Standards are more important than size

What effect does government have on the growth of the economy? The orthodox view in Russia seems to be: overwhelmingly bad. Andre Illarionov, chief economic adviser to the president, says that to meet Putin’s target of doubling Russian GDP by 2010, government spending should be halved from 36 to 18% of GDP. It is difficult to say how much of this view is derived from economic theory and evidence and how much from the fact that the Russian government is corrupt and incompetent.

In the theory of the matter, it is important to distinguish between short-run and long-run effects. In the short-run a deficit created by tax cuts or higher spending helps growth; in the long run adding to government debt is likely to hurt growth by raising interest rates and thus reducing private-sector investment. In long run budgets should be balanced, with current spending covered by taxes. Public investment should ‘pay for itself’ by producing an extra cash flow to service the debt. This leaves open the question of how much of the national income the government should tax and spend.

Those who believe that economies grow fastest where the state is smallest argue that government will inevitably use resources less efficiently than the private sector. Thus if a government builds a road or railway system it will cost more than if private enterprise did it. This is probably true. What it ignores is the possibility that, in the absence of public enterprise, no road or railway system at all would be built. Adam Smith, no champion of collectivism, listed as one of the duties of the state ‘erecting public institutions and public works’, which while ‘in the highest degree advantageous to society’ could ‘never repay the expense to any individual or small number of individuals’. He singled out transport and education. As we would say today, the social rate of return on investment in transport, education, health care, and so on is higher than the private rate of return, and thus serves to lift the growth rate of the whole country.

What does the empirical evidence tell us? Illarionov says that international experience provides irrefutable evidence that excessive public spending injures growth. But what is ‘excessive’? An important study by IMF economists Vito Tanzi and Ludger Schuknecht concluded that ‘small governments do not perform worse and often perform better than big governments in promoting social and economic well-being’. But by ‘small governments’ they meant governments which spend an average of 35 per cent of GDP-roughly what the Russian government spends today.*

There is thus no decisive evidence that slashing government spending automatically boosts the growth rate. Much more important –within limits –than the absolute size of the state is what it spends the money on and how well it performs its necessary tasks.

Most governments should spend more, not less, on education and infrastructure than they now do. Standing in the way is the accounting convention which treats public expenditure on education and roads as consumption rather than investment. If government borrows to finance these investments, the accounting framework recognizes the liability, but takes no account of the corresponding asset. As economist Joe Stiglitz points out, it is a framework designed to squeeze the government and inhibit growth-enhancing investment.

Nor is it inevitable that government is bound to do badly the things it should be doing. Governments vary enormously in the level of corruption of their public officials and the amount of red tape they impose on business. The Russian government scores badly on both counts. This is probably at the root of Illarionov’s enthusiasm for downsizing it. But this is to ‘throw out the baby with the bathwater’ as they say in England. Russia will not grow faster by making its government smaller than it now is, but by improving its standard of performance. This is not communist doctrine: it is the lesson of capitalism the world over.

*V. Tanzi and L. Schuknecht, ‘Can Small Governments Secure Economic and Social Well-Being?’ Frontier Centre for Public Policy, 1 January 1999.