IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
WP 2013-05. Executive Summary
Although it is generally agreed that government size has a negative impact on economic growth, it is also manifest that the intensity of this causal relationship varies across countries and over time. It is usually argued that these differences can be explained in terms of institutions, policies and social trust. In partial contrast with the traditional literature, this paper argues that another key factor is government legitimacy, which is here defined as citizens’ belief that government structures, officials and processes operate according to the rule of law (lack of arbitrary power and corruption) and that politicians follow agree-upon norms of behavior. Put differently, legitimacy is a matter of trustworthiness (policymakers are thought to be concerned about the common good) and procedural justice, and the idea is it has an effect on the way government size affects economic performance.
In theory, legitimacy can play both a positive and a negative role. For example, people who consider the government legitimate may be more willing to work hard and undertake innovation and investment at any given tax rate; and if citizens trust their government, less resources must be devoted to the enforcement of policies (including tax collection), which frees up these resources for more productive spending. By contrast, one might suggest that a government supported by an aura of legitimacy escapes monitoring and must pay a lower (political) cost when it misbehaves; for example, it may be easier to introduce regulation and populist spending, which usually harms growth.
This contribution develops these ideas in depth and tests the validity of the various hypotheses by relying on a rich dataset derived from EuroBarometer polls. In brief, the results show that:
> Government size has a clear, negative effect on growth in the longer run, while the short-run effect is ambiguous.
> Government legitimacy is currently rather low in Italy, Portugal and France, while the opposite is true for countries like Denmark, Luxembourg and Finland. Yet, it varies over time. For example, in the mid-1980s, government legitimacy was very low in Denmark, and increased dramatically between 2001 and 2009. By contrast, in Germany legitimacy has been declining steadily since the early 1970s.
> The effect of legitimacy with regard to growth is positive when the size of government is relatively small (government final consumption below 25% of GDP and tax revenues below 43% of GDP). Since small government is usually associated with “good policymaking”, legitimacy tends to shore up the effectiveness of growth-enhancing governmental activities.
> The effect of government spending with regard to growth is particularly negative when legitimacy is high (hence less legitimacy may enhance growth).
> In recent years, and according to the two parameters mentioned above, France, Denmark, Finland and Sweden are characterized by “large governments”. Hence weak government legitimacy in France could partially compensate for the damages provoked by the size of government. Instead, it is possible that strong legitimacy in the Nordic countries sharpens the negative effect of big government with regard to long-run growth.
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