Big government doesn’t kill growth???

I take issue with this article published in Macrobusiness:

Sorry Coalition, “big Government” doesn’t kill growth

By Leith van Onselen

During the Federal Election campaign, Labor’s shadow treasurer, Chris Bowen, confirmed that the overall tax burden would hit 24.8% GDP by 2026-27 under Labor, up from 23.5% in 2019-20:

Mr Bowen told The Australian Financial Review that his number was lower than the 25.7 per cent of GDP that Treasurer Scott Morrison claimed Labor would deliver, but higher than the Coalition’s ceiling of 23.9 per cent.

Mr Bowen said the alternative would be spending cuts to essential services.

“Let me be clear: tax-to-GDP will be higher over the medium term under both the Coalition and Labor government. Either that, or the Coalition will continue to deliver more savage cuts to Medicare and education,” he said.

The admission was immediately seized upon by Treasurer Scott Morrison, who claimed that a higher tax burden would damage the Australian economy’s growth:

“Labor might want to think you can have a tax-to-GDP ratio approaching 26 per cent and that will have no impact on the Australian economy. They are kidding themselves…”

The Coalition’s 23.9% of GDP ceiling on tax is based on the National Commission of Audit’s recommendation that taxation revenue as a share of GDP should be capped at 24%.

The assumption that higher tax equals less economic growth is a popular one among conservatives, not just in Australia.

However, four American academics have published an important new book, entitled “How Big Should our Government Be?”, which examines in detail the vexed issue of government size and growth.

According to the Washington Post, which provides a good summary of the book, there is actually a positive correlation between the size of government and economic growth per capita:

ScreenHunter_14443 Aug. 10 08.40

Using data on 12 advanced economies from 1870, the authors of the book conclude with the following:

“In the century and a half since then, government expenditures as a share of GDP have risen sharply in these countries. Yet they didn’t experience a slowdown in their long-run economic growth rates. The fact that economic growth has been so stable over this lengthy period, despite huge increases in the size of government, suggests that government size probably has had little or no impact on growth.”

The authors also note that “A national instinct that small government is always better than large government is grounded not in facts but rather in ideology and politics,” and that the evidence “shows that more government can lead to greater security, enhanced opportunity and a fairer sharing of national wealth.”

In particularly, the authors call for more investment in infrastructure, education, as well as proper safety nets for the unemployed and those that get sick.

The Turnbull Government should take note as it considers taking an axe to Australia’s public services.

MY REBUTTAL:

Let me start by saying that I am not in favor of austerity as a response to a major economic slow-down. If anything that will exacerbate unemployment and prolong the contraction. Instead I advocate major infrastructure programs to stimulate the economy. But with two caveats: (1) investments must generate a market-related return on investment; and (2) there must be strong involvement from the private sector. Investment in assets that do not generate direct revenue leaves future taxpayers with a pile of debt and no income (or saleable assets) that can service (or repay) it. Involvement of the private sector should be structured to ensure that the benchmark of market-related returns is not superseded by projects selected to win the most votes. Also, the private sector should have skin in the game to restrict cost blowouts. They are not immune to cost blowouts but are not in the same league as big government.

I also believe that weak government will harm an economy. We need strong regulators, rule of law, police and military to ensure stability. Also spending on education and science to foster growth.

But the article by Jared Bernstein in the Washington Post typifies the kind of rubbish pedaled to voters around election time. And seems to have been swallowed hook-line-and-sinker by the author of the MB article.

Where do I start?
First, the fact that a book by four unnamed academics is cited as proof in itself should tell us how much credibility to attach to their claims.

Second, the author mentions that there is “a positive correlation between the size of government and economic growth per capita…”. A positive correlation is any correlation coefficient greater than zero. The highest correlation is a value of 1.0 which represents a perfect fit. No correlation coefficient is provided in either article and judging from the graph I would assume it is closer to zero than 1, meaning there is only a vague correlation. If you ignore the line drawn on graph, the data looks randomly scattered with no clear trend.

Also the author overlooks that he is only dealing with a sample of 12 countries, which again would give a low level of confidence in any result.

Further, in the WP article the author concedes that correlation is not equal to causation: “That positive slope in the figure on the left above could easily be a function of reverse causality: As economies grow, their citizens demand more from them.” This is omitted in the MB report.

Then the study of data for the 12 economies from 1870 up top the present is used to argue that growth in government expenditures does not hinder GDP growth. I would be surprised if the data didn’t show growth in government across all countries as it spans the era from horse-drawn carts up to the area of modern jets and space travel. From the country GP with a stethoscope to modern nuclear medicine and MRIs. From slate and chalk to super-computers and digital technology. Of course the demand for infrastructure has grown exponentially over that time. To argue otherwise would be stupid.

But that is not an argument in favor of a welfare state or increased government expenditure. In fact, most of those advances in technology were driven by private individuals and not by government.

Finally, I will use another graph from “How big should our government be,” Bakija et al in the same Washington Post article to argue the case for lean government (as opposed to small government circa 1870):

Tax Revenue as Percentage of GDP and GDP Growth

The graph shows that tax revenues as a percentage of GDP have steadily declined, since the late 1990s, for every country except France. Why has this occurred in even model welfare states like Sweden and, to a lesser extent, Canada? Simply because they reached “peak welfare” in the 1990s and realized that the only way to revive GDP growth was to reduce the role of government in the economy.

Tax Revenue as Percentage of GDP

The only one who hasn’t accepted the evidence is France. Which may well be contributing to their poor economic performance.

3 thoughts on “Big government doesn’t kill growth???

  1. […] Rising public debt is only sustainable if invested in productive infrastructure that yields market-related returns. Not in sports stadiums and public libraries. Difficult as this may be to achieve, with politicians poor history of selecting projects based on their ability to garner votes rather than economic criteria, it is our best bet. What is required is bi-partisan selection of projects and of private partners to construct and maintain the infrastructure. And private partners with enough skin in the game, to enforce market discipline. I have discussed this at length in earlier posts. […]

  2. Jay Toner says:

    Dear Colin..your 2 caveatal conditionals in your rebuttal are,in my opinion nonsensical..1) – There must be strong market returns on investment…sorry Colin..but this is pie in the sky economics..government infrastructure spending has an epic poor record ! Because, the accountability of the treasury is in fact fractured (I’m being kind here)…government departments have for so long done business in the overpaying for contracts ( very much opposed to private enterprise)..if you fail to believe this..you are living in lalaland….government contracts for goods and services is 100% more expensive than the private sector…oh yes…governments can make all the promises they like about accreditation and non corruptive work practices….the fact remains…with the type of easy money infrastructive contracts you are talking about..the win contract price is a sham….the contractors are well versed in attractive governmental quotative structures and long standing principles…quote to get the contract…then tell said government,after works have started..that in fact..price submitted is inadequate…and said company will require a topup soas not to offload workforce taken on for project…typical government response is…ok.. you have the topup…but you must take on another 100 workers…and on it goes…that’s the way it works and it is foolhardy to believe otherwise…so your point B is redundant….love Keynesians…as Margret Thatcher said…’The problem with socialism is that sooner or later you run out of other peoples money’ ….and that all means your point ‘B’ is redundant ! Cheers..Jay 🙂

    • ColinTwiggs says:

      Jay, I am happy to debate infrastructure spending at length as I think it is of vital importance to Australia’s economy.

      I advocate major infrastructure programs to stimulate the economy but with two caveats:

      …(1) investments must generate a market-related return on investment; and (2) there must be strong involvement from the private sector. Investment in assets that do not generate direct revenue leaves future taxpayers with a pile of debt and no income (or saleable assets) that can service (or repay) it. Involvement of the private sector should be structured to ensure that the benchmark of market-related returns is not superseded by projects selected to win the most votes. Also, the private sector should have skin in the game to restrict cost blowouts. They are not immune to cost blowouts but are not in the same league as big government.

      We seem to share similar concerns. Government tender processes are ineffective and political decisions take priority over economic decisions. With the best will in the world, government-selected, funded and supervised projects are unlikely to generate market-related returns. That is where private sector involvement is critical ….. in project selection, appointments, contract awards, funding and especially supervision. Many infrastructure projects are simply too big, legally-complex and long-term to be driven by the private sector and require government involvement. Sydney Harbour Bridge and Snowy Mountain Hydro are two of the best examples. But the private sector must have skin in the game else costs are likely to balloon in much the manner you described.

      Government involvement has distinct advantages. It can pass laws, expropriate land, use its tax base to achieve lower cost of borrowing than private sector projects, and raise revenue through value capture.

      Private sector involvement is critical to minimize political interference in project selection and supervision. It also offers specialised skills in terms of contract negotiation and supervision. However, their primary goal is profit maximization. If you hand them a monopoly, they will maximize profits not public welfare.

      The challenge is to create an effective partnership that capitalizes on the strengths of each party while avoiding their weaknesses. Complex structures seldom work and generate unintended conflicts. Separating ownership and operations has generated problems for the French Rail system:

      Moves are under way to merge the two entities that separate ownership of the infrastructure (RFF) from the operator (SNCF). SNCF Networks president Jacques Rapoport: “With the separate companies of RFF and SNCF, we had opposing interests,” says Rapoport. This was most acute in the way that responsibility for the network and its maintenance was shared between the two organisations. Rapoport says it was very difficult to modernise the conventional network efficiently, with the result that it has become degraded after 17 years under the former regime. “It is a huge task to modernise the network and we need to integrate the organisation to achieve it,” Rapoport points out. “You can’t provide a good service with an old network and old equipment.”

      Solutions are likely to vary, but I see a public company with state and federal governments owning more than 50% of the equity and guaranteeing long-term debt in exchange for security over the assets. The balance of equity would be raised by public tender/private placement. The board of directors, who appoint management and award contracts, in turn should be appointed by shareholders, with government representatives selected through a bi-partisan process. Equity raised must be sufficient to ensure that default is unlikely.

      An independent authority to select and plan future projects on a national scale should also be bi-partisan.

      I should add that you still need pricing supervision by a regulator. Both fixed-price and cost-plus revenue models have their problems. More work needs to be done in this area.

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