Government Size and Growth: Accounting for Economic Freedom and Globalization

Several recent studies have found a negative relation between government size and economic growth in rich countries. Since countries with big government have experienced above average improvements in both the Economic freedom index and the KOF globalization index, we argue that existing studies suffer from an omitted variable problem. Using Bayesian Averaging over Classical Estimates (BACE) in a panel of OECD countries, we show that the negative effect from government size is very robust and may have been underestimated in previous studies. The dataset is an updated and extended version of the data used by Fölster and Henrekson (2001), covering the period 1970-1995. We find clear evidence that globalization has a positive effect on growth, but find no effect of economic freedom. Finally, we find that the negative effect of government size decreases substantially in size but remains significant when we add the period 1996-2005 to the sample. Our results support the idea that countries with big government can use institutional quality such as economic freedom and globalization to mitigate negative growth effects of taxes and public expenditure.