The economic role of the state in the 21st century.

• Author: Tanzi, Vito

The last half-century has witnessed major developments in the economies of the industrial countries and in the role that the governments of these countries have played especially through the instrument of public spending. This article describes some of these developments and focuses on the role that the governments of these countries should play in the future. (1)

The Growth of Public Spending

The tax levels of many industrial countries are today at an all-time high. Only a century ago, the situation was far different. Discussing the optimal level of taxation in 1888, the French economist Paul Leroy-Beaulieu concluded that tax revenue of 5-6 percent of GDP could be considered "moderate," revenue of 8-10 percent of GDP would be "normal," while revenue beyond 19, percent of GDP would be "exorbitant" and would damage the growth prospect of countries (Leroy-Beaulieu 1888: 127-28). In the context of today's tax burdens on industrial countries, and even of many developing countries, such as Brazil or Argentina, that position seems extreme. However, it was far from extreme at the time Leroy-Beaulieu wrote his book. At that time, most of today's industrial countries had levels of taxation and of public spending of around 12 percent of GDP. (2) For example, in 1870, France and Italy had public spending and tax levels of about 13 percent of GDP, and the United States had even lower levels. The economic role of the state at that time was limited and was focused on "core" functions such as defense, protection of individuals and property, administration, justice, and large public works. These core functions were largely those described by Adam Smith in the Wealth of Nations. Table 1 shows that between 1870 and 1913, a period of intense globalization, there was little growth in the relative levels of taxation and public spending (Tanzi and Schuknecht 2000).

In later years public attitudes regarding the economic role of the state started changing. In 1926, John Maynard Keynes called for the "end of laissez-faire" in a book of the same title and proposed a widening of the role of the state (Keynes 1926). In 1932, in an article in L'Encyclopedie Italienne, Mussolini predicted that the 20th century would become the "century of the state." Mussolini had initially been an economic liberal but he changed his views during the Great Depression. Perhaps he saw political advantage in a larger role of the state in the economy. From an economic perspective, his prediction proved to be right.

At the time when Keynes and Mussolini were expressing these views, other pressures were coming from both the political right and the political left for enlarging the role of the state. Countries that adopted fascism and communism or socialism endorsed the view that the state should play a larger role in the economy. Even Roosevelt's New Deal reflected this view.

These pressures, together with developments such as the Russian Revolution, World War I, World War II, the advent of totalitarian regimes (both fascist and communist) in several important countries, and the Great Depression created a social environment and some of the economic conditions that ultimately were to encourage the phenomenal expansion of the economic role of the state that would take place in the rest of the 20th century (see Table 1). Public spending started to grow in the 1920s but grew slowly until about 1960. The great acceleration came in the period between 1960 and the mid-1980s when many countries, and especially the European countries, created mature welfare states that aimed at the economic protection of individuals from the "cradle to the grave." In that period, in several European countries (Austria, Belgium, Denmark, France, Germany, Ireland, Italy, the Netherlands, and Sweden), public spending approached or exceeded 50 percent of GDP. This level of public spending, and the taxes needed to finance it, would have been considered unthinkable in the earlier part of the 20th century.

Economists contributed indirectly and perhaps unintentionally to the growth of public spending by developing or popularizing economic concepts that provided convenient theoretical justifications for greater governmental interventions in the economy. Budget experts developed public management tools which, they claimed, would facilitate the scientific or objective analysis and evaluation of government programs. This was supposed to help avoid policy mistakes and to limit government-imposed inefficiencies. Concepts such as public goods, externalities, merit goods, natural monopolies, built-in stabilizers, multipliers, and so on were developed and were often used to justify greater public-sector interventions. Also a perception developed that larger public sectors would make economies more immune to business cycles.

Tools such as social cost-benefit analysis, public programming and budgeting systems, zero-based budgeting, capital budgeting, and so forth provided at times a kind of scientific cover for evaluations of governmental programs that, in many cases, in reality continued to be guided largely by political pressures and by political considerations. At times these tools were bent to justify more public spending as, for example, when some economists in the mid-1960s argued that cost-benefit evaluations of public investments and other spending should give more weight to one dollar of benefit that goes to a poorer person than a dollar that goes to a richer person, or should take into account the unemployment rate of a region. The calibrating of benefits and costs often led to the justification of public expenditure with low economic justification. This meant that in practice the economists--and their advice--contributed to driving up public spending.

Spending Levels and Economic Welfare

There is much debate on whether the large increase in public spending, especially in the last 50 years, contributed to a genuine improvement in the welfare of the majority of citizens, or whether the citizens would have been better off with a lower growth in that spending that would have left them with more after-tax income but less governmental services. Greater public spending often went toward paying for social services--health, education, and other benefits, including pensions. Government often provided such services directly through the public sector. Because public-sector intervention often displaces existing institutions or private intervention, it does not necessarily add, on a net basis, to the informal arrangements for social protection that the residents of a country were receiving or could have received through private programs. For example, in some countries there were extensive networks that informally provided some social protection to those in need. Ludger Schuknecht and I have challenged the view that the growth in public spending necessarily increased welfare (see Tanzi and Schuknecht 1997 and 2000).

It is often assumed that the welfare of citizens is linked to the numerical results of certain socioeconomic indicators--such as life expectancy, infant mortality, educational achievements, literacy rates, growth in per capita incomes, inflation, and others--that governments attempt to influence through their public spending. The evidence, however, shows that there has been little relationship, if any, in recent decades between the changes in the countries' shares of public spending in GDP and the changes, in the desired direction, of these socioeconomic indicators. Countries that allowed their public spending to grow significantly more than other countries do not show, on average, better quantitative results for these indicators than countries that kept their governments smaller and leaner. On the other hand, by reducing the after-tax income of the citizens, the countries that allowed their public spending to grow more undoubtedly reduced economic freedom.

When used as a general reference index for social welfare, the United Nations Human Development Index (HDI) shows that among the 20 countries with the best scores on this index, some have high shares of public spending to GDP--such as Austria, Belgium, Denmark, France, Germany, and Sweden--and some have low shares of public spending--such as the United States, Australia, Ireland, Canada, and Japan (see Table 1). The HDI combines indicators of longevity, educational attainment and enrollment ratios, and living standards. Furthermore, some countries not shown in Table 1, including Singapore, Taiwan, and Hong Kong--with small, but highly efficient governments--have levels for the HDI index and for various socioeconomic indicators almost as good as those for the countries with much higher public spending.

Some of the countries with the highest HDI scores and with high levels of public spending, such as Norway, Canada, Sweden, Belgium, the Netherlands, and Finland, have in recent years significantly reduced their public spending while retaining their high HDI index (see Table 2 and Schuknecht and Tanzi 2005). Thus, there is life after public spending reduction. These countries have shown that public spending can be significantly reduced without causing the large fall in public welfare that many expect. A scatter diagram (Figure 1) shows that there is no identifiable relationship between levels of public spending and HDI. This is confirmed by the absence of any correlation between the two variables.

Because the high taxes needed to finance high public spending reduce the post-tax (or disposable) income of taxpayers, thus restricting their economic freedom and, most likely, over the long run, have a negative impact on the efficiency of the economy and on economic growth, the question arises whether the level of public spending and, consequently, of taxation should be reduced if this could be done without reducing public welfare. That is to say, if public welfare is not reduced on any objective criteria by reduced public spending, then...