Friday, April 25, 2014

The Optimal Size of Government

I generally analyze how government actions affect economic growth. In this post I will go through some of the empirical evidence on the optimal size of government. In the following studies, the optimal size of government is measured by government spending (as a % of GDP) which maximizes economic growth.
First it's worth noting that the majority of the empirical literature on the relationship between government size and growth finds that government spending is contractionary (meaning it decreases economic growth). Consider a recent survey of the literature which states:
"The most recent studies [on the relationship between government size and 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." [1]
Keep in mind the studies surveyed controlled for many others variables such as population, lagged per capita GDP, net debt to GDP ratios, institutional factors, economic freedom, regional variations, etc in order to isolate the affect government spending has on economic growth.
Using evidence provided by studies like the one previously mentioned, researchers have been able to predict the optimal (growth maximizing) size of government. For example:
Chobanov and Mladenova (2009) finds:
"The evidence indicates that the optimum size of government, e.g. the share of overall government spending that maximizes economic growth, is no greater than 25% of GDP (at a 95% confidence level) based on data from the OECD countries." [2]
Di Matteo of the Fraser Institute concludes:
"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 (of GDP); beyond this ratio, economic growth rates decline." [3]
Our friends over at Unbiased America have provided more studies:
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
NOTE: There are even more studies than these, the highest estimates I've seen is 37% for European Countries. Almost all studies purport that the optimal size of government is 30% or less, with the majority finding it to be between 15-25%.

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