Government and economic growth: Does size matter? (TP11/01)

Abstract

The size and structure of the state sector plays an important role in overall economic performance, with general or total government expenditure accounting for more than 40% of GDP. This paper explores the theory and evidence around the impact on economic growth of the level and composition of government expenditure and revenue. It focuses on the implications for potential economic growth over the long term arising from the size and structure of government, rather than its role in smoothing economic cycles or the economic impact of running government deficits and building up debt. It also has a relatively narrow focus on the inter-relationship between fiscal policy and economic growth, rather than broader measures of government size or wider government objectives.

Theory and evidence suggest that it is possible for large governments to undermine 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. However, much expenditure contributes to economic growth and some taxes are more damaging for economic growth than others. Therefore, the impact on economic growth of the level of expenditure will depend on the type and quality of expenditure and the mix of taxes used to finance it.

Given the importance of the type and quality of expenditure, it is difficult to draw firm conclusions about the scope for changes in the ‘size' of New Zealand's government from the type of high-level analysis in this paper. However, it concludes that there appears to be scope to lower the tax take as a share of the economy or, alternatively, to better position the Crown to deal with long-term expenditure pressures without increasing the tax take. This could be achieved by reducing or limiting growth in expenditures that do not measurably contribute to raising the economy's potential economic growth rate.

The economic benefits of lower taxes need to be balanced against other Government objectives. However, expenditure programmes need to meet a high burden of proof in demonstrating that their contribution to government priorities outweighs the cost of financing them.

Acknowledgements

The authors would like to thank Norman Gemmell, Jeremy Couchman and Matthew Gibbons for their contributions to this paper. Douglas Sutherland and Peter Hoeller at the OECD and Mario Di Maio at the IMF provided valuable external review and insights. Any errors are the responsibility of the authors and not the reviewers.

Disclaimer

This paper reflects the current views, conclusions and recommendations of the New Zealand Treasury. It is intended to contribute the Treasury’s views to current public policy debates.

Access to data used in this study was provided by Statistics New Zealand under conditions designed to give effect to the security and confidentiality provisions of the Statistics Act 1975. The results presented in this study are the work of the New Zealand Treasury and not Statistics New Zealand.