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Government and economic growth: Does size matter?

2.3  Why do governments differ in size?

As well as looking at the impact of size of government on economic growth, there is also a branch of literature focused on the drivers of differences in size across countries. The size of the public sector ultimately reflects political choices and different socio-cultural factors across countries. However, economic theory also provides some reasons for differences in the size of governments over time and across countries (Barrios and Schaechter, 2008):

  • Governments may be bigger in wealthier countries as government expenditure tends to grow faster than the economy for both demand and supply reasons. On the demand side, the appetite for public goods expands as nations get wealthier, while at the same time the ability to raise revenues rises (known as Wagner's Law). On the supply side, as highlighted in section 2.2, public sector wages tend to increase more strongly than public sector productivity (known as Baumol's disease), increasing the share of government expenditure in nominal GDP for a given bundle of government goods and services.
  • Technological change has an ambiguous impact on the size of government. Some technological developments increase the scope for government activities, such as the traditional example of the invention of street lighting and the more topical example of health care (see section 2.2). However, some technological developments may erode the need for the public sector to be involved in the delivery of some services or create greater scope for private sector involvement in public services.
  • Political economy theory argues that the pressures of re-election lead to a bias toward higher deficits and bigger public sectors. The larger the number of parties forming the government and the higher the frequency of elections, the stronger this tendency. It also seems more prevalent in cases of proportional rather than majority-based election systems (for example, see Persson and Tabellini, 1999, 2002).

In addition, smaller countries tend to have large governments as a share of GDP, while more open economy governments also tend to be bigger. However, it is not clear whether openness in itself leads to larger governments or whether small countries tend to have both larger governments and be more open (Alesina and Wacziarg, 1998). Rodrik (1996) argues that openness increases vulnerability to exogenous shocks and, therefore, open economies need a larger government to play a stabilising role. He finds that measures of the riskiness around openness, such as measures of export diversification and the variability of the terms of trade, do play a key role in determining government size.

Despite this correlation, there may actually be a stronger case for a smaller government in a small open economy, like New Zealand, given the upward pressure of government expenditure on the exchange rate (see Box 1 and Treasury, 2010a). As government tends to consume more non-tradeable than tradeable goods and services, it increases the relative price of non-tradeables and, therefore, increases the real exchange rate facing export industries (see Ricci et al, 2008 and Galstyan and Lane, 2009 for some empirical evidence). Therefore, managing growth in government expenditure could be a key dimension to enabling the rebalancing of growth towards investment and exports.

There may also be issues around the ‘race to the bottom' in a globalizing world where the increasing mobility of capital and skilled workers puts pressure on governments to offer a competitive tax environment (Tanzi and Schuknecht, 1997). This is potentially true for all countries but may be particularly relevant for small, open economies, which depend upon foreign investment and face concerns over the migration of skilled workers. However, investors may also be attracted by ‘productive' expenditure that, for example, improves the quality of infrastructure or the skills of the labour force. Therefore, the same balancing act between taxation and productive expenditure may hold in an international context.

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