2010 Bergh, Henrekson - Government size and implications for economic growth

BIG GOVERNMENT: GOOD OR BAD FOR GROWTH? 15 Social Inequality. Another important reason big government may be growth-promoting is that government spending and taxation can reduce the cost of social inequality. According to Myrdal (1960), social inequality impedes growth for at least two reasons: It leads to a waste of human capital as a consequence of poverty, and it restricts the opportunities for lowincome individuals to exploit their talents. This idea has been further refined in “the social affinity theory” (Kristov et al. 1992), which predicts that government redistribution will be greater, the wider the pre-tax income gaps above median and the lower the gaps below median income. A greater government involvement in the economy can, in part, be aimed at reducing inequality.

Technical Arguments. In addition to the arguments based on institutions, market failure, and the costs of inequality, some statistical and technical factors might contribute to findings of a positive relationship between some measures of government size and economic growth. For example, in some studies, government goods and services are valued at their cost of production. This procedure gives rise to a number of difficulties that bias research results, due to the implicit assumptions that government output is produced with a constant-returns-to-scale technology, that all government production can be classified as final output rather than intermediate inputs lowering private sector production costs, and that the market value of government output is equal to the cost of production.7 Yet another factor to keep in mind is that both government consumption and investment are part of GDP when measured from the expenditure side. Thus, when these parts of government spending increase, GDP will increase by definition. In a way, explaining GDP growth by changes in government spending involves explaining something partly by itself. In particular, this problem lends an upward bias to the estimated effect during periods when the government spending share is increasing.

Finally, Kaldor (1966) claims that a high rate of utilization has a beneficial effect on long-run productivity growth. Insofar as an expansion of the public sector results in a higher utilization rate, there could be a positive effect on economic growth—a relationship known as Verdoorn’s Law.