FLASH: New ECB Research Shows Big Government Retards Economic Growth

The research is here.

Abstract

We construct a growth model with an explicit government role, where more government resources reduce the optimal level of private consumption and of output per worker. In the empirical analysis, for a panel of 108 countries from 1970-2008, we use different proxies for government size and institutional quality. Our results, consistent with the presented growth model, show a negative effect of the size of government on growth. Similarly, institutional quality has a positive impact on real growth, and government consumption is consistently detrimental to growth. Moreover, the negative effect of government size on growth is stronger the lower institutional quality, and the positive effect of institutional quality on growth increases with smaller governments. The negative effect on growth of the government size variables is more mitigated for Scandinavian legal origins, and stronger at lower levels of civil liberties and political rights. Finally, for the EU, better overall fiscal and expenditure rules improve growth. [Emphasis mine]

Non-Technical Summary

Governments tend to absorb a sizeable share of society’s resources and, therefore, they affect economic development and growth in many countries. However, despite necessary, government intervention is not a sufficient condition for prosperity, if it leads to the monopolization of the allocation of resources and other important economic decisions, and societies do not succeeded in attaining higher levels of income.

The existing literature presents mixed results as to the relationship between government size and economic development. On the one hand, the former may impact economic growth negatively due to government inefficiencies, crowding-out effects, excess burden of taxation, distortion of the incentives systems and interventions to free markets. On the other hand, government activities may also have positive effects due to beneficial externalities, the development of a legal, administrative and economic infrastructure and interventions to offset market failures.

Our paper includes several contributions: i) we construct a growth model allowing for an explicit government role, we characterize the conditions underlying the optimal path of the economy and determine the steady-state solutions for the main aggregates; ii) we analyse a wide set of 108 countries composed of both developed and emerging and developing countries, using a long time span running from 1970-2008, and employing different proxies for government size and institutional quality to increase robustness; iii) we build new measures of extreme-type political regimes which are then interacted with appropriate government size proxies in non-linear econometric specifications; iv) we make use of recent panel data techniques that allow for the possibility of heterogeneous dynamic adjustment around the long-run equilibrium relationship as well as heterogeneous unobserved parameters and cross-sectional dependence; vi) we also deal with potentially relevant endogeneity issues; and vii) for an EU sub-sample we assess the relevance of
numerical fiscal rules in explaining differentiated GDP and growth patterns.

Our results show a significant negative effect of the size of government on growth. Similarly, institutional quality has a significant positive impact on the level of real GDP per capita. Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries). Moreover, i) the negative effect of government size on GDP per capita is stronger at lower levels of institutional quality, and ii) the positive effect of institutional quality on GDP per capita is stronger at smaller levels of government size. [Emphasis mine]

On the other hand, the negative effect on growth of the government size variables is more attenuated for the case of Scandinavian legal origins, while the negative effect of government size on GDP per capita growth is stronger at lower levels of civil liberties and political rights. Finally, and for the EU countries, we find statistically significant positive coefficients on overall fiscal rule and expenditure rule indices, meaning that having stronger fiscal numerical rules in place improves GDP growth.

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