BOX 2-2

Government Size and Economic Growth

The government’s share of the economy varies widely, even among affluent nations. It has been widely assumed that if taxes are high and used to finance increased social spending, economic growth will slow. Economic theory generally posits that taxes impose a “dead weight” loss on the economy by discouraging productive effort and that the transfer of resources to poor and elderly people prevents their use for more productive purposes. The counter vailing view is that government investments in education, infrastructure, and research and development will contribute to future economic growth.

Because levels of taxation and social spending vary widely from country to country, it is possible to empirically test the two views. In such a study, controlling statistically for other factors—such as the proportion of the population of working age—that might explain international variations in growth rates, Lindert (2003) found no clear relationship. In recent years, GDP grew as fast in countries with high tax-based social spending as in others.

Lindert also tried to determine why countries that tax and transfer one-third of national GDP have grown no more slowly than countries that devote only one-seventh of GDP to social transfers. He concluded that the keys to this puzzle include the following:

  • High-budget welfare states choose a mix of taxes that are more pro-growth than the mix chosen in the United States and other relatively private-market countries of the Organisation for Economic Co-operation and Development (OECD).

  • Universalist welfare states have adopted several policies that create strong incentives for young adults to work and obtain training.

  • Government subsidies to early retirement bring only a tiny reduction in GDP, partly because the more expensive early retirement systems are designed to encourage the least productive employees to retire.

  • Similarly, larger unemployment compensation programs have little effect on GDP because although they lower employment they also may get the least productive workers out of their jobs.

  • Social spending, including education spending, often has a positive effect on GDP, even after weighing the effects of the taxes used to finance it.

Whatever the explanation, it appears that merely increasing the size of government through higher taxes and increased social spending does not necessarily reduce economic growth. Much depends on specific policy choices, such as the structure of the tax system and how social programs are designed.

In most cases, the larger size of other Organisation for Economic Cooperation and Development (OECD) country governments (as a percentage of GDP) reflects more comprehensive systems of publicly financed pension and health insurance programs. The apparently smaller public sector in the United States than in almost all other affluent countries, as measured

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