The Incidental Parameters Problem in Testing for Remaining Cross-Section Correlation

In this article, we consider the properties of the Pesaran CD test for cross-section correlation when applied to residuals obtained from panel data models with many estimated parameters. We show that the presence of period-specific parameters leads the CD test statistic to diverge as the time dimens...

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Bibliographic Details
Published in:Journal of business & economic statistics Vol. 40; no. 3; pp. 1191 - 1203
Main Authors: Juodis, Artūras, Reese, Simon
Format: Journal Article
Language:English
Published: Alexandria Taylor & Francis 2022
Taylor & Francis Ltd
Subjects:
Cross-section dependence
Factor model
Longitudinal studies
Matematik
Mathematical Sciences
Natural Sciences
Naturvetenskap
Panel data
Probability Theory and Statistics
Sannolikhetsteori och statistik
Time fixed effects
U-statistic
ISSN:0735-0015, 1537-2707, 1537-2707
Online Access:Get full text
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Summary:In this article, we consider the properties of the Pesaran CD test for cross-section correlation when applied to residuals obtained from panel data models with many estimated parameters. We show that the presence of period-specific parameters leads the CD test statistic to diverge as the time dimension of the sample grows. This result holds even if cross-section dependence is correctly accounted for and hence constitutes an example of the incidental parameters problem. The relevance of this problem is investigated for both the classical two-way fixed-effects estimator and the Common Correlated Effects estimator of Pesaran. We suggest a weighted CD test statistic which re-establishes standard normal inference under the null hypothesis. Given the widespread use of the CD test statistic to test for remaining cross-section correlation, our results have far reaching implications for empirical researchers.
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ISSN:0735-0015
1537-2707
1537-2707
DOI:10.1080/07350015.2021.1906687