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Government: Small, Medium or Large? How about Rational?

You often hear the following when people discuss government – “The government that governs the least, governs the best.” The mantra of politicians on the right is for “smaller” government. But is a government that “governs the least” synonymous with “smaller”?
The answer is no. “Smaller” is subjective because we have no defined standard of measurement. The same problems occur with the term “big” government. How do you define big?

Despite this lack of definition, these terms are the basis for the “pseudo wisdom” in the dialog surrounding government budgets, debt, regulation, and private verses public sector roles in society.

In Adam Smith’s economic world, the market’s laissez faire behavior is efficient, producing the greatest quantity at the minimum cost, due to minimal government interference. Smith doesn’t advocate any particular size for government – just minimal government interference – allowing competition to drive the market. However, there are situations where competition does not or cannot exist. For example, sewer systems and many other utilities are only possible when we allow them to operate as monopolies. No matter the size of government, it must have the resources to accomplish these tasks, with the size of the government functionally defined.

The big question surrounds the allocation between the private and public sectors. In our country the general rule is that the private sector is consumer-driven, while the public is guided by democratic decision making. Economists have a formula to handle this allocation. The efficient balance between the two sectors occurs when the last dollar spent goes to the sector that has the largest net social benefit to society.

Consider our current sequestration. With the $85 billion sequester spending cuts we are reducing the safety of airports, food, our military in battle zones, and our child care/Head Start programs. This spending cut is a tradeoff for the unwillingness to raise taxes $93 billion for the upper 1% of the income distribution by changing the taxation of carried interest, changing the depreciation rules on corporate jets, capping the value of deductions at 28%, and repealing tax incentives for oil and gas.

It is hard to imagine that our country is better off with the cuts to the public sector. Consider a concrete example. Ask yourself if it makes sense to pay less tax on your corporate jet, and then fly it into an understaffed airport – or as in the case of the Kalispell, Montana airport – an airport with no air traffic controllers after sequestration. If you offered me a flight on the jet to Kalispell my response would be, “I’ll drive, thank you.” Executives never sacrifice safety for a bit more income because they are smart. They know you need to be alive to enjoy income.

This conceptual guide means that the optimal size of the public and private sectors is determined jointly. Public infrastructure determines the capacity of society to produce, and private sector business determines the specific products that are produced.

Worldwide the ratio is approximately 40% Government to 60% private for countries with the highest per capita incomes. If the public sector is below 20% or above 80% the country is undeveloped in both sectors, and at the extremes positioned to be a failed state. At the extremes we find very marginal countries such as Iraq on the high side and Cambodia on the low side. What matters is the ratio, not the size, in absolute terms of the public or private sectors. During economic recessions the Government percentage increases. In periods of rapid growth it declines. The ratio must flex with society’s needs.

The ratio also adjusts during major events, such as war, increasing defense spending, and during demographic shifts. An aging population increases public health needs. In contrast innovation and technology expand the private sector along with times where a younger population provides more productivity and growth of the private sector. There is nothing mysterious about this ratio and how it moves.

The mystery comes from those want the ratio at a specific level for reasons outside any rational basis society wide. The specific level of the ratio becomes arbitrary. “Small” will eventually find its place with “big” on the scrap heap as a term defining government. The question is – ”how much damage must we endure until then to our economy?”

Living with change is part of a dynamic economy. The change must be driven by a process of rational adjustments of the ratio of public to private sector economic activity. If this occurs risk has an explanation. If the ratio is arbitrary it introduces uncertainty and has no explanation. A ratio that flexes across the range that serves all the society not just its self-serving extremes is the bedrock of a sustainable society and economy.

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