Question: Is large government spending bad for economic growth?

Readers Question: Is large government spending bad for economic growth? to what extent does empirical evidence support this assertion?

How Government Spending Might Lead to Lower Economic Growth

• Higher spending leads to higher taxes. Higher income taxes may discourage people from working. High corporation tax might discourage firms from setting up in that country. (e.g. Ireland has attracted significant inward investment due to low corporation tax)
• Generous government welfare benefits may discourage people from taking a job, creating voluntary unemployment.
• Arguably government spending tends to be more inefficient than private sector spending. There tends to be greater bureaucracy and government civil servants don’t have the same profit motive as the private sector. (This leads to poor decisions like Concorde, Millennium Dome)
• Government spending decisions may be taken for political rather than economic motives (e.g. subsidising a failing firm to prevent politically unpopular job losses.)
• Government Borrowing to finance higher spending can push up interest rates and cause financial crowding out
• Higher share of government spending leads to lower share for private sector.

How Government Spending Might Increase Economic Growth

• Government spending can overcome market failure. e.g. spending on education and infrastructure can help increase productive capacity of the economy in a way the private sector never would. In the private sector, there would be under-provision of public goods and merit goods.
• In a recession, expansionary fiscal policy (government spending financed by borrowing or printing money) can help the economy to recover and lead to faster rates of growth.
• Higher Taxes don’t necessarily create disincentives to work. See: Supply side economics pros and cons
• Some major OECD countries have close to 50% of GDP spent by government (Sweden 52%, France 52%), yet there growth rates are comparable to countries  have much lower % of GDP spent by government (Japan 37%, United States 38%)

List of Government Spending and Economic Growth.

 Evaluation Points

• There are many different factors that can cause economic growth apart from the size of government. It is difficult to isolate one factor like government spending and link to growth rates.
• Conflicting evidence.
• Cause and Effect. Just because a country with the small economy has fast growth it doesn’t mean that the small size is the cause of the faster growth. Perhaps countries with slower growth need more government intervention to overcome market failure. China has a very rapid rate of economic growth because there is much spare capacity and potential for efficiency savings brought about privatisation (shifting industries into private sector)
• It depends on the type of government spending. E.g Greece and Germany have similar share of GDP spent by government, but Germany has better track record of spending government money in an efficient way.
• The Soviet Union experienced very high growth rates in the 1930s. This was despite it being a Communist economy, with nearly 100% state intervention. Yet, in the 1980s, the Soviet Union growth rates slowed down considerably.
• Economic Growth isn’t the only target. We need to consider impact on equality.

Countries with highest levels of government spending as % of GDP have amongst highest living standards.

Related

•  Rahn curve