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Government and economic growth: Does size matter?

2  Why does size matter?

Economic theory suggests that a large government may undermine economic growth through the cost of financing expenditure and differences in the rate of productivity growth between the public and private sector. This theoretical section, and the following section on empirical evidence, focuses on these ‘direct' mechanisms through which government size can impact on growth. While not covered in this paper, we recognise that there are also a number of more ‘indirect' impacts. These may work at the ‘micro' level, such as the impact of benefits on incentives to work, or at the ‘macro' level, such as biasing growth away from the export to the domestic sector (see, for example, Treasury, 2010a).

This paper also largely draws on theory and evidence from the endogenous growth literature. In exogenous growth models, fiscal policy cannot affect long-term economic growth as it is driven by population growth and unspecified technological progress. However, more recent endogenous growth models shows that fiscal policy can have persistent impacts on economic growth by influencing investment and innovation (see for example, the early contributions of King and Rebelo, 1990; Lucas, 1990 and Barro, 1990).

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