Don't judge government by its size

In the early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

In the early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

In the early 1980s, not long after I got into the economic commentary business, Maggie Thatcher and Ronald Reagan were riding high and the great enthusiasm of the moment was the need for Smaller Government.

Thirty years later, government is no smaller but the attraction of the idea is undiminished.

Its latest champion is Tony Abbott, who promises to eliminate government waste and cut taxes - and return the budget to surplus. Julia Gillard isn't far behind. She'd never admit to being against smaller government, and is insistent on getting the budget back to surplus next financial year and not a day later.

Smaller government is an idea that appeals at every level. It's attractive to libertarians, economists and business people, who remain suspicious of government. And it appeals to every voter who doesn't like paying more tax.

But Ian McAuley, a lecturer in public finance at the University of Canberra, questions our uncritical support for the smaller government ideal in an extended essay published today by the Australian Collaboration, The Australian Economy: Will our prosperity be short-lived?

Contrary to some perceptions, he writes, Australia already has a small public sector and a low level of public debt. ''Successive governments have kept taxes and deficits down by keeping expenditures down. As a result Australia has one of the smallest public sectors of all developed countries.''

Over the seven years to 2008, taxes paid in Australia to all levels of government averaged 29 per cent of gross domestic product, compared with a developed-country average of 35 per cent. Only Japan and the United States pay less than us - 27 per cent - and that's because they run perpetual budget deficits.

If you judge it by total government spending, rather than total taxation, our spending averages 34 per cent of GDP, compared with the developed-country average of 40 per cent. (In our case, the gap between taxation and spending is covered by non-tax revenue.)

Our aversion to supposed big government includes an obsession with government debt even though, with government net debt no higher than 13 per cent of GDP, Australia's public debt is ''way below the level of almost every other developed country''.

Economists' and business people's support for smaller government stems from their entrenched belief that big government causes economies to malfunction. One small problem: after decades of searching they can't find evidence to support such a link.

There's no correlation between size of government and rate of economic growth. Some countries with big public sectors do well some countries with small public sectors do badly.

Many business people - who wrongly imagine countries compete the same way firms do - worry a great deal about their country's ''competitiveness''. So let's examine the (highly subjective and ever-changing) World Economic Forum's global competitiveness index.

Top of the ranking in 2011 is Switzerland, with the same rate of tax to GDP as us, 29 per cent. We come 20th. The United States, with a tax rate of 27 per cent, comes fifth. But it's pipped by Finland, on fourth, with a tax rate of 44 per cent and Sweden, on third, with a rate of 48 per cent.

Denmark, the country with the highest tax rate - 49 per cent - comes eighth. Germany, with a tax rate of 36 per cent, comes sixth, while the Netherlands, with a tax rate of 38 per cent, comes seventh.

As McAuley concludes, what counts rather than size of government are the uses to which public revenues are put and whether government services are provided efficiently.

Nor is there any necessary connection between the size of a country's government and its discipline in keeping the two sides of its budget within cooee of each other and thus limiting budget deficits and avoiding excessive government debt.

When we observe the bother the Americans and various European countries have got themselves into after decades of deficits, we see the upside of our debt-and-deficit phobia.

But, as McAuley reminds us, that phobia has a downside. What is important economically, he says, is not so much the level of debt as the use to which that debt is put. If governments borrow to fund present consumption, that's unsustainable over any extended period.

''There is no reason, however, to avoid using debt to finance productive infrastructure. Well-chosen infrastructure can provide good returns,'' he says.

You can divide public spending into spending on public goods (including physical assets such as roads, as well as services such as health care) and ''transfer payments'' (such as pensions, family allowances and industry subsidies).

McAuley argues we've yielded to pressure for ever-increasing spending on transfer payments, with the share of total federal spending on social security rising from 21 per cent in 1972 to 33 per cent today. This doesn't count the ever-growing amount of revenue forgone in the form of tax concessions for superannuation, private health insurance, capital gains and much else. Many of these benefits go to people who are reasonably well-off.

Combine this with our pre-occupation with limiting overall government spending and taxation and you find we've been crowding out spending on public services. We've gone for years squeezing our spending on education - particularly tertiary education - which is really an investment in the human capital of our future workforce.

We've also neglected investment in physical infrastructure and environmental protection. But these are important investments if we're to have a prosperous economy in a world where success rests on wise use of human and natural resources.

Bottom line: the only path that's both politically feasible and economically responsible - one that sustains transfer payments while spending more on needed public services - is for us to pay higher taxes.

Ross Gittins is the economics editor.

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