Returning British Columbia to Prosperity

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Government Spending: The Root of BC's Economic Problem

A government's fiscal policy includes both its spending and the taxation required to finance it. The British Columbia government's single greatest failure over the past decade has been its fiscal policy. The government has increased spending dramatically, and this has led to increased provincial taxes and debt levels. In a single decade, the province has gone from having a frugal, focused government that emphasised fiscal conservatism to an activist, interventionist government that undertook the expansion of the state.

This section begins with a brief summary of the economics of government spending. It then presents an empirical analysis of government spending in British Columbia, along with comparative data from other Canadian jurisdictions, both historic and current. Finally, it offers a series of policy recommendations.

Economics of Government Spending: Achieving the Optimal Size of Government

Government spends money to accomplish specific goals: to ensure the health of its citizens, to provide military protection, to supply a justice system, or to educate citizens. Nearly all economists agree that there are a number of functions and services that the government must provide, finance, and/or regulate. Thus, for most economists, the optimal size of government is a value greater than zero. Similarly, most people do not want government to use all of society's resources. Thus, somewhere between 0 and 100 percent, there is an optimal size of government. The debate over fiscal policy is most often rooted in determining what constitutes that optimal size.

Government expenditures come at a price: taxes. Taxes, as the Taxation section illustrates, create economic distortions (Browning, 1976). They do this by changing the relative prices of certain activities, goods, or services, while at the same time altering economic incentives (Aaron and Pechman, 1981).

Size of Government and
Economic Growth

A great deal of research has examined the relationship between the size of government and economic growth. Both Daniel Landau (1983) and Robert Barro (1991) investigated the relationship between the size of government and economic growth in a number of countries over a number of time periods. Both studies concluded that countries with smaller governments, that is, with less government spending, experienced higher rates of economic growth.

Similarly, research by Keith Marsden (1983) and William Easterly and Sergio Rebelo (1993) found that countries with lower marginal tax rates experience faster economic growth than countries with higher marginal tax rates. In fact, a 1990 study by Robert King and Sergio Rebelo found that increasing a country's taxes by 10 percent reduced its economic growth (measured as the annual change in GDP) by nearly 2 percent.

A number of studies completed by The Fraser Institute corroborate these findings. For instance, the Economic Freedom of the World project, which has now published four international reports along with one provincial report, provides overwhelming empirical evidence of the relationship between increasing levels of economic freedom (usually implying smaller government) and


increased rates of economic growth and income (Gwartney, Lawson, and Block, 1996; Gwartney and Lawson, 1997, 1998, 2000; Arman, Samida, and Walker, 1998). Similarly, research by Johnny Chao and Herbert Grubel concluded that historically, economic growth was maximized when government taxes and spending equalled 34 percent of national income, 5 percentage points lower than the roughly 39.0 percent we have today (Chao and Grubel, 1998).

To reiterate: smaller governments impose fewer distortions on economic activity because they are able to levy much lower and much less distortionary taxes. As a result, economies with smaller governments are likely to be more efficient, and this is reflected in higher rates of economic growth (Easterly, 1993).

Size of Government and Social Progress

The argument that larger government impedes economic growth is not unusual. In fact, it is quite intuitive and well-accepted. Less well known is the growing field of research that suggests that larger government also fails to achieve greater social progress than smaller government. For example, a series of studies completed by International Monetary Fund (IMF) economists Vito Tanzi and Ludger Schuknecht concluded that countries with governments whose expenditures exceed 50 percent of GDP do not materially (statistically significantly) outperform countries with smaller governments—those whose expenditures are less than 40 percent of GDP. In fact, Tanzi and Schuknecht have found that not only do large-government countries fail to outperform smaller-government countries, but that countries with medium-sized governments (those with expenditures between 40 and 50 percent of GDP) also fail to materially outperform smaller government countries (Tanzi and Schuknecht, 1995, 1997a and 1997b, and 1998).

Another important study recently completed by Professor Gerald Scully of the University of Texas (Dallas) supports the findings of Tanzi and Schuknecht. Professor Scully examined 1995 data for 16 indicators of social progress, including literacy, infant mortality, life expectancy, caloric consumption, access to health care, infrastructure, political freedom, civil liberties, and economic freedom, across 112 countries. He concluded that there was little or no difference in social outcomes among countries in which governments spent less than 40 percent of GDP and those that spent in excess of 50 percent of GDP (Scully, 2000).

Another striking conclusion contained in the Scully research is that government spending ceases to yield any further social progress, as measured by the 16 social indicators, at 18.6 percent of GDP for advanced countries (Scully, 2000). There is some variance among countries; for instance, the rate at which government spending ceases to provide any marginal benefits in Canada is 19.5 percent of GDP. This is particularly striking as the Organisation for Economic Co-operation and Development (OECD) in its June 2000 Outlook estimated that total government spending in Canada would be 39.0 percent in 2001, significantly exceeding the estimates of optimality provided above (OECD, 2000).

Government spending produces economic distortions that impede economic growth because of the taxes associated with government spending. Furthermore, as mentioned, mounting research indicates that larger governments do not necessarily achieve increased social progress. Clearly, there is some optimal size of government where social progress is maximized while the level of economic distortions and impediments to economic growth are minimized. This optimal level is clearly below the current level of government spending in British Columbia.

Where Are We Today?

Government Spending in British
Columbia

This study will employ three primary sources, as well as supplementary supporting documents, to assess government spending: Statistics Canada's Financial Management System, Statistics Canada's Provincial Economic Accounts, and the Province of British Columbia's 2000 Budget.

Statistics Canada's Financial Management System is the best source for inter-governmental comparisons because it is standardized across jurisdictions. The Financial Management System (FMS) coupled with the Provincial Economic Accounts will be the basis for all historical analysis. The study will use budget information to provide some insight into the government's plans.

Spending Figure 1 illustrates the real (inflation-adjusted) growth in provincial government expenditures between 1975 and 2000 for BC, Alberta, Ontario, and Canada as a whole. Government expenditures increased significantly over the period in British Columbia. In fact, the increase in government expenditures in British Columbia outpaced the increase in the next highest-spending province, Alberta, by nearly 50 percentage points.

More startling, however, is the significant difference in expenditure growth over the last decade (Spending Figure 1). While Canada as a whole and Ontario recorded increases of 10.7 and 13.2 percent, respectively, over the period, and expenditures in Alberta actually declined 4.8 percent, government expenditures in British Columbia increased an astounding 35.4 percent.

Examining aggregate increases in government expenditures alone can be too simplistic. For instance, they ignore population growth. A jurisdiction could, for instance, experience shrinking government in both per capita terms and as a share of the economy while total aggregate expenditures increased. In order to effectively gauge government spending, it should be measured either on a per capita basis, or as a share of the economy.

Real Per Capita Spending

Spending Figure 2 depicts real per capita government spending in British Columbia between 1975 and 2000. Except for a brief period in the early to mid 1980s, the BC government's increase in real per capita expenditures has been unrelenting, rising from $4,188 in 1975 to $6,465 in 2000— a real increase of 54.4 percent.

British Columbia has also, unfortunately, resisted the last decade's trend of restrained government spending. Between 1990 and 2000, real per capita government expenditures in British Columbia increased 7.5 percent. Real per capita government expenditures in Alberta, Ontario, and Canada as a whole decreased 19.7 percent, 0.6 percent, and 1.0 percent, respectively. These declines were a central part of the initiatives undertaken to balance the books of these various jurisdictions.

Government Spending as a
Percent of GDP

An alternative way to examine government spending is by comparing it to the size of the economy. Spending Figure 3 depicts government spending as a percent of the economy (GDP) between 1975 and 2000 for Ontario, Alberta, and British Columbia. The figure illustrates two important details.

First, all three provinces began the period (1975) with similar levels of government spending relative to GDP: Ontario (16.1%), Alberta (15.4%), and British Columbia (16.7%).

Second, while Alberta and Ontario ended the period (2000) with nearly the same levels of spending as a percent of the economy as they started, 16.2 percent and 16.1 percent, respectively, British Columbia diverges significantly. Government spending as a percentage of the economy increased 5.9 percentage points in British Columbia, from 16.7 percent in 1975 to 22.6 percent in 2000.

Of further interest is the relative performance of all three provinces compared to Canada as a whole over the last decade. Spending Figure 4 shows government spending as a percent of GDP for all four jurisdictions in the 1990s. In the early 1990's recession, all four jurisdictions experienced an increase in government spending as a percent of the economy. However, as the economy improved, Canada as a whole, Alberta, and Ontario experienced a marked decline in the percentage of their economies consumed by government spending. Specifically, government spending as a percent of the economy declined from its peak in Ontario, Alberta, and Canada as a whole by 22.7 percent, 28.9 percent, and 17.4 percent, respectively over the course of the 1990s.

On the other hand, British Columbia's government spending as measured against the size of the economy declined from its peak, but by only 3.8 percent over the period. Unfortunately, British Columbia started the 1990s with the second lowest level of government spending (as a percent of GDP) of the four jurisdictions, but ended with the highest.

Overall, real provincial expenditures in British Columbia increased, according to the Financial Management System (FMS) by 19.4 percent between 1991/92 and 1999/00. In inflation-adjusted or real terms, health care expenditures increased by 40.5 percent, education by 18.6 percent, and social services by 16.3 percent. Together, these three areas of provincial expenditure account for 71.4 percent of total provincial expenditures.

Consolidated FMS Data: A Comprehensive View

[Note: Due to a limited time series, we were not able to provide an analysis prior to 1989/90.]

In addition to the provincial-only data, Statistics Canada also publishes information on provincial spending, which is consolidated to include local (municipal) activities. Therefore, it provides a more comprehensive view of government spending differences among provinces.

This is an important addition to the provincial-only data since it adjusts for differences in municipal responsibility among provinces. In other words, it eliminates any advantage or disadvantage a province may have by spending more or less at the local rather than the provincial level.

Per Capita Analysis

In 1999/00, there was a nearly 10-percentage point difference in the ratio of local to consolidated provincial² spending among the three "have" provinces (see Spending Figure 5). Ontario had the highest proportion of spending at the local level with 29.4 percent of consolidated provincial spending undertaken at the local level. British Columbia maintained the lowest proportion of local spending with 20.2 percent of consolidated provincial spending done at the local level. Put differently, of the $8,105 in consolidated real per capita government spending in British Columbia in 1999/00, $6,465, or 79.8 percent, was spent by the provincial government with the remainder consisting of local expenditures (Spending Figure 5).

Unfortunately, making adjustments for local expenditures does not reverse the trend of larger government in British Columbia over the last decade. Consolidated real per capita spending remained constant in Ontario over the decade, recording a zero growth rate. Alberta actually reduced real per capita spending, on a consolidated basis over the 1990s, by 21.3 percent (Spending Figure 5). British Columbia, on the other hand, increased consolidated real per capita spending by 5.8 percent.

Population growth is an important dynamic influencing per capita analyses. Over the 1990s, Ontario experienced the lowest population growth rate of the three provinces, with an increase of 12.7 percent. Real consolidated expenditures increased 13.9 percent over this period, close to the increase in population. The increase in real consolidated provincial spending did not result in higher per capita consolidated spending.

On the other hand, Alberta actually reduced real consolidated expenditures by 6.7 percent while its population increased by 17.3 percent, resulting in a real per capita decrease in government consolidated expenditures of 21.3 percent. British Columbia recorded the largest increase in population of 23.1 percent and, not surprisingly, the largest increase in real consolidated expenditures of 33.3 percent. The increase in real consolidated expenditures more than compensated for the increase in population, and resulted in a net increase in real consolidated per capita government expenditures of 5.8 percent over the decade.

Percent of GDP Analysis

An alternative way to view consolidated expenditures is by comparing them to the size of the economy. Spending Figure 6 illustrates consolidated real provincial expenditures as a percent of provincial GDP between 1989/90 and 1999/00. Again, British Columbia stands out in resisting the trend towards smaller government exhibited by the two other "have" provinces. Ontario reduced consolidated provincial government spending as a share of GDP over the decade by 2.2 percent. Alberta more dramatically reduced the size of government, decreasing consolidated provincial expenditures as a share of the economy by 28.4 percent. British Columbia, however, increased the share of the economy consumed by consolidated provincial expenditures by 11.5 percent.

Although consolidated provincial expenditures present a more comprehensive view of government spending, they do not alter the conclusion that British Columbia, unlike the other "have" provinces, embarked on a path of increased government expenditures and thus bigger government over the course of the last decade. Regardless of whether consolidated or provincial-only data is examined, it is clear that government spending has increased in BC over the 1990s.

Budget & Fiscal Performance Index: Jurisdictional Comparisons

The Fraser Institute produces two studies that compare performance in fiscal policy: the Fiscal Performance Index (2001) and the Budget Performance Index (2000). The Fiscal Performance Index compares tax and spending performance among Canadian provinces and US states, while the Budget Performance Index compares spending, tax revenues, and debts and deficits among Canadian governments.

In the recently-released 2001 Fiscal Performance Index, British Columbia ranked 32nd out of 54 US states and Canadian provinces in spending control with a score of 56.3 out of a possible 100. British Columbia ranked lower than any other Canadian province (Emes, 2001).

In the Budget Performance Index (2000), British Columbia ranked 8th out of 10 for spending control with a score of 28.2 out of a possible 100 (Emes, 2000). British Columbia's performance in both indices presents a serious indictment of government spending in the province relative to both other Canadian governments and US states.

Where Are We Going?

Unfortunately, the government of British Columbia seems to have failed to comprehend the severity of its current spending problem. The 2000 Budget called for a 6.0 percent increase in total government spending relative to the original 1999/00 estimates, representing a nominal increase of $1.255 billion. In addition, the government of British Columbia just announced a new, $400 million day care program (BC Ministry of Social Development and Economic Security, 2001).

A full 86.4 percent of the planned increases in government spending occur in the core areas of health, education (both K-12 and post-secondary), and social services. These four spending envelopes are expected to increase 7.1 percent, 4.4 percent, 6.1 percent, and 3.2 percent, respectively (BC Ministry of Finance & Corporate Relations, 2000 Budget). Each of these spending areas is dealt with in later sections of the study.

Conclusion

The dramatic increases in government spending across a number of areas should be cause for concern. Recall that current increases in government spending usually result in increases in taxation either now, or in the future. Tax increases subsequently imply lower rates of economic growth with little or no social progress, assuming government is spending beyond the optimal level. It seems clear that the experiment with larger government, as measured by government spending over the last decade, has yielded only small social gains, if any, while dramatically affecting the province's economic growth rate. British Columbia desperately needs a rational and prudent plan for reducing the level of government spending, both in terms of per capita spending and as a share of the economy.

Policy Recommendations

(1) Decrease the percentage of the economy accounted for by government.

Provincial government spending in British Columbia represented 28.3 percent of total provincial GDP, 33.3 percent more than Alberta and 24.3 percent more than Ontario. British Columbia must forcefully implement fiscal policies aimed at reducing the size of the economy consumed by government so as to move the province towards the optimal level of government, one which maximizes social and economic progress while minimizing economic distortions. The size of reductions required implies cuts in core areas, including health care, education, and welfare. However, as the subsequent policy sections discuss, reform of the delivery systems and the introduction of competition can result in cost-savings with no adverse program affects.

(2) Broadly restructure government to focus on outcomes.

The government of British Columbia must be fundamentally overhauled so that it focuses on outcomes rather than simply continuing on a path which leads to ever increasing government spending without commensurate increases in economic well-being or social progress.

(3) Reduce the public service and have the private sector provide more services.

As discussed in the Economic Performance and Regulation sections, the public service in British Columbia has not been curtailed to the extent that it has in other jurisdictions. Through privatization and a greater reliance on the private sector for the delivery of goods and services, the civil service must be reduced, both in absolute numbers and as a percent of total employment. Part of this process should include greater competitive bidding for the provision of government goods and services by both private and public providers.³

(4) Introduce a strong Expenditure Limitation law.

Strong Tax and Expenditure Limitation laws (referred to as TELs) have proven successful in stemming the growth of government and ensuring fiscal responsibility in the United States (Krol, 1996 and 1997; Stansel, 1994; Matsusaka, 1995). Both tax and expenditure limitation laws effectively constrain the ability of governments to increase either taxes or spending without popular approval. For instance, expenditure limitation laws require any spending increase in excess of inflation and population growth to be specifically approved by referendum. Such a system has caused re-prioritizing in the US as states are forced to focus on the goods and services actually required of them as opposed to special-interest driven projects.

Fraser Institute Policy Contacts

Jason Clemens, Director of Fiscal Studies
Phone: (604) 714-4544
E-mail: jasonc@fraserinstitute.ca

Joel Emes, Senior Research Economist,
Fiscal Studies
Phone: (604) 714-4546
E-mail: joele@fraserinstitute.ca

Recommended Readings

[Note: For complete publication data, please see the list of references.]

Robert J. Barro (1990). "The Neoclassical Approach to Fiscal Policy. In Robert J. Barro, Modern Business Cycle Theory.

William Easterly and Sergio Rebelo (1993). Fiscal Policy and Economic Growth: An Empirical Investigation.

Joel Emes (2001). "Fiscal Performance Index."

Joel Emes (2000). Budget Performance Index 2000: Comparing the Recent Fiscal Conduct of Canadian Governments.

Robert Krol (1997). A Survey of the Impact of Budget Rules on State Taxation, Spending, and Debt.

Gerald W. Scully (2000). Public Spending and Social Progress.

Vito Tanzi and Ludger Schuknecht (1997). Reconsidering the Fiscal Role of Government: The International Perspective.

Vito Tanzi and Ludger Schuknecht (1998). "Can Small Governments Secure Economic and Social Well-Being?"

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