Government size and economic growth

by on July 8, 2011 at 2:55 am in Economics, Political Science | Permalink

I thought the new paper by Andreas Bergh and Magnus Henrekson was both useful and wise:

The literature on the relationship between the size of government and economic growth is full of seemingly contradictory findings. This conflict is largely explained by variations in definitions and the countries studied. An alternative approach – of limiting the focus to studies of the relationship in rich countries, measuring government size as total taxes or total expenditure relative to GDP and relying on panel data estimations with variation over time – reveals a more consistent picture. The most recent studies 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. We discuss efforts to make sense of this correlation, and note several pitfalls involved in giving it a causal interpretation. Against this background, we discuss two explanations of why several countries with high taxes seem able to enjoy above average growth: (i) that countries with higher social trust levels are able to develop larger government sectors without harming the economy, and (ii) that countries with large governments compensate for high taxes and spending by implementing market-friendly policies in other areas. Both explanations are supported by current research.

That is the working paper version, there is a published and gated version in Journal of Economic Surveys.  By the way, here is a new video on economic freedom.

1 Craig Austin July 8, 2011 at 8:18 am

The root of our economic problems is operational rather than political. Well-intended policymakers are only as good as their economic advisors. Economists are simply giving the wrong advice to policymakers because they misunderstand monetary operations. The objective is never to balance the budget. The objective is always to optimize the budget. Fiscal optimization at any level of public spending requires balancing tax revenues with spending while running deficits at a rate corresponding to users saving rate. In order to balance spending with tax revenues, government must destroy money through taxes before it creates money to spend in the marketplace. Recognizing that some users choose not to spend, government deficits must correspond to the users savings rate in order to maintain a given level of output. The challenge of the issuer is to spend enough money to displace the saving rate but not enough to exceed it. For those of you interested I’ve outlined a laymen’s explanation here –

Seriously where are the adults these kids are going nuts!

2 econokeen July 8, 2011 at 9:42 am

That is an interesting and complex way of looking at it. I will have to read a bit more of your thoughts to see. I think I am with you in the abstract.

3 mjw149 July 8, 2011 at 8:25 am

I’m not familiar enough with economics literature, is there any discussion of unhealthy growth? It seems that the US is in a devolving spiral the last 20 years or so of short term crazy growth fueled by deregulation/low taxes/less effective public services which inevitably crashes, like sugar highs in a person. So I suspect that larger government sectors, within reason, provide a steadier framework for long term growth – because there are deeper more predictable systems built within the framework of gov’t regulation, as we saw in the continuing real estate crisis.

I’m not sure I like the study’s simplistic assumption of formulating the question of gov’t size and taxes vs. better governance. Yes, you can’t measure wise governance, but obviously how they spent their money is more important than how much they spent.

In other words, we should reduce our research to reproducible numbers as much as possible, but with comparative international studies of governments, it’s difficult to ignore that every nation is a snowflake and some are just run better than others, or have built-in advantages or different cultures. Ireland is the ultimate example of over-fueling growth with low taxes, but even I wouldn’t say it’s applicable everywhere.

I’d venture that China, for an example, is generally well-run, but not predictable for outside investment. Would they grow faster with less government? Hardly. It’s a seething maelstrom of 19th century chaos as it is. Would they grow faster if they opened their markets the way we have? I’m not sure, but their practice of forcing foreign companies to be subordinate seems to be brutally effective, and I suspect they’ll come out on top as a result. They’re well on their way.

After all, the debate of open vs. closed economies ignores the possibility of opening your market in a way that is exclusively advantageous, as China has done. China has done this. The debate of large vs. small government ignores the idea of large, smart government. I suspect the government sectors in Europe are better educated for their specific roles, particularly in the UK and France.

4 Cliff July 8, 2011 at 9:32 am

Your post makes no sense. “Crashes” would be included in the average growth rate. Europe was a part of this study. And any country would do better by opening their markets.

5 mjw149 July 8, 2011 at 2:08 pm

Yes, but frequent crashes are generally an unwanted ‘feature’ of any economy. Are you suggesting a slightly higher growth rate is ok if it means a near complete collapse every 5 years? Eventually you crash too hard to recover.

6 Dan Dostal July 8, 2011 at 4:32 pm

It worked for Russia!

7 TallDave July 8, 2011 at 9:48 am

Would they grow faster with less government? Hardly.

I’m not sure you understand what “transitioning from Communism” means.

8 mjw149 July 8, 2011 at 2:20 pm

They privatized their economy. I’m not sure that counts as less government per se, they have allowed more local councils at the same time, which would technically be more government. And I’m not even positive it was the privatization that really fueled their growth, but instead the huge increase in international investment – which was carefully controlled by the gov’t to be one-sided.

I understand the popular use of the terms communism=socialism, which is rather bothersome. Communism was/is a dictatorship combined with a state controlled economy. Socialism is something every country practices, such as US farm subsidies and health care. If we’d like to draw the line here, and say what it means, i.e. complete ownership of an entity by the gov’t, that’s fine, but then how do we describe the government supported or directed industries? People call Obama socialist, and there’s been no gov’t takeovers of private industry, so it’s a bothersome term for many people.

I’m sure you still disagree, but I don’t think Chinese growth would be hampered by a more controlled approach, i.e. environmental regulation and more planning. And that was my point. I’d love them to shift their censorship resources to something more productive, but they hardly have any incentive to do so.

Do you still consider them communists? Their government still calls itself that. Though of course the economy isn’t centrally planned in the same manner as before.

9 blabla July 9, 2011 at 7:22 am

You seem to have some misconceptions about economics. While I’m not an expert by any means so take what I say with a grain of salt.

1)Europe has less financial regulation than the US,the tax revenue is lower in the US but per capita government spending within high tax states doesn’t differ much from countries such as Germany and the Netherlands. The main difference in policy between countries that got hit hard by the recession and that that weren’t was the policy of their central bank. Countries such as the US fear deflation more while most European countries fear inflation more and the central banks acted on these sentiments.

2) China has relatively speaking a larger private sector than the US and the EU. While China benefited from international investment calling it one sided is missing the point. Investors,western consumers and the Chinese government have all benefited from these deals. The chinese consumers have lost out because their currency is kept weak to fuel exports. The Chinese government is basically paying the US to buy their goods. If the Yuan would be allowed to float freely it would rise and goods in China would become much cheaper while exports would become more expensive. Financial regulation and other government incentives have resulted in a real estate bubble so I wouldn’t say regulation or a closed economy as you described it is any securer than what we have in the west. Just google Chinese ghost towns. China can be described as Marxist-leninist though at the moment it is on a crossroad. Either it goes for full blown leninism or it moves towards something like Japan.

3) Your use of communism isn’t correct. While self-proclaimed communists usually did what you described they weren’t communists by any stretch of the imagination. It usually involves communal ownership instead of government or private ownership. What your loose definition of socialism describes is social democracy which every western country falls under. Even socialist parties within the EU aren’t really all that gung-ho anymore about nationalizing businesses because they noticed several things:
-You don’t need ownership to control a business. Regulation does that just fine.
-You don’t need ownership to get the money. Taxes allow the government to profit without having to take risks.
-People work harder when they think they are working for themselves.
-If something in the economy goes wrong the government doesn’t get blamed aslong as they don’t own the sector.

4) Obama is a social democrat and hes left even by European standards.

Some things I disagree with that I read inbetween the lines but you don’t really say yourself so I apologize if I misread you.

1) The only scandinavian country that has the same wealth level as the US is Norway and thats largely fueled by oil. While the nominal gdp of scandinavian countries are fairly high their PPP is much lower than that of the US. Nominal gdp is rather tricky since even during WW2 the nominal per capita GDP rose above depression levels while everything was rationed and a large amount of the US population was drafted and send abroad. I doubt many would say that it was a major improvement over the depression.

2) Regulation and spending doesn’t create wealth but investment and labour does. The public sector tends to consume much more than the private sector relatively speaking and when it does invest the returns are lower. R&D spending in most countries is done primarily by the private sector. This is especially the case in Asian countries but even in the US the majority of the R&D spending comes from the private sector.

3) You give off the impression that the private sector doesn’t plan. It in fact does though it is done in a more decentralized manner. If a corporation would get a monopoly it wouldn’t be organized any different from a government that monopolized the same sector.


The US spends more on education than Sweden.
————————————————— has written quite a lot about the comparison between the US and the EU.

Of particular interest are:

10 dennis July 10, 2011 at 8:04 pm

Obama is a social democrat to the left of Europe? Wow. Just wow.

11 TallDave July 10, 2011 at 7:09 pm

They privatized their economy. I’m not sure that counts as less government per se,

Yes, that’s actually exactly what it means.

I’m sure you still disagree, but I don’t think Chinese growth would be hampered by a more controlled approach, i.e. environmental regulation and more planning.

Again, that is what “transitioning from Communism” means. No more centrally-planned Five Year Plans, more private decision-making.

People generally don’t realize how much of a basket-case they used to be before free-market reforms; they were were basically North Korea without the charm. They were doing insane things like having all the country’s steel forged in people’s homes. By some estimates 65 million people died. Today, they’ve transitioned to a crony-capitalist state that puts growth ahead of the environment, the poor, and everything else.

12 Floccina July 8, 2011 at 11:23 am

What is funny is that you might be right they are “Like sugar highs in a person”, that is mythical. Look at any real randomized trial on “sugar highs”. Their is no such thing as sugar highs.

13 mjw149 July 8, 2011 at 2:29 pm

ok. Thanks for that. I just think of how I shake after a Swiss Cake Roll. Must be the caffeine.

14 foosion July 8, 2011 at 8:27 am

>>note several pitfalls involved in giving it a causal interpretation>>

That appears to be the key sentence

15 Lord July 8, 2011 at 9:23 am

A richer country will have a larger government as more social goods will be desired and less room for growth from catching up.

16 Jamie_NYC July 8, 2011 at 2:00 pm

US of A

17 TGGP July 8, 2011 at 9:42 am

I agree with the bottom-line of the economic freedom video, but the amount of non-obviously related factors they show are correlated with freedom makes the question of causality all the larger, and they don’t even attempt to distinguish possible causes (by measuring growth rather than levels, for instance).

18 TallDave July 8, 2011 at 9:45 am

Thanks for sharing, Tyler.

This should be well-known by now, of course.

19 Pedro July 8, 2011 at 10:11 am


Exactly. As it stands now, this paper has zero normative power. I didn’t read the whole paper, but only by the abstract I can think of many reasons why the structural parameters are NOT identified.

20 jc July 8, 2011 at 10:54 am

FYI, here are some partial correlations b/w economic freedom and economic growth via Doucouliagos et al. (2006). Hope this displays correctly. 🙂

Study Correlation

Abrams and Lewis (1995) 0.35*
Adkins et al. (2002) 0.06
Ali (2003) 0.32*
Ali and Crain (2001, 2002) 0.21*
Assane and Grammy (2003) 0.51*
Bengoa and Sanchez-Robles (2003) 0.22*
Berggren and Jordahl (2005) 0.49*
Carlsson and Lundstrom (2002) 0.53*
Cole (2003) 0.44*
Comeau (2003a) 0.29*
Dawson (1998) 0.13*
Dawson (2003) 0.12*
de Haan and Siermann (1998) 0.26*
de Vanssay and Spindler (1994) 0.59*
de Vanssay and Spindler (1996) 0.19*
Easton and Walker (1997) 0.44*
Farr et al. (1998) 0.11*
Fidrmuc (2003) 0.13*
Goldsmith (1995) 0.38*
Goldsmith (1997) 0.37*
Gounder (2002) 0.39*
Grammy and Assane (1996) 0.20*
Gwartney et al. (1999) 0.29*
Hanke and Walters (1997) 0.61*
Hanson (2003) 0.66*
Heckelman (2000) 0.15*
Heckelman and Stroup (2000) 0.68*
Islam (1996) 0.25*
Johnson and Lenartowicz (1998) 0.71*
Karabegovic et al. (2003) 0.67*
Lall et al. (2002) 0.78*
Leschke (2000) 0.37*
Nelson and Singh (1998) 0.18*
Norton (2003) 0.42*
Park and Ginarte (1997) 0.32*
Pitlik (2002) 0.34*
Ram (2000) 0.13
Scully (1988) 0.27*
Scully (2002) 0.20*
Spindler (1991) 0.12
Sturm and de Haan (2000, 2001) 0.33
Sturm et al. (2002) -0.01
Torstensson (1994) 0.32*
Weede and Kampf (2002) 0.13
Wu and Davis (1999) 0.07*

21 Roland July 8, 2011 at 1:25 pm

I never like the use of panel data as an alternative to having a large sample set … too many unobserved, path dependent factors get smuggled in..

22 Cahal July 8, 2011 at 5:54 pm

Maybe if governments across the world started taxing land and rent instead of labour and capital then there wouldn’t be a negative correlation..

23 Steve Roth July 8, 2011 at 10:29 pm

> countries with large governments compensate for high taxes and spending by implementing market-friendly policies in other areas

This is the conclusion I’ve been coming to. A robust social support system gives governments the freedom to implement policies (particularly in labor and trade) that, absent such a system, are both draconian and growth-retarding.

24 mick July 9, 2011 at 12:56 am

High taxes and low regulation is possible, as in Norway. 60% is nothing in the modern world if you are allowed to drill at will.

25 Misaki July 10, 2011 at 8:03 pm

“The most recent studies 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.”

One thing they hopefully took into account is that countries try to reduce unemployment when possible, and so the alternative to government in many cases will not be “higher economic growth” but rather “higher unemployment and lower growth than if government were not involved”.

But of course, government size increases that also lead to deficits must balance the utility of short-term reduction of unemployment with long-term debt with no assurance of retaining that lower unemployment if deficits are eliminated. This is why it would seem much better to eliminate unemployment without government spending:


*It has come to my attention that many people think the reason that there aren’t more jobs is that companies are not doing well.*

This is one of the main oppositions to increasing wage for lower amounts of work. It therefore follows that people should support a DECREASE in the average wage for permanent employees working full time, if they are given the option of instead working part-time at the original wage rate (or even a higher wage rate if full-time employees get the reduced rate). Wages would eventually equalize anyway, but apparently people don’t realize that.

Please contact the White House via the contact form to encourage this policy to reduce unemployment, if doing so is in your interests.

What does “low consumer demand” really mean?

From : ‘That is why so many companies identify their number one problem as “lack of customers”.’

But as helpfully pointed out to me,
of course that is utterly and 100% meaningless and stupid.
It is like sayng the number one problem of cancer researchers is they have not found the cure. It is a given that no business has too many customers and no researchers have too many cures for cancer. OMG!!!!

More specifically, this means businesses would not increase profits by lowering their prices, because the slight increase in sales would not make up for the loss in per-unit profit, even if their product is significantly cheaper than others on the market.

Decreasing the cost of a car from $35k to $25k will not make a rich person buy it instead of a $200k luxury car, because they don’t care about saving $10k. In other words, companies that are NOT profitable enough are the ones who feel like they have problems from lack of customers.

Companies that are profitable don’t feel like they have a lack of customers because they are profitable, even if they could make more profit for every new customer.

This lack of competition is the same as described [here]: http:/ and derives from the very slightly higher amounts of utility of the more expensive goods, even if the utility is only “having a brand that people will recognize”. This is what lack of customers really means, that the low-end companies have problems not the high-end ones, and is exactly what changing the wage system would fix by lowering profits for the high-end companies and increasing demand for products of the low-end ones.

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