Government size and economic growth in EU-31

The relationship between government and economic growth has been an important topic in public economics. This paper discusses the theoretical foundations for the existence of an optimal size of government as depicted by an inverted U curve (Army curve) based on a panel data of 31 European countries. Data properties were analyzed to determine their stationarity using the LLC, IPS, ADF and PP unit root tests which indicated that the series are I(1). We find a cointegration relationship between economic growth and government expenditure by applying Kao panel cointegration test. The evidence indicates that the optimum size of total tax rate in the economy measured as the share of government spending as a percentage of GDP (Tax) that maximizes economic growth, is no greater than 27% of GDP (at a 95% confidence level) based on data for the period of 1995 to 2010. In addition, the evidence indicates that the optimum level of government consumption on final goods and services as a share of GDP is 26%. However, due to model and data limitations, it is probable that the results are biased upwards, and the “true” optimum government level is even smaller than the existing empirical study indicates. Optimal government size is also, of course, influenced by the quality of a government. Because the measures of “government quality” are inherently subjective, no attempt was made to incorporate them in this study