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Shrinking the state

We live in an era of big government. The Office for Budget Responsibility forecasts that even by 2025 – after four years of restraint – public spending will account for more than two-fifths of national income. That’s five percentage points more than it did in 2002, after five years of Labour government. And because of this, the share of taxes in GDP is forecast to rise to its highest proportion since 1950.

There’s a reason for this – and it has much more to do with economic stagnation than with political philosophy.

History tells us as much. During the first three years of the Thatcher government, public spending rose as a share of GDP, from 41.5 per cent in 1978-79 to 43 per cent. During the first three years of the 1997-2010 Labour government, however, the share fell. Did this happen because Margaret Thatcher was a socialist committed to increasing the size of government while Gordon Brown was a libertarian determined to shrink it? Obviously not. It was simply because the economy shrank in the early 1980s recession but grew nicely in the late 1990s. Variations in the share of public spending in GDP are much more about what happens to GDP than they are about politicians’ ideals.

Public spending is counter-cyclical; it rises relative to GDP in downturns and falls in upturns. Since 1973 – the end of the long post-war boom – the correlation between five-year GDP growth and five-year changes in the share of public spending in GDP has been a hefty minus 0.64. Maynard Keynes famously said “Look after the unemployment, and the Budget will look after itself.” We can rephrase that: “Look after the economy, and the size of the state will look after itself.”

If you want to see the share of government shrink, the best chance lies not in any libertarian tax-cutting instincts of this government – which are much more discussed than observed – but in the economy doing better than expected. Personally, I think this is a forlorn hope, but history tells us it is the best one there is.

But why should we want the state to shrink? There are cultural reasons, but some perceive an economic reason too. Lord Frost, the government’s chief Brexit negotiator, said recently: "We know what the formula for success as a country is. It's low taxes.” In truth, the evidence for this is dubious. In his recent book Fully Grown, Dietrich Vollrath at the University of Houston writes: "It is very hard to find real effects of taxation and regulation on the aggregate growth rate of real GDP”. Scandinavian economies, for example, have done just fine with high taxes.

There is, however, a big difference between an economy that has high taxes because it made a deliberate political choice and one that fell into high taxes because it couldn’t finance public services from economic growth. Big government might not be a direct cause of slower growth, but the economic dysfunction that leads to it might very well be.

If you want a smaller state, you need to boost economic growth. Which is really tricky, because longer-term growth might not be much under the influence of national government. One option here, though, is not to impose trade barriers between the UK and EU and within the UK. Which makes it perplexing that so many who purport to want a smaller state should be so keen on a hard Brexit.