Saturday, February 8, 2014

The Optimal Size of Government

Countless studies confirm the Classical Liberal belief that the economy grows fastest when the size of government (measured as a % of GDP) stays small. This is most likely due to the fact that the private sector allocates capital and resources to ventures that will be much more productive than the ones pursued by governments. As capital and resources are diverted from private firms and instead used by government, the economy’s growth rate slackens. Predictably  a recent study published by the Research Institute for Industrial Economics noted that:

“The most recent studies [on the relationship between government spending and economic growth” find a significant negative correlation: An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.….When we singularly focus on studies that examine the correlation between growth of real gross domestic product (GDP) per capita and total government size over time in rich countries (OECD and equally rich), the research is rather close to a consensus: the correlation is negative.” [1]

The Fraser Institute has also made a similar conclusion:

“A survey of the literature shows that numerous studies document a negative empirical relationship between government size and economic growth rates. As well, there seems to be an association between smaller public sectors and greater efficiency in public service provision, as well as better performance outcomes” [2]

So what is the optimal size of government? The Fraser Institute believes it is somewhere around 26% of GDP. They note that:

“All other things given, annual per capita GDP growth is maximized at 3.1 percent at a government expenditure to GDP ratio of 26 percent; beyond this ratio, economic growth rates decline. This demonstrates that there is an optimal size for the public sector when it comes solely to the effect on economic growth.” [2]

Most studies (below) find that the optimal size of government, as a percentage of GDP, is between 15-25%. Currently, total US government spending is around 40% of GDP, which suggests that our government is a large burden on our economy. If the US wants to see its economy grow faster, the first thing they should do is rollback the size of the state.

Research on the optimal size of government (taken from the Facebook page ‘Unbiased America’):

16% +/- 3% of GDP.
Karras, G. (1997). “On the Optimal Government Size in Europe: Theory and Empirical Evidence,” The Manchester School of Economic & Social Studies
17.3% +/- 3% of GDP.
Gunalp, B. and Dincer, O. (2005). “The Optimal Government Size in Transition Countries,” Department of Economics, Hacettepe University Beytepe, Ankara and Department of Commerce, Massey University, Auckland
17% to 20% of GNP.
Peden, E. (1991). “Productivity in the United States and its relationship to government activity: An analysis of 57 years, 1929-1986,”
The average rate of federal, state and local taxes combined should be between 21.5 and 22.9% of GNP.
Scully, G. (1994). “What is the optimal size of government in the US?,” National Center for Policy Analysis, Policy Report No. 188
28.9% of GDP
Vedder, R. and Gallaway, L. (1998). “Government Size and Economic Growth,” Joint Economic Committee, Washington D.C., p. 5
14.7% of GDP
Davies, A. (2008). “Human Development and the Optimal Size of Government,” Journal of Socioeconomics, forthcoming

Research on how government spending affects economic growth:

All below text is taken from an article written by Economist Dan Mitchell which can be found here:

§  A European Commission report acknowledged: "[B]udgetary consolidation has a positive impact on output in the medium run if it takes place in the form of expenditure retrenchment rather than tax increases."
§  The IMF agreed: "This tax induced distortion in economic behavior results in a net efficiency loss to the whole economy, commonly referred to as the 'excess burden of taxation,' even if the government engages in exactly the same activities-and with the same degree of efficiency-as the private sector with the tax revenue so raised."
§  An article in the Journal of Monetary Economics found: "[T]here is substantial crowding out of private spending by government spending.…[P]ermanent changes in government spending lead to a negative wealth effect."
§  A study from the Federal Reserve Bank of Dallas also noted: "[G]rowth in government stunts general economic growth. Increases in government spending or Taxes lead to persistent decreases in the rate of job growth."
§  An article in the European Journal of Political Economy found: "We find a tendency towards a more robust negative growth effect of large public expenditures."
§  A study in Public Finance Review reported: "[H]igher total government expenditure, no matter how financed, is associated with a lower growth rate of real per capita gross state product."
§  An article in the Quarterly Journal of Economics reported: "[T]he ratio of real government consumption expenditure to real GDP had a negative association with growth and investment," and "Growth is inversely related to the share of government consumption in GDP, but insignificantly related to the share of public investment."
§  A study in the European Economic Review reported: "The estimated effects of GEXP [government expenditure variable] are also somewhat larger, implying that an increase in the expenditure ratio by 10 percent of GDP is associated with an annual growth rate that is 0.7-0.8 percentage points lower."
§  Public Choice study reported: "[A]n increase in GTOT [total government spending] by 10 percentage points would decrease the growth rate of TFP [total factor productivity] by 0.92 percent [per annum]. A commensurate increase of GC [government consumption spending] would lower the TFP growth rate by 1.4 percent [per annum]."[
§  An article in the Journal of Development Economics on the benefits of international capital flows found that government consumption of economic output was associated with slower growth, with coefficients ranging from 0.0602 to 0.0945 in four different regressions.
§  Journal of Macroeconomics study discovered: "[T]he coefficient of the additive terms of the government-size variable indicates that a 1% increase in government size decreases the rate of economic growth by 0.143%.”
§  A study in Public Choice reported: "[A] one percent increase in government spending as a percent of GDP (from, say, 30 to 31%) would raisethe unemployment rate by approximately .36 of one percent (from, say, 8 to 8.36 percent)."
§  A study from the Journal of Monetary Economics stated: "We also find a strong negative effect of the growth of government consumption as a fraction of GDP. The coefficient of -0.32 is highly significant and, taken literally, it implies that a one standard deviation increase in government growth reduces average GDP growth by 0.39 percentage points."
§  The Organisation for Economic Co-operation and Development acknowledged: "Taxes and government expenditures affect growth both directly and indirectly through investment. An increase of about one percentage point in the tax pressure-e.g. two-thirds of what was observed over the past decade in the OECD sample- could be associated with a direct reduction of about 0.3 per cent in output per capita. If the investment effect is taken into account, the overall reduction would be about 0.6-0.7 per cent."
§  A National Bureau of Economic Research paper stated: "[A] 10 percent balanced budget increase in government spending and taxation is predicted to reduce output growth by 1.4 percentage points per annum, a number comparable in magnitude to results from the one-sector theoretical models in King and Robello."
§  Another National Bureau of Economic Research paper stated: "A reduction by one percentage point in the ratio of primary spending over GDP leads to an increase in investment by 0.16 percentage points of GDP on impact, and a cumulative increase by 0.50 after two years and 0.80 percentage points of GDP after five years. The effect is particularly strong when the spending cut falls on government wages: in response to a cut in the public wage bill by 1 percent of GDP, the figures above become 0.51, 1.83 and 2.77 per cent respectively."
§  An IMF article confirmed: "Average growth for the preceding 5-year period…was higher in countries with small governments in both periods. The unemployment rate, the share of the shadow economy, and the number of registered patents suggest that small governments exhibit more regulatory efficiency and have less of an inhibiting effect on the functioning of labor markets, participation in the formal economy, and the innovativeness of the private sector.
§  Looking at U.S. evidence from 1929-1986, an article in Public Choice estimated: "This analysis validates the classical supply-side paradigm and shows that maximum productivity growth occurs when government expenditures represent about 20% of GDP.
§  An article in Economic Inquiry reported: "The optimal government size is 23 percent (+/-2 percent) for the average country. This number, however, masks important differences across regions: estimated optimal sizes range from 14 percent (+/-4 percent) for the average OECD country to…16 percent (+/-6 percent) in North America."
§  A Federal Reserve Bank of Cleveland study reported: "A simulation in which government expenditures increased permanents from 13.7 to 22.1 percent of GNP (as they did over the past four decades) led to a long-run decline in output of 2.1 percent. This number is a benchmark estimate of the effect on output because of permanently higher government consumption.


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