November 23, 2014 11:00am by Marcus Vinicius

The optimum size of government

Introduction

Earlier this year the Fraser Institute from Canada who research and analyze public policy issues published an article about the optimum size of government. The article cites the research of Canadian economist Livio Di Matteo who has written a research paper on this topic (see end of this post for the web link).

The key question is at what point does increasing government spending actually hinder economic growth and progress on complex social issues?

Over the years, economists have measured the effect of the size of government on economic growth and social outcomes such as life expectancy, infant mortality, homicide rates, educational attainment, and student reading proficiency.

The source data used by Di Matteo was from the OECD.

Findings

The key findings were.

Di Matteo’s analysis confirms other work showing a positive return to economic growth and social progress when governments focus their spending on basic, needed services like the protection of property. But his findings also demonstrate that a tipping point exists at which more government hinders economic growth and fails to contribute to social progress in a meaningful way.

The big takeaway in Di Matteo’s paper is that government works best (ie. economic growth) when government spending is 26% of GDP. For societal programs the optimum figure is 30-35%. Beyond this point the benefits of unchecked spending by governments on social programmes show less and less benefits. Di Matteo (page 86) cites increased government spending on programmes to reduce infant mortality rates at birth as a typical example.

US Federal Government spending was according to the OECD in 2012 40% of GDP. Also bear in mind the huge US pubic debt ($US18 trillion) is too high. By comparison as of 2014 New Zealand government spending is just under 36% of GDP.

According to the Fraser Institute Canada is an example of what can be achieved by reducing the size of government.

The federal and many provincial governments took sweeping action to cut spending and reform programs. This led to a major structural change in the government’s involvement in the Canadian economy. The Canadian reforms produced considerable fiscal savings, reduced the size and scope of government, created room for important tax reforms, and ultimately helped usher in a period of sustained economic growth and job creation.

This final point is worth emphasizing: Canada’s total government spending as a share of GDP fell from a peak of 53 percent in 1992 to 39 percent in 2007, and despite this more than one-quarter decline in the size of government, the economy grew, the job market expanded, and poverty rates fell dramatically.

It is of note that reducing government spending didn’t increase poverty rates in fact the opposite happened.

[UPDATE]: The Fraser Institute article mentions poverty in Canada. Note the article was written in March 2014 and as clearly stated are not discussing the most recent data and is talking about a specific period.

Conclusions

There are of course many debating points here but the challenge for economists and politicians is to better understand the specific effects of state spending. The mind-set should be that government spending be carefully monitored and not expanded unless there are concrete reasons to do so.