CHAPTER 7
· There can be threshold effects of government size, where size starts to matter only after it reaches a crushing mass. While the choice of a threshold for what constitutes “big government” is arbitrary, this chapter uses 40 percent of GDP, which is close to the average government size in high-income countries in 1995–2010.3 Tanzi and Schuknecht (2000), for example, suggest this as the upper limit for sufficient public spending. The results provide support for a threshold effect. The impact of government size on growth is negative for the countries with initial government spending of 40 percent of GDP or more, but positive (and mostly insignificant) for countries with smaller government sizes. The same pattern holds for the world sample. This might explain why government size is harmful for growth in Europe but not elsewhere. Median government expenditures over the last decade and a half were 26 percent of GDP in the world, but 43 percent of GDP in Europe. · Parameter estimates can be sensitive to the selection of variables. Sala-i-Martin, Doppelhofer, and Miller (2004) have used the method of Bayesian averaging of classical estimates (BACE) to find out which combination of these variables explains economic growth best. BACE uses all possible combinations and generates average coefficients for each variable, weighted by the goodness-of-fit of each regression, as well as inclusion probabilities. Our goal is more modest: to find out whether government size is one of the variables among the set of nine explanatory variables that contributes to a high explanatory power of the regression model. This implies running more than 500 regressions. The coefficient on government size is negative in both Europe and the world, but larger in absolute terms in Europe. The inclusion probabilities are in excess of 90 percent for Europe, but below 33 percent for the world. This confirms our findings of a robust negative relationship between initial government size and growth in Europe, but not in the world sample. · Government revenues can be studied as alternative measures of government size. Bergh and Karlsson (2010) argue that looking at tax revenues is one way to address concerns about reverse causality. Tax revenues as a share of GDP tend to increase during booms and decline during recessions (table A7.3). This makes it less likely that the causality runs from higher growth to lower government size. Since tax revenue data are harder to come by, total revenues have to be used rather than tax revenues. (For the sample of EU and OECD countries, tax revenues make up about 85 percent of overall revenues.) The results suggest that large public revenues come with slower growth (box 7.3).
Social transfers hinder growth—and public investments help Some types of public spending increase growth, others reduce it (for example, Lucas 1988; Barro 1990; Barro and Sala-i-Martin 1992; Gemmell, Kneller, and Sanz 2011). But the literature fails to agree on which categories of public spending are likely to be growth-friendly. Consensus is hard to come by because the growth impact of public spending is tied to a range of factors. Public spending programs can be executed well or poorly, and may work well in some stages of development but not others. High government consumption can reflect well-paid public servants who provide vital services to people
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