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Notes on the size of government

August 16th, 2006

I’m working on a summary of the evidence on economic effects of the size of government. I’ll probably cite the usual suspects such as Barro and DeLong in due course, but I’d be interested in comments, particularly pointing to evidence outside the usual pattern of growth regressions and so on.

Size of government and economic growth

The emergence of the debate over the optimal size of government roughly coincided with the development of large data sets giving broadly comparable measures of national output for a large number of countries over time, and with the development of the computing power and econometric techniques required to undertake statistical analysis of such data sets. The standard data set in this context is derived from the International Comparisons Project undertaken by the OECD, and is currently managed by the World Bank (it was originally developed by researchers at Penn State University the University of Pennsylvania, and is commonly referred to as the Penn World Tables). Another source of evidence, suitable for statistical analysis, is derived from data sets in which the 50 US states are compared.

The most common form of statistical analysis is the ‘growth regression’ in which estimates of the rate of economic growth are modelled as functions of a range of explanatory variables, commonly including measures of government expenditure. Vast numbers of these regressions have been estimated and relatively few consistent results have been obtained. Correlations that appear significant in one formulation of the model frequently disappear when the model is respecified or the data set is varied.

Bearing this qualification in mind, the general consensus of the literature is as follows. There is no well-established relationship between aggregate levels of government expenditure (expressed as a sure and subsequent economic growth. However, there is a strong causal relationship running in the opposite direction. Countries with high income levels resulting from past economic growth tend to have higher levels of government expenditure, reflecting greater demand for the services (health, education and income security among others) commonly provided by governments.

Although attempts to relate aggregate government expenditure to economic growth have been unsuccessful, there has been more success in the examination of particular components of government expenditure. The general pattern is unsurprising. Government investment expenditure is found to increase subsequent economic growth, while consumption expenditure is found to reduce subsequent growth, exactly as would be expected for investment and consumption in general.

It appears, however, that the benefits of government investment in both physical infrastructure and human capital (mainly education, but also childrens services and some components of health care) are greater than for private investment. Conversely, the negative growth effects of government consumption appear to be greater than those of private consumption, perhaps because government consumption tends to ‘crowd out’ government investment.
It should be noted that the fact that investment leads to future growth, does not mean that investment should always be favoured over consumption. Consumption is, after all, the ultimate purpose of economic activity, and investment is simply a means of generating higher consumption in the future. Thus, for example, while committing public or private resources to improving the health of elderly people is unlikely to yield any contribution to future economic growth, but that does not mean that expenditure in this area should necessarily be reduced.

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  1. August 16th, 2006 at 08:37 | #1

    Have you seen Peter Lindert’s work? he tries to explain why big government does not have the negative impacts a basic economic analysis would predict.

  2. Terje (say tay-a)
    August 16th, 2006 at 09:20 | #2

    I think you make a reasonable start but I would offer a few immediate points (more later).

    Firstly I think you are wrong to characterise the debate as new. I think in fact this debate is quite old. I don’t have his name handy but the point was laboured extensively in the writings of at least one 14th century islamic scholar.

    I think your division between investment and consumption is important. One of the central arguments for lower taxation is that it reduces the wedge on domestic trade and hence lifts efficiency (through better labour and resource allocation and incentives). However an investment in better roads may offer similar benefits so there is a valid discussion to be had about which is better.

    If we were to cut government spending and taxes in half we may not get higher growth forever, yet all we need is higher growth for a long enough period that the economic output of public plus private goods rises to a level higher than what it might otherwise have been. Beyond that point you may have growth no better than before and the original decision may still have been worth it. As such I think comparing nations to look for a correlation between tax burdens and growth rates is flawed. It is the temperal effect. Likewise if we were to double the level of government spending and taxation the long term growth rate may be no worse, however in the short to medium term the size of the economic output in public and private goods may decline or grow slower such that the size of the tax base long term is smaller.

    As you indicate there are factors of significance beyond economic growth. I think lowering unemployment is a social good even if the extra productivity is marginal. In so far as taxes can be a disincentive to both workers and employers I think they are a problem.

    Whilst not entirely related I think there is also a need for more discussion about the cost of government in absolute terms. Per capita we pay around twice the price for government than we did a decade ago. Even as people complain that the level of service has declined. If bread had doubled in price and declined in utility we would be asking the baker why.

  3. Terje
    August 16th, 2006 at 09:43 | #3

    Arthur Laffer offered the following on the history of this debate:-

    The Historical Origins of the Laffer Curve

    The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th century Muslim philosopher, wrote in his work The Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.”

    A more recent version (of incredible clarity) was written by John Maynard Keynes:

    When, on the contrary, I show, a little elaborately, as in the ensuing chapter, that to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied…
    Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more–and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.

    FROM: http://www.heritage.org/Research/Taxes/bg1765.cfm

    The quote of Ibn Khaldun that Laffer provides comes from “The Muqaddimah” and the relevant chapter (translated to english) can be found below:-

    http://www.muslimphilosophy.com/ik/Muqaddimah/Chapter3/Ch_3_36.htm

  4. August 16th, 2006 at 11:07 | #4

    Not to be parochial about things, but rather, to catch a small error: the Penn World Tables are developed at the University of Pennsylvania (not Penn State). The International Comparison Project’s homepage is: http://pwt.econ.upenn.edu/

  5. Terje
    August 16th, 2006 at 13:09 | #5

    To illustrate my earlier point about a tax cut giving a temporary growth response here are some very hypothetical numbers.

    Imagine that you have an economy with a GDP of $1000 billion. Lets say that economic growth will be 2% per annum forever. Currently the government takes 30% of GDP via taxation. It consumes some of it in the form of public services (eg Medical services) and invests some for the future.

    Assuming no change then in a decade the economy will be $1000 billion x 1.02^10 = $1219 billion.

    Now lets say we could get an extra 3% growth for a decade (ie 5% growth for 10 years then back to 2% growth again). That would then mean that the GDP in ten years was going to be $1629 billion. This larger tax base is a major asset for the government because it represents a healthier fruit tree from which it can harvest revenue. It means that the sum of public and private goods will be larger.

    What sort of expense would be worth it for a larger asset like this?

    If we contend that lowering the tax rate expands the economy in the manner outlined above but not forever, and that tax cuts mean higher government borrowing (from abroad perhaps) in the ten year interum, then there are two interesting questions:-

    1. What amount of tax cuts would be needed to get an extra 3% growth for a decade?

    2. Would it be worth it?

    Lets assume that we have a selfish government that is only interested in long term revenue (ie public goods) and not in the broader issue of social well being (public + private goods). Given that the tax base in ten years would be 34% higher we might be okay with a cut in the tax rate from 30% to something like 24% except for the pain of lost revenue in the interum. And of course there is a question as to whether you would actually get the extra growth as advertised.

    If cutting the tax burden to 24% did yield an extra 3% growth for a single decade and if the government had to make up the revenue shortfall over the ten years by racking up debt, then so long as the government could borrow at an interest rate of 5% the debt it carried in ten years time would have a servicing cost equal to the additional revenue produced by having a larger tax base.

    And of course the provision of private goods in the larger economy would be a lot higher.

    Would reducing the tax burden from 30% to 24% achieve 3% higher growth for a decade? And could the government borrow at 5% interest? It’s debatable. And how you sit in the debate will be effected by your views on expanding the supply of private goods.

    A tax cut will cause us to reorganise our affairs. This will not cause extra growth forever but rather just a redivision of labour and capital to a situation that is more efficient. A subsequent tax rise will cause us to retreat back to less efficient means. As such comparing nations side by side looking at their current tax level with their current growth level is probably meaningless.

    Of course all of this assumes that we need more and more government each year as the economy grows. A contention I am not sure I agree with in any case. I would be happy to freeze the size of government (in absolute per capita terms) for a decade or more irrespective of questions about economic growth, simply because I would prefer more personal discretion over how my share of the extra output is expended.

  6. taust
    August 16th, 2006 at 13:51 | #6

    If Government per se is not the problem then the efficiency of Government achieving objectives would still remain a useful field to research.

    I would guess that enough data exists to tease out what has been the change in efficiency(total output over total resources) of privatised activities on privatisation so that some estimate can be made of the resulting change in economic parameters.

    I think there have been a number of estimates that for social welfare activites that roughly half the value of the input appears to get delivered as output. Is there really a way of measuring this say for welfare payments? Given that social welfare is a high proportion of the budget getting at some measure of the efficiency of delivery of services would seem to be useful.

  7. econwit
    August 16th, 2006 at 14:34 | #7

    The high level of “Economic Rent” inflicted on this country by the three tiers of the public sector can only be described as extortion.

    In our political economy, exploitation of the consumer is a cooperative endeavour by rent-seeking individuals, private institutions, and governments.

    The greedy political class and their “rent seeking” cronies continue to exploit the productive individual in this country.

    Whether the associations are in superannuation, banking, energy, telecommunications or toll roads to name a few.

    The mandated monopolies and oligopolies associated with the three greasy hands of the tiers of government in an individuals pocket, coupled with their exponentially growing bureaucracies and associated advancing taxation levels, is prima facie evidence of the economic effects of the excessive size of government.

  8. jquiggin
    August 16th, 2006 at 17:32 | #8

    Fixed now, thanks,Justin. I’ve never quite got on top of that whole U of X vs X State thing.

  9. Uncle Milton
    August 16th, 2006 at 17:46 | #9

    U of Penn is a better university, academically, but Penn State has a better football team.

  10. James Farrell
    August 17th, 2006 at 14:31 | #10

    While you’re fixing things, John, there seems to be an inadvertent deletion in the fourth line of the paragraph that begins with ‘Bearing this qualification in mind…’.

  11. Fred Argy
    August 17th, 2006 at 15:41 | #11

    John I strongly endorse your conclusion that the COMPOSITION of public expenditure is crucial in assessing the impact of government spending on economic growth.

    My own work is very narrowly focused on methods of redistribution and social objectives. I believe that “passive� redistribution devices which only relieve hardship and reduce inequality of outcomes are both SOCIALLY and ECONOMICALLY inferior to “active� instruments of redistribution which seek also to
    • expand physical infrastructure (especially urban roads and public transport);
    • improve human capital (education, training, active labour market programs, health, housing and child development services) and
    • change human behaviour in economically positive ways through reciprocal obligations and incentives.

    The social returns from active redistribution are greater because they seek not only to relieve hardship and reduce inequality of outcomes but also to improve income mobility and reduce inequalities of opportunity.

    Both passive and active redistribution devices involve higher taxes (active intervention may even require higher taxes in the short term), so they both have economic efficiency costs. But, on the expenditure side, passive redistribution delivers few economic benefits (and may even encourage welfare dependence and discourage work) so there is a net overall economic cost. On the other hand, active redistribution generates important economic benefits which tend to outweigh the economic costs.

    In short the impact of social spending on economic growth depends crucially on the structure and composition of the spending. That is my tentative conclusion from the cross-country literature. Of course the methods of financing the expenditure are no less important in determining the economic outcomes. I spell out my arguments in my recent Discussion Paper no. 85 for the Australia Institute.

  12. taust
    August 19th, 2006 at 15:23 | #12

    Fred;
    given that it is possible to provide both physical infrastructure (roads, rail, ports, etc) and at least some social infrastructure (education, health) by both Government investment and private investment what are the criteria that makes Government investment better than private or visa versa.
    I take it as given that both sources have inefficiencies (failures) but is there a way of choosing the most likely ‘best’ for a given set of circumstances.

  13. Fred Argy
    August 20th, 2006 at 09:55 | #13

    taust, your sure raise a big topic.

    In my view, Private ownership, through so-called public-private partnerships (PPP’s), Build, Own, Operate (BOO) arrangements or other similar devices, makes good sense where
    (a) there is a genuine transfer of risk involved;
    (b) the private sector is clearly better at bearing and managing the risk than the public sector;
    (c) private capital markets function efficiently; and
    (d) the public interest can be safeguarded.

    These four conditions are hard to fulfil in practice even with economic infrastructure. They are harder still to fulfil with social investment of the hard or soft variety, where the risks of the project are mainly regulatory and political rather than commercial in character. And any risk management advantage by the private sector needs to be weighed against the high up-front transaction expenses.

    That said, I acknowledge that with economic infrastructrure, there may be potential untapped benefits from private ownership such as in management of costs, maintenance and innovative design. And if private equity can sensibly be used to finance economic infrastructure, it releases government resources for social investment and lessens the risk that an increase in government borrowing will incite a financial market backlash.

  14. taust
    August 20th, 2006 at 18:13 | #14

    Fred Argy;

    PPP’s suffer (as does all regulation) in that it is usual for the private party to have much better information than the public and for the private people to be much better motivated to achive the fruits of the better infromation. ie we can expect a high proprtion of PP’s to earn economic rents for the private party.

    Is theri any evidence that removing all economic regulation (ie getting rid of the ACCC and the rumps of State economic regulators and removing all public ownership of producing activities), whilst it would produce a different result from now, would actually produce an economy that would grow at a lesser rate than now?

  15. Paul Walter
    August 21st, 2006 at 13:41 | #15

    fascinating discussion.
    Has me in mind of Peter Garrett’s answer to his last question received at press club luncheon. This pertained to to soc.reproduction and amount of time, money and effort spent by “small” govt that is actually incrementally “bigger” , to coerce perception that it is small.
    Apparently, surveillance and ideological warfare, history wars, public/private “bads”, all ensure large chunk of intellectual and economic wealth is kept away from productive endeavours.
    Quiggin and Argy (the abacii stick together!!), seem to allude to this in their comments: the justification for bad a nd big government on the basis of bad policy.
    This creats discord, ensuring further “big”government to police “inappropriate” responses,with these themselves consequently maintained at a crescendo by further defective public policy (harrassment of Welfare beneficaries; degrading of tertiary education).
    Fascinating thing, human affairs, with the species this early into its evolution.
    A rich vein of anxiety is created and mined by a certain type of politician to ensure that this state of affairs is consolidated and stasis acheived for all.

  16. August 23rd, 2006 at 11:23 | #16

    Hi John,

    Always worth mentioning in these discussions, in my opinion, is that efficiency or maximising economic growth may not be the sole purpose of taxation and government spending. As I’m sure you’re aware, there’s pretty good evidence for diminising marginal utility to per-capita GDP once a certain point is passed. Therefore, in most developed countries – if maximising utility is your objective – you might well be happy to accept the trade off (if one exists) between somehat reduced growth and things like: increased equality, better education, better health, more green spaces etc.

    Anyhow, I read this blog from time to time and I from what I’ve read I’m sure you know all this.

  17. stephen bartos
    August 24th, 2006 at 16:20 | #17

    john, frank castles (ex ANU, now at Edinburgh) has some useful thoughts on compositional issues, especially debunking the myth that there have been cutbacks in government spending based on cuts in social welfare among western governments over the past 20 years. he may still be around ANU if you wanted to call him, I went to a very interesting seminar he gave last week there, but in any case there’s always email.

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