The New Horizon

A new world explored with a rational view

Govt sizing – too little or too large?

with 6 comments

I came across the quantitative measurement of a country’s economic freedom in a report presented by Economic Freedom of the World. The report concludes that “Countries with more economic freedom have substantially higher per-capita incomes”, with their chart at page 17.

This shows that the least free countries also lags in per capita income and the most free ones have high income.

To derive to a Economic Freedom index, the Journal of Economic Survey assigned numerical marks to each country in each of the categories. There are four basic categories they classify their numbering into – Size of Govt, Legal Structures, Access to money, Freedom to trade, Regulations (Credit, Labor and Business). The one I am going to discuss now, is basically the first one, i.e. Size of Government: Expenditures, Taxes, and Enterprises.

As per their description, this category has four further sub-categories –

  • General government consumption spending as a percentage of total consumption
  • Transfers and subsidies as a percentage of GDP
  • Government enterprises and investment
  • Top marginal tax rate

Their basic argument goes like this (quoted from the report) –

“When government spending increases relative to spending by individuals, households and businesses, government decision-making is substituted for personal choice and economic freedom is reduced. … When government consumption is a larger share of the total, political choice is substituted for personal choice. Similarly, when governments tax some people in order to provide transfers to others, they reduce the freedom of individuals to keep what they earn. … They (Govt Capital) often operate in protected markets. Thus, economic freedom is reduced as government enterprises produce a larger share of total output. … Such rates (High income tax rates) deny individuals the fruits of their labor. Thus, countries with high marginal tax rates and low income thresholds are rated lower. …  countries with low levels of government spending as a share of the total, a smaller government enterprise sector, and lower marginal tax rates earn the highest ratings in this area.”

But does it translate to prosperity? Does it at all contribute towards higher per capita income? Surprisingly, the statistics shows a negative correlation between Govt size and Per capita income. I tried to come up with a chart where I list out 20 countries with highest rating in Govt. size and their rank in World Bank per capita income list.

Per Capita GNI rank vs Govt Size rank Graph

Per Capita GNI rank vs Govt Size rank

So, we’ve got an interesting list. Most of these countries are poor, except for tax havens and Singapore. Besides, the top ranked Hong Kong’s Military and Foreign relations are managed by Mainland China that scores poorly in the Govt size index.

Now let’s see how it looks like for the countries who are rated poorly. The bottom 20 of Govt size countries are –

Per Capita GNI rank vs Govt Size rank graph

Per Capita GNI rank vs Govt Size rank

So that becomes interesting, the list includes countries such as Scandinavian ones, Benelux members – countries those offer highest freedom to their population. And more interestingly, on an average, the average rank of these 20 countries is 99.5 in the per capita GNI compared to that of 123.85 for top 20 countries.

So, the end chart of top-10 vs bottom-10 looks like this –

Top 10 vs Bottom 10

Top 10 vs Bottom 10

FYI, the Top 10 avg drops to 12,502 if we keep Hong Kong out of the list.

Now let’s revisit the facts and hypothesis. Fact one – more Govt intervention/size is correlated to higher per capita GNI. Fact two – more economic freedom is correlated to higher per capita income. However, the hypothesis, as per the report, is that less govt intervention/size should contribute towards higher economic freedom!! How good is the hypothesis then? Doesn’t it falsify the conventional wisdom of higher Govt intervention implies less prosperity? In other words, doesn’t it falsify the neo-liberal economists and World Bank/IMF dogmas?

GNI Per Capita incomes are collected from World Bank Website.

The data about Economic Freedom Index are collected from Free the World website.

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Written by Diganta

April 25, 2011 at 7:02 am

6 Responses

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  1. Hi Diganta, nice post poking holes in a few Tea Party style myths. When it comes to the size of government and prosperity, there are two types of issues we need to think about.

    The first issue is microeconomic. What does the government do, and how it does it? Of course, if the government is going to run grocery shops (as was the case in USSR), that would be a bad outcome. On the other extreme, most people would agree that the government should provide law and order and enforce contracts. The problem for developing countries is not that there is too much government or too little government. Rather, it’s that the government either does the wrong thing, or that it doesn’t do the right thing properly.

    Let me illustrate with a simple example: traffic. All developed countries have well functioning traffic system run by government. Most big cities in developing world don’t. But in developing world, there are two kinds of cities. In some cities, there are traffic cops on the beat, but they usually take bribe and commit extortion. In other cities, there are hardly any cops. It’s a tricky question to answer which is worse.

    There is a different, macroeconomic, issue. It’s about how the government is paid for. If the government doesn’t raise enough tax, ie runs deficits, then it risks either a Greek-style debt crisis or a Zimbabwe-style hyperinflation — and this will happen even if everything the government does it does efficiently and it doesn’t do anything that it shouldn’t do.

    Interesting thing is that while on the micro front, the developed world is unquestionably better, on the macro front, it’s the western/northern countries that run big debts and deficits. The emerging world (notable exceptions include India and Pakistan) has been pretty good at living within its means.

    Finally, a small gripe on an otherwise great post. You are being unfair to the IMF and World Bank. These institutions do not peddle the Tea Party line about the evils of government. Most IMF-WB publications tell you exactly what I’ve said above using technical language and charts.

    jrahman

    July 2, 2011 at 10:41 am

  2. I know there must be something I’m missing here, but if you could illuminate.

    You write:

    🔘 ❝Now let’s revisit the facts and hypothesis. Fact one – more Govt intervention/size is correlated to higher per capita GNI.❞

    *But that’s not what the chart [per capita GNI average] shows❗* The bottom 10 have higher per capita GNI than the top 10. This surely means that less government size is correlated to higher per capita GNI, as per the chart.

    Unless I have radically misunderstood the ranking index by government size ▬ where a higher number indicates _more_ government [where I had assumed it meant that it has less].

    Please clarify.

    BDAF

    September 1, 2014 at 12:19 am

    • From the data/graph shown, which gdp-per-capita quarter the country belongs to, is correlated to govt size, i.e. it’s a secondary correlation. There’s no correlation coefficient computed and shown.
      Leaving academics apart, my intention was to discuss the wide variety of countries within the top and bottom 10 to show there’s no single theory of success and even if it does, govt size probably doesn’t matter. My attack is more on the line correlation doesn’t mean causation.

      Diganta

      September 5, 2014 at 4:51 pm


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