Edited by Francesco Forte, Ram Mudambi and Pietro Maria Navarra
Chapter 15: Optimal size of governments and the optimal ratio between current and capital expenditure
The concept of optimal size of governments finds its origin in a book of 1995 by Armey, who proposed the homonym curve, analogous to the Laffer's inverted U-shaped curve, which represents the relationship between tax revenue and the average tax rate. The Armey's curve shows the relationship between public expenditure (expressed as share of GDP) and economic growth. With very low levels of public expenditure, the State would fail to ensure contract compliance and protection of property rights, and it would result in a zero or negative rate of economic growth. On the contrary, with very high shares of public expenditure, citizens would have little incentive to invest and produce, since the levels of fiscal burden would be exorbitant, and also in this case the growth would suffer. Consequently, expenditure increases up to moderate levels of GDP generate a strong boost to economic activity, while their expansion to high levels results in a slowdown of the economic dynamics. Thus, there is an optimal value of public expenditure share of GDP from the point of view of the maximization of GDP growth. The analysis conducted by Forte and Magazzino (2011) revealed that, for the EU-27 Member States, the peak of the BARS curve is attained for an expenditure of 37.29% of GDP, while the average effective ratio is 47.90%: that is, 10 p.p. more.
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