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Government and economic growth: Does size matter?

1  Introduction

New Zealand's economic performance over the last six decades has been poor compared with most other Organisation for Economic Cooperation and Development (OECD) countries. While New Zealand has grown at around the average of OECD countries since the 1990s, we have not been able to regain the ground lost in earlier decades, leaving us with a relatively low level of Gross Domestic Product (GDP) per capita compared with a majority of OECD countries.

Some commentators have suggested that New Zealand could lift its growth performance by reducing the size of its government as a share of the overall economy. This paper summarises the theory and evidence around the impact on economic growth of the level and composition of government expenditure and revenue.

This paper focuses on the longer-term growth impacts of the size and structure of government rather than its role in smoothing economic cycles (stabilisation) or the economic impact of running government deficits and building up debt (sustainability). It also has a relatively narrow focus on the inter-relationship between expenditure and, to a lesser extent, revenue and economic growth. We recognise that expenditure is only one dimension of government size - government also affects economic growth through regulation and ownership interventions - and economic performance is only one dimension of government's objectives. Though economic growth is an important contributor to living standards, it is not the only factor and governments must also consider the distributional impact of their policies. However, understanding the economic impact of expenditure and revenue policies is important in analysing all government expenditure and in understanding the trade-offs that are involved in policies to achieve broader objectives.

Theory and evidence suggest that high levels of government expenditure, as a share of the economy, can be detrimental to economic growth due to the economic costs of raising taxation to finance expenditure. There is strong evidence that taxes reduce economic growth through their negative impact on incentives to work, save and invest. The provision of public services may also drag down growth if public sector productivity is lower than in the private sector. However, both theory and empirical research emphasise that we cannot divorce the economic growth impact of the level of expenditure from the mix of expenditure and revenue. Government has to balance the economic costs of taxation against the benefits of expenditure, much of which contributes to economic growth, such as infrastructure and education spending. The cost of financing expenditure will also depend on the mix and design of taxes, as some taxes are more detrimental to growth than others.

The level and composition of expenditure in New Zealand is in line with OECD averages. However, the share of total government expenditure in GDP has increased significantly over the last five years, driven by increases in central government expenditure. While some of this growth has been in areas that may be supportive of economic growth, more than half of core Crown expenditure is likely to be non-growth enhancing and (until recently) it has been growing at a faster rate than GDP. Reducing these expenditures, and improving the efficiency of government expenditure in general, would help reduce economic imbalances and lift national savings. It would also allow for reductions in growth-distorting taxes, while better positioning the Crown to deal with long-term expenditure pressures without increasing the tax take as a share of GDP.

The benefits of enhancing the growth focus of expenditure must be balanced against other government objectives. However, expenditure programmes and proposals need to meet a high burden of proof that their contribution to government's objectives outweighs the cost of financing them. It may also be possible to reduce the economic cost of financing expenditure by reducing our reliance on the more distortionary tax types, particularly those on personal and corporate income.

Sections 2 and 3 of this paper explore the theory and empirical evidence around the impact on economic growth of size of government. Section 4 analyses the level and mix of expenditure and revenue in New Zealand and section 5 draws preliminary conclusions on the implications for size of government in New Zealand.

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