The Optimum Size Of Government

Commentary, Role of Government, Frontier Centre

To many, it’s a contradiction. How can smaller government and lower taxes lead to higher levels of public spending?

But it’s merely a paradox. Countries with smaller governments and lower taxes grow faster. A small piece of a bigger pie may weigh more than a big piece of a smaller pie. Is it time for the numerous advocates of increased government spending to change their tune?

In the year 2000, government will consume about 32% of the American economy. Governments in Canada, meanwhile, will absorb about 42% of ours. Proportionately, their take is almost 30% larger than in the U.S., but the personal income of Canadians, roughly equal 25 years ago, is now smaller.

As of 1997, governments in the United States were spending more than Canadian governments on a per person basis according to the Fraser Institute. In fact, U.S. governments now spend over 25% more per capita than ours on health care. So much for the warm and fuzzy rationalizations about paying more taxes in exchange for more services.

In the face of this and other evidence, the views of mainstream economists are shifting. Once governments pass a particular, optimal size, the tax burden begins to suffocate business growth and relative living standards fall.

Up to a point, government spending will boost economic growth. Think of spending on roads and infrastructure; on courts to enforce the rule of law, property rights and contracts; on basic education and healthcare to create a healthy, skilled labour force. This is expenditure on public goods that benefit the entire community.

Past some point, however, the extra spending is mostly wasted. The taxes and deficits required to carry it progressively smother natural investment and growth opportunities. The community becomes poorer than it should be.

Canada started to throw away income parity with the U.S. in 1974, when our governments spent only 32% of the economy. The public sector’s share rose to 49% by 1996. This expansion was accompanied, predictably, by continuous tax increases and an overhanging debt from a generation of deficits. Today, our dollar buys 50% less, and the net worth of the average family is a pale shadow of its Yankee counterpart.

Canada is not unique in embracing the policies of decline. But will we learn the obvious lessons from the experience? Other countries have recognized that bigger government is not better government. Leaders of rising nations have explicitly rejected the welfare-state policies behind the growth of public sector spending in Europe and Canada. Ireland, whose per capita income recently surpassed our own, combined a 10% corporate tax rate with public sector restraint to create its red-hot economy. Ontario and Alberta continuously outgrew other provinces by aggressively cutting taxes and slimming down their public sectors. (Alberta reduced its civil service from 38,000 to 24,000 in the mid-nineties).

So what exactly is the optimum size of government?

John Maynard Keynes was last century’s most influential economist whose theories provided the intellectual basis for activist, expansionist government. He wrote a colleague: "25% is probably near the maximum tolerable proportion of taxation."

A 1997 paper by International Monetary Fund economists Vito Tanzi and Ludger Schuknecht reviewed 125 years of public spending in industrial economies. In 1870, government spending made up 8% of the average industrial economy. By 1994, government spending on average accounted for 47% of the economies of rich industrial countries. Welfare spending accounted for much of the vast increase.

They found that public spending is subject to diminishing returns. As government spending grows past a certain point, the benefits trail off and disappear. Life expectancy and school enrollment are comparable whether the government spends big or not. Indeed, as a general rule, those with the lowest spending increase are also the most innovative and efficient. Low-spending countries register more patents and suffer much lower unemployment. Countries with smaller governments also had much higher incomes per capita.

Tanzi and Schuknecht conclude there is considerable scope for reducing government spending in many countries and that average public spending may not need to be any bigger than it was 30 years ago — around 30% of Gross Domestic Product.

And that may still be too high. Between 1995 and 1996, separate agencies of the New Zealand government commissioned different academics to determine the optimum level of government there. The studies, using dissimilar methods, suggested that the growth-maximizing size lies between 15% and 25% of the Kiwi economy (not the present 40%).

These studies make a strong case for dramatically reducing government expenditure across the board. A 50% reduction over a decade would require us to restrain spending by only a few percentage points every year to achieve the benefits of faster growth, more jobs and higher living standards.

A larger economy pays more taxes. And — for all those romantic 20th-century thinkers out there –allows more government per capita.