The ‘size of Government’ obsession: public spending and economic growth

This week, the PM suggested we do what the New Zealanders had done and put a cap on the size of the Federal Government.

‘And one of the points that I made in my speech to the Press Club last week is that if you look at what New Zealand did with fiscal consolidation, they had a very tight clamp on new spending. They didn’t engage in big cuts. They had a tight clamp on new spending and New Zealand has got government, as a percentage of GDP, from 35 per cent to 30 per cent – a very big change in just a few years.’ 

The suggestion is that rather than change the direction of policy (by raising taxes or cutting spending more fairly), the Budget will just move more slowly in the same direction, or perhaps not at all! With no steering, no acceleration and no brake, there’s not a lot of room for the next Budget to move. Might as well garage it for a year and avoid the political angst!

Let’s set aside the important question of whether the Budget should stimulate the economy or consolidate public finances (last year’s Budget struck a sensible balance on that score – the big cuts were postponed to future years, but the recent RBA decision to cut interest rates shows that circumstances have since changed for the worse).

The-not-so hidden assumption behind the PM’s statement, and last year’s Budget, is that smaller Government is better. That’s why all of the action in last year’s Budget was on the spending side. Given the targeting of most public spending in Australia, that almost inevitably means the Budget was a regressive.There’s not much room for large cuts outside social security, health and education.

revenue and expenditure to 2013-page0001

Yet, as ACOSS argued in its Commission of Audit submission in 2013, most of the damage to the Budget bottom in recent years came from sliding revenues, not higher expenditures.

There’s on old neo-liberal economics argument that smaller Government is better for long term economic growth (setting aside any temporary economic stimulus) because taxes and spending dampen and distort market signals in the economy.

In the same submission, ACOSS addressed this issue by dipping into what economic research said about the size of Government and economic growth. It turns out that that there is a (loose) association between size of Government and economic growth, though it is hard to clearly identify the impact of public spending and taxing given all of the other factors that determine long term growth levels. There’s also the problem of reverse causation: the slower the economy grows, the higher is public spending on unemployment and other benefits.

But the real story is not about the quantity of public spending and taxing, it’s the quality that matters for long term growth. Some forms of spending, such as public infrastructure investment, are more growth enhancing than others. Countries that achieve their social goals in a cost effective way are also more likely to be rewarded with stronger economic growth.

The size of Government is mainly a political (and ideological) decision, not an economic one.

Here’s an extract:

ACOSS Commission of Audit submission (2013)

Appendix 5: The ‘size of Government’ and economic growth.

The effect of the size of public revenues and expenditures on long term productivity and economic growth has been vigorously debated for many years. In studies exploring this relationship, ‘size of Government’ is usually proxied by public revenues (or tax revenues) or public expenditures as a proportion of GDP. Early studies suggested that there was an optimal size for Government, above which future economic growth would be constrained.43 A number of subsequent empirical studies of the public revenues and expenditures and economic growth have found that higher revenues and expenditures are associated with slower long-term growth in wealthy countries.44

However, it does not follow from a simple association between Government size and economic growth that one ‘causes’ the other. There are four problems with this apparently ‘simple’ story:

1. The character of public spending and taxes may be as important as its ‘size’. Studies have found that pubic investment in physical infrastructure and human capital development (education) are positively associated with economic growth. Much of what is usually classified as ‘social expenditure’ promotes employment participation and productivity. More broadly, the efficiency of the public sector matters.45

2. Whether or not the size of Government has an impact on economic growth, other policies may have a countervailing effect. While long term economic growth rates have been stronger in recent decades in the Anglo-Saxon countries (which have below average tax levels) than in continental Europe (with above average tax levels), the Nordic countries have both high tax levels and high long term economic growth rates (see table below). One suggested explanation is that the economic openness of the Nordic countries more than compensates for their relatively high tax and expenditure levels 46 .

Tax levels and growth in three types of welfare systems

Country group tax to GDP ratio (%) Average annual real GDP growth (1995 to 2004 – %)
Nordic 45.7% 2.5%
Anglo-saxon 31.6% 2.3%
Continental European 38.8% 1.5%

Bergh & Henriksen, 2011, ‘Government Size and Growth: A Survey and Interpretation of the Evidence’, Research Institute of Industrial Economics, IFN Working Paper No. 858, 2011 Stockholm.

3. Causation may be in the opposite direction. For example, slower long term growth rates in many continental European countries may be associated with higher unemployment rates (which increase the cost of unemployment benefits) or older populations (which increase the cost of pensions and health care services).

4. In any event, Australia, which is the third-lowest spending country in the OECD, and has a relatively cost efficient social security system and human services, has considerable room to move before higher public revenues and expenditures put a brake on economic growth.

43. For example, Barro 1990, ‘Government spending in simple model of endogenous growth’, Journal of Political Economy Vol 98, No5.

44. Bassanini and Scarpetta 2001, ‘The driving forces of economic growth’, OECD Economic Studies No 33.

45. Angelopoulos et al 2008, Does public sector efficiency matter? Revisiting the relation between fiscal size and economic growth in the world sample, Public Choice, Springer, vol. 137(1), pages 245-278

46. Bergh & Henriksen, 2011, ‘Government Size and Growth: A Survey and Interpretation of the Evidence’, Research Institute of Industrial Economics, IFN Working Paper No. 858, 2011 Stockholm

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