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

By Artūras Juodis, Simon Reese. Journal of business & economic statistics, 2018

310 citations recorded by the source corpus.

Abstract 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.

Subfields: Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/ff1fb67ccae6c55cbf525f2f845d0e64bbb1cf6e

Citations in the corpus

• Estimation and inference for spatial models with heterogeneous coefficients: An application to US house prices (2020, unknown): “First, as Juodis and Reese (2019) point out, the CD test most likely over-rejects when it is applied to residuals from a regression on unobserved common factors.”