Government Size And Economic Growth

My reading of Treasury material in the last decade on whether high government spending harms economic growth is that size doesn’t matter in its view – the public sector can in principle spend taxpayers’ money as well as they can spend it themselves.

This view implicitly holds that the government is not constrained by problems of information and incentives.  Therefore if there is a problem it is only because not enough is being spent on ‘productive’ categories of spending and too much on ‘unproductive’ categories.  Treasury papers have also been at pains to make the trite observations that government spending can be too low as well as too high, and that the quality of spending matters, which of course it does.

Treasury has never engaged with a point the Business Roundtable has made countless times, namely that no OECD country with government spending over 40 percent of GDP has achieved sustained annual per capita GDP growth of 4 percent or more – the kind of growth rate necessary if New Zealand is to climb back to the top half of the OECD income range (the last Labour government’s goal) or to catch up to Australian income levels by 2025 (the current government’s goal).

This month the Treasury has released the paper Government and economic growth: Does size matter?  It is a slight advance on previous efforts.

In its two reports to date, the 2025 Taskforce has been in no doubt that the answer to this question is ‘yes’.  It said in its first report:

Our judgement, informed by a reading of the international historical experience, is that it would be almost impossible to achieve the sort of sustained transformation of our growth performance with the size of government at current levels (around 45 percent of GDP).

In its latest paper the Treasury still cannot bring itself to endorse this obvious conclusion.

The Treasury paper appears to be poorly researched.  For example, it does not cite a 2010 book by Andreas Bergh and Magnus Hendrekson on the very same topic, Government Size and Implications for Economic Growth.  The key conclusion of these authors is that in rich countries, a 10 percentage points increase in tax revenue as a share of GDP (say from 30 to 40 percent) leads to annual economic growth being between one half and one percentage point lower – a large reduction.

Even more curiously, the paper does not cite the study How Much Government: The Effects of High Government Spending on Economic Performance published by the Business Roundtable.  The author was Winton Bates, previously a senior official in the Australian Productivity Commission, a consultant at the New Zealand Treasury, and an adviser to the 2025 Taskforce.  Bates’ “conservative” estimate was that “a reduction in government spending from 40 to 30 percent of GDP could be expected to add about 0.5 percent to the rate of growth of GDP over about a decade.”

A subsequent Business Roundtable study by Bryce Wilkinson Restraining Leviathan, which had much to say on the subject, is also not cited.

Nor, when it comes to discussing public sector productivity, did the paper cite the Business Roundtable study overseen by former Treasury secretary Graham Scott, Productivity Performance of New Zealand Public Hospitals 1998/99 to 2005/06, authored by Mani Maniparathy.  It concluded, among other things, that overall productivity of personnel in public hospitals actually decreased by 8 percent in the five years to 2005/06.

The paper even fails to note research that the Treasury commissioned itself from Australian economist Ted Sieper which argued that the provision of public goods and a modest safety net  in New Zealand would require government spending of no more than 14-15 percent of GDP.

The following table from the 2025 Taskforce’s second report shows that this is not an unreasonable estimate.  Government spending today is as high as it is largely because of the level of government spending on ‘social assistance’.  Much of this spending presumes that governments can spend taxpayers’ money on health, education and welfare services better than individuals and households.   This presumption took over the Western world around the 1960s, as has been documented by Tanzi and Schuknecht. It is dubious to say the least.

Click to enlarge

Furthermore, the Treasury’s examination of the ways in which government spending may harm growth is much too narrow.  Winton Bates noted that “Big government adversely affects economic performance in many different ways”, and listed some as follows:

  • When the range of services provided by the government extends into areas where it has no competitive advantage the cost of services tends to increase.
  • High levels of government spending on goods and services (including public sector employment) often involve waste of resources.
  • Excessive regulation imposes large compliance costs on businesses and individuals.
  • Attempts to regulate the macro economy using counter-cyclical fiscal policies do not necessarily have intended effects and may lead to worse economic outcomes over the longer term.
  • Redistribution of income has adverse effects on the incentives of the intended beneficiaries, including possible changes in norms of behaviour leading to greater welfare dependency.
  • Increases in government spending tend to encourage wasteful lobbying activities by suggesting to interest groups that governments are likely to be responsive to their pressures.  As a result, much government spending – in areas such as health, education and retirement incomes – provides private goods for the benefit of middle-income families and is funded by the same people. Such government funding of private goods displaces more efficient private arrangements.
  • The deadweight costs involved in raising additional revenue rise more than proportionately as the amount of revenue increases. When account is taken of deadweight costs associated with both taxation and delivery of benefits it is likely that these costs are equivalent to more than half of each additional dollar of government spending in New Zealand.

The Treasury’s focus is almost exclusively on deadweight costs and public sector productivity.  The omission of any material discussion of rent-seeking, and public choice issues in general, is extremely important.  The Treasury’s general framework presumes that governments spend money in order to overcome ‘market failures’ and fails to consider the more plausible proposition that they spend money in order to get re-elected or to favour their most important constituencies.  There is no assessment of the level of spending that could be justified on genuine public interest grounds.  Basically, incentives in the government sector are not a problem, so the paper implicitly assumes.

Another serious weakness of the paper is that its benchmarks are OECD countries in their modern, typically big-government, form.  Nowhere is there any recognition of the current reality that the majority of the Western welfare states are in deep economic trouble and the model may well prove to definitively broken.  The 2025 Taskforce in its first report pointed out that the average OECD country:

… isn’t the only model.  In several high-performing Asian economies (Singapore, Hong Kong and Taiwan), themselves with diverse political systems and spending imperatives, total government spending as a share of GDP has consistently been less than 20 percent.

These high-income countries, and other emerging economies, are more likely to offer lessons for New Zealand than the ‘old’ OECD.

Another frame of reference (missing in the paper) would be the performance of today’s OECD countries when the share of government in their economies was much smaller. In the 1950s and 1960s, for example, many of these countries had government spending ratios of around 25 percent. They also enjoyed much faster growth rates.

There are sundry other problems with the paper.  In discussing the Baumol hypothesis for creep in the size of government, it fails to consider why it did not apply in local government for at least a century.  It accepts ‘merit goods’ as a justification for government spending whereas many economists have jettisoned this idea.

Needless to say, there are useful observations in the paper.

It is dismissive of the Wilkinson and Pickett inequality argument and is supportive of privatisation.  It also mentions the bias toward big government of MMP:

The larger the number of parties forming the government and the higher the frequency of elections, the stronger this tendency. It also seems more prevalent in cases of proportional rather than majority-based election systems (for example, see Persson and Tabellini, 1999, 2002).

Overall, my judgment is that the paper is an advance on earlier Treasury work in the area.  But that is faint praise. Both theory and evidence indicate that government spending around New Zealand’s level is seriously detrimental to growth.  I hope some New Zealand academics join in with critiques.

MMP Mythologising

Philip Temple is a Dunedin-based author of novels and children’s stories.

He has also been a long-time crusader for MMP.

Last week he had an article in the National Business Review that criticised an article on MMP by James Allan, a professor of law at the University of Queensland and formerly at the University of Otago, and a critic of the MMP system.

Mr Temple’s article was more fiction and fairytale than fact.

Start with his economic understanding, which seems almost non-existent.  He writes:

Professor Allan can’t make up his mind whether Helen Clark or MMP is responsible for New Zealand’s “relative decline in economic performance … Divide the blame up … in whatever proportions tickle your fancy.”

This is pretty slack thinking from a professor of law, especially when we have been reminded frequently that, after nine years of Clark and Cullen, New Zealand was better positioned to weather the global financial crisis than those FPP bastions, the UK and the US.”

Better positioned?  The Clark/Cullen legacy was a rate of productivity growth that has slumped to close to zero, an economy in recession before the GFC struck, and a string of budget deficits that will take years to correct.

The article goes on:

And what western country has weathered the current crisis best of all?  Why the home of MMP, Germany, with its endless coalitions.

Mr Temple seems to have overlooked our nearest neighbour Australia, and for that matter Canada, both of which sailed through the crisis better than others in the OECD.  Germany by contrast is in dire straits with weak banks and an anaemic growth outlook.  It only looks better than the sick economies that surround it.  The days of Germany as the ‘free market economic miracle’ are long gone.

Even more ludicrously, the article then says:

In any case, given that most of our economy is owned or part-owned by overseas interests, the fate of our economy is in others’ hands.

What rubbish!  Most New Zealand assets are owned by New Zealanders, globalisation is a worldwide phenomenon, and New Zealand is totally sovereign economically: our decisions on our own institutions (like our electoral system) and policies largely determine our economic fate.

In respect of institutions, MMP is a serious ball and chain on the economy.  Economic research indicates that proportional systems are associated with higher levels of government spending.  In New Zealand MMP has contributed to over-expanded government and to stalemate and compromise.  How many worthwhile economic reforms have happened under MMP?

When it comes to political arrangements, the article doesn’t get any better.

Mr Temple observes that you can get minority government under first-past-the-post (FPP) as well as under MMP, and cites recent elections in the United Kingdom and Australia.

That is disingenuous in the extreme.  Minority governments in those countries have occurred once every few decades; under MMP they are routine.

In response to Professor Allan’s criticism that after an election under MMP there is all sorts of horse-trading and bargaining between parties to try to form a coalition government, Mr Temple writes:

And as for the “horse-trading and bargaining,” at least this is out in the open and not behind two-party closed doors.

But there’s nothing wrong with debate and compromise within parties – that happens under MMP as well as FPP.  The point is that under MMP no party can assure its voters that it will deliver on its election promises.  Horse trading occurs after voters have had their say.  MMP institutionalises promise-breaking.  Think National’s commitment to abolish the Maori seats and the deal that it struck with the Maori Party.

The article goes on:

The list component also allows the inclusion of talented politicians who have expert skills to offer, over and above electorate legwork.  Transport Minister Stephen (sic) Joyce, a list MP, is a prime example of this benefit of MMP.

This is a fair point but it is not an unalloyed benefit.  All electoral systems have strengths and weaknesses.  MMP may throw up a Steven Joyce but it may also throw up an Alamein Kopu – candidates who would never get elected in a direct constituency vote.  Moreover, as the outstanding UK member of the European Parliament Daniel Hannan writes in his new book The New Road To Serfdom: A letter of warning to America:

In most European countries, where legislators are elected on party lists through proportional representa­tion, politicians are even further removed from their electorates. If you are near the top of your party list, you are effectively irremovable. So, naturally enough, you spend your time sucking up to the person who de­termines which position on that list you will occupy: your party leader. Once you have secured a high­ranking place, you are invulnerable to public opinion. Even if your party suffers a heavy defeat, you will still be in the national assembly and with a fair chance of being in government as a minor coalition partner.

This gets to the heart of the problem of MMP (and other proportional systems).  What is the key issue in considering any voting system?  The political philosopher Karl Popper concluded, rightly in my view, that it is the ability of the electorate to throw out a government it dislikes.  This almost always happens under FPP or similar systems; it often doesn’t under MMP or other PR systems.  We saw that in the very first MMP election in 1996: Winston Peters’ party gained votes in the expectation that it would not back National, but it turned around after the election and gave National three more years of power.

A final howler: Mr Temple writes:

The only small parties to have survived throughout since the advent of MMP in 1996 are the Greens and United’s Peter Dunne.

Last time I looked the ACT Party was still in parliament!

A footnote to the article states that Mr Temple has been given a Wallace Award by the Electoral Commission for his writing on electoral matters.  If this article is any indication of the quality of his work, and if the award involved money, taxpayers have been well and truly ripped off.

The virtues and perils of gridlocked government and policy packages

With the dust somewhat settled I thought I’d take a look at a couple of interesting aspects of the seismic shift in government power in the United States.

In a surge of voter dissatisfaction at the state of the US economy, Republicans took back the House of Representatives in the mid-term elections last week.

So what can Americans expect from the new congress? At least a breather, according to distinguished American legal scholar, frequent visitor to New Zealand and past presenter of the Business Roundtable’s Sir Ronald Trotter Lecture, Richard Epstein:

The good news is that the incoming crowd could not repeat the blunders of the outgoing Congress even if it tried.  Divided government counts gridlock as one of its greatest virtues.  Even a long overdue political bed rest from the next round of Obama legislative mischief should provide a strong tonic for the economy.

But clearly something else has to be done.  Unfortunately, our complex system of divided government has a downside that will be difficult to overcome.  It is just as hard to repeal bad legislation once it is in place as it was to enact that bad legislation in the first instance.  Ties go to the status quo, which in this instance is not enough.

He goes on to suggest some stronger remedies:

The first and most obvious task is to find some political way to derail or postpone the introduction of the health care bill whose internal flaws become only more apparent with each painful administrative announcement. 

The hugely costly but ultimately ineffectual and unpopular health reforms seemed to be a major factor in the demise of many Democrats.  

He also advocates moves in the direction of a flat tax:

On a second front, Congress could opt again toward a flat tax by refusing to raise the top rates on the wealthy.  Only the New York Times editorial board—incorrigible after an electoral drubbing—could be so short-sighted as to think that some deep attachment to income redistribution should drive all tax policy, when incentives for production, labor and investment matter so much more.

and argues that a vigorous programme of deregulation is needed:

Start with easing all the restrictions on employment so that it actually makes economic sense to hire people on terms and conditions that make sense for workers and employers alike.  Then push forward a free trade agenda that removes all the bottlenecks to the movement of labor, goods and capital across national boundaries.  Then be relentless in the opposition to the continued dominance of public unions. And finally open up education to competition from the private sector, including the for-profits, so that entrenched public institutions do not continue to hold their implicit monopoly position. 

The economy and, in particular, government spending, was undoubtedly the defining issue in the US mid-terms.  Plenty of lessons there for New Zealand, and let’s hope it adds impetus to the New Zealand government’s efforts to pursue its 2025 goal.   

Another lesson for New Zealand is contained in Richard Epstein’s explanation of his deep personal aversion to publicly endorsing political candidates for office:

The reason has nothing to do with any sense of personal shyness about taking strong stands on substantive issues.  Indeed, the concern is precisely the opposite.

Candidates represent what might be called tied purchases of a market basket of goods.  The only choices that are given to hapless voters is to pick one such basket over another.  Anyone who offers the menu at a Chinese restaurant gets to choose one from column A and one from column B.  Yet that form of flexibility is denied in choosing people for political office.  It is not because of any inherent defect in the political system.  It is simply because the person is the smallest unit for which it is possible to cast a vote for holding public office.  The only comfort that one takes is that no voter is required to vote for the entire slate of candidates from either party, but can pick and choose among them.

No such comfort in New Zealand.  Under New Zealand’s MMP system, one of the two votes you cast does force you to vote for an entire slate of candidates. More’s the pity.

Another ‘takeaway’ is that voting (politics) is a very crude way for people to pursue their preferences. Markets and voluntary cooperation are often infinitely superior. We should reserve for voting only those things that need to be decided through the political system.

I recommend reading Richard Epstein’s full article. 

As a postscript, I was interested to note that the Tea (Taxed Enough Already) Party – surely one of the most spectacularly successful grass roots movements of our times – is not the ‘extreme conservative movement’ it’s sometimes been painted as. The movement has in fact brought together huge numbers of Americans of a variety of political hues, united in a belief in fiscal austerity as a solution to the country’s economic problems. Interestingly one recent survey showed that 28% of Tea Partiers are independents, and 17% Democrats. 

Much of the movement’s success in uniting such a large and diverse constituency (Moe Tucker of the band Velvet Underground has been a vocal supporter) can be attributed to a desire to maintain a steadfast focus on the economy, and in particular government spending. Another lesson for New Zealand?

For an interesting pre-election view on the biggest myths of the mid-term elections which covers Tea Party misconceptions, read Kimberly Strassel’s article.

Australians Prefer First-Past-the-Post

An interesting poll here commissioned by the Institute of Public Affairs, a Melbourne thinktank.

The Newspoll survey finds that most Australians (57%) support a first-past-the-post (FPP) voting system compared with 37% who support Australia’s current preferential system.

Both systems are constituency-based compared with MMP, which is a proportional system – the make-up of parliament is essentially determined by the party vote.

Both FPP and a preferential voting (PV) system will be on the ballot paper for next year’s MMP referendum.  The two systems will also be the subject of a referendum next year in the United Kingdom.

PV can encourage strategic voting and is not necessarily an accurate reflection of voters’ preferences.  All voting systems have pros and cons.  The great political philosopher Karl Popper considered the key feature of a good democratic system was the ability it gave voters to throw out a government it disliked.  FPP does that decisively whereas PR systems like MMP don’t.

The full study is here

RIP Graeme Hunt

Graeme Hunt 1952-2010


It was with deep sadness that I learned of the sudden death of Graeme Hunt today. Graeme was a widely-respected author, historian and journalist, and a tireless campaigner for electoral reform in New Zealand.   

He was also standing as an independent candidate for the Albany ward of the new Auckland Council and was reportedly leading in the polls.   

Graeme was passionate about New Zealand history and one of our foremost business historians. He was a walking encyclopaedia who, while chatting, could go into extraordinary detail about a huge variety of topics including long-forgotten people, places, organisations and issues.   

Together with Peter Shirtcliffe, Graeme founded the Put MMP to the Vote lobby group and it’s extremely sad that he won’t be here to see the outcome of the referendum at next year’s election. Graeme wrote the book on Why MMP Must Go and has been a commentator on the subject since before the system was implemented. I greatly admired his tenacity in this regard – a largely thankless task that he pursued relentlessly because he believed New Zealand would be a better place without MMP.  Those of us who share that view should, in Graeme’s memory, redouble our efforts to make the case for change.   

Graeme was an award-winning journalist and former editor-at-large of the National Business Review. The NBR reported his death this morning.   

I’ve lost a good friend and a much respected colleague, and New Zealand has lost one of its most talented and public-spirited journalists.   

My sincere condolences go to his wife Saluma and his son Robert and daughter Ellen.