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Specification testing with grouped fixed effects

We propose a bootstrap generalized Hausman test for the correct specification of unobserved heterogeneity in both linear and nonlinear fixed-effects panel data models. We consider as null hypotheses two scenarios in which the unobserved heterogeneity is either time-invariant or specified as additive individual and time effects. We contrast the standard fixed-effects estimators with the recently developed two-way grouped fixed-effects estimator, that is consistent in the presence of time-varying heterogeneity under minimal specification and distributional assumptions for the unobserved effects. The Hausman test exploits the general formulation for the variance of the vector of contrasts and critical values are computed via parametric percentile bootstrap, so as to account for the non-centrality of the asymptotic chi-square distribution arising from the incidental parameters and approximation biases. Monte Carlo evidence shows that the test has correct size and good power properties. We provide two empirical applications to illustrate the proposed test: the first one is based on a linear model for the determinants of the wage of working women and the second analyzes the trade extensive margin.

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