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As economists and policymakers strive to understand the causes of the global financial crisis, pinpointing the relationship between government size and economic growth is crucial. In this comprehensive evaluation of existing economic research, Andreas Bergh and Magnus Henrekson find that in wealthy countries, where government size is measured as total taxes or total expenditure relative to gross domestic product (GDP), there is a negative correlation between government size and economic growth--where government size increases by 10 percentage points, annual growth rates decrease by 0.5 to 1 percent.

Bergh and Henrekson stress that statistical correlations, even when highly significant, are not law. Some countries with high taxes enjoy above-average growth, and some countries with small governments have stagnant economies. The Scandinavian welfare states, for example, have enjoyed steady growth over the last decade despite their large governments. However, these nations compensate for high taxes by employing market-friendly policies in other areas, such as trade openness and inflation control.

Government Size and Implications for Economic Growth concludes that, in every case, economic freedom is a crucial determinant of economic growth--suggesting that government intervention in the marketplace may be the wrong approach to solving the economic crisis.

Andreas Bergh is a research fellow at the Ratio Institute in Stockholm, Sweden, where he researches welfare state reform and institutional economics. Bergh is affiliated with Stockholm’s Research Institute of Industrial Economics.

Magnus Henrekson is president of the Research Institute of Industrial Economics in Stockholm, Sweden, and was formerly Jacob Wallenberg Professor of Economics at the Stockholm School of Economics. His research focuses on institutional determinants of entrepreneurial activity and explanations for cross-country differences in economic performance.