Determining the Optimal Size of Public Expenditure: Key Theories

How big should government be? It’s a question that has puzzled economists, policymakers, and citizens for generations. When governments spend too little, essential services and infrastructure suffer. When they spend too much, economic growth stagnates under the weight of excessive taxation. Finding the sweet spot between these extremes is one of the most critical challenges in public economics. Over the decades, several influential theories have emerged to help determine the optimal size of public expenditure, each offering unique insights into how governments should balance their spending and revenue decisions.

The Rahn Curve: finding the growth-maximizing government size 🔗

American economist Richard W. Rahn proposed an intriguing concept in the 1990s that challenged conventional thinking about government size. The Rahn Curve suggests there exists an optimal level of government spending, typically estimated between 15 and 25 percent of GDP, that maximizes economic growth. Below this threshold, government provides essential services like law enforcement, contract enforcement, and basic infrastructure that enable markets to flourish. Above it, excessive taxation and bureaucratic intervention begin to drag down economic performance.

The logic behind the Rahn Curve is straightforward yet powerful. Initially, government spending helps improve economic outcomes by funding public goods that markets cannot efficiently provide. Roads, education systems, and legal frameworks all contribute to productivity and growth. However, once government exceeds a certain size, the negative effects of high taxation and regulatory burden outweigh these benefits. Research examining 129 countries found that the optimal government size maximizing economic growth was approximately 18 percent of GDP, with slight variations between developed and developing nations.

Think of it like watering a plant. Too little water and the plant withers; too much water and the roots rot. The Rahn Curve essentially argues that many advanced economies, particularly in Western Europe where government spending often exceeds 40-50 percent of GDP, have moved well past the optimal point. Critics point out that the curve oversimplifies complex relationships and that maximizing growth isn’t necessarily the only goal governments should pursue. Issues of equity, environmental protection, and social welfare matter too.

Dalton’s principle of maximum social advantage 🔗

British economist Hugh Dalton took a different approach to determining optimal government size in the early 20th century. His principle of maximum social advantage states that public expenditure should be increased until the marginal social benefit equals the marginal social sacrifice of taxation. In simpler terms, government should keep spending as long as each additional dollar of public expenditure creates more value for society than the burden it imposes through taxation.

Dalton’s framework rests on two key concepts. Marginal Social Benefit (MSB) represents the additional welfare society gains from one more unit of government spending on services like healthcare, education, or infrastructure. Marginal Social Sacrifice (MSS) captures the burden taxpayers experience when government collects one more unit of revenue. The principle assumes that as government spends more, each additional dollar generates less benefit due to diminishing returns. Meanwhile, as taxes increase, each additional dollar extracted causes greater sacrifice because people are parting with income they value more highly.

The intersection point: where social welfare peaks 🔗

The magic happens at the intersection of these two curves. At this equilibrium point, the last dollar spent on public services provides exactly the same value as the burden of the last dollar collected in taxes. Any spending beyond this point would impose more sacrifice than benefit, reducing overall social welfare. Any spending below this point would mean missed opportunities to improve society’s wellbeing.

Consider a government deciding whether to expand its public transit system. The first buses on new routes might provide tremendous benefits to commuters who previously had no access. However, the twentieth new route added might serve only a handful of riders, while the taxes needed to fund it create significant burden on businesses and families. Dalton’s principle would guide policymakers to expand the system only until the benefit of the marginal route equals the sacrifice of the marginal tax.

While elegant in theory, Dalton’s principle faces practical challenges because utility and sacrifice are subjective and difficult to measure quantitatively. How do you compare the value of a new school to the burden of higher income taxes? Different people experience these costs and benefits differently, making the optimal point hard to pin down in reality.

Niskanen’s budget maximization model 🔗

What if bureaucrats don’t actually seek to serve the public interest but instead pursue their own goals? This provocative question drives William Niskanen’s budget maximization model, a cornerstone of public choice theory. Niskanen argued in his 1971 work that rational bureaucrats seek to maximize their department’s budget to increase their own power, prestige, and job security.

The model paints a picture of bureaucratic behavior quite different from traditional public administration theory. According to Niskanen, government agencies operate like monopolies. They’re the sole providers of certain services and possess much more information about costs than legislators do. This information asymmetry allows bureaucrats to overstate their needs and secure larger budgets than socially optimal. A bigger budget means more staff, higher salaries, greater influence in policy circles, and better career prospects for those running the department.

The consequences of budget maximization 🔗

The implications are concerning. When agencies maximize budgets rather than efficiency, they produce beyond the socially optimal level, leading to oversupply of services and allocative inefficiency. In a competitive market, firms expand production only until marginal cost equals marginal benefit. But Niskanen predicted that bureaucracies would expand until average costs equal average benefits, resulting in excessive production and waste.

Imagine a government agency responsible for infrastructure maintenance. Under budget maximization, managers might push for more road repaving than necessary, not because roads are in dire condition, but because a larger road maintenance budget translates to departmental growth. The agency might employ more workers than needed and use more expensive methods than required, all to justify continued budget expansion.

Critics of Niskanen’s model point out that it may overstate the problem. Not all bureaucrats are single-minded budget maximizers, and oversight mechanisms exist to check bureaucratic excess. However, the model’s core insight remains influential: institutional incentives matter, and poorly designed governance structures can lead to government growth beyond what citizens desire.

Brennan and Buchanan’s Leviathan model 🔗

Perhaps the most dramatic theory of government size comes from economists Geoffrey Brennan and James Buchanan. In their 1980 book “The Power to Tax,” they proposed viewing government as a revenue-maximizing monopolist, which they called “Leviathan” after Thomas Hobbes’s metaphor for all-powerful government. In this framework, the state isn’t a benevolent provider of public goods but rather a self-interested entity seeking to extract maximum revenue from taxpayers.

The Leviathan hypothesis challenges fundamental assumptions of traditional public finance. Instead of asking how government should design optimal tax systems to promote social welfare, Brennan and Buchanan asked: how can citizens protect themselves from government’s natural tendency to overtax? Their answer lay in constitutional constraints that limit government’s fiscal powers before those powers can be exercised.

Constitutional constraints as the solution 🔗

Brennan and Buchanan argued that only constitutional limits can effectively restrain Leviathan’s appetite for revenue. These constraints might include tax rate caps, balanced budget requirements, restrictions on the types of taxes government can impose, or limitations on deficit spending and money creation. Perhaps most importantly, they championed fiscal federalism as a check on government size.

The fiscal federalism argument works like this: when multiple levels of government compete for tax revenue and mobile taxpayers can “vote with their feet” by moving to jurisdictions with better tax-service combinations, governments face pressure to keep taxes reasonable and spending efficient. If the national government tries to overtax citizens, they might relocate to states or municipalities with lower burdens. This competition among jurisdictions constrains Leviathan by breaking its monopoly power.

Think of it as competition in the market for governance. Just as businesses must offer good value to retain customers who can shop elsewhere, governments in a federal system must provide reasonable tax rates and quality services to retain mobile residents and businesses. A single monopolistic government faces no such discipline.

The model has generated extensive debate and empirical testing. Research on tax competition has produced mixed results, with some studies finding that decentralization restrains government growth while others suggest the relationship is more complex. Critics argue that the Leviathan view is too cynical and that democratic accountability provides sufficient check on government excess. However, the constitutional economics perspective has profoundly influenced discussions about fiscal rules, tax limitations, and the design of federal systems worldwide.

Which theory offers the best guide? 🔗

Each of these theories illuminates different aspects of the optimal government size question. The Rahn Curve focuses on empirical relationships between spending and growth, offering a quantitative benchmark though one that may vary across countries and time periods. Dalton’s principle provides a welfare-maximizing framework but struggles with the practical challenge of measuring subjective costs and benefits. Niskanen’s model highlights the danger of bureaucratic incentives misaligned with public interest, while Brennan and Buchanan’s Leviathan hypothesis emphasizes the importance of constitutional constraints on government power.

Rather than choosing one theory as definitively correct, policymakers might benefit from considering insights from all four. The Rahn Curve reminds us that government size has real consequences for economic growth. Dalton’s principle emphasizes balancing benefits against costs at the margin. Niskanen warns us about bureaucratic incentives. And the Leviathan model underscores the value of institutional safeguards against government overreach.

In practice, determining optimal government size remains as much art as science. It depends on a country’s level of development, institutional quality, cultural values, and specific circumstances. What works for Singapore with government at 15 percent of GDP may not work for Sweden at 50 percent, and vice versa. The key is maintaining systems that encourage efficient provision of public goods while preventing government from growing beyond what citizens truly desire.

What do you think? Given these different theoretical perspectives, how would you assess whether your own country’s government is too large, too small, or about right? What mechanisms do you believe work best to constrain government growth while ensuring adequate provision of essential public services?

References

1. https://en.wikipedia.org/wiki/Rahn_curve
2. https://www.sciencedirect.com/science/article/abs/pii/S0165176515005194
3. https://bbamantra.com/principle-maximum-social-advantage/
4. https://en.wikipedia.org/wiki/Budget-maximizing_model
5. https://www.econlib.org/library/Buchanan/buchCv9.html
6. https://www.sciencedirect.com/science/article/abs/pii/S0047272719300891