Firm Profits and Government Activity: An Empirical Investigation

Firm profits play a pivotal role in government activity. In times of crises, when profits are low, governments increase their size. Also, if firm profits rise to a level far above what would have been earned in a competitive economy, firms might gain market power, which in turn might influence the activity of the government. But are these changes in the activity of the government also efficient? In this paper, we perform a detailed empirical study on the potential effects of firm profits and markups on government size and effectiveness. Using data on 22 European countries for a period of 17 years and an instrumental variables approach, we find that there exists a robust relationship between firm gains and the activity of the state, in the sense that higher firm profits reduce government size and effectiveness. Even in a group of developed countries, such as the European countries, firm power may affect state activity.