.

Keywords: government size, government effectiveness, firm profits

JEL Classification: H11