You Decide: How does government size impact the economy?
by Dr. Mike Walden N.C. Cooperative Extension
Perhaps few topics can start a verbal clash more than the debate over government size and the economy. The competing sides are well known. One position says government gets in the way of the economy, by levying taxes, writing restrictive regulations and directing spending to less productive activities. The opposing side says government spending is vital to keeping the economy growing, improving lives and ensuring fairness.
This debate is heard at both national and state levels. Ever since the federal government began running large annual budget deficits, the economic effects of government size have been a flashpoint. Also, here in North Carolina, the most recent session of the General Assembly featured a lively discussion about the role of government in economic growth.
As I always strive to do, my role here is not to choose sides and promote a particular position but to present analysis and insights that economists have accumulated over decades of studying the intersection of government and the economy.
First, let me begin by addressing how government’s size has changed in recent decades. Economists’ preferred measure of the size of any sector in our economy – whether it is government, manufacturing or health care – is to look at spending in the sector as a percent of all income. This is similar to a household tracking its own spending by examining spending amounts for food, clothing, shelter or transportation as a percent of the household’s total income. The most comprehensive measure of aggregate income in our economy is a concept called “gross domestic income,” or GDP.
At the national level, federal government spending as a percent of GDP has remained remarkably stable in recent decades, at around 19 percent. Of course, during recessions, when GDP declines and federal spending usually rises, the rate can move higher, often near 25 percent.
There’s a similar picture in North Carolina. For the last 30 years, combined state and local government spending in our state – omitting federal funds administered by the state – has hovered around 6 percent of North Carolina’s GDP. Again, the rate tends to move up during recessions and then back down during economic expansions.
Next, can economists say anything definitive about the relationship between the relative size of government spending and the economy? There have been two levels of inquiry on this issue, one comparing countries from around the world and the other comparing states within the U.S.
A recent economic paper summarized a large number of studies focusing on how the size of government affects the economic growth of nations. The authors concluded that the majority of studies showed a larger government sector leading to slower economic growth. However, the authors noted several caveats. First, the relationship was relatively small. Every one percentage point increase in government’s size as a percentage of GDP led to between a 0.05 to 0.1 percent reduction in the annual national economic growth rate.
Second, the relationship between government spending and economic growth depends on the type of spending. Many studies find that spending on education and infrastructure (highways) improves economic growth, while spending on transfer programs reduces growth.
Third, some countries – primarily in Scandinavia – appear to be exceptions to the rule, with large government sectors but high economic growth. Some economists speculate these countries are able to counteract the adverse effects on growth of government size with pro-business regulatory and research policies.
Now, what are the findings about government size and the economy at the state level? Unfortunately, the many studies done by economists linking the two are less than conclusive. Perhaps the best that can be said is that any effect that does exist is very small.
There may be two reasons for this conclusion. First, the relative size of government at the state and local level is much smaller than the relative size of the federal government, so changes at the federal level will often have more impact. Also, most of the states are clustered within a couple of percentage points in measures for the relative size of their state and local governments.
Second, there are a whole host of other factors that impact state economic growth besides the size of government, factors like the type and importance of different economic sectors in the state, the cost of doing business, worker training and skills, access to raw materials and markets, natural amenities and even the climate.
People will continue to argue about the size of government, and economists will continue to churn out new studies looking at the impacts of government size and spending on the economy. Maybe the issue will never be resolved, but we’ll still try to decide.
Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy.
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