Size of Government and Economic Growth

Frontier Centre, Role of Government, Uncategorized, Worth A Look

Gerald Scully of the University of Texas (Dallas) investigated the aggregate tax burden that maximized the rate of economic growth in the United States. Using data for the years 1949 to 1989, Scully concluded that the growth maximizing tax rate for the U.S. was between 21.5 percent and 22.9 percent (Scully 1994). He further concluded that the excess aggregate tax burden (beyond the optimal) had resulted in roughly $30 trillion in lost output in the U.S. between 1949 and 1989 (Scully 1995).

Philip Grossman investigated the size of the U.S. government and its effect on economic growth using data for 1929 to 1982. He hypothesized that government spending would initially contribute positively to overall economic growth but that the decision-making processes of government would lead to incremental expenditures that result in an inefficient quantity of public goods. Grossman’s analysis confirmed his hypothesis that there was indeed a negative relationship between growth in government and the rate of economic growth.

Richard Vedder and Lowell Gallaway investigated the size of the US government and its effects on economic growth for the Joint Economic Committee of the US Congress. Among their many findings were that large transfer payments had negative consequences for economic growth, that the moderate downsizing of the federal government between 1991 and 1997 had resulted in increased rates of economic growth, that the marginal effect of government activities is negative, and that further downsizing of government would be growth-enhancing (Vedder and Gallaway 1998). In fact, Vedder and Gallaway recommended reducing the size of US governments to 17.45 percent GDP in order to garner sizable and permanent increases in GDP (Vedder and Gallaway 1998).

Edgar Peden and Michael Bradley attempted a more comprehensive examination of the effects of the size of government. Specifically, they attempted to measure the effect of the size of government on economic output and productivity using U.S. data between 1949 and 1985. They concluded that the “level of government activity in the economy has a negative effect on both the economic base [GDP] and the economic growth rate [GDP growth]” (Peden and Bradley 1989: 239). They further concluded that increases in the size of government relative to the overall size of the economy had long lasting negative effects on the growth in output (GDP growth). Finally, they found that “permanent increases in the share of output devoted to the government result in a significant erosion in productivity” (241). Put more simply, Peden and Bradley concluded that the size of government, “beyond the optimal point” (243) resulted in lower GDP, lower rates of GDP growth, and significant deterioration in productivity.

In a supplemental study, Peden attempted to quantify the optimal size of government in the United States using data from 1929 to 1986. He found that the optimal size of government in terms of productivity growth over this period was approximately 17 percent of GDP (Peden 1991).

The Fraser Institute’s Herbert Grubel and co-author Johnny C.P. Chao investigated the size of government in Canada that maximized rates of economic growth between 1929 and 1996. They concluded that between these years, government that consumed approximately 34 percent of GDP maximized GDP growth (Chao and Grubel 1998).

William Mackness examined government spending in Canada and concluded that the optimal level of government spending was in the area of 20 to 30 percent of GDP, substantially below the levels currently maintained by government (Mackness 1999).

Scully conducted a similar study to that of his analysis of the United States for New Zealand. Using data for the years 1946 to 1994, he found that New Zealand’s growth maximizing aggregate tax rate was roughly 20 percent of GDP (Scully 1996).

Cross-Sectional Studies

In addition to these single country studies, a number of scholars have undertaken similar studies using multiple country data.

Gerald Scully explores the relationship between tax rates, tax revenues, and economic growth for 103 countries. He found, in general, that economic rates of growth were maximized when governments took no more than 19.3 percent of GDP (Scully 1991). His conclusion was that “increases in the size of the government share of the economy adversely affect economic growth and the allocation of resources…that the rise in the size of the government has had a substantial depressing effect on economic growth (Scully 1989: 161).

Kevin Grier and Gordon Tullock examined economic growth among OECD countries between the years 1951 and 1980. They concluded that “government growth is negative and significant” in its effect on economic growth (Grier and Tullock 1989: 274).

Zsolt Besci of the Federal Reserve Bank of Atlanta investigated the effects of regional differences in taxation. He concluded that the relative marginal tax rates had a statistically significant negative relationship with relative state growth (Besci 1996). In other words, as a state’s relative marginal tax rates increase, its relative rate of economic growth decreases.

One of the more high profile studies completed was by Harvard economist, Robert Barro. Barro investigated a wide variety of variables in an attempt to determine their affect on economic growth. He found that government consumption, that is, expenditures by government not deemed to be public investment such as education and defence, “had no direct effect on private productivity…but lowered saving and growth through the distorting effects from taxation or government-expenditure programs” (Barro 1991: 430). He further found a “significantly negative association” between government consumption relative to the economy (government as a percent of GDP) and GDP growth (430).

Bruce Benson and Ronald Johnson looked at the impact of taxes on future capital formation across different countries using time-series data. They concluded that movement upwards in the relative tax rates resulted in downward movement in the relative amount of investment. In other words, higher tax rates resulted in less capital formation in the future. Based on this negative relationship, Benson and Johnson concluded that “taxes negatively affect economic activity” (Benson and Johnson 1986: 400).

L. Jay Helms similarly investigated the effect of government expenditures on growth in the U.S. states. Helms found that states that increased taxes or fees to finance transfers experienced reduced growth in state income (Helms 1985).

Richard Vedder investigated the effect of state and local government spending on rates of economic growth in the U.S. states. Vedder concluded that increased government spending, particularly when based on increased income assistance spending had a significantly negative effect on state GDP growth rates (Vedder 1993).

Most recently, Stefan Folster and Magnus Henrekson examined the growth effects of government spending and taxation in ‘rich’ countries. Folster and Henrekson limit their study to rich countries due to differences in the composition of government spending between rich and poor countries. Covering the period 1970-1995, Folster and Henrekson find a robust negative relationship between government expenditure and economic growth. In addition, they conclude that a 10 percent increase in government expenditure as a percent of GDP is associated with a decrease in the economic growth rate by 0.7 – 0.8 percentage points (Folster and Henrekson, 2001).

Size of Government and Social Progress: Big Cost = No Results

The advance of government beginning in the 1960s into areas of social welfare and increased income subsidization was rationalized as achieving social progress. That is, governments argued that society could bear higher tax burdens in order to achieve more social progress and ultimately higher rates of economic growth. The data is rather overwhelming that increased government does not lead to increased rates of economic growth, in fact, quite the opposite. However, many still cling to the notion that we as a society will give up some economic growth in order to achieve greater social progress. Unfortunately, the high cost of big government, in terms of both direct taxation and the accordant reduction in economic growth has not apparently been matched by social progress.

A series of studies have been completed by International Monetary Fund (IMF) economists Vito Tanzi and Ludger Schuknecht regarding the size of government and social progress. They concluded that:

…countries with “small” governments generally do not show worse indicators of social and economic well-being than countries with “big” government—and often they achieve an even better standard. Countries with “small” governments can provide essential services and minimum social safety nets while avoiding the disincentive effects caused by high taxes and large-scale redistribution on growth, employment, and welfare. (Tanzi and Schuknecht in Grubel, ed. 1998: Page 70.)

More specifically, they found that countries with governments whose expenditures exceed 50 percent of GDP do not materially (statistically significantly) outperform countries with smaller governments – those whose expenditures are less than 40 percent of GDP. In fact, Tanzi and Schuknecht have found that not only do large government countries fail to outperform smaller-government countries, but that countries with medium-sized governments (those with expenditures between 40 and 50 percent of GDP) also fail to materially outperform smaller government countries (Tanzi and Schuknecht, 1995, 1997a and 1997b, and 1998) in terms of social progress.

Another important study on social progress was completed by Gerald Scully, which buttresses the findings of Tanzi and Schuknecht. Professor Scully examined 1995 data for 16 indicators of social progress, including literacy, infant mortality, life expectancy, caloric consumption, access to health care, infrastructure, political freedom, civil liberties, and economic freedom, across 112 countries. He concluded that there was little or no difference in social outcomes among counties in which governments spent less than 40 percent of GDP and those that spend in excess of 50 percent of GDP (Scully, 2000).

Another striking conclusion contained in the Scully research is that government spending ceases to yield any further social progress, as measured by the 16 social indicators, at 18.6 percent of GDP for advanced countries (Scully, 2000). There is some variance among countries; for instance, the rate at which government spending ceases to provide any marginal benefits in Canada is 19.5 percent of GDP.

Jason Clemens is the Director of Fiscal Studies at The Fraser Institute. He has an MBA from the University of Windsor.

Niels Veldhuis is Senior Research Economist at the Fraser Institute. He has an MA in Economics from Simon Fraser University.

(Originally published in September 2002 by the Fraser Institute)

References

Barro, Robert (1990). Government Spending in Simple Model of Endogenous Growth. Journal of Political Economy 98, 5:S103-S125.

_____ (1991). Economic Growth in a Cross Section of Countries. The Quarterly Journal of Economics (May): 407-43.

Becsi, Zsolt (1996). Do State and Local Taxes Affect Relative State Growth? Economic Review 81, 2 (March/April): 18-36.

Benson, Bruce, and Ronald Johnson (1986). The Lagged Impact of State and Local Taxes on Economic Activity and Political Behaviour. Economic Inquiry 24 (July): 389-401.

Emes, Joel, and Dexter Samida (unpublished). Canada’s Tax on Economic Growth. Unpublished work for The Fraser Institute.

Folster, Stefan, and Magnus Henrekson (2001). Growth effects of government expenditure and taxation in rich countries. European Economic Review 45: 1501-1520.

Grier, Kevin, and Gordon Tullock (1989). An Empirical Analysis of Cross-national Economic Growth, 1951-80. Journal of Monetary Economics 24: 259-76.

Grossman, Philip (1988). Government and Economic Growth: A Non-Linear Relationship. Public Choice 56: 193-200.

Helms, L. Jay (1985). The Effect of State and Local Taxes on Economic Growth: A Time Series-Cross Section Approach. The Review of Economics and Statistics 67 (4): 574-82.

King, R.G., and S. Rebelo (1990). Public Policy and Economic Growth: Developing Neoclassical Implications. Journal of Political Economy 98 (5): 126-150.

Mackness, William (1999). Canadian Public Spending: The Case for Smaller More Efficient Government. Public Policy Source #13. Vancouver, BC: The Fraser Institute.

Mintz, J.M., and T.A. Wilson (2000). Taxes, Efficiency, and Economic Growth. PEAP Policy Study 2000-1 (Toronto: Institute for Policy Analysis).

Mitchell, Daniel J. (1997). Taxes, Deficits, and Economic Growth. Heritage Lecture 565. Washington, DC: Heritage Foundation.

Peden, Edgar (1991). Productivity in the United States and Its Relationship to Government Activity: An Analysis of 57 Years, 1929-1986. Public Choice 69: 153-73.

Peden, Edgar, and Michael Bradley (1989). Government Size, Productivity, and Economic Growth: The Post-War Experience. Public Choice 61: 229-45.

Scully, Gerald W. (1989). “The Size of the State, Economic Growth and the Efficient Utilization of National Resources.” Public Choice 63: 149-64.

_____ (1991). Tax Rates, Tax Revenues and Economic Growth. Policy Report No. 98. Dallas, TX: National Center for Policy Analysis.

_____ (1994). What is the Optimal size of Government in the United States? Policy Report No. 188. Dallas, TX: National Center for Policy Analysis.

_____ (1995). “The ‘Growth Tax’ in the United States.” Public Choice 85: 71-80.

_____ (1998). Measuring the Burden of High Taxes. Policy Report No. 215. Dallas, TX: National Center for Policy Analysis.

_____ (2000). Public Spending and Social Progress. Policy Report No. 232. Dallas, TX: National Center for Policy Analysis.

Tanzi, Vito (1995). Government Role and the Efficiency of Policy Instruments. IMF Working Paper. Washington, DC: International Monetary Fund.

Tanzi, Vito, and Ludger Schuknecht (1997a). “Reconsidering the Fiscal Role of Government: The International Perspective.” American Economic Review 87: 164-68.

_____ (1997b). “Reforming Government: An Overview over the Recent Experience.” European Journal of Political Economy 13: 395-417.

_____ (1998a). “Can Small Governments Secure Economic and Social Well-Being?” In Herbert Grubel, ed. How to Use the Fiscal Surplus: What is the Optimal Size of Government? Vancouver, BC: The Fraser Institute.

_____ (1998b). “The Growth of Government and the Reform of the State in Industrial Countries.” In Andres Solimano, ed. Social Inequality. Ann Arbor, MI: Michigan University Press.

Vedder, Richard K. (1993). Economic Impact of Government Spending: A 50-State Analysis. Policy Report No. 178. Dallas, TX: National Center for Policy Analysis.

Vedder, Richard K., and Lowell E. Gallaway (1998). Government Size and Economic Growth. Paper prepared for the Joint Economic Committee of the US Congress.