Third, we construct a simple proxy for the quality of public infrastructure by using an intuitive index with a sufficiently long time-series dimension, also used by Tanzi and Davoodi (1998). Our regressions show that only in those years in which our measure of government quality deteriorates relative to the previous year, a larger government size is bad for growth. By contrast, when our measure of quality improves relative to the previous year, the growth effect of government size is insignificant. It is the significantly negative effects that dominate over time; this is why on average larger sizes are found to hurt growth (see the first result above). Thus, what really matters to growth is the size-efficiency nexus, not size per se.
It is worth pointing out that the introduction of the above quality index improves the fit of our regressions impressively. The growth in the share of government in GDP, when allowing for a non-linear Laffer curve-type effect, can explain - along with some simple political dummies - around 80% of the variation of the growth rate in the Greek economy over the last forty years.
These findings imply some policy lessons. Other things equal, a reduction in government consumption can become an engine of growth. But, it is necessary to look beyond size: the composition and efficiency of the public sector are also important. In particular, a fiscal consolidation can become especially expansionary if it is in the form of cuts in expenditure on wages and salaries in the public sector. A reallocation of funds into public investment could further contribute to growth. Concerning efficiency or quality, it is striking that in years of improved government quality or efficiency, increases in an already over-sized public sector have not hurt growth.
The rest of the paper is as follows. Section 2 reviews the empirical literature. Section 3 describes the data and investigates their time-series properties. In section 4, we test how the government size affects growth. In section 5, we analyze the effects of disaggregated fiscal-tax policies. Section 6 examines how the growth effects of size depend on the quality of government. Conclusions and extensions are in section 7.
2. Related literature and econometric problems
Empirical studies of growth have primarily focused on cross-country differences in long-time period averages. In these cross-section and panel studies, there is some general indication that the overall size of the public sector (see below how this size is measured) is negatively associated with economic growth (see e.g. Barro and Sala-i-Martin, 2004, and Folster and Henrekson, 2001).