Government size and economic growth

By Paul Walker 17/03/2014 7


The theoretical literature on economic growth offers support for both positive and negative effects of government size on economic growth. There are core areas of government which are said to help growth – e.g. provision of public goods such as infrastructure, rule of law, and protection of property rights – while there are also arguments outlining detrimental effects for growth arsing from the size of government. These occur via mechanisms such as the distortionary effects of high taxes and public borrowing, diminishing returns to public capital, rent-seeking activities and bureaucratic inefficiencies. Such negative effects are said to become more prevalent as the size of government increases.

Such ideas have been formalised in the endogenous growth literature as a non-monotonic relationship between growth and the increasingly distortionary effect of the rising tax rates which are required to fund ever larger government expenditure. In one such model, due to Robert Barro, when government is relatively small growth rises with increases in productive government services, as the positive effects of more public goods dominates, but beyond some critical point the disincentive effects of higher taxes on savings and investment reduce the growth rate. If the non-linear hypothesis is valid and the effect of government spending on long-run economic growth does vary with its size this would offer clearer guidelines on the appropriate fiscal policy prescription for a country of a particular government size. Furthermore, implicit in the non-linear hypothesis is the existence of some optimal size of government which would maximise economic growth.

There is a new paper – The Effect of Government Spending on Economic Growth: Testing the Non-Linear Hypothesis by Tamoya Christie – in the Bulletin of Economic Research which examines the relationship between government size and long-run economic growth. The paper explicitly accounts for the likelihood of a non-linear effect. It contributes to the literature in a number of ways.

First, in terms of methodology, the paper makes improvements to previous empirical studies by applying threshold analysis (Hansen, 2000) to a panel of countries. This technique has been widely used as the preferred method to identify threshold effects (Khan and Senhadji, 2001; Adam and Bevan, 2005; Chen and Lee, 2005; Falvey et al., 2006; Haque and Kneller, 2009), particularly when the variable of interest is observable, but the position of the threshold is not known. The methodology uses a sample-splitting framework and follows an objective strategy for identifying and testing changes in the slope. One important advantage of threshold analysis is that it avoids the ad hoc, subjective pre-selection of threshold values – a major critique of previous studies. In addition, the generalized method of moments (GMM) dynamic panel technique is applied to address potential endogeneity of government expenditure, which is measured as a share of GDP. Second, with respect to data, the study employs an updated dataset with a broad cross-section of countries over a long time span. Pulling data from the IMF’s Government Finance Statistics (GFS), the sample contains 136 countries over the period 1971–2005. Most important, this data source offers a more comprehensive measure of government size by using total government expenditure (excluding interest payments) as opposed to government consumption expenditure as the proxy. The consumption measure, though widely used in empirical studies, does not include public capital formation and so cannot fully capture the productivity-enhancing effects of government services. Moreover, the GFS data contain sectoral decompositions of government spending, which facilitates isolating productive elements of government spending from the total.

Likely the most interesting result of the paper is that it finds evidence in support of Barro’s non-linear hypothesis. For total government spending above 33 percent of GDP, there is a strong negative effect on growth. However for governments of a size less than this level the negative effects are much smaller and even becomes positive when productive government spending is singled out. The paper’s findings also suggest that the level of economic development and the quality of government present additional sources of potential non-linearities.


7 Responses to “Government size and economic growth”

  • This is all very well. The thing is any analysis of government effectiveness requires much more than an economic analysis.

    I sense that this paper is highlighted here as a comment on the size of government. For that use, the paper is interesting but flawed.

    We want governments to provide the public goods, including: security, healthcare, education, aspects of community and culture to name a few. So economic goals will work with and offset other goals. We accept that reality.

    The problem here is in the use of GDP as the end point. By selecting GDP the authors are biasing the discussion to a limited economic view because GDP cannot be used as a surrogate for the other factors.

    Before we as a society can judge the appropriate size of government, we need full information on the trade-offs involved.

    The paper lacks critical information and is of little use.

  • Two quick points: 1) as the paper makes clear it is the provision of public goods that helps explain the positive relationship between growth and the size of government. 2) while not a measure of welfare as such, real GDP per capita tends to be positively correlated with welfare enhancing factors. eg education is better in high income countries, the environment is better, health care is better etc.

  • Yes I know that.

    “GDP tends to be positively correlated” but is not a measure. We agree.

    My point is not to over use GDP. We need specific measures of public goods (and externalities) in addition to quick and cheap ones like GDP. Relying on GDP as a surrogate could well be leading us astray.

    An easy example, GDP shows our friend the USA growing using GDP but using a genuine progress indicator it is doubtful that there has been “real” growth in 30 years. (https://en.wikipedia.org/wiki/Genuine_progress_indicator)

  • Maurice: Two points:
    1. Depending on what you want to take away from the paper, the results can be both interesting and non-flawed. if the take-away point is an estimate of the optimal size of government, then using GDP as the end-point would be obviously flawed. But just showing that there is an inverse-U-shaped relationship between size of government and GDP provides useful information about the interaction of government with the rest of the economy. That is worthy of a paper.

    2. You say: “So economic goals will work with and offset other goals”, instancing “security, healthcare, education, aspects of community and culture”. If those things are not economic goals, then what we teach at University (at least at Canterbury) doesn’t seem to be Economics. Most of us get through entire courses talking about goals like healthcare, education, etc. and never even mention GDP!

  • Seamus. With regard to pint 1. I agree the interesting point from the paper is the inverse-U shaped relationship. But as to the use GDP, yes and no. Clearly GDP isn’t a perfect measure but if we let people add in whatever they think is right, according to their idea of what makes up useful public goods then I’m sure you can get any result you want by adding in the “right” things in the “right” way.

  • the trick then, like most economic modelling (or indeed most scientific modelling), is in recognising and acknowledging freely the limits of the assumptions and data the model is based on…

  • Thanks Seamus, I am pleased the Canterbury University is thorough. In answer to your question; yes, economics; health, environment, education and so forth are studied within the frames and methods of economics. Clearly that is necessary but it is not sufficient! Health, education, environment and so forth are also studied using the frames and methods of the field themselves and as interdisciplinary topics. My answer is no; economics informs these areas but these are societal questions and the answers will be complex, multidimensional and interdisciplinary (not just economic).

    Thanks Paul; the Genuine Progress Indicator is not an attempt to fiddle the numbers but an attempt to explore and understand when two of the more obvious limits to GDP are addressed. That is a sensible and useful thing to do. Pure critical thinking which I encourage.

    Thanks Ashton, the more transparent the model (and clear the limits) the better.

    I just think we need to be careful not to overuse GDP, probably we all agree that its use in the media is frustratingly simplistic.