The Treasury

Global Navigation

Personal tools

2.4  Summary

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.

First, there is strong theoretical support for the proposition that high levels of government expenditure can be detrimental to economic growth. Though some types of expenditure enhance economic growth, at some point the economic costs of raising taxes to fund that expenditure will outweigh its benefits. This suggests that there is an optimal level of government expenditure, from an economic growth perspective, which balances the economic benefits of expenditure against the economic cost of taxes. However, the economic growth impacts will depend on the tax and expenditure mix, as well as the level of expenditure. Though government can be too large even when all of its expenditures are growth enhancing, a decline in taxes will have a bigger boost to economic growth if financed by reductions in ‘non-productive' spending.

Secondly, if government is providing a large share of the goods and services in the economy, it will tend to drag down economic growth if it has lower productivity than the private sector. The public sector may be generally less productive than the private sector due to the inherent nature of public goods and services (Baumol's disease) and/or the existence of stronger incentives for the private sector to be efficient.

Overall, theory suggests that both the size and mix of government matters for economic growth. Whether it matters more for small and open economies, like New Zealand, is not conclusive. Governments do tend to absorb a higher share of the economy in small, open economies. However, enabling exports, and attracting or retaining investment in a globalising world, suggest potential benefits from a relatively smaller government.

Page top