Further important determinants and theoretical predictions

The simple model in the previous subsection is naturally insufficient to grasp further determinants of government size aside from economies of scale that seem of importance. Specifically, it is only valid when we con-sider economies of scale in the provision of public goods as the sole source for the level and structure of public expenditure. There are many arguments that may question that proposition. Although we have men-tioned a lot of other determinants of government size in Table A.2, the-re athe-re some determinants which athe-re mothe-re closely the-related to country size and population. They will be discussed qualitatively in the following and taken up again in subsequent chapters of this study. Some of them, for which we conjecture a significant effect on public sector size, reappear as control variables in the regressions in Section 3.2:

– A lot of publicly provided goods are clearly rival or partially rival.

In fact, they display optimal scales of production that are signifi-cantly smaller than the number of inhabitants of even a small

coun-try. Elementary schools, transfer payments, police, etc. are general-ly provided on the lowest or – if existent – an intermediate jurisdic-tional level in large as well as in small countries. Concerning econo-mies of scale per capita, expenditure for those goods should not be systematically dependent on country size. Moreover, these goods may be even more costly in larger countries with large agglomera -tions because of negative external effects associated with congestion phenomena.³⁵Therefore, the argument has to be restricted to non-rival public goods, such as for example legal systems, external secu-rity, governments or monetary systems.

It is astonishing that a lot of these almost or entirely nonrival pub -lic goods are not produced by small countries, which does not mean that they are not provided. Take Liechtenstein, for example, a very small but nevertheless prosperous country. Liechtenstein does not

«produce» an army or a monetary system and does not provide uni-versities of its own. Important parts of its fiscal, social and legal system do not originate in the country. Liechtenstein leaves the pro-duction of public goods to its neighbors and restricts itself to gua-ranteeing provision through mostly advantageous contracts and treaties or simply free rides. The former is sometimes referred to as

«international outsourcing», which elegantly grasps the main idea (see Gantner and Eibl, 1999); we will henceforth stick to this termi-nology and analyze international outsourcing thoroughly in Chapter 4. The negative connotations the term «free ride» do often not apply to VSC, since the marginal costs caused by the popula tion of the VSC are close to zero in many cases and therefore negligible for large countries.³⁶It is possible that marginal costs are even nega -tive in special cases. The similarity between certain laws concern ing the financial sector in Switzerland and Liechtenstein, which is the result of Liechtenstein adopting Swiss legislation, might be viewed as providing some advantages for Switzerland or Swiss citizens with out extra costs.

35 Alesina and Wacziarg (1998) control for congestions in their regressions through pop ulation density, which seems to be a very rough measure on the country level, be-cause the impact of congestions, intuitively, depends more on the existence of conur-bations or big centers.

36 The marginal costs of providing security to the Monegasque by the French army seems to be sufficiently close to zero (at least in peacetimes) to be neglected by the latter.

To summarize this first argument, non-rival public goods clearly ex-hibit diseconomies of scale in their production, which obviously leads to disadvantages for smaller countries, caused by higher public expenditure than in larger countries relative to GDP. Nevertheless, the cost disadvantage should decline, when we take into considera-tion that many public goods can be provided by means of «interna-tional outsourcing». Regarding the development of regional and in-ternational cooperation and integration within the last decades, a steady decline of the disadvantages of smaller countries due to dis-economies of scale should be observable.

– The above-mentioned possibility of a free ride can easily be under-pinned by game theory. The argument may be traced back to Olson (1965) and has already been mentioned in Section 2.2.2.1. The group member with the largest portion of the group gain in a non-unitary group will probably provide the public good (depending of course on benefits and costs for him) and cannot exclude smaller members from its consumption.³⁷Thus, in the language of game theory, the strategy-pair defection by small countries and cooperation by larger ones may be a Nash equilibrium.

– Another argument in favor of a greater feasibility of being small is that the evidence simply suggests it. There are currently 193 coun-tries in the world, of which 54 have under two million inhabitants;

34 countries have fewer than 500,000 residents. The dynamics of the process are even more impressive. In 1914 there were only 62 sovereign states on the entire globe; at the end of the second world war the number increased to 74.³⁸Thus, within less than a hundred years the number of independent countries more than tripled, a deve lopment which has surely not reached its limit yet. There are separation movements almost everywhere in the world. Think of Scot land, the Kosovo, Quebec, Chechnya and East Timor, to name

37 Think, for instance, of measures against global warming. If the United States had de-cided to significantly reduce carbon dioxide emissions, all other countries could not have been excluded from the advantages, even if they had not decided to contribute.

In a similar vein, the small countries in NATO were able to exploit the U.S.A. by contributing relatively little for their security during the cold war.

38 See The Economist,Jan. 3rd, 1998, p. 63f.

only a few. This development can, of course, be attributed to politi-cal changes and politipoliti-cal determinants (the collapse of the Soviet Union³⁹or the end of colonial rule). But judging by the evidence, the conclusion that split ups have become more feasible also from an economic viewpoint has to be taken into consideration.⁴⁰ Note that there are, of course, some convincing arguments in favor of smaller units along the line of the well-known phrase that «small is beautiful». They however go beyond traditional economic analy-sis in general, and we will account for them in detail in Chapter 5.

One nevertheless has to be careful not to overinterpret the dy -namics within the last century, because many regions or nations simply did not have the option to choose independence after World War 1. Moreover, there have also been phases in history where there were more sovereign entities in the world than now, although the international economic environment then was totally different.

– One might also argue that the size of the public sector may be con-strained by a government’s power to tax. Especially failed states are sometimes unable to collect taxes due to administrational inefficiency, corruption or widespread illegal economic activities. It is how -ever not unreasonable to assume that country size and the actual power to tax are unrelated, so that we can leave revenue potentials aside.⁴¹

Obviously, country size is not only a question of economics. Ethnic he-terogeneity, the political system, religion, security considerations, geo-graphic conditions, the extent of federalism and the relationship with ad-jacent countries play a prominent role in the determination of the

opti-39 It might be argued that the end of the Soviet Union is associated with centrifugal po-litical forces mainly based on nationalism in the former Soviet Republics. There doubtlessly are many political explanations for the collapse of the super power. As an economist, one would nonetheless ask: Would the collapse have happened if split ups had not been so feasible from an economic point of view?

40 For special treatment of the economic rationales for secessions see, e.g., Alesina and Spolaore (1997), Bolton and Roland (1997), Friedman (1977), Tietzel (1997) or Witt -man (1991).

41 We tested for the influence of corruption, which should be strongly related with the power to tax, on public sector size in Section 3.2 but did not arrive at significant re-sults, although we applied more than one possible index for corruption and bu-reaucratic (in)efficiency.

mal country size.⁴² Note, for instance, that many of the VSC in the world and all of the prosperous ones are located in a relatively stable po-litical environment.

Summarizing all arguments of this section and condensing them for the empirical examination in Section 3.2, we obtain three main theoreti-cal predictions from our discussion:

Hypothesis 1:The evidence should show a negative relationship be -tween country size and government size in line with Alesina and Wacziarg (1998) even in the nineties.⁴³

Hypothesis 2:The extent and significance of that relationship should have, nevertheless, declined substantially due to the deepening and widening of regional as well as global integration and a higher over-all degree of trade openness over the last three decades.

Hypothesis 3:We should detect that the relationship of country size and public expenditure differs between groups of countries. Spe ci fi cal ly, OECD members should only display an insignificant diffe -rence between larger countries and smaller ones with respect to their pub lic expenditure because of trade openness and more or less peace-ful adjacent countries. Geographically remote countries should show large differences with regard to relative government size, because they have fewer options to organize public good provision and, hence, the diseconomies of scale effect should be more severe.