U.S. policymakers find themselves engaged in an often intractable and largely polarized debate about the size of government and its relationship to overall economic growth. A cause (or perhaps symptom) of this partisan polarization is a number of studies with highly variable results on the impact of government size on economic growth.
Some of the research examined shows a potentially negative relationship between government size and growth: “The most recent studies find a negative correlation: An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.” However, the researchers question whether previous research demonstratively established causality between government size and slower economic growth.
The paper warns against over-generalization of measures of government size and policies. For example, “not all taxes are equally harmful, and some studies identify public spending on education and public investment to be positively related to growth.”
While previous literature has struggled to explain the growth of Scandinavian states, the researchers note that “welfare states with high taxes … compensate negative growth effects from large government by applying other growth-promoting policies.”
There is a strongly observed correlation between government size and social trust, which enables countries to sustain larger governments without harming the economy. Additionally, studies have shown a link between trust and overall economic growth. Thus omitting “trust” as a variable from any analysis may lead to bias.
High rates of growth are seen in a diverse group of nations, some with large governments and others with small governments. “This does not mean low-tax countries can increase taxes without expecting negative effects on growth, nor that the various mechanisms by which high taxes distort the economy do not apply in Scandinavia.”
Once mitigating factors and context are taken into account, there is actually near consensus in the correlation displayed by previous studies. Causality is hard to establish, however, and academically it is meaningless to discuss a specific causal effect from broad aggregate measures such as government size on economic growth.
The researchers conclude that these “results do not imply that government must shrink for growth to increase. There is potential for increasing growth by restructuring taxes and expenditures so that the negative effects on growth for a given government size are minimized.” The study’s findings, they note, have only “ambiguous policy implications.”