THE Scottish Parliament has approved the Budget and the Government has reaffirmed its commitment to raising Scotland's rate of economic growth - but without discussion of whether the scale of public spending is damaging our economic growth.

Many in Scotland argue that with public spending amounting to 52 per cent of GDP compared to around 41 per cent in the UK, funds and resources are being diverted from more productive private sector use to the detriment of economic growth.

But is the argument correct?

There is little doubt that - other things remaining equal - very high tax rates serve as a disincentive to enterprise. However, other things are not equal. If high taxes are associated with high amenity provision - like good public transport or an efficient health service - incentives may not be damaged. Individuals may be content to take a return that comprises a social as well as a private wage, as is the case in countries such as Sweden and Finland.

Public spending in Scotland is higher than in the UK because it is funded by the UK taxpayer so it is wrong to claim that over half the economy is absorbed by public spending. More relevant is the tax burden of around 39 per cent, which is affected in the short term not only by spending but also by the size of the UK public sector deficit. The fiscal crowding-out effect on the private sector of this tax burden will be the same as for the UK since we share a tax structure and tax burden.

Yet, since Scotland runs a large fiscal deficit compared to the UK can this cause crowding out and lower growth? The answer must be no, because Scotland shares the UK interest rate, which is influenced by net borrowing at the UK not the Scottish level.

If public spending is higher per head in Scotland than in the UK won't that lead to prices and wages being bid up here at the expense of the economy's competitiveness?

Yes, at least initially, but not necessarily to the overall detriment of growth. Model simulations at the Fraser of Allander Institute suggest that the positive effect of higher public spending on demand and output outweighs the negative effect of higher wages and input prices on private sector output. Moreover, since markets tend to adjust more effectively between regions and countries within a stable monetary union, resources flow readily in response to price and quantity signals so that any pressure on price and supply due to increased public spending is eventually eased.

However, there are other routes through which the size of the public sector may crowdout private sector activity and reduce growth.

One key route is the effect of the public sector as a producer. It accounts for around 24 per cent of employment in Scotland compared to 20 per cent in the UK - much less than the 52 per cent share of public spending in GDP.

The main possibility for a negative effect arising from this would be if workers diverted into the public sector become less entrepreneurial.

There is evidence from Italy that the scale of public employment has damaged entrepreneurial activity but our work in the Centre for Public Policy for Regions on new firm formation in Britain suggests a positive link between public sector share and business birth. The jury is therefore still out on this.

Recent evidence from researchers in Austria on the optimal size of the public sector, suggests that overall crowding out effects only occur when own-financed public spending reaches around 40 per cent of GDP - a figure close to Scotland's tax burden and the public spending ratio in the UK.

This may imply that the Government's drive to improve performance and efficiency - while welcome - may ultimately run up against the diseconomies of scale that may be the inevitable outcome of a large public sector.

What one can say from this evidence is that there is little support for increasing the size of the public sector and spending in Scotland but there may be a case for cutting it, on efficiency grounds at least.
