Hey big spenders, upsizing our government only shrinks its value

The size of government in Australia is 37 per cent of national income, taking into account all spending at federal, state and local government levels. While below that of many European countries, Australia's government spending remains well above that of its Asian trading partners.

At the beginning of the 20th century, public spending in industrialised countries was, believe it or not, on average only about 10 per cent of national income. It subsequently grew quickly because of the two world wars and the Depression. After ratcheting up during each of these major crises, government's share of national income failed to return to earlier, lower levels.

Historically, public spending accelerated fastest in Western economies in the 1960s and 70s with unprecedented expansion of the welfare state and spending on education, health and age pensions. Meanwhile, from the 70s numerous Asian economies - notably Japan, Hong Kong, Taiwan, Singapore and South Korea - reached advanced economy income levels yet, interestingly, the size of their government sectors remained significantly below those of Western economies.

International Monetary Fund data shows there is now major variation in the size of government among advanced and emerging economies. Contrast, for instance, government size in France at about 57 per cent of national income at the top of the advanced economy league, with China's 32 per cent, and Singapore's 19 per cent.

Why government grows, and how its size affects the broader economy, are important questions that have attracted surprisingly ­little attention as topics for economic research. What, for instance, does economics suggest is the optimal level of public spending as a share of national income?

To answer this, it is necessary to understand that certain forms of government spending are essential for economic growth up to some point, beyond which, in various other forms, such as industry assistance, it detracts from growth.

If government spending is too low, for instance on the legal system that ensures property rights and the rule of law, or on basic ­education and healthcare, essential infrastructure, and income support for the deserving poor, economic growth is less than it could be. This is obviously the case in many developing economies.

Yet, beyond a certain level of public spending, the size of government adversely affects economic growth because of increased inefficiencies and disincentives arising from the higher income taxes needed to pay for it. Higher public spending also crowds out private investment via higher interest rates, and net exports via an overvalued ­exchange rate.

And if higher public spending is debt financed, greater economic uncertainty arising from increasing public debt worsens business and household confidence, thereby further retarding private investment and future economic growth.

In other words, when government expenditure exceeds a certain percentage of GDP, dim­in­ish­ing macro-economic returns set in. This suggests a trade-off between government size and economic growth beyond some optimal level.

In a paper,The Optimal Size of Government in Australia, co-authored with Julian Pearce and Shyama Ratnasiri and presented at the Annual Conference of Economists in Canberra last week, we estimate what level of government spending would deliver the highest growth rate for the economy based on data from recent decades. Our preliminary estimates show it is 31 per cent, close to the average of our Asian trading partners, yet well below the present 37 per cent share in Australia.

Since increased spending on education, health, pensions and social welfare has contributed most to the expansion of public spending in advanced economies in the postwar era, it is often assumed that even higher shares of government would further increase economic wellbeing.

Yet a broad socio-economic indicator, the Human Development Index published by the UN Development Program, suggests the opposite for advanced economies.

The HDI was devised to assess economic wellbeing in a wider sense than national income per capita. To measure the standard of living, it combines a health dimension based on life expectancy, an education dimension based on years of schooling, and national income per head. Several countries ranked in the top 30 on this broad measure, notably Switzerland, Singapore, Hong Kong, South Korea and Ireland, all with significantly lower government spending than Australia, outperform many European countries with higher government spending shares, notably France, Belgium, Finland, Austria, Slovenia, Italy, Spain, Czech Republic and Greece.

Australia enjoys a high HDI ranking, tied at No 2 with Switzerland. Meanwhile, in the World Economic Forum's latest international competitiveness rankings, a measure of overall economic efficiency, quite distinct from the HDI, Switzerland is No 1 while Australia languishes at No 21, just ahead of France. This suggests considerable scope for reducing the size of Australia's government to improve competitiveness and hence future economic growth, without necessarily harming the standard of living.