Saturday, February 15, 2014

Government spending and growth

A study in the Journal of Macroeconomics reports:

"The Government Size and Economic Growth coefficient of the additive term of the government-size variable indicates that a 1% increase in government size decreases the rate of economic growth by 0.143%, ceteris paribus" [1]

When the authors say 'ceteris paribus', they mean that they controlled for all the independent variables other than the one being studied, which in this case is the size of government. Thus, they are able to discern the effect the size of government has on the economic growth rate. According to the statement above, as government grows, the economy grows more slowly.

According to the author's conclusions, a 10% increase in the size of government (measured as a % of GDP) will decrease a country's economic growth rate by 1.43%. A country's economic growth rate is extremely important for short run employment, but even more important for long run prosperity.

Economists use what is known as the rule of 70 to determine how long an economy is expected to double in size. According to the rule of 70, (70/ economic growth rate), let's analyze how many years it will take for an economy to double in two scenarios.

Scenario 1) Government spending is 15% of GDP and the economy grows at 5% per year (adjusted for inflation).

70/ 5 = 14 years. Thus, according to the rule of 70 it will take 14 years for the economy to double in size, which will raise the standard of living for all its citizens.

Scenario 2) Government spending is 25% of GDP. Based on the findings above, we can expect the growth rate to be 1.43% lower.

70/3.57 = 19.6 years. According to the rule of 70, it will take this economy 19.6 years to double in size. This means that the economy in scenario 2 will take 33% longer to double the size of its economy than the economy in scenario 1.

Many other studies find similar results [2]. If we want the standard of living to rise for everyone, keeping government small is a step in the right direction. Also, if you like posts like this be sure to leave a comment.

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