earlier. Moreover, the countries with the greatest peak spending and transfers tended to have the greatest declines from the peaks to 1992.

We ask whether some of this apparent leveling or peaking of sizes of government may be a result of limits to taxation. The "limit to taxation" might be defined in several ways. For instance, a well-informed electorate that desires an extensive safety net may rationally keep transfers and spending below maximum feasible levels because efficiency losses per marginal unit of tax revenue could be infinite at maximum revenue (Atkinson and Stern [1974], Browning [1976], Meltzer and Richard [1981], and Svensson [1990]). On the other hand, the political-economy analysis of Brennan and Buchanan [1977] posits that government maximizes revenue in long-run equilibrium, and Buchanan and Lee [1982] model a simple political process that leads to an equilibrium tax rate greater than the rate that maximizes long-run revenue.

We compute theoretical spending and transfer maxima calculated in a model of the long-run Laffer curve and compare these maxima to observed levels of spending and transfers. The model differs primarily from those in the literature in that the focus is on the size of government - for example, spending, transfers, and revenue - rather than on the tax rates that maximize revenue. Although the model is simplified by treating capital as constant, the tax rates that maximize revenue in the model are comparable to the rates that maximize revenue in other models of the long-run Laffer curve (e.g., Fullerton [1982]).

In the model, government provides public goods and private goods, and transfers are defined as the net claims to private goods that result directly from government fiscal decisions about budgeted spending and its funding. This definition differs from the accounting definition underlying Table 1, in which transfers are simply amounts recorded on public budgets when governments make payments to provide private goods. To compare transfers calculated in our theoretical model with actual data, the first step is to measure transfers as we define them in our theoretical model. Because accounting practices vary from country to country, using a measure of transfers that is consistent with our theoretical model can also make comparisons across countries and time more informative than comparisons based on traditional measures from public budgets.

We find that tendencies toward flat or falling spending and transfer percentages are somewhat more marked with measures corresponding to our definition of transfers than the accounting-based relationship observed in Table 1. The pattern that countries with the greatest peak fiscal sizes usually experienced the greatest declines in fiscal sizes is also more marked with our measures. We find, moreover, that calculated long-run limits under reasonable assumptions are less than observed peak ratios of spending, transfers, and revenue to GNP in several OECD countries.

Because the greatest observed fiscal sizes exceed calculated long-run maximum fiscal sizes, and because the countries with the greatest peak fiscal sizes also had the greatest declines in fiscal sizes, we cannot reject the idea that fiscal sizes in some developed countries have bumped up against limits to taxation. Put differently, political processes in a number of developed countries may for a period of time have led to spending and transfers greater than the maximum levels that can be supported in a theoretical long-run equilibrium.

In section 5.2 we calculate maximum spending, transfers, and tax revenue that can be supported in a theoretical long-run general equilibrium. Section 5.3 begins with a description of the approach used to derive internally consistent measures of fiscal size of government, then presents measures of fiscal size established with actual data, and finally compares these numbers to numbers derived in section 5.2. Section 5.4 concludes this paper.

The well-known Laffer hypothesis (Laffer [1979]) posits a maximum sustainable size of government. It is not generally known, however, how close actual spending and transfer patterns are to these theoretical maxima. We address this issue by comparing observed levels of spending, transfers, and tax revenue to limits derived in a theoretical model.

We categorize government spending as either transfers (T), spending on public goods (G), or interest on preexisting debt (r b). Note that G includes only public provision of public goods, which is usually a small part of total government spending. We categorize the sources of government revenue as either tax revenues (R), non-tax payments from households to government (N) (e.g., fines, fees, forfeitures, penalties, and sales), non-tax revenue in the form of financial returns from government enterprises (F), or the government's budget deficits (D b), which equals the increase in the household's holding of government debt. The government budget is written as

(1)

According to the Laffer hypothesis one tax rate, or a vector of tax rates, maximizes equilibrium tax revenue. Similarly, there are associated maximum levels of spending and transfers for given levels of public goods (G), interest on the debt (r b), non-tax revenue (N + F), and the deficit (D b). Such maximum levels of spending, transfers, and tax revenue may be thought of as theoretical limits to the fiscal size of government.

We compute rough technical limits by embedding the government and household budgets (described below) into a general-equilibrium model in which the aggregate household receives utility from net income (y), leisure, and public spending. We simplify the model by not allowing capital to vary. While including capital distortions would permit a more accurate representation of the economy, it introduces a number of important complications such as whether to model the economy as open or closed (Feldstein and Horioka [1989], Mendoza and Tesar [1995]), whether to use a naive or optimization model of investment (Bernanke, Bohn, and Reiss [1988]), and what values to assume for the elasticity of intertemporal substitution (Judd [1987], Hansen and Singleton [1983], Mankiw and Zeldes [1991], and Engen and Gale [1997]). In the end, we limit our analysis to labor distortions because, averaged across OECD countries over 1972-1992, labor income was 63 percent of total income.

The aggregate household receives income from labor, capital, and holdings of government bonds (debt), and pays taxes to government on each type of income. The household also receives transfers from government and makes payments to government to cover nontax liabilities and to augment holdings of government bonds.

The aggregate household’s total income, net of all payments to government,

is written as

(2)

where t_l, t_k, t_b, are the marginal tax rates faced by the aggregate household on labor income, capital income, interest income from government bonds; w and r are gross returns to labor and capital; r is the interest rate on government debt; l is labor supplied by the household; k is capital owned by the household including capital owned indirectly through firms; b is the net level of (preexisting) government debt; and T is transfers. The corresponding tax revenues are thus R º t_lwl + t_krk + t_br b. All variables are defined over a given accounting period, taken below to be a year, and time subscripts are suppressed.

The model is parameterized to fit a stylized "average OECD economy" in a calibration allocation described in appendix C, with labor supply elasticities in empirically reasonable ranges. Because most differences in spending reflect differences in transfers (see Table 1), we compute equilibria at different values of the tax rate on labor income (t_l) when T adjusts to keep the government budget (1) in balance. In these calculations, G, t_k, t_b, N, and F are held constant, government meets interest obligations on preexisting debt at a given interest rate, and primary deficits (deficits net of interest payments) equal zero, which approximates actual average primary deficits over our sample. By comparing equilibria, we find the value of t_l at which spending, transfers, and tax revenue attain maxima, and divide by the associated level of GNP to compare with observed fiscal sizes reported above.^,

We assume initially that GNP is a Cobb-Douglas function, a₀K^al⁽1-a), where a is a parameter equal to capital’s share of GNP and K is the sum of private capital (k) plus government capital (k’). Without loss of generality, we choose units so a₀ = 1, K=1, and, in the calibration allocation, l = 1. Under competition, gross returns to labor and capital are then

(3)

and

(4)

Factor payments exhaust GNP (wl + rk + F = K^al⁽1-a)), so (3) and (4) imply that returns on private and government capital are equal (F = rk’).

An equilibrium is an allocation such that (1), (2), (3), and (4) hold, and the household maximizes utility by choice of l subject to the budget (2), taking t_l, w, t_k, r, k, t_b, r , b, T, N, D b, and G as given. Utility is assumed to be a Stone-Geary-modified CES function:

(5)

where a , w , and d parameters and V is a function that captures utility effects of G and utility effects of T not operating through consumption of net income (y). The form of V does not affect the results.

The parameters a , w , and d are chosen such that: (i) the uncompensated labor supply elasticity equals a given value in the calibration allocation; (ii) the compensated labor supply

elasticity equals a given value in the calibration allocation; and (iii) the calibration allocation is an equilibrium. To reflect the uncertainty that exists about labor supply elasticities, we consider two pairs of uncompensated and compensated elasticities: 0.1 and 0.25; and 0.44 and 0.52.

When the uncompensated and compensated elasticities are assumed to be small (0.1 and 0.25, respectively), maximum spending, transfers, and tax revenue occur when the marginal labor tax rate is 81 percent, at which point spending is 72 percent of GNP, transfers are 58 percent of GNP, and tax revenue is 68 percent of GNP. When large uncompensated and compensated elasticities are assumed (0.44 and 0.52, respectively), maximum fiscal size occurs when the labor tax rate is 64 percent, at which point spending is 61 percent of GNP, transfers are 48 percent of GNP, and tax revenue is 57 percent of GNP. The revenue-maximizing tax rates in these two cases are quantitatively similar to those in Fullerton [1982], who used a more detailed model with variable capital.

Sensitivity analysis in appendix A indicates that computed limits to the fiscal size of government are not particularly sensitive to reasonable alternative assumptions about the initial level of government debt, labor’s share, the elasticity of substitution in the aggregate production function, the interest rate on government debt, or the level of taxes on labor at which the model is calibrated. Results are somewhat sensitive, however, to the values of t_k and t_b, primarily because the assumptions of constant capital and given debt make taxes on capital and debt lump-sum taxes in the model. Computed limits are obviously sensitive to assumed labor supply elasticities, and presumably would also be sensitive to assumptions that would be made if the analysis were broadened to treat capital and debt as endogenous (see appendix A for a brief analysis).

We make two adjustments to the accounting definition of transfers used by the OECD in order to increase the comparability of our theoretical peak levels with the observed data. First, we add tax expenditures, that is subsidies given through tax exclusions, deductions, and credits. Whereas a cash transfer is a payment from government, a tax expenditure is a reduction in payments to government. Second, we subtract indirect taxes paid by recipients of cash or equivalent transfers. Taken together, these two adjustments greatly improve the consistency of the raw data with our definition of transfers, namely that transfers are net claims to private goods that result directly from government fiscal decisions about budgeted spending and its funding.

To put the first adjustment into perspective, consider two countries that are identical except that the government in country A provides cash payments to a group or activity and records this as an expenditure on its budget, while the government in country A¢ provides the same size of subsidy to the same group or activity in the form of tax expenditure which shows up on budget as a reduction in tax revenue. The two governments use different accounting practices but provide households with the same net claims to private goods or transfers. One way to account for this discrepancy is to count tax expenditures as transfers.

The traditional approach to measuring tax expenditures is to list a set of exclusions, deductions, and credits; calculate the values of each of these for each taxpayer at the taxpayer’s own marginal rate; and sum to obtain total tax expenditures (see e.g., Surrey and McDaniel [1985]). Forming the list of exclusions, deductions, and credits in turn requires a large number of decisions about how to treat each aspect of the tax code. The approach we develop avoids this difficulty. We recover inclusive measures of tax expenditures as well as government spending, transfers, and tax revenue from data on marginal tax rates and other variables using a form of the government budget constraint written in terms of marginal tax rates that are taken to be constants, as in linear-tax models and as is implicit in traditional calculations of tax expenditures.

The second adjustment is useful because transfers paid in cash or the equivalent are typically subject to indirect taxes such as sales and value-added taxes, so transfers recorded on official budgets - that is the gross amounts paid to governments - overstate the net claims to private goods provided by government. Netting out indirect taxes from calculated transfers better reflects the actual benefits conferred.

Implementing these adjustments empirically is a complicated matter. We put them into practice and describe some important features in what follows.

We begin by assuming that each national economy can be characterized to contain an aggregate or representative household. This assumption greatly reduces data requirements but is not required generally for the approach. In appendix B, we show how the approach can be generalized to calculate tax expenditures, transfers, spending, and revenue from data on a large number of households in an economy, each of which faces its own marginal tax rates. The appendix also contains a numerical example showing that calculations based on disaggregate data could yield results essentially similar to results based on aggregate data.

The government budget (1) constraint can be rewritten as,

(1')

Because tax revenue R º t_lwl + t_krk + t_br b, and because we wish to distinguish R from tax revenue as measured on official budgets (R⁰), we refer to R as full tax revenue. We establish below that S and T are also inclusive measures, including tax expenditures as well as on-budget spending, so these might similarly be termed full government spending and full transfers. For brevity, however, we suppress "full" in referring to S and T.

Because it is useful to distinguish between transfers that are not subject to indirect taxes (t_i), in-kind transfers (T_#), and transfers that are subject to indirect taxes, cash transfers or the equivalent (T_$), we break transfer into two components, where T º T_# + (1-t_i) T_$. We refer to transfers that are subject to indirect taxes as pecuniary transfers.

We use (1') to measure S, T, and R over time in OECD countries. Specifically, we use data on t_l, wl, t_k, rk, t_b, and r b for a given year and country to find the value of R, and then add N, F, and D b to find the value of S. Thereafter we subtract G and r b to find the value of T. We also break transfers into in-kind and pecuniary components by solving T º T_# + (1-t_i) T_$ for T_$ and inserting data on T_# and t_i to find the value of T_$.

A central property of this approach is that transfers include tax expenditures; specifically, pecuniary transfers equal on-budget cash transfers plus tax expenditures. To see this, let x_l, x_k, and x_b denote income excluded from labor-income, capital-income and debt-interest taxation, let d_l, d_k, and d_b denote deductions permitted against labor income, capital income, and debt-interest income,

and let c denote total tax credits. Then on-budget tax revenue is

(6)

Similarly, on-budget transfers consist of in-kind transfers plus cash transfers (denoted T_$$), and equal total on-budget sources of funds (R⁰ + N + F + D b) less on-budget spending on public goods and interest (G + r b), or

(7)

Finally, tax expenditures (E) are the loss in revenue from all exclusions, deductions, and credits. The exclusion of one currency unit of income that otherwise would be taxed at rate t results in a loss of revenue of t currency units. A deduction of one currency unit similarly results in a revenue loss of t currency units. A tax credit of one currency unit, on the other hand, costs the government one currency unit in revenue. Thus tax expenditures are

(8)

An immediate consequence of the definition of full tax revenue, (6) and (8) is that tax expenditures are the difference between full tax revenue and on-budget tax revenue, with an adjustment because on-budget tax revenue includes revenue from taxation of pecuniary transfers but full tax revenue does not:

(9)

Note that t_iT_$ is netted from gross transfers of T_# + T_$ on the spending side of the government budget (1) and hence is not included in full tax revenue on the sources-of-funds side. Below, we

report values of tax expenditures calculated using (9). Instead of beginning with an explicit list of all tax preferences, these calculations start with full tax revenue and recover tax expenditures indirectly as a revenue difference.

From (1), (7), and (9):

(10)

This "transfer identity" says that gross transfers, T_# + T_$ = T + t_iT_$, are identically equal to on-budget transfers plus tax expenditures. The transfer identity, (10), and the definition T = T_# +

(1- t_i)T_$ then imply that

(11)

which establishes that pecuniary transfers equal cash transfers plus tax expenditures.

It should be clear that E is a broad notion that captures the values of all reasons why on-budget tax revenue is less than full tax revenue plus revenue from indirect taxation of pecuniary transfers, including all explicit and implicit exclusions, deductions, and tax credits. The inclusive

treatments of tax expenditures and transfers parallel the inclusive notion of full tax revenue.

A feature of tax expenditures calculated using (9) is that our tax expenditures have a progressive nature. Because the approach here treats the marginal tax rates t_l, t_k, and t_b as constants, any progressivity in the rate structures of actual tax systems shows up not in t_l, t_k, and t_b but rather as exclusions, deductions, and credits. Specifically, a progressive rate structure means that some infra-marginal labor income is taxed at rates below t_l. A household is better off if infra-marginal income is taxed at rates below t_l than if that income is taxed at rate t_l. Under the approach here, the household is viewed as taxed at t_l on each unit of labor income, and government is then viewed as providing a lump-sum transfer to the household equal to the benefit of lower rates on infra-marginal income. The resulting progressivity tax expenditure reflects the net claims to private goods that government provides by applying lower tax rates at lower income levels.

Because we treat each economy as containing an aggregate household, progressivity tax expenditures reported below are the sums of both positive and negative components. Thus, the aggregate household in a country represents the household sector in the country, so the marginal tax rates t_l, t_k, and t_b are measured below as the rates that apply to an "average" household in the country. In actual economies with progressive rate structures, this means not only that some income is taxed at rates below t_l, t_k, and t_b, but also that some higher-income households face marginal rates above t_l, t_k, and t_b. Income taxed at rates below t_l, t_k, and t_b results in positive progressivity tax expenditures, whereas income taxed at rates above t_l, t_k, and t_b results in negative progressivity tax expenditures. That is, households with income taxed at rates greater than t_l, t_k, and t_b are viewed as paying lump-sum transfers to government, and such payments reduce the calculated value of E. An implication is that, under the aggregate-household assumption, the progressivity tax expenditure could in principle be negative; this could occur in a tax system with marginal tax rates that are relatively constant up to the income at which rates t_l, t_k, and t_b apply, and strongly progressive at higher incomes.

Although aggregate tax expenditures calculated below using (9) can be larger or smaller than tax expenditures calculated using the traditional "list-and-sum" approach, there are two reasons why (6) might give larger numbers. First, traditional data generally exist for national governments only, and miss tax expenditures by subnational governments. Second, the list of exclusions, deductions, and credits underlying the traditional approach may not be inclusive. For example, traditional calculations typically do not include a progressive tax expenditure. Another example is that the approach here counts as tax expenditures the tax savings to households that arise because personal income taxes are eliminated or postponed when corporations retain capital income.

A potential downside of including tax expenditures as transfers, however, is that it can distort cross-country comparisons of government size. For instance, a country that has high marginal tax rates but generous tax credits will appear to have a larger government than an otherwise identical country that has lower marginal tax rates but tax credits just low enough that the households in the two countries are equally well off. Nevertheless, this is not necessarily a weakness. There is, indeed, clearly greater government involvement in the first country despite an equal net result.

A description of data used to implement the approach is given in appendix C.

Table 2 reports summary statistics for fiscal sizes as percentages of GNP for the 22 countries in the sample averaged across the years 1972-1992. Spending, transfers, and full tax revenue varied by a factor of about two, where the U.S. had the smallest and Sweden the largest values during the period. A clear geographical pattern is that countries with relatively greater fiscal sizes of government lie in northern and, to a lesser extent, central Europe, home to, for instance, all countries with spending above 56 percent of GNP, transfers above 47 percent of GNP, or full tax revenue above 54 percent of GNP except Italy and Canada.

The difference between our measure and measures reported in official budgets is substantial. Formally, we measure government spending as S = T + G + r b, whereas government spending measured on official budgets is S⁰ º T⁰ + G +r b. From the definition T = T_# + (1- t_i)T_$, (7), and (11), the difference is

(12)

Transfers dominate other spending in Table 2. Averaged across all countries and the entire time period, transfers made up 84 percent of total spending, spending on public goods made up 12 percent of total spending, and net interest payments made up 3.8 percent of total spending.

Differences in government spending across countries primarily reflect differences in transfers. For instance, the correlation coefficient across countries between the transfer percentage and the spending percentage, both averaged over 1972-1992, is 0.96. Similarly, the range of transfers across countries reported in Table 2 substantially exceeds ranges of spending on public goods or net interest payments.

Our estimates of gross tax expenditures (E) are larger than estimates calculated using the traditional approach of listing a set of specific tax breaks and summing values of these tax breaks over all taxpayers. To provide a rough comparison, we took traditional tax expenditure calculations from three collection volumes to obtain a comparison set of one or more years of estimates for nine countries (Australia, Austria, Canada, France, Germany, Ireland, Spain, the U.K., and the U.S.). We then computed the average traditional tax expenditure across available years for each country, and also found the average for that country across the same years from our calculations of E. That left nine pairs of tax expenditure estimates. Across the nine, average gross tax expenditures were 22.4 percent of GNP using our approach versus 8.4 percent of GNP using the traditional approach.

Table 3 summarizes the peaking of inclusive spending (S), transfers (T), and full tax revenue (R) in the same format as Table 1, which summarized peaking of on-budget spending (S⁰), transfers (T⁰), and tax revenue (R⁰). Graphs of S, T, and R are

appended after the appendix. In reading the graphs, note that non-tax revenue (N + F) is generally small and varies little over time relative to GNP, so the budget deficit

in a year can be read roughly as the difference between the S and R graphs, less a few percent of GNP, for that year. (The main exception is for New Zealand, where N + F rose from 2.3 percent of GNP in the mid-1970s to 8.2 percent of GNP in 1987, before falling to 4 percent of GNP in 1992.)

In the five countries that attained the greatest peak spending percentages (Belgium, Ireland, Sweden, Denmark, and the Netherlands), the average decline in spending from peaks until 1992 was 15.4 percent of GNP. In the other 17 countries, the average decline was 5.9 percent of GNP.

The peaking of government spending reflects the peaking of transfers. This relationship is easily seen in the country graphs, where changes in government spending closely track changes in transfers. More formally, the average value across countries of the correlation coefficient between annual spending and annual transfers is 0.96. This correlation between annual transfers and spending indicates that differences in government spending across time mainly reflect differences in transfers.

Transfers appear to be on upward trends (as defined above) as percentages of GNP only in Finland, Luxembourg, Turkey, and possibly Canada. For the other 18 countries, thus, it is natural to ask whether the transfer percentage has been on a downward trend since reaching its peak over the period or has been essentially level since its peak. By the criterion proposed above, 11 of the countries have downward-trending transfers and seven have transfers that are essentially level. In contrast, only eight countries had downward-trending transfers by the measure used in Table 1.

Reductions in peak transfers as a percentage of GNP until 1992 were generally greatest in the countries with the greatest peak transfer percentages, i.e., Sweden, Belgium, Ireland, Denmark, and Finland. The average decline in transfers from peaks until 1992 was 12.6 percent of GNP in these five countries but only 6.7 percent of GNP in the other 17 countries.

Full tax revenue is less sensitive to short-term business-cycle influences than spending and transfers, so it may be a better indicator of longer-term trends. We see from the country graphs and Table 3 that full tax revenue appears to be trending upwards as a percentage of GNP only in Canada, Italy, and Turkey. Of the other 19 countries, 10 have full-tax-revenue percentages on downward trends (as defined above) and nine have full-tax-revenue percentages that are essentially level. Thus while Table 1 provided only weak evidence of breaks in upward trends in on-budget tax revenue (R⁰) over 1972-1992, Table 3 presents a reasonably clear picture of breaks in upward trends in full tax revenue (R) over the period.

For the five countries with the greatest peak full-tax-revenue percentages (Belgium, Denmark, Sweden, Norway, and Ireland), the average decline in full tax revenue from peaks until 1992 was 9.0 percent of GNP. The average decline in the other 17 countries was 4.1 percent of GNP. So again our measures make peaking more evident.

A general pattern emerged in many of the countries. Spending rose more than full tax revenue over a relatively long period of time, so deficits grew. Full tax revenue reached a plateau at about the same time that spending peaked, though high deficits persisted for several years after the spending peak before spending and deficits fell. Although many of the countries fit some aspects of this pattern, the pattern is particularly prominent in four of the countries that reached the highest levels of government spending. Belgium, for instance, had the greatest peak spending (92 percent of GNP in 1984) and roughly 10 years of large deficits; averaged over 1977-1988, deficits were 10.4 percent of GNP. By comparison, the average deficit across all countries and years was 4.4 percent of GNP. Similarly, Ireland (the second largest with peak spending at 86 percent in 1985) had average deficits of 15.1 percent of GNP over 1974-1987, Sweden (third with a peak at 84 percent in 1982) had average deficits of 7.3 percent of GNP over 1976-1986, and the Netherlands (fifth with a peak at 79 percent in 1983) had average deficits of 6.5 percent of GNP over 1979-1989.

The countries that attained the greatest peak fiscal sizes tended to have greater declines in spending, transfers, and full tax revenue than other countries. Moreover, peak spending in Belgium, Ireland, Sweden, and the Netherlands coincided with peak transfers and with large deficits that lasted for periods of 10 years or more. A possible explanation for these patterns is that political forces may have pushed transfer spending to, or beyond, levels that can be sustained in equilibrium by taxation. This may have contributed to periods of deficits and weak economic performance, and ultimately to reductions in spending.

To see whether this conjecture seems plausible, we compare numbers calculated in the long-run Laffer curve model to the actual peak levels observed in our sample of OECD countries. Note that tax revenue in the model is equivalent to full tax revenue and may be compared directly with revenues reported in Tables 2 and 3, and that computed limits for S, and T may be compared with spending and transfer experiences of OECD countries.

Fourteen of the countries studied (all but Japan, New Zealand, Portugal, Spain, Switzerland, Turkey, the U.K., and the U.S.) had peak spending, transfers, and full tax revenue in excess of theoretical limits calculated under relatively large labor supply elasticities (see Table 3). That is peak spending, transfers, and full tax revenue were in excess of 64, 48, and 57 percent of GNP, respectively. Belgium, Denmark, Norway, and Sweden had peak spending, transfers, and full tax revenue in excess of theoretical limits calculated even under the small labor supply elasticities. That is peak spending, transfers, and full tax revenue were in excess of 72, 58, and 68 percent of GNP, respectively. This may help explain why fiscal sizes have fallen in some OECD countries. By 1992, for instance, only 12 of the countries had spending, transfers, and full tax revenue in excess of theoretical limits calculated under large labor supply elasticities, and only Belgium and Denmark had spending, transfers, and full tax revenue in excess of theoretical limits calculated under small labor supply elasticities. The theoretical limit calculations here are admittedly crude, but they suggest that fiscal sizes of government in many OECD countries may be or have been close to theoretical limits.

We ask whether the apparent leveling or peaking of fiscal sizes that many developed countries have experienced after a century of nearly uninterrupted growth in government size may be a result of limits to taxation. We address the issue by comparing numbers computed in a long-run Laffer curve model with actual observed data from OECD countries. To improve the consistency of the comparisons we use an alternative to the conventional accounting definition of transfers that more closely captures the actual size of government. A drawback of conventional measures is that countries use different accounting practices to transfer resources to households and, thus, appear to have different sizes of government. Another problem is that, in many instances, numbers reported in official budgets are for national government and miss expenditures made by subnational governments. This can also be misleading if countries vary in governmental organization. We define transfers, instead, as the net claims to private goods that result directly from government fiscal decisions about budgeted spending and its funding, including tax policy. Our approach to calculating transfers so defined, as well as inclusive measures of government spending, tax revenue, and tax expenditures, uses data on marginal tax rates and a form of government budget constraint. We apply the method to study peaking of fiscal sizes of government in OECD countries over 1972-1992.

Based on defendable assumptions about labor supply elasticities, our findings suggest that fiscal size may reach a maximum when spending equals roughly 75 percent of GNP, transfers equal roughly 60 percent of GNP, and tax revenue equals roughly 70 percent of GNP. The experiences of countries with the greatest peak fiscal sizes suggest that some combination of political and economic forces may restrict sustainable spending above levels remarkably similar to the theoretical maxima. Fiscal sizes exceeded these levels only for short periods around times of peak fiscal sizes in these countries.

It may also be worthwhile to note the obvious; fiscal sizes peak at different levels in different countries. The determinants of these observed differences are not well known, and a full empirical assessment is beyond the scope of this paper. Several observations from this study may be useful for future research, however.

Our model suggests that labor supply elasticities are key determinants of how big government can become. High income tax rates, of course, discourage working more where the labor supply is elastic than where it is inelastic. Large differences in labor supply elasticities across countries, particularly for women, and the factors that explain them may be an important part of the explanation. For example, consider the uncompensated female labor supply elasticities reported for Canada, Germany, the U.K., and the U.S. in Killingsworth and Heckman [1986]. They aligned exactly with peak government size in these countries. Specifically, the elasticity was greatest and peak government size lowest in the U.S. In Canada, the elasticity was lowest but peak government size the highest. Germany and the U.K. lay in between for both measures.

Numerous country- and time- specific factors such as business cycles, political structure, history likely influence the size of government and deserve attention. Moreover, more research should be devoted to further improving the measurement of government size to make comparisons across countries and time more informative. A first step may be to use a more disaggregated measure than that used here.

1. Description of Calibration Allocation. It is necessary to choose parametric values for a, t_k, t_b, b, D b, N, F, G, and r as well as a value of t_l in the calibration allocation. For a, t_k, t_b, r , and t_l, we set these values equal to weighted average values over 1988-1992 across all countries using the data described in appendix C. For b, D b, N, F, and G, we use weighted averages of ratios to GNP. Weights are purchasing-power-parity-based GDP shares reported in OECD (a, 1995, p. A2).

Resulting values are a = 0.391, t_k = 0.441, t_b = 0.319, b = 0.576, N = 0.003, F = 0.003, G = 0.085, r = r b / b = 0.032 / 0.576 = 0.056, and t_l = 0.480. To adjust assumed deficits so that the primary deficit (D b - r b) equals zero, we set D b = r b = 0.032. Note that the actual average value of D b across our sample was 0.029, so actual primary deficits averaged -0.3 percent of GNP.

2. Sensitivity Analysis. The following sensitivity analyses assume that labor supply elasticities are small (0.1 and 0.25) and each makes a single change in parameterizing assumptions:

(a) Several countries have run up large national debts in recent decades. Number one in this regard is Belgium, which had a national debt that was 1.41 times its GNP in 1992. The assumption that b = 1.41 instead of b = 0.576 lowers transfers at maximum fiscal size ("limit" transfers) from 58 percent of GNP to 55 percent of GNP, raises limit spending from 72 to 74 percent of GNP, and raises limit tax revenue from 68 to 69 percent of GNP.

(b) In the model, taxes on capital and interest are lump-sum taxes. Increasing the assumed values of each by 0.1 (so t_k = 0.541 and t_b = 0.419) raises limit transfers from 58 to 62 percent of GNP, raises limit spending from 72 to 76 percent of GNP, and raises limit tax revenue from 68 to 71 percent of GNP.

(c) An increase in the assumed value of capital's share from a = 0.391 to a = 0.441 lowers limit transfers from 58 to 57 percent of GNP, lowers limit spending from 72 to 70 percent of GNP, and lowers limit tax revenue from 68 to 66 percent of GNP. Replacement of the Cobb-Douglas production function with CES functions with elasticities of substitution of 0.5 and 1.5 (instead of 1.0 in the Cobb-Douglas case) affects limit transfers, spending and tax revenue as percentages of GNP only at the third (or in one case the second) significant figure.

(d) An increase in the assumed value of r by 0.01 affects limit transfers, spending, and tax revenue only at the third significant figure. A potentially more important change is to assume that arbitrage in long-run equilibrium leads the return on government debt (r ) to equal the return on private capital less a constant premium on government debt over private capital (p ), or

where q is a scaling factor needed because r is a traditionally-measured interest rate but the unit choice K = 1 implies that r is capital’s share of GNP. We find the appropriate value of q by noting that, in the calibration allocation, r takes a known value of 0.056 and from (11) r = a, so (13) implies q = (0.056 + p ) / a. We assume somewhat arbitrarily that p = 0.01. (Because changes in r affect results only at the third significant figure, this assumption is innocuous.) This change causes maximum transfers not to coincide with maximum spending and tax revenue. At maximum transfers, transfers are 60 percent of GNP, spending is 73 percent of GNP, and tax revenue is 67 percent of GNP. At maximum spending and revenue, transfers are 59 percent of GNP, spending is 72 percent of GNP, and tax revenue is 67 percent of GNP.

(e) It might be argued that labor supply behavior in the economies under study has not adjusted fully to 1988-1992 levels of taxation of labor income. We therefore assume as an alternative that the labor tax rate in the calibration allocation equals 0.430 instead of 0.480. This reduces limit transfers from 58 to 57 percent of GNP, reduces limit government spending from 72 to 71 percent of GNP, and reduces limit tax revenue from 68 to 67 percent of GNP.

To generalize to a framework with n ³ 2 households or individuals in an economy, each with specific values of the variables in (1') and (2), the government budget would be written

where j is an index of households or individuals. All national-income accounting relations in section 5.3 would continue to hold, mutatis mutandis.

To illustrate that disaggregate calculations would provide essentially similar but not necessarily identical results, consider an economy with three households, with w¹l¹ = 1, w²l² = 1.5, w³l³ = 2, and k = b = N = F = D b = G = 0. Suppose a graduated labor income tax is the only tax and total tax payments are

where I is household labor income. The three households face marginal tax rates of .4, .5, and .6, and make actual tax payments of R⁰ = 0 + .2 + .45 = .65. Full tax revenue is R = .4*1 + .5*1.5 + .6*2 = 2.35. Tax expenditures in this example are due solely to progressivity, with E = (.4*1) + (.5*1.5 - .2) + (.6*2 - .45) = 1.7, which equals R - R⁰.

Under an aggregate household view, note that aggregate labor income is 4.5, and take the aggregate marginal tax rate to be the median rate .5. Then full tax revenue would be R = .5*4.5 = 2.25, and tax expenditures would be R - R⁰ = 2.25 - .65 = 1.6. This example makes clear that choices of marginal rates matter, just as they matter in traditional calculations of tax expenditures.

We study OECD economies over 1972-1992. Greece and Iceland are excluded due to lack of data. Data for Turkey begin in 1975. Calculation of transfers, spending, and full tax revenue in a given economy and year requires taking values of t_l, wl, t_k, rk, t_b, r b, N, F, D b, and G for that economy and year. Calculation of tax expenditures requires, in addition, values of R⁰, t_i, and T_#. We study consolidated (general) government, which includes national (central) and subnational (state, local, provincial) budgetary government plus social security funds.

Tax-rate data are crucial. Consistent tax-rate data are available in OECD publications starting from 1972.

An important issue is that personal income taxes typically have progressive rate structures, so it is necessary to specify a rule for choosing the income level at which to evaluate each country’s marginal income tax rate. In the OECD data, this choice has been made: the income level is "the income of an average production worker". Our use of the OECD data thus interprets the aggregate household in a country as reflecting the experience of the average production worker in the country and compares countries based on the experiences of average production workers. It should be stressed that if income levels different from those of average production workers were chosen, marginal taxes would sometimes differ and hence so would calculated sizes of government. In this way, calculated sizes of government are conditional on the rule for choosing the incomes at which marginal income tax rates are evaluated.

We take the marginal rates t_m and t_m’ to be .75 times the appropriate marginal rate in the OECD data for a married average production worker with two children plus .25 times the marginal rate for a single average production worker. Data on t_m and t_m’, and t_p are from OECD (g), (h), and (i). OECD source material does not report values of t_m and t_m‘ for 1979-1981. Values are interpolated for these years. Because t_i is the rate of indirect taxation of disposable income, we calculate t_i as total indirect tax revenue divided by disposable income using data in OECD (e) and (f).

Total labor income (wl) is the sum of compensation of employees plus an estimate of the labor income of employers and own-account workers. Data on compensation of employees are directly available in national income accounts. To estimate the labor income of employers and own-account workers, we assume that compensation of employees divided by the number of employees equals labor income of employers and own-account workers divided by the number of employers and own-account workers. With this assumption, total labor income equals compensation of employees (source: OECD (e)) times one plus the ratio of the number of employers and own-account workers to the number of employees (sources: ILO and OECD (d)).

The tax rate on private capital income includes corporation and related business taxes (at rate t_c), personal income taxes, indirect taxes, and property and wealth taxes (at rate t_w). Starting from nominal private capital income of rk, we reason that (1 - t_c)rk remains after corporation and related business taxes are drawn, (1 - t_c)(1 - t_m)rk remains after personal income taxes are drawn, and [(1- t_c t_c)(1 - t_m)- t_w]rk remains after property and wealth taxes are drawn, leaving [(1 - t_c)(1- t_m)- t_w](1- t_i)rk to be consumed. We thus calculate t_k as t_c + t_m - t_c t_m + t_w + t_i – t_i [t_c + t_m - t_ct_m + t_w]. We measure t_c as the ratio of corporation income taxes to private capital income and t_w as the ratio of total wealth and property taxes to private capital income (sources: OECD (e) and (f)), which assumes that the two ratios approximate the additional corporation taxes and property and wealth taxes that would be paid if private capital income in a country (rk) rose marginally. Given the relatively small magnitudes of t_c and t_w in our data, this approximation should affect resulting calculations of T, S, R, and E little (and in uncertain direction).

We take private capital income (rk) to be GNP (source: OECD (e)) minus total labor income and minus public capital income (F). The source for F for most countries is UN, Table 3.12, from which F is operating surplus plus property income net of interest. For other countries, the source is

IMF, from which F is nontax revenue minus other property income (largely interest) and minus fines, fees, forfeitures, penalties, and sales.

The tax rate on interest on government debt (t_b) includes personal income taxes and indirect taxes. We calculate t_b as t_m + t_i – t_mt_i.

Government interest payments (r b) equal nominal interest paid minus interest received for consolidated government except in the cases of Japan and New Zealand, where net-interest data are for budgetary central government only. The source for r b for most countries is UN; for a few countries, the source is IMF. The increase in private holdings of government debt (D b) is also measured for consolidated government except in the cases of Japan and New Zealand, where available data are for budgetary central government (source: IMF).

Data on fines, fees, forfeitures, penalties, and sales (N) for most countries are from UN. For a few countries, data on N are from IMF.

Data used to form series of expenditures on public goods (G) and transfers (T_# and T_$$) are from OECD (e), UN, and IMF, which contain coarse breakdowns of public spending by categories. We count spending categorized as general public services, defense, public order and safety,

and economic services as G; count spending categorized as education, health, and housing and community amenities as T_#; and count spending categorized as social security and welfare as T_$$. The only other non-debt spending categories are recreational, cultural, and religious affairs, and other. These generally contain mixtures of public goods and transfers not subject to indirect taxes, so we count one-half of these expenditures as G and one-half as T_#.

Data on on-budget tax revenue (R⁰) are from OECD (f).