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OECD Economic Research Finds That Government Spending Harms Growth
By Daniel J. Mitchell of Cato. Excerpts:
"A new working paper
by two economists at the OECD contains some remarkable findings about
the negative impact of government spending on economic performance. If
you’re pressed for time, here’s the key takeaway from their research:
Governments in the OECD spend on average about 40% of GDP
on the provision of public goods, services and transfers. The sheer
size of the public sector has prompted a large amount of research on the
link between the size of government and economic growth. …This paper
investigates empirically the effect of the size and the composition of
public spending on long-term growth… The main findings that emerge from
the analysis are… Larger governments are associated with lower long-term
growth. Larger governments also slowdown the catch-up to the
productivity frontier.
For those who want more information, the working paper is filled with useful information and analysis.
Here’s one of the charts from the study, showing how government spending is allocated in OECD nations.
The report also acknowledges that there’s a lot of preexisting
research showing that government spending hinders economic growth.
There is a vast empirical literature investigating the
relationship between the size of the government and economic growth (see
Slemrod, 1995; Myles 2009; Bergh and Henrekson, 2011 for overviews). A
review by Bergh and Henrekson (2011), based on papers published in peer
reviewed journals after 2000, suggested a negative relationship in OECD
countries. Likewise, a recent OECD study confirmed a negative
relationship between the size of government and GDP growth (Fall and
Fournier, 2015). …the link between the size of government and growth may
vary with the income level and could be hump-shaped (Armey, 1995). A
few studies have found support for the existence of a non-linear
relationship between the size of government and growth (e.g. Vedder and
Gallaway, 1998; Pevcin, 2004; Chen and Lee, 2005).
By the way, the reference to “hump-shaped” means that the OECD is even aware of the Rahn Curve.
The methodology in the paper is not ideal from my perspective. For
all intents and purposes, the economists compare economic performance of
the OECD’s big-government nations with the growth numbers from the
OECD’s not-quite-as-big-government nations. But even with that
limitation, the study generates some powerful results.
…the simulation assumes that in countries where the size
of government is above the average level of countries in the bottom half
of the sample, the government size will gradually converge to this
level (36% of GDP). Similar to the spending mix reforms, this reform is
phased in over 10 years. Such a reduction in the size of the government
could increase long-term GDP by about 10%, with much larger effects in
some countries with currently large or ineffective governments. …a
reduction of the size of government has a positive, but moderate, effect
on the income of the poor. The average disposable income also rises.
However, the rich gain relatively more. Finally, in countries where the
government is less effective (such as Italy) the growth effect dominates
and a moderate reduction of the size of government would have a large
growth effect, so that it would lift all boats.
And here’s a chart showing how much more growth would be possible if
the countries with really-big government downsized their public sectors
to the somewhat-big level.
Even with the methodology limitations I described, these results are
astounding. Potential GDP gains of more than 30 percent for Greece and
Italy. Gains of more than 20 percent for Slovenia, France, and Hungary.
And more than 10 percent for Belgium, Czech Republic, Portugal, and
Poland.
The working paper also looks at the composition of government spending. In other words, just as not all taxes are equally damaging, the same is true for spending programs.
The results from the estimation of the size of the
government and the public spending mix illustrate that public spending
matters for long-term growth…pension and subsidy spending [are] the two
items with a significantly negative effect on growth. As each regression
includes the size of government and one spending share, the estimates
provide the effect of increasing this type of spending while decreasing
spending on other items to keep the spending to GDP ratio unchanged…
larger governments are in several specifications significantly and
negatively associated with long-term growth. This is consistent with the
literature… Larger governments can impede convergence (Table 8, columns
1 and 3), because they are associated with higher taxation that can
discourage business investment including foreign investment and
households to supply labour.
Pensions and subsidies seem to cause the most economic harm.
Reducing the share of pension spending in primary
spending yields sizeable growth gains with no significant adverse effect
on disposable income inequality. This reduction could be achieved by an
increase in the effective retirement age or by cutting the replacement
rate. …Cutting public subsidies boosts growth, as public subsidies…can
distort the allocation of resources and undermine competition.
…Education outcomes depend not only on education spending but also on
the effectiveness of education policies, and the literature suggest the
latter can be more important. Since the seminal work of Coleman (1966), a
broad literature suggests that there is no clear link between education
spending and education outcomes. …policies aimed at increasing
education spending effectiveness can be more appropriate than an
across-the-board rise of education spending. …It may be that, beyond a
certain point, additional spending on investment has adverse effects, if
poorly managed.
For those of you with statistical/econometric knowledge, here’s some relevant data from the study.
And you can match the numbers in Table 6 with these excerpts.
…pension spending reduces growth (Table 6, columns 2, 5, 7
and 10). Increasing the share of pension spending in primary spending
by one percentage point (offset by a reduction in other spending) would
decrease potential GDP by about 2%. …Public spending on subsidies also
reduces growth (Table 6, columns 3, 5, 8 and 10).
…increasing the share
of public subsidies in primary spending by one percentage point would
decrease potential GDP by about 7%.
If you’re not a stats wonk, these two charts may be more helpful and easy to understand.
What jumped out at me is how the normally sensible nation of Switzerland is very bad about subsidies. That’s a policy they obviously need to fix (along with the fact that they also have a wealth tax, which is very uncharacteristic for that country).
But I’m digressing.
Let’s return to the study. One of the interesting things about the
working paper is that it notes that bad fiscal policy can be somewhat
mitigated by having market-oriented policies in other areas, which is a
point I always make when writing about Scandinavian nations.
…countries with a high level of public spending may also
be characterised by features that partly offset the adverse growth
effect of government size. …in Sweden the mix of growth-friendly
structural policies…may have offset the adverse growth effect of a large
government sector.
In other words, the moral of the story is that smaller government is good and free markets are good. Mix the two together and you have best of all worlds.
P.S. Even if the OECD published dozens of quality studies like this one, I would still argue that American taxpayers should no longer be forced to subsidize
the Paris-based bureaucracy. And even if the OECD’s political types
stopped pushing statist policies, I would still have the same view about
ending handouts from American taxpayers. This has nothing to do with
the fact that the bureaucrats once threatened to have me arrested and thrown in a Mexican jail. I simply don’t think taxpayers should fund international bureaucracies.
P.P.S. Other international bureaucracies, including the World Bank and European Central Bank, also have published good research about the negative effect of excessive government spending."
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