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Opinion

Political economy of the size of government: What shakes and what Shapes


Bangladeshpost
Published : 19 Jun 2020 08:37 PM | Updated : 07 Sep 2020 03:40 PM

Jamaluddin Ahmed

(Continued from last day's section)

Why do Government expenditures affect economic growth:

In theory the relationship between government expenditures and economic growth is ambiguous. Long ago, Thomas Hobbes (1651) described life without government as “nasty, brutish, and short” and argued that the law and order provided by government was a necessary component of civilized life (Rothbard 1973). 

Taking the Hobbesian view, certain functions of government such as the protection of individuals and their property and the operation of a court system to resolve disputes should enhance economic growth (Knack and Keefer 1995) and Keefer and Knack 1997). V

iewed from another angle, secure property rights, enforcement of contracts and a stable monetary regime provide the foundation for the smooth operation of a market economy.

Governments can enhance growth through efficient provision of this infrastructure. In addition, there are a few goods—economists call them “public goods”—that markets may find troublesome to provide because their nature makes it difficult (or costly) to establish a close link between payment for and receipt of such goods. 

Roads and national defense fall into this category. Government provision of such  goods might also promote economic growth. However, as government continues to grow and more and more resources are allocated by political rather than market forces, three major factors suggest that the beneficial effects on economic growth will wane and eventually become negative. 

First, the higher taxes and/or additional borrowing required to finance government expenditures exert a negative effect on the economy. As government takes more and more of the earnings of workers, their incentive to invest, to take risks, and to undertake productivity-enhancing activities, decreases (Browning 1976). 

Like taxes, borrowing will crowd out private investment and it will also lead to higher future taxes. Thus, even if the productivity of government expenditures did not decline, the disincentive effects of taxation and borrowing, as resources are shifted from the private sector to the public sector, would exert a negative impact on economic growth. 

Second, as government grows relative to the market sector, diminishing returns will be confronted. Suppose that a government initially concentrates on those functions for which it is best suited (for example, activities such as protection of property rights, provision of an unbiased legal system, development of a stable monetary framework, and provision of national defense).

Relationship between size of government and economic growth: 

Gwartney et al  (1998) illustrated the relationship between size of government and economic growth, assuming that governments undertake activities based on their rate of return. 

As the size of government, measured on the horizontal axis, expands from zero (complete anarchy), initially the growth rate of the economy—measured on the vertical axis—increases. 

Gwartney et al  (1998)  illustrated this situation in their study. As government continues to grow as a share of the economy, expenditures are channeled into less productive (and later counterproductive) activities, causing the rate of economic growth to diminish and eventually decline (See Barro 1990). 

The range of the curve beyond B illustrates this point. In the real world, governments may not undertake activities based on their rate of return and comparative advantage. Small government by itself is not an asset. When a small government fails to focus on and efficiently provide core functions such as protection of persons and property, a legal system that helps with the enforcement of contacts, and a stable monetary regime, there is no reason to believe that it will promote economic growth. 

This has been (and still is) the case in many less developed countries. Governments—including those that are small—can be expected to register slow or even negative rates of economic growth when these core functions are poorly performed. Unless proper adjustment is made for how well the core functions are performed, the empirical relationship between size of government and economic growth is likely to be a loose one, particularly when the analysis involves a diverse set of economies.

A fundamental model of economic growth developed by Robert Solow (1956) suggests that while some economies may be wealthier than others, in the long run they should all grow at the same rate. 

More recent work has suggested that not only do economies actually have substantially different growth rates over lengthy time periods (Quah 1996; Gwartney and Lawson 1997), there are also good theoretical reasons for believing that countries can maintain the different rates (Lucas 1988; Romer 1990). 

This issue is important because if long-run growth rates across countries are all the same (or approximately the same), the long-term consequences of economic policies that impede growth are less severe. 

Government  expenditures and  economic  growth in the  United  States:

Gwartney et al  (1998) illustrated  this growth in government expenditures in the United States, and showed that the increase in government expenditures is primarily due to the growth of transfers and subsidies, rather than in the core areas of government.. 

In the 1960s government expenditures at all levels of government averaged 29.9 percent of GDP, and increased to 32.8 percent of GDP in the 1970s, 34.7 percent of GDP in the 1980s, and 35.3 percent of GDP in the 1990s. As a share of GDP, transfers and subsidies have more than doubled since the 1960s. 

They have risen from 6.4 percent of GDP in the 1960s to 13.5 percent of GDP during the 1990s. Thus, transfers and subsidies consumed an additional 7.1 percent of GDP in the 1990s than during the 1960s. The share of GDP devoted to total government expenditures rose by 5.4 percent over that same period (and 6.2 percent between 1960 and 1996). This expansion in the size of the transfer sector is likely to reduce economic growth. 

Transfers and subsidies that enlarge the size of government will require higher tax rates, which will reduce productive incentives. Compared to expenditures in core areas, additional government expenditures on transfers will exert little positive impact on growth. Transfers and subsidies also bring with them the problem of rent seeking. 

Gwartney et al  (1998) found that as investment has fallen over the four decades from the 1960s to the 1990s, the growth in output per hour has also fallen. In turn, the slowdown in productivity has reduced the growth rate of real GDP during each of the last three decades(see Gwartney et al,  1998). 

The story told by Gwartney et al  (1998)   is that as government has grown, it has crowded out investment which has resulted in declining productivity growth and a slowdown in the growth rate of real GDP. Larger government leads to less economic growth.

Evidence from the OECD Countries:

Compared to most other countries around the world, the institutional arrangements and income levels of the 23 long-standing OECD members are relatively similar. Politically, all OECD countries are stable democracies. Their legal structures generally reflect a commitment to the rule of law. Monetary arrangements have been stable enough to avoid hyperinflation during the post World War II era. 

In the area of international trade, OECD members have been at the forefront of those promoting more liberal trade policies within the framework of GATT and the World Trade Organization. Gwartney et al  (1998) presented data on the average year-to-year growth rate of GDP according to the size of government. 

As illustrated, total government expenditures summed to less than 25 percent of GDP in seven OECD countries in 1960. In total, there were 81 cases during 1960- 1996 where a nation had government expenditures less than 25 percent of GDP. Countries in this category averaged a GDP growth rate of 6.6 percent during these years. 

When the size of government was between 25 percent and 30 percent of GDP during a year, the average growth rate fell to 4.7 percent. 

The year-to-year growth declined to 3.8 percent when government expenditures consumed between 30 percent and 40 percent of GDP. Still larger government was associated with still lower rates of growth.

Japan did register very high growth rates for several decades. But even here there is a revealing story (Gwartney et al  (1998). At the beginning of the 1960s, the total expenditures of the Japanese government were only 17.5 percent of GDP and they averaged only 22.0 percent of GDP during the decade. 

With that environment, the Japanese economy registered an average annual growth rate of 10.6 percent in the 1960s. During the 1960s the Japanese economy fits the small government, high growth mold. 

Over the next three decades, the Japanese government grew steadily; by 1996 government spending had soared to 36.9 percent of GDP. 

At the same time, Japan's growth rate moved in the opposite direction, falling to 5.4 percent in the 1970s, 4.8 percent in the 1980s and sagging to 2.2 percent in the 1990s. As in United States, the growth of government in Japan has been associated with a slowdown in the rate of economic growth. 

(To be continued)


Jamaluddin Ahmed is General Secretary, Bangladesh Economic Association and Chairman, Janata Bank