Can we require more efficiency from our elected Government? The net effects of government spending on economic growth

Posted on May 11, 2010 by

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Government size and the Implications for Economic Growth

A summary of new research by Andreas Berg and Magnus Henrekson

Do countries with big government grow faster or slower? yes or no? if yes, can the relationship be interpreted as causal?

This new empirical analysis is derived from the theoretical models used in Dr Henrekson’s previous research, published in the European Journal of Political Economy and in Public Choice. The effects of government size on Economic growth are particularly important because we have suddently noticed an increase in Government spending in the US, historically around 20% of GDP to now approximately 25% of GDP. Small differences in the short run can add up to large differences in income levels in the long run. In this empirical analysis, the authors compared Scandinavian countries, Sweden in particular and the United States. The authors choose to try to determine the effects of government size on GDP per capita because there is a very strong correlation between GDP per capita and other measures of Welfare/Well-being.

There are positive effects of government spending such as the correction of market failures, reducing the cost of social inequalities etc… There are also well known negative effects such as distortionary taxes which create a wedge between social and private value of allocated goods, the crowding effects of public expenditures on private spending, investment etc… This research attempts to find the net effects of an increase in government size on economic growth while controlling for all other determinants of growth.

The results:

Controlling for other variables, Professors Henrekson and Berg find that there is a significant negative relationship between the size of government and economic growth. A 10% increase in government spending lowers growth by between 0.5% to a full percentage point annually. Professor Henrekson and Berg also find that some countries are able to run large governments if they manage to introduce reforms that could offset the negative effects of high taxation that finances big government. In the example of Sweden, a country with more taxes and a bigger government than that of the US, Sweden was able to introduce reforms such as deregulation/privatisation, freedom of trade, enforcement of property rights. These reforms that contribute to an increase in economic freedom, have enabled Sweden to keep growing despite a big government.

Conclusion:

High taxes on labor income reduce the incentive to work and promote black market activity. They also act as a subsidy for leisure, which simply translates to a lower absolute level of employment, less investment, less entrepreneurship, less technological advances and lower productivity. Large governments can offset the negative effects of taxation by reforming institutions and policies, mainly by promoting economic freedom. In the case of the United States, a country that is already “free”, the only way to offset a growth in government size would be by requiring a more efficient government. One suggestion would be to replace our complex income tax system (eliminating loopholes, tax credits etc…) with a flat tax on consumption such as a VAT.

Why do Scandinavian countries have such big governments? It is a difficult question to answer but it could be that the cost of the welfare state may be cheaper in Scandinavian countries than it is in other places. There are higher levels of trust in government for an efficient allocation of goods and services. The danger of having a big government is that small policy mistakes often lead to a very high cost on the growth rate.

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