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

Artūras Juodis, Simon Reese

Research output: Contribution to journalArticlepeer-review

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.

Original languageEnglish
Pages (from-to)1191-1203
JournalJournal of Business and Economic Statistics
Volume40
Issue number3
Early online date2021 May 4
DOIs
Publication statusPublished - 2022

Subject classification (UKÄ)

  • Probability Theory and Statistics

Free keywords

  • Cross-section dependence
  • Factor model
  • Panel data
  • Time fixed effects
  • U-statistic

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