Government spending can help drive economic growth — but only up to a point, according to new research from the School of Economics and Finance at the University of the Witwatersrand.
The study by Mthokozisi Mlilo and Eliphas Ndou finds an inverted U-shaped relationship between government consumption and economic growth, suggesting that public expenditure initially supports economic activity but eventually reaches a level where additional spending delivers diminishing returns.
The research estimates that the optimal size of government consumption falls between 11% and 20%, although the threshold varies significantly between countries and regions.
The findings add to a long-running economic debate over how large the state should be and how much governments should intervene in their economies.
Rather than arguing that the government should play a minimal role, the study highlights the importance of finding the right balance between public intervention and economic efficiency.
“Government expenditure enhances growth up to a threshold, beyond which diminishing marginal returns outweigh the positive impact,” the study says.
One of the study's most important findings is that government size cannot be considered in isolation from the quality of institutions.
Countries with stronger institutions are better positioned to turn public expenditure into economic growth, while weak institutions can increase the economic costs associated with government activity.
Effective rule-of-law systems, stronger accountability and lower levels of corruption can improve the efficiency of government programmes by reducing public-agency problems and rent-seeking.
This means a government may not necessarily need to spend more to achieve better outcomes. Improving the way the state operates could allow it to deliver more with fewer resources.
The research points towards institutional reform as an important component of fiscal policy.
For countries with weaker institutions, the study recommends prioritising reforms in areas such as the rule of law and anti-corruption measures. Greater institutional efficiency can ultimately allow governments to operate with a smaller and more effective public sector.
The research also cautions against applying a single government-spending target to every economy.
Developing countries with lower institutional quality may initially require higher levels of government expenditure to establish basic infrastructure and public goods.
The challenge is ensuring that increased spending is accompanied by improvements in institutional capacity.
For these economies, simply cutting expenditure could be counterproductive if it reduces investment in essential public services and infrastructure. At the same time, continually expanding the state without improving efficiency risks creating a government sector that becomes increasingly expensive without generating equivalent economic returns.
The study's findings suggest that the optimal level of government spending should therefore be determined according to each country's economic structure, level of development and institutional strength.
The paper said that using single-country time-series and panel threshold estimation techniques across a sample of 63 countries, the study estimates that government consumption should average around 12% in Organisation for Economic Co-operation and Development (OECD) countries.
For non-OECD economies, the estimated threshold is higher, at approximately 15% to 19%.
The difference highlights the role played by institutional and economic development in determining how effectively governments can deploy public resources.
The research also identifies the redistributive arm of government as a major contributor to the expansion of government size.
Redistribution can play an important role in raising living standards and providing economic security. However, the study makes clear that different components of government spending can have very different effects on economic performance.
The question is therefore not simply how much the government spends, but where the money goes and how effectively it is used.
The research carries an important message for policymakers facing pressure to expand government programmes: bigger government does not automatically mean faster economic growth.
Once government consumption moves beyond its economically productive threshold, the additional costs can begin to outweigh the benefits.
But the opposite is also true. A government that is too small or incapable of providing basic public goods can constrain economic development.
The policy challenge is to identify the point at which public intervention is generating genuine economic value — and then ensure that institutions are strong enough to deliver those services efficiently.
For emerging markets in particular, this creates a two-part policy agenda: provide the public goods needed for development while simultaneously strengthening the institutions that determine whether government spending produces results.
yogashen.pillay@nationalmg.co.za