Trade openness and government size of small developing countries An instrumental approach

This paper examines the causal effect that trade openness has on government size in small developing countries (SDCs). We use the construction of the trade cost variables based on Baltic Dry Index in primary goods as instruments of trade openness to address the endogeneity issue. We find that the increase in trade openness leads to an increase in government size: a 1 percent expansion in trade openness (trade GDP ratio) raises government consumption over GDP ratio by approximately 0.1-0.2 percentage points on average. Its quantitative significance emphasizes the importance of rethinking the costs and benefits of trade openness for SDCs.