Introduction:

How much of a drag is the modern welfare state on economic performance? Many studies have weighed in on this question, mostly focusing on particular elements of government activity, e.g. tax distortions, crowding out, or expenditure effects. For example, one standard approach has been to estimate the disincentive effects of taxes and deduce that lower taxes would imply higher welfare. However, in the context of modern democracies, this argument begs the question why voters prefer an inferior economic outcome (a higher tax burden) instead of voting for parties that would minimize taxes. One obvious answer to this question stems from the fact that taxes are not levied out of malice, but – with a binding government budget constraint – reflect the need to pay for desirable and arguably beneficial government expenditure. Methodologically, a comprehensive framework that ties together the revenue and expenditure effects of government is needed.

The recent debate over the failure of European countries to catch up with U.S. economic performance over the last 3 decades also points to the need for a better assessment of the economic effects of large governments. Over the last three decades, European countries have not made inroads in closing a gap in per capita income vis-à-vis the US. One line of inquiry has stressed that inherent measurement issues may be presenting a misleading picture (Mahoney and van Ark, 2004). Alesina et al. (2005) point to the role of labor market institutions, while Blanchard emphasizes the role of differences in tastes. Yet another approach has pointed to the importance of the size of government.

This paper focuses on the latter, i.e., the role of the size of the public sector, for a number of reasons. First, measurement issues are unlikely to explain the divergence in the growth of per-capita GDP between the US and most of Western-Europe over the last 30 years. While data revisions based on sectoral accounts do paint a less bleak picture of European performance (Mahoney and van Ark, 2004), they are subject to their own shortcomings (Bell, 2004); also, more detailed micro data on firm productivity tend to support the a more vibrant growth of productivity and in U.S. firms (Bartelsman 2004). Similarly, a strong role for labor market institutions, while intuitively plausible, is not supported by the inconclusive empirical evidence (Rogerson 2005). Finally, an explanation based on tastes is even more problematic as tastes are – almost by definition – unobservable. At best, their relevance as an explanatory variable is assessed as a residual item after having explained the contribution of other factors, such as the size of government. The literature studying the impact of government on economic performance is large. Theory has focused on welfare effects – stressing the distortionary impact of taxation and government spending on the one hand, and market failures on the other – but is typically less concerned with analyzing macroeconomic aggregates. In contrast, empirical work (reviewed, e.g., in Garcia-Escribano and Mehrez (2004)) has offered insights into this matter, but has only imperfectly addressed the direction of causality. Moreover, owing to the non-stationarity of the relevant time series data, most econometric work has looked at the effects of government on economic growth rather than income levels.

This paper uses a theory-based cross-country quasi-accounting framework based on Prescott (2002), which explicitly tracks the effects of the size of government on the level of income. These predicted effects are then contrasted with data from a much wider sample than considered by Prescott. It turns out that Prescott’s model offers a surprisingly good description for key euro-zone economies, but does not perform well in the wider sample. Several richer specifications of the model show some evidence that government spending can raise economic efficiency, but observed government sizes generally tend to be too large, thus depressing welfare in many countries.

The paper is written for a more general audience, with a view toward explaining the key theoretical constructs and facilitating the presentation through graphs. To further lighten the text presentation, more technical issues are relegated to appendices, which the reader can skip if only interested in the main results.