The debate over how much government spending is appropriate for the well-being of our society is often disappointingly one-dimensional. Those who demand more spending seem to be saying that it is simply a question of social solidarity, that the rich and middle classes should agree to be taxed a little more in order to pay for the services and transfers that will benefit the poor and the middle classes. Anybody who opposes more spending is denounced as a mean-spirited defender of the establishment and of the egotistical interests of the rich.
We know that high levels of taxation bring disincentives to work and invest, provoke an outflow of entrepreneurs and competent manpower to other jurisdictions and stifle growth in the private sector. But the corresponding high levels of spending, usually presented as positive for the economy, also have the long-term effect of lowering economic growth.
There are many reasons for that. The bigger government becomes, the more its productivity decreases. Resources get lost in a maze of bureaucratic structures. Capital is crowded out of the private sector in order to finance public projects that are often more profitable from a political than from a financial perspective. Also, the more money government redistributes through various programs, the more incentives there will be for individuals and corporations to try to improve their condition through government favours instead of productive activities.
Big government supporters will probably say again that all these consequences are just abstract theorizing, like the market itself and its so-called invisible hand, while the poor people who suffer are real people, and economic theory should not prevent us from spending even more money to come to their help.
But it is precisely in order to get the means to fight poverty that we need to pay more attention to wealth creation. And now, for the first time, we have precise data to illustrate the trade-off between government spending and economic growth. They clearly show that the growth of government in recent decades has had a noticeable negative impact on our standard of living.
Last year, the Montreal Economic Institute welcomed Robert Lawson of Capital University in Ohio, one of three authors of a study that compared the size of government and economic growth in 23 OECD countries over a period of four decades. Using a regression analysis, they found a strong and persistent negative relationship between the two. The higher the level of public expenditures in a given country, the lower we can expect its economic growth to be. Their results suggest a 10-percentage-point increase in government expenditures as a share of GDP (say, from 35 per cent to 45 per cent) leads to a permanent one-percentage-point reduction in annual economic growth.
One per cent may seem to be an insignificant number. Who would notice it if Canada’s economy grew by 2.5 per cent instead of 3.5 per cent this year? But over a period of decades, such a loss, year after year, leads to tremendous reductions in income.
That original study applied the regression analysis to the American situation. It found per capita revenue was C$8,693 (US$5,860) smaller than it might have been had expenditures by all levels of government in the United States not increased as they did over the last four decades, from 28.4 per cent to 34.6 per cent of GDP.
This year, we asked Lawson to apply the same methodology to Canada and Quebec. Public spending in Canada by all levels of government grew much faster than in the United States during the period since 1960, from 28.6 per cent of GDP to 46.0 per cent in 1998. So we can expect the stifling effect of government growth will be greater. The hard numbers tell a story more eloquent than any theoretical explanation would.
Had public spending in Canada remained at its 1960 level, the Canadian economy would have grown so much faster that by 1998, it is estimated that our GDP would have reached $1,318 billion instead of $861 billion. This means revenue per capita, that is, the amount of wealth produced on average for each Canadian man, woman and child, would have been $15,065 larger. For a typical family of four, that’s $60,259.
Lawson found similar results for Quebecers. Numbers for Quebec’s gross provincial product were not available before 1971, and the data do not take into account the fact that public spending in this province grew even faster than in other provinces. So the impact is probably underestimated, although the numbers are still quite significant.
If the overall size of government in Canada had remained at its 1971 level of approximately 36% of GDP, the increased economic growth this would have permitted in the province would have made each and every Quebecer $12,412 richer, on average, by 1998 (or $49,648 for a family of four). In other words, per capita revenue would have been $39,158 instead of the $26,746 we in fact achieved.
Yes, this means the government would be doing fewer things today. But each of us – rich and poor – would have more money to pay for services that the government provides now and might not be providing in this hypothetical situation. Not just because we would pay less taxes, but because in a more productive economy we would all be much richer.
One does not necessarily have to conclude from these numbers that we need a smaller state. The point to remember is there is a trade-off between bigger government and smaller economic growth. Those who are still willing to keep the present big government – or to have an even bigger one – in the name of fairness and equality should at least be aware of what they and everybody else have to give up for it in terms of long-term growth, wealth and well-being.
Michel Kelly-Gagnon is President of the MEI.