Public expenditures have been steadily increased since the beggining of the 20th century in most developed countries in the world, from 10-15% of GDP prior to the World War I to the current level, which is close to half of the GDP. This is even more pronounced in European countries where public expenditures in some countries regularly exceed this threshold. However, this high share of public expenditures undermines future growth, by allocating resources to less productive areas.
The Wagner’s Law, proposed by a German economist Alfred Wagner in late 19th century, states that government expenditures are to rise in industrializing countries, due to social, political and economic pressures for new state functions and income redistribution. Since this rise in public expenditures is higher than the average growth rate, it means that public expenditures as a share of GDP will continue to increase. There is some empirical evidence for this statement, since the level of relative average public consumption in European countries rise with the level of income.
The graph shows a 10 year average of public expenditures for European countries, in order to eliminate possible temporary effects of economic cycles or other events. There is a clear trend path - higher the income, higher the public consumption. However, there are differences from the rule: some countries are characterized by frugal and some by profligate public spending.
Among countris in transition, Serbia, Croatia, Bosnia and Herzegovina, Montenegro and Hungary have a much higher public expenditures than their level of income would suggest; Slovenia and Czech Republic are broadly in line with the proposed trend while other countries have public sectors that consume significantly lower portions of their respetive GDP. Among developed countries, France, Belgium and Austria coupled with Scandinavian countries have higher public spending than comparable countries such as Germany or the UK.
Public expenditures do not fall out from the sky - those are resources taken from the economy and used in a way that is often suboptimal, in order to achieve some social, political or economic goals desired by significant parts (or majority) of populace in democratic countries. In order to collect these resources, taxes need to be raized, which leaves less resources to entrepreneurs and consumers. Public investments crowd out private ones, largesse of welfare programs induce people to decrease their effort and private savings etc. All of this in turn have negative effects on economic growth. Although this is not the only, and pobably even not the most important factor, it does contribute to slow economic perfomance in European countries.
The optimum size of government would be the one which maximizes economic growth. Different econometric research that aimed to measure what is the optimal size of government tend to disagree on the actual level, due to different techniques used and different country sample or timeframe. However, they all agree that the level of public consumption in European countries is much higher than it would be desireable: most of the research estimate public consumption level to be between 17% and 40% of GDP, with the median being 20-30% of GDP.
What to do?
Demographic shifts in Europe will create new pressure on public finances, due to increased expenditures on public retirement and health system. High level of public debt further fuels this problem, leaving little fiscal space and possible spikes in the interest rates can further aggravate the situation. Trimming public expenditures is necessary both in the short and the long run, in order to make public finance viable and create space for tax rate decrease. Is this politically possible? Swedish experience of the austerity and reform programs in the 1990-ih says so: the program greatly improved the prospects of the Swedish economy, its political actors continued to play important political roles, and the Swedish society did not collapse but prospered.