The Hub is delighted to announce The Business of Government, a special series hosted by award-winning journalist and best-selling author Amanda Lang about how government works and, more importantly, why it sometimes doesn’t work. In this five-part series, Lang conducts in-depth interviews with experts and former policymakers and puts it all in perspective for the average Canadian. Listen to the accompanying interview with Livio Di Matteo on your favourite podcast app or at The Hub.

When it comes to the size of government, it can quickly feel like a political question. Government that plays a larger role in the lives of citizens, or “big government,” is deemed to lean Left, while a more limited, or smaller government is the domain of the Right.

In the end, the size of government, as measured by the roles it will play, from services delivered to regulatory burden, will and should be a political question. But even in the context of the size voters want, big or small, we can still ask about effectiveness. Because like any other organization, there may be an optimal size for government for maximum efficiency and output.

So how are we doing, Canada?

Livio Di Matteo is an economist in northern Ontario who has studied the size of government, including analysis of the work of many economists looking at the issue. Turns out that to optimize growth, there is a perfect size of government relative to the economy. Government spending does affect economic growth, so that too little of it can stunt a country’s potential. Just enough maximizes economic activity, while too much acts as a drag on output.

“The general rule of thumb is there are diminishing returns beyond a certain point to any activity, even government,” Di Matteo says.

So, what is the sweet spot for government spending? A comparison of industrialized nations over the long term suggests that 26 percent of GDP is the growth-maximizing size of government. Spending above that level will act as a drag on growth potential. The difference can be growing at 3 percent versus landing at 2 percent.

“People may say, ‘Well what’s 1 percent,’” Di Matteo says. “But because of the power of compounding over time, over 30 or 40 years, that difference can mean per capita incomes that are 20 to 30 percent lower.”

In Canada government spending has ranged from 34 percent to a high-water mark of 53 percent in the 1990s and “we’ve never really been in the range that maximizes economic growth,” Di Matteo says.

Size of government here is not just the literal size—in Canada’s case a recent surge to 357,247 federal government employees—but spending on goods and services as well, or program spending. Different measures of size of government also calculate control of the economy through regulation and taxation, but it’s harder to make a country-by-country comparison since each one will be so different.

Over time government in Canada has waxed and waned. From a historic low of 5 to 10 percent in pre-industrial times, to the higher levels of the past decades. A period of shrinking governments from the late 1990s was interrupted by three surges in spending. The first was the terrorist attacks of 9/11 with a host of new security measures. The second was fiscal support after the great financial crisis around 2008, and the last being the massive increase in spending during the COVID-19 pandemic. Estimates of the size of government now are about 45 percent of GDP. Part of the problem with a government that exceeds its growth-fostering range is that it requires higher taxes to fund. Or in the case of periods of surge spending, deficit funding.

Some government spending, on things like infrastructure or education, is naturally growth-enhancing, because it creates a better foundation for the private sector. And there are a host of things that governments do, like protecting economic freedom, fostering low corruption, and promoting robust rule of law, which are less quantifiable yet are essential to a well-functioning private sector.

“Governments obviously do other things, but there is a trade-off involved. And the question is, what is the value of all these other things that we are doing? And, you know, what can you do to bring yourself closer to that optimum to maximize growth?” Di Matteo says.

It almost seems as though policymakers in Canada shape spending based on outdated views of our economy.

“We always like to spend based on the growth we had, during the great golden age from 1945 to the mid-1970s,” Di Matteo says. Then real economic growth was 4 to 6 percent. “We often justified it by saying if we send this the economy will grow,” but the reality is growth in Canada runs closer to 2 percent these days, “if that.”

Di Matteo doesn’t want to be drawn into making policy prescriptions about the kinds of spending government should do, saying those are political questions best left to elected representatives. But he will offer up the view that not all spending is created equal: health and education, for instance, are investments government can make in the human capital of a country that could be considered a worthy investment.

But even there, it’s important to ask if the spending is being done wisely. Canada has a decent health-care system, by most global measures. But do we get good results for the spending on it, at about 11 percent of GDP?

Here Di Matteo is more circumspect. “We always compare ourselves to the United States, which spends 17 to 20 percent of its GDP on health, and yet its outcomes in many respects, things like mortality, longevity, infant mortality, etc, are actually even worse than ours.” But before declaring victory, he would point to countries like Germany or the Netherlands, where outcomes are better, and the spending is less. “And so, the question is, how do we get more value for money?”

And there are other questions about government that go beyond sheer size, about how effective they are. “Why is it when the Dutch have a public-sector project, say they build a bridge, they do it in a few months? And it takes us a few years? What are we doing wrong or not as well, that we could improve upon?”

Government subsidies for business is one area that economists like Di Matteo point to as places of questionable return.

“How much you spend is important, but what you spend it on is also important. And sometimes it’s not even so much the amount of spending, but are you getting value for money for what you’re spending.”

In other words, size does matter, but it’s also what you do with it that counts.

The Hub’s resident book reviewer Patrick Luciani tackles My Journeys in Economic Theory by Edmund Phelps, published by Columbia University Press in 2023. Watch for Patrick’s book reviews every two weeks at thehub.ca.

If there’s one thing that has mystified Canada’s government economists, it is the country’s perpetual low productivity performance. They lament that we lag in innovation and the diffusion of technology once we have it. We thought it was a question of dishing out more subsidies and incentives for businesses to innovate and catch up to the Americans, but things are only getting worse. 

In 2000, we were 82 percent as productive as the average American worker. By 2020, that has dropped to 77 percent. We are doing worse on that scale than Italy, France, the U.K., and Australia. Imagine the French are doing better with all their vacation time, meal breaks, and laws forbidding workers from taking their work home. According to one study, the Canadian worker would have to put in 30 percent more hours to catch up to the same productivity as the American worker. Canada’s most productive firms aren’t keeping up with world-leading firms. Ottawa is trying once more by launching the Canada Innovation Corporation (CIC) to boost innovation and more R&D. Unfortunately, cajoling firms to catch up won’t work.

The reason may be found in the work of economist Edmund Phelps at Columbia University, who won the Nobel Prize in Economics in 2006. His latest book with the rather uninspiring title of My Journey in Economic Theory—but don’t let that throw you off, it’s a great read—Phelps has spent the last twenty years thinking about why some countries are better than others when it comes to innovation and inventing things. His answer is in a country’s culture rather than incentivized government programs. 

To understand what Professor Phelps is getting at, we need some history of what drives economic growth. For the Austrian economist Joseph Schumpeter, who worked at the turn of the last century, capitalist economies are never static and always evolving. Capitalism drives new innovations that disrupt old ways of doing things, leading to what he termed “creative destruction” that forces out old ways of doing things. At the heart of free market systems is the entrepreneur, who recognizes the power of new ideas and brings them to market. Schumpeter recognized that the entrepreneur was the driver of economic dynamism. Schumpeter had no time for the ingenuity of businesspeople and bankers, who he said showed no creativity.

In the mid-1950s, another Nobel economist, Robert Solow, added that productivity growth was driven by these so-called “exogenous” shocks from people’s minds, from Ely Whitney and Thomas Edison to Steve Jobs. Solow’s contribution to economic growth was still in the spirit of Schumpeter in that they couldn’t completely explain why these ideas germinated. 

Phelps asked what if these new ideas and innovations didn’t appear without explanation but were actually “endogenous.” That is, factors inside the economic system could explain innovations. Could it be that the average worker was capable of generating ideas and innovations within a country, not just those of scientists, inventors, or entrepreneurs? 

Phelps theorized that to achieve “wide indigenous innovation in a country, it is crucial that the many workers have the qualities needed for dynamism.” But what is this dynamism, and how do you measure it?

Here, he came up with two cultural variables that could be measured: the importance of work, the incentive to get up each day and go to work, and involvement in one’s work, the willingness to do a good job. Given Europe’s crafts and guild history, Phelps assumed Europeans would score higher on both variables, but it was the Americans who scored higher on these variables than Germans, the French, Italians, Brits, and Canadians. He concludes that a nation with the right values “is capable of much innovation beyond what may be imported from abroad [or] opened up by new scientific discoveries at home.”

If Phelps is right, a country’s values are crucial to driving prosperity on a massive scale, an idea he developed in his 2013 book entitled Mass Flourishing. The genius of prosperity is found not in government stimulus programs but in the ethic of work and discovery in average citizens who take pride in their labour. Prosperity and economic growth driven by ideas is a process initiated from the bottom up, not the top down. Institutions such as property rights and stable government are necessary in Phelps’ world, but they play supporting roles rather than take centre stage. The real action is on the ground where the spirit of the average worker flourishes. 

This view of the future starkly contrasts with the more pessimistic conclusions in Bradford DeLong’s recent book Slouching Towards Utopia (2023)—a book I reviewed last year—that concludes the era of growth in America started in 1870 died around 2010 when America’s engine of productivity began to stall under a failed neoliberal democracy. Phelps isn’t naïve to ignore the climate crisis or the lack of skills many need as we move to a world that demands technical expertise, but his vision of the future is more encompassing, a future that relies on the culture and values of ordinary people and not just the skills of trained experts or hard-driving entrepreneurs. 

If culture and work values play important roles, where does that leave public policy in the race to catch up to America’s higher levels of productivity? First, we should acknowledge that top-down programs have limited value in stimulating innovation. Second, public funds might be better spent on instilling the virtues of pride in work as soon as kids start going to school. On a grander scale, if culture matters more than the political and economic factors that ended the long twentieth century, we might have the good fortune to end up living in Edmund Phelps’s world rather than Bradford DeLong’s.