The tide of big governments is receding

It is a fact that no society in history has ever secured a high level of economic affluence without a government. Where governments did not exist, anarchy reigned and little wealth was accumulated by productive economic activities. After governments took hold, the rule of law and the establishment of private property rights often contributed importantly to the economic development of the Western countries and other societies as well. Having a government is a necessity though by no means a sufficient condition for prosperity. It is also a fact, however, that where governments monopolise the allocation of resources and other economic decisions, societies are not successful in attaining relatively high levels of economic affluence. Economic progress is limited when governments constitute zero per cent of the economy and when it is at or near 100 per cent as well. The experience of the former Soviet Union is revealing, as was the comparison of East with West Germany during the Cold War era or of North Korea with South Korea today.
Growth in governments can also give rise to a drive in search for greater efficiencies on the part of reform-oriented politicians, making government growth more sustainable and increasing its efficiency. Classical liberals have traditionally been concerned with growth in the size of governments because of its potentially adverse implications for economic efficiency and living standards. They also recognise that growth in governments can weaken the rule of law and undermine the voluntary relationships that constitute civil society. The size of government as a share of the economy has been on a rising trend since the glorious Revolution of 1688-89, which established Britain as a modern constitutional democracy.
PARADIGM SHIFT:  There are numerous signs that the tide of big governments is receding. Interest is growing in high compliance costs of government. Osborne and Gaebler's book Reinventing Government (1992) suggests that governments are trying to increase the efficiency of public spending. In his 1996 State of the Union Address, US President Bill Clinton announced that the 'era of big government is over'. In the late 1990s, there were talks and even some action, in the United Kingdom, the United States, Australia and New Zealand on replacing welfare handouts with 'workfare'. The principal reason for this disillusionment with big governments is that if it grows beyond a certain point, the public sector reduces welfare rather than increasing it.
WHY DO GOVERNMENT EXPENDITURES AFFECT ECONOMIC GROWTH: Governments can enhance growth through efficient provision of infrastructure. In addition, there are a few goods-economists call them 'public goods'-that markets may find troublesome to provide because their nature makes it difficult (or costly) to establish a close link between payment for and receipt of such goods. Roads and national defence fall into this category. The government provision of such goods might also promote economic growth. However, as the government continues to grow and more and more resources are allocated by political forces rather than market, three major factors suggest that the beneficial effects on economic growth will wane and eventually become negative. First, the higher taxes and/or additional borrowing required to finance government expenditures exert a negative effect on the economy. Like taxes, borrowing will crowd out private investment and it will also lead to higher future taxes. Thus, even if the productivity of government expenditures did not decline, the disincentive effects of taxation and borrowing, as resources are shifted from the private sector to the public sector, would exert a negative impact on economic growth. Second, as the government grows relative to the market sector, diminishing returns will be confronted.
SIZE OF GOVERNMENT AND ECONOMIC GROWTH:  Gwartney et al  (1998) illustrated the relationship between size of government and economic growth, assuming that governments undertake activities based on their rate of return. As the government continues to grow as a share of the economy, expenditures are channeled into less productive and later to counterproductive activities, causing the rate of economic growth to diminish and eventually decline. Small government by itself is not an asset. When a small government fails to focus on and efficiently provide core functions such as protection of persons and property, a legal system that helps with the enforcement of contacts, and a stable monetary regime, there is no reason to believe that it will promote economic growth. Governments-including those that are small-can be expected to register slow or even negative rates of economic growth when these core functions are poorly performed. A fundamental model of economic growth developed by Robert Solow (1956) suggests that while some economies may be wealthier than others, in the long run they should all grow at the same rate.
EXPENDITURES AND GROWTH IN THE US: Gwartney illustrated this growth in government expenditures in the United States, and showed that the increase in government expenditures is primarily due to the growth of transfers and subsidies rather than in the core areas of government. He found that as investment has fallen over the four decades from the 1960s to the 1990s, the growth in output per hour has also fallen. In turn, the slowdown in productivity has reduced the growth rate of real GDP during each of the last three decades. The story told by Gwartney is that as the government has grown, it has crowded out investment which has resulted in declining productivity growth and a slowdown in the growth rate of real GDP. Larger government leads to less economic growth.
EXPERIENCES FROM OECD COUNTRIES: Total government expenditures amounted to less than 25 per cent of GDP in seven OECD countries in 1960. In total, there were 81 cases during 1960-1996 period where a nation had government expenditures less than 25 per cent of GDP. Countries in this category averaged a GDP growth rate of 6.6 per cent during these years. When the size of government was between 25 per cent and 30 per cent of GDP during a year, the average growth rate fell to 4.7 per cent. The year-to-year growth declined to 3.8 per cent when government expenditures consumed between 30 per cent and 40 per cent of GDP. Still larger government was associated with still lower rates of growth. Japan did register very high growth rates for several decades. But even here there is a revealing story that at the beginning of the 1960s, the total expenditures of the Japanese government were only 17.5 per cent of GDP and they averaged only 22.0 per cent during the decade registering growth rate of 10.6 per cent in the 1960s. Over the next three decades, the Japanese government grew steadily; by 1996 government spending had soared to 36.9 per cent of GDP and growth rate moved in the opposite direction, falling to 5.4 per cent in the 1970s, 4.8 per cent in the 1980s and sagging to 2.2 per cent in the 1990s.
SHRINKING GOVERNMENT: There are three instances of a substantial decline in government expenditures as a share of the economy among OECD countries during the 1960-96 period. The first case is that of Ireland, which saw government expenditures as a share of GDP grew from 28 per cent in 1960 to 52.3 per cent in 1986. This situation was reversed during the 1987-96 period. As a share of GDP, government expenditures declined from the 52.3 per cent level of 1986 to 37.7 per cent in 1996, a reduction of 14.6 percentage points. From 1960 to 1977, government expenditures increased from 28 per cent to 43.7 per cent, and Ireland's real GDP growth rate was 4.3 per cent. It declined to 3.4 per cent during 1977-86 period, as the government further expanded to 52.3 per cent of GDP. During the recent decade of shrinking government, the annual growth rate in Ireland's real GDP rose to 5.4 per cent. As government expenditures shrank in Ireland, its economic growth increased.
The experience of New Zealand is also revealing. Between 1974 and 1992, New Zealand's government expenditures as a share of GDP rose from 34.1 per cent to 48.4 per cent. Its average growth rate during this period was 1.2 per cent. Recently New Zealand began moving in the opposite direction. The percentage of GDP devoted to government expenditures was reduced from 48.4 per cent in 1992 to 42.3 per cent in 1996, a reduction of 6.1 percentage points. Compared to the earlier period, New Zealand's real GDP growth has increased by more than two percentage points to 3.9 per cent.
Jamaluddin Ahmed, PhD, FCA is the General Secretary of Bangladesh Economic Association. In professional life, he is Chairman, Emerging Credit Rating Limited.
 [email protected]