Government Size and Economic Prosperity
Recently Ed Dolan had a post on his blog on Medium arguing
that small government was not in fact conducive to prosperity (https://medium.com/@dolanecon/does-the-government-that-governs-least-really-govern-best-142106728cba),
as libertarians often argue. Specifically, he shows that the size of government
is actually negatively correlated with measures of prosperity, freedom, and
quality of government; on the other hand, quality of governance was positively
associated with per capita GDP. I came across this post, I should note, when
Tyler Cowen linked to it on his blog as evidence for “state capacity
libertarianism.”
But there’s a problem with Dolan’s analysis, or at least the interpretation he provides of it with respect to the role of government size in economic prosperity. It
may seem pedantic to repeat the old canard that ‘correlation does not equal
causation,’ but the problem is more than that: there is an equally plausible
explanation for the correlation he observes in which causation runs in the
opposite direction. That is, it is plausible that prosperity leads to the
enlargement of the state, rather than vice versa. In fact, it may be the case
that state enlargement has a negative effect on economic growth, but economic
growth itself has a larger positive effect on the size of the government,
leading to a positive correlation. This is precisely what I argue is the case,
and it’s a major flaw in Cowen’s case for ‘state capacity libertarianism.’ I
think ‘state capacity’ is more a consequence than a cause of prosperity. A big
government, with a generous welfare state and extensive provision of public
services, is a societal luxury good. When societies get rich, they can afford
to buy these things, but they do not, in and of themselves, promote growth, and
in fact more likely than not impede it. The argument against small government or in favor of more ‘capacious’
government in order to bring about greater prosperity, I contend, is akin to someone arguing that, from the correlation between luxury
car ownership and wealth, we can conclude that buying a luxury car makes one
wealthier.
Hence, looking at mere correlation is plainly the wrong way
to assess the effect of size of government on economic growth. A couple other way came to mind to get a
better idea of what the real relationship is between government size and
economic growth, so I downloaded some World Bank data on per capita GDP, per
capita GDP growth, and government spending as a % of GDP for all recorded
nations going back to 1960 (as far back as the data goes). Here’s what I found in my own little rather cursory analysis.
First, I ran a linear regression for each country in the
data set using both per capita GDP and government spending (again, as a % of
GDP) as regressors, which I’ll hence forth just call G, and per capita GDP
growth rate as the dependent variable. If G really does have a positive effect
on per capita GDP, then we should expect countries with higher values of G to
also have a higher rate of per capita GDP growth, after controlling for current
per capita GDP (which we would expect to have a negative relationship with
growth, since more developed countries tend to grow more slowly). Instead, I
found the opposite tends to be the case:
Next, I looked at whether increases in G tended to predict
an increase or decrease in the rate of economic growth, controlling for per
capita GDP.
This time, we’re looking at the coefficient and p-value for % change in G relative to the previous
year on per capita GDP growth rate.
Given that individual countries often didn’t have very much
data, I tried this using each ‘country-year’ in the data set as an independent
data point. Plotting current year per capita GDP growth against G for all 60
years across all countries gives us the following plot.
For what it’s worth, the coefficient on G is -0.14, and is,
according to the Pearson test, was statistically significant with a P-value of
pretty much 0 (or as close to 0 as is you can get in R, which I’m using to do
these computations). Of course, the plot looks a bit iffy, and may not pass an
‘eyeball test.’ The concentration of data points makes it hard to see if
there’s a trend, and in light of the recommendations of the American
Statistical Association, perhaps we ought not trust p-values.
Given that, visually speaking, the trend looks questionable,
I decided to look at what the relationship was between change in G and per
capita GDP growth rate up to years in the future. I then plotted the
coefficient of G on per capita GDP growth rate n years into the future:
The size of each point is the negative square root of the log
of its p-value (basically, the bigger the point, the more significant) Red
points have p-values below 0.01. What we see is that the coefficient of G on
per capita GDP growth appears negative and significant at first, then declines
in magnitude (and significance) until it converges to 0 about 4 years after the
increase in G. It seems pretty unlikely to me that, if there were no
relationship between G and per capita GDP growth, we would see such a trend by
chance.
Finally, I did something similar with per capita GDP growth
rate as the independent variable to see how well it predicted growth in G in
the future up to 10 years.
The coefficients are all positive and half have p-values
below 0.01. In other words, increases in per capita GDP tend to predict future
higher in G, while increases in G tend to predict lower increases in per capita
GDP.
Overall, what my cursory analysis suggests is that, if
anything, an increase in G has a negative effect on per capita GDP, not a
positive one. Now, plenty of caveats apply: this is macoreconomic data after
all, and there are myriad possible confounders, and the trends are not
consistently negative across all countries. But this is macroeconomics data, so
beggars can’t be choosers, and it is clear that the more data we have on a
country, the more likely it is to have a negative relationship between annual
change in G and per capita GDP growth, once we control for current per capita
GDP. What trends we do see seem unlikely to be explained by chance alone. The
correlation between G and per capita GDP is thus most likely, as I hypothesized
early, due to the effect prosperity has on government spending, not the other
way around, and given what data we have, more likely than not, government size
itself does indeed have a negative effect on economic growth.
The data I used here (government spending as % of GDP, per capita GDP, and per capita growth as % of GDP, all by country going back to 1960) are from the world bank: https://data.worldbank.org/
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