The Proper Size of Government

President Obama has frequently cited the seemingly intractable debate about the size of government currently consuming the political class as his primary obstacle to getting major reforms through a divided Congress.

For example, in his State of the Union address he said:

"For several years now, this town has been consumed by a rancorous argument over the proper size of the federal government. It's an important debate" one that dates back to our very founding. But when that debate prevents us from carrying out even the most basic functions of our democracy "when our differences shut down government or threaten the full faith and credit of the United States then we are not doing right by the American people."

Let's look at the facts to help resolve this debate. A large body of empirical research has examined the relationship between the size of government and economic outcomes, and based on that research, the United States has much room to scale back. In addition, and close to home, Canada's recent experience with government retrenchment is an example of a country shrinking government without a trade-off in economic and social outcomes. In fact, a smaller government could achieve better outcomes for the American people.

Over the years, economists have measured the effect of the size of government on economic growth and social outcomes such as life expectancy, infant mortality, homicide rates, educational attainment, and student reading proficiency. One recent addition to the mounting evidence against large government is a study published by the Fraser Institute, entitled "Measuring Government in the 21st Century," by Canadian economist and university professor Livio Di Matteo.

Di Matteo's analysis confirms other work showing a positive return to economic growth and social progress when governments focus their spending on basic, needed services like the protection of property. But his findings also demonstrate that a tipping point exists at which more government hinders economic growth and fails to contribute to social progress in a meaningful way.

The premise that underpins these findings may be a bit counterintuitive. It seems self-evident that government programs and services contribute to economic and social well-being. More police officers keep our streets safer. New infrastructure helps to promote commerce and trade. Additional funding for education helps children learn and grow into productive adults. Indeed, the research shows that certain levels of public services do help grow the economy and achieve positive social outcomes. That is not in doubt.

The fundamental question is at which point incremental government spending impedes economic growth and social outcomes, or achieves the latter only at great marginal cost. Government spending becomes unproductive when it goes to such things as corporate subsidies, boondoggles, and overly generous wages and benefits for government employees. In these cases, regular Americans do not see tangible benefits from additional spending.

Like other researchers, Di Matteo analyzes total government spending (at all levels) as a percentage of gross domestic product (GDP). There are shortcomings to this yardstick, since it excludes government regulations and various special tax deductions that can distort markets and contribute negatively to a government's economic footprint, but it is the best available measure of the size of government.

Di Matteo examines international data and finds that, after controlling for confounding factors, annual per capita GDP growth is maximized when government spending consumes 26 percent of the economy. Economic growth rates start to decline when relative government spending exceeds this level. In other words, there is a hump-shaped relationship between the size of government and economic growth (this relationship is often referred to as the Scully Curve, named after the economist Gerald Scully).

According to OECD data, the size of government in the United States was approximately 40 percent of GDP in 2012. While Di Matteo's estimate of the tipping point is based on international data, it suggests that President Obama should reduce government to boost the U.S. economy. This conclusion is supported by a larger literature that has also found that a smaller size of government than what currently exists in the United States would translate into higher annual economic growth.

Canada as Example

For a real-life example of how scaling back government has led to positive and practical economic benefits, Americans should look north. For much of the second half of the 20th century, the conventional wisdom in Canada favored increasing the size of government. This led to significant growth in government as a share of the economy from 1970 to 1992 (see accompanying chart). Specifically, total government spending as a share of GDP went from 36 percent in 1970 (just over 2 percentage points higher than in the United States) to 53 percent when it peaked in 1992 (14 percentage points higher than in the United States).

This massive growth in government spending "along with a corresponding increase in government debt" led the country down a precarious path that attracted unwanted international attention. In fact, in a January 12, 1995, editorial, the Wall Street Journal called Canada out on its debt problem, saying it had "become an honorary member of the Third World" and warning that it "could hit the debt wall."

Soon after, the federal and many provincial governments took sweeping action to cut spending and reform programs. This led to a major structural change in the government's involvement in the Canadian economy. The Canadian reforms produced considerable fiscal savings, reduced the size and scope of government, created room for important tax reforms, and ultimately helped usher in a period of sustained economic growth and job creation.

This final point is worth emphasizing: Canada's total government spending as a share of GDP fell from a peak of 53 percent in 1992 to 39 percent in 2007, and despite this more than one-quarter decline in the size of government, the economy grew, the job market expanded, and poverty rates fell dramatically.

As the chart shows, total U.S. government spending has grown since 2000; it peaked in 2009 at 43 percent of GDP and fell thereafter. The empirical evidence, along with Canada's experience, indicate that an ambitious reduction in the size of government at both the federal and state level can lead to better economic outcomes for the United States.

These facts should transcend party lines and form the basis of a major reform agenda for the remainder of the president's second term. There will always be plenty of issues to debate in Washington. The proper size of government does not need to be one of them.