To Get Growth, Shrink the State

To Get Growth, Shrink the State
The best stimulus is a smaller government.
By TIM KNOX AND RYAN BOURNE

Confusion reigns supreme. The International Monetary Fund told the U.K. this week that it should cut taxes and boost spending while also praising the fiscal consolidation of 2010, which saw a mere 1% cut from public spending. Labour and Conservative politicians argue over the extreme severity of the coalition's spending cuts while ignoring the fact that the national debt is set to increase to a staggering £1.6 trillion by 2015, from £1 trillion in 2010. A false dichotomy—will "austerity" get us out of the economic crisis or will "growth"?—is posed as if the right answer will somehow lead us out of economic despair.

At a time such as this, we need clarity. We need to know where we want to go—and then to boldly implement the policies that will get us there. For all those who wish to see a return to enduring prosperity, new research published today by the Centre for Policy Studies suggests a simple, specific destination. We find that the size of government as a proportion of GDP is a major influence, controlling for other factors, on a country's rate of economic growth. If you want growth, scaling back the state should be an aim whether you have a deficit or not.

We examined the 28 OECD countries defined as "advanced" by the IMF between 1965 and 2010. Using regression analysis to control for the growth rates of the factors of production (physical capital, labor and human capital) and initial GDP, our results suggest that reducing the ratio of taxes or spending to GDP by five percentage points increases the growth rate of GDP per capita by 0.5 to 0.6 percentage points per year.

A broader sample of all "advanced" countries (again, as defined by the IMF) over the past 10 years seems to support these findings. Over this period, countries whose governments tax and spend less than 40% of GDP have grown more quickly than the big-government countries.

These differences in growth rates are important. Small differences in percentage growth rates roll up to huge differences in wealth generation over a number of years. If the differential of the last 10 years were to be constant over 25 years, then the economies of those countries with small governments would have more than doubled (an increase of 115%) while big government countries would have only seen growth of 64%.

Is this conclusive proof that cutting the size of government will always increase growth? Of course not. The accumulation and quality of other factors are also important. But this evidence shows that other things equal, countries with small governments and with small tax burdens grow faster.

Everyone—perhaps apart from the ultra-green fringe—accepts that higher growth is a good in itself. But it also has other benefits. Higher growth rates mean more money to spend on public services. As Margaret Thatcher used to say, if you want a bigger slice of cake, bake a bigger cake.

The fact that small-government countries can increase their spending on public services more quickly than big-government countries may explain another fascinating result: that key measures of health and education are similar in both groups of countries—and in many cases are better for the small-government countries. For example, according to the OECD's PISA studies, pupils in small-government countries achieve significantly better results in reading, math and science than those in big-government countries. Life expectancy is also slightly higher in small-government countries (at 81.3 years) than in big-government countries (79.9 years).

Our findings add to the already significant body of economic literature that suggests that small-government countries grow more quickly after accounting for other characteristics. It also shows that there appears to be little correlation between government size as a proportion of GDP and some key outcomes in health and education. The implication is that in the medium term, constraining the size of the state is good for growth, and can also provide social outcomes that are at least as good as those in big-government countries.

Three lessons can be drawn. First, we need financed tax cuts now. Government spending must be quickly reduced, balanced by targeted tax cuts to encourage business growth. This should not be considered as draconian in any way. Spending in the U.K. increased by a huge 53% in real terms in the New Labour years. To cut spending back after such a binge should be merely considered as prudent.

Second, politicians should focus on results, not the amount of money spent, when discussing public services. While New Labour boasted about its "record investment in the NHS" without mentioning the stagnant productivity, today the coalition seems to think that increasing its overseas aid budget is a good thing in itself. This should stop. It makes no sense to judge competency in a policy area by the proportion of GDP spent on it.

Finally, we need an exclusive focus on supply-side reform to promote growth. Luxuries such as family-friendly employment legislation or green initiatives such as the carbon taxes are no longer affordable in the age of austerity.

—Mr. Knox is director, and Mr. Bourne is head of economic research, at the Centre for Policy Studies, which today publishes "Small is Best: Lessons From Advanced Economies."

http://online.wsj.com/article/SB10001424052702304707604577423720925560872.html?mod=WSJ_Opinion_LEFTTopBucket