Government activity and economic growth – one size fits all?

Different to other empirical studies on the growth effect of government we look at the implications of the overall package of government activity, i.e. spending and regulation, and argue that inconclusive results in the literature are due to the fact that one size of government does not fit all countries because of differences in the institutional framework:

-          Institutional complementarities described in the Varieties of Capitalism (VoC) literature predict different roles for governments in Liberal Market Economies (LMEs; mainly the Anglo-Saxon countries) and Coordinated Market Economies (CMEs; mainly the Scandinavian and Continental European countries). While this theory focuses on regulations in the first place, the literature on Worlds-of-Welfare-States provides an extension to government spending and taxation. We attempt to provide a first test on the relevance of these literatures for determining the growth effects of overall government activity.

-          The literature on institutions and growth is rather conclusive on a positive role of better institutions. However, indirect effects of institutions through government activity are not explicitly tested for and important information on the role of economic development and location-specific context is excluded by sample limitation to developed or developing. We attempt to provide an empirical test based on a worldwide sample, in which we allow for direct as well as indirect effects of institutions.

We test these hypotheses by implementing cross-terms between government activity and institutional quality / economic systems in panel regressions for 111 countries and data average for 5-year periods between 1971 and 2010. According to preliminary results, this reveals the following insights:

-          The growth impact of government activity is generally positive but inversely u-shaped with a low impact on the extreme ends. For recent years, there is no indication that governments are too large.

-          Government activity is clearly more effective for better governed countries. The maximum growth impact increases and is reach at lower levels of government activity.

-          Most importantly, the u-shaped relationship is different of cluster countries determined by different economic systems. Polar cases of LMEs and Scandinavian CMEs exhibit the highest growth rates but this is reached for above average government activity in CMEs and below average government activity in LMEs. To some extent, the same divide is evident for developing and Eastern European countries.