TCS Daily


Less Is More

By Constantin Gurdgiev - May 22, 2006 12:00 AM

When it comes to government spending, less is more. Less government spending and involvement in the economy - both in terms of regulatory interference and taxation burden - are associated with higher rates of economic growth, better productivity and more diverse markets for products. This is supported by country-specific evidence and several long-running international indices ranking economic environments.

To discount the benefits of the minimal government, the state-reliant opponents of free markets and personal freedom usually argue that while less government may indeed mean more economic prosperity, smaller governments deliver lower quality of public services. In doing so, supporters of the large welfare state usually point to the alleged lack of public services in the US - a myth hardly supported by reality. The supposedly contrasting social-services-in "rich" European welfare states are similarly mythical.

Two recent studies released by UK and Swiss researchers provide some insight into the overall argument: is smaller government better for a country's non-economic well-being?

First, a group of Swiss and Danish researchers from the WIF Institute of Economic Research in Zurich looked at whether government involvement in the economy is conducive to life satisfaction across 74 countries. The results show that life satisfaction actually decreases with higher government spending. This negative impact of the government is stronger in countries with a left-leaning median voter. It is alleviated by government effectiveness - but, crucially, only in countries where the state sector is already small. In general, a one standard deviation increase in government spending yields a median decrease of 4.42 percent in self-reported satisfaction by the voters, a drop in the degree of economic competition of 4.17 percent and a shift in voter preferences in rightward ideological direction of 4.15-9 percent.

Another comprehensive study released by the Centre for Policy Studies (CPS) in the UK summarized available data from various sources, to show that modern governments that spend less can, indeed, provide better public services, a better standard of living and more equitable incomes than high-spending governments.

The CPS report, titled "Lean, Not Mean: How Small Government Works", uses data from international entities such as the World Trade Organization, International Monetary Fund, World Bank, United Nations and the Organization for Economic Cooperation and Development (OECD), to compare the performance of 10 countries over the last 20 years in 20 different areas of spending and economic performance measures.

With tax revenue accounting for around 37 percent of GDP, Canada, Ireland, New Zealand, Spain and the US were classified as a group of low-spending governments. These countries were contrasted by the countries with tax share of GDP reaching 45 percent - the high-spending category - that included France, Germany, Italy, Portugal and the UK.

The first result of the study is that in lower-spending countries, per-capita income was on average 12 per cent higher than in larger-government countries. More importantly, the gap between the two types of economies is widening - real GDP grew more rapidly in the leaner countries. Leaner governments reduced their tax and other receipts, as a proportion of GDP, by an average of 6.5 percentage points over the last two decades while larger governments grew their tax and other receipts by an average of 4.8 percent. At the same time, between 1997 and 2005, it grew at an average annual rate of 4.1 percent in the former group of countries compared to 1.9 percent in the latter.

In terms of household consumption, both types of states had the same growth rate in consumption expenditure during 1980-1990 period. However, since 1990, leaner states averaged consumption growth of 3.6 percent per annum, while states with larger governments saw household consumption growth of just 2.1 percent per annum.

According to the report, "the most surprising finding to some observers is what has happened to public services. In the leaner government group, the growth in spending on public services accelerated to an average annual rate of 4.3% in 2000-2005, up from 2.4% in 1980-90. This suggests that an increased share of national income left in private hands stimulated greater efficiency and faster growth in the private sector, thus boosting individual and corporate tax revenues despite lower rates." The report cites Ireland as the exemplary case of what is known in the economic literature as the expansionary fiscal contraction phenomena - the case of reduced fiscal burdens of the state spending leading to improvement in government revenue. As Ireland's corporate tax rate fell to 12.5 percent, expanding tax base supported 6.4 percent average annual increases in public service spending since 1999, compared with just 0.1 percent growth during the 1980s.

The study also addresses the effectiveness of the leaner states in supporting non-economic social and human development. Using the United Nations' Human Development Index that measures the average achievements in a country in basic dimensions of human development: life expectancy at birth; the adult literacy rate, the combined gross enrollment rate for primary, secondary and tertiary schools; and a standard of living. The table below summarizes the study results.

The data show that since 1985 Ireland achieved the highest rate of growth in the Human Development Index of all ten countries both in absolute terms and in terms of relative global rankings.

Human Development Index (HDI)

HDO Global Ranking

2003

1985

2003

1985

Leaner Governments

Canada

0.949

0.909

5

1

Ireland

0.946

0.845

8

21

New Zealand

0.933

0.868

19

15

Spain

0.928

0.868

21

15

US

0.944

0.901

10

2

Average: Leaner Governments

0.940

0.878

13

11

Larger Governments

France

0.936

0.881

16

9

Germany

0.93

0.869

20

14

Italy

0.934

0.866

18

17

Portugal

0.904

0.826

27

24

UK

0.939

0.863

15

19

Average: Larger Governments

0.929

0.861

19

17

In life expectancy and mortality measures, there is no significant difference between the leaner governments and the larger governments in the rich industrialized countries. However, in overall health spending the results are different. Leaner governments spent an average of 6.2 percent of GDP on health in 2002, 0.9 percentage points less than their ideological rivals. But their populations benefited from higher total allocations (9.5 percent of GDP versus 9.2 percent), because private funding of health care by individuals and enterprises was 1.5 times higher. These figures may underestimate private health spending because they often exclude individual co-payments and some out-of-pocket expenditures.

The US topped the list for total health spending with 14.6 percent of GDP. Since 54.8 percent of the overall US healthcare spending accrues to private health care sector, taxpayer-funded programs accounting for 6.6 percent of GDP are largely concentrated on the most vulnerable segments of the population the poor and the elderly. Although the larger states have slightly higher number of physicians and hospital beds per capita, adjusting for higher efficiency of resources utilization under private provision and the younger age profile of the leaner states, these differences are hardly significant.

As with healthcare spending, higher private expenditure on education in the countries with leaner government implies better performance of education system in these states over the countries with larger government role in economy. The table below illustrates this point and shows that the overall advantage in total spending on education is also associated with the overall advantage of the leaner states in Research & Development.

Education Expenditure, %GDP, 2002

Primary Pupil-Teacher Ratio, 2002-2003

Tertiary Education Enrolment Rate (% of relevant age group), 2002-2003

R&D Expenditure, 1996-2003, %GDP

Researchers per million people. 1996-2002

High-Tech exports, % of all exports, 2003

Leaner Governments

Canada

6.5

17

58

1.91

3,487

14

Ireland

6

19

50

1.13

2,315

34

New Zealand

5.5 (public)

18

74

1.16

2,593

10

Spain

7.3

14

59

1.03

2,036

7

US

6.8

15

81

2.66

4,526

31

Average: Leaner Governments

6.7

17

64

1.58

2,991

19

Larger Governments

France

6

19

54

2.26

3,134

19

Germany

5.6

14

49

2.53

3,222

16

Italy

6.2

11

53

1.11

1,156

8

Portugal

5.9

11

53

0.93

1,745

9

UK

6.1

17

64

1.88

2,691

26

Average: Larger Governments

5.9

14

55

1.74

2,390

16

Not surprisingly, the data show that countries with smaller governments also outperformed those with larger state spending in domestic savings (by over 31 percent), investment (which grew 2.5 times faster in the 1990s in the leaner states), and lending to private sector. Since 1987, the leaner states also say lower inflation and slightly higher wages growth, implying that inflation adjusted wages grew faster in the smaller government states over the last 20 years period. Controlling for the native firms investments abroad, countries with smaller government enjoy the stock of FDI that is twice the size of that found in the states with larger governments. Similar trends hold for private sector productivity growth, private non-residential investment growth and the overall size of the countries' stock markets.

However, contrary to popular beliefs, the better economic and social spending indicators performance by the leaner countries were also associated with the relative strength of their performance in terms of environment. In 1990, states with larger government produced some 0.4 kg pf carbon dioxide emissions per 1 unit of income. By 2000 this figure fell to 0.3 kg. Comparable measures in the states with leaner governments were 0.5 kg in 1990 and 0.4 kg in 2000. On the surface, this appears to be the story of matched improvements across the two types of states with the leaner states continuing to lag behind the larger states. The problem with this arithmetic is that it neglects the vital role of CO2 sinks, such as forests, capable of absorbing the emitted pollutants. Leaner states have 11.6 times greater volume of sinks than the larger states and their forestry areas are increasing at double the rate of forestry growth in the states with large government. Adjusting for the average absorption rates for forestry sinks and relative size of sinks in two groups of countries, the states with leaner government have net CO2 emissions of 0.25 kg per unit of output. This, effectively, is less than the pollution intensity of output that is hoped to be achieved under the Kyoto Protocol.

Overall, the study concludes that "It may be surprising, even counter-intuitive, to find that countries with leaner governments spend more on health and education than those with larger governments (and have been growing that expenditure at a faster rate), that they have a better standard of living, better employment records and similar spending on income support. But the data... should give policy-makers some confidence in arguing [that] ...the leaner governments clearly benefit their citizens more than the narrow illusory benefits offered by larger governments."

The lesson is a simple one. If the real objective of European governments is to improve social and personal well-being, they should lower taxes, cut state spending and let the private sector do its job.

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