Hsiao, C., Pesaran, M.H. and Pick, A.

Diagnostic tests of cross section independence for limited dependent variable panel data models

Oxford Bulletin of Economics and Statistics

Vol. 74(2) pp. 253-277 (2012)

Abstract: This article considers the problem of testing for cross-section independence in limited dependent variable panel data models. It derives a Lagrangian multiplier (LM) test and shows that in terms of generalized residuals of Gourieroux et al. (1987) it reduces to the LM test of Breusch and Pagan (1980). Because of the tendency of the LM test to over-reject in panels with large N (cross-section dimension), we also consider the application of the cross-section dependence test (CD) proposed by Pesaran (2004). In Monte Carlo experiments it emerges that for most combinations of N and T the CD test is correctly sized, whereas the validity of the LM test requires T (time series dimension) to be quite large relative to N. We illustrate the cross-sectional independence tests with an application to a probit panel data model of roll-call votes in the US Congress and find that the votes display a significant degree of cross-section dependence.

JEL Codes: C12, C33, C35

Publisher's Link: http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0084.2011.00646.x/abstract