There are so many misconceptions about tax policy and the size of government that it's almost impossible to sort through them all. But I'm going to do the best I can.
I will deal first with claims that high ratios of government spending to GDP are necessarily deleterious to economic growth. These claims are wrong. To my knowledge, there isn't a compelling theoretical foundation for this conclusion. And as far as I can tell, neither does the available empirical evidence support it. In this survey, Xavier Sala-i-Martin (who speaks with a certain amount of authority in this field) observes that "[t]he size of government does not appear to matter much. What is important is the 'quality of government'." Obviously, it is a very bad idea to let Robert Mugabe allocate a significant share of GDP. But governments in the Nordic countries offer an important counter-example: these countries have large public sectors, and are also rich, democratic and - by all accounts - pleasant places to live. Simply put, there is no apparent trade-off between government size and national income.
So a stated preference for a small(er) government sector can only be justified on ideological grounds. A political party may campaign for a larger or smaller public sector, but the justification cannot be that this choice will have a material effect on national income or on economic growth rates.
What does matter is how those government revenues are generated. The subject of the optimal 'tax mix' of taxes on labour income, capital income and consumption has been the subject of an enormous amount of theoretical and empirical inquiry. The theoretical literature has reached certain broad conclusions:
- Taxes on capital income generate the most distortions. In a small open economy, the elasticity of supply is very large (in principle, infinite), so small changes in the rate of return on capital can have large effects on investment.
- Taxes on consumption generate the least distortions. Since they don't affect post-tax rates of return, they don't affect savings and investment decisions.
The available empirical literature supports this consensus. An interesting recent OECD study on the optimal tax mix finds that a strategy of shifting away from income taxes - and especially corporate income taxes - in favour of consumption and property taxes has a positive effect on national income. (Shifting away from consumption taxes to income taxes has the opposite effect.) Since property taxes are generally left to the municipalities in Canada, this leaves consumption taxes as the preferred instrument for Canadian federal and provincial governments.
This lesson has been learned by all successful social democracies. As Peter Lindert explains in his book Growing Public, the secret to the Nordic countries' success is to make sure that their extensive social programs are financed by a tax mix that doesn't penalise economic growth. In particular, they make sure to offer low tax rates on capital income, and high tax rates on consumption. (See this post for more detail on this point, as well as some nifty graphs illustrating it.)
The broader point is that regardless of what you think the appropriate size of government should be, you should prefer a policy mix that penalises economic growth the least. And that means a recipe of (relatively) low taxes on capital income and (relatively) high taxes on consumption.
Sadly, Canadian political discourse is contaminated by what can only be described as tax policy fetishism: an irrational obsession for - or aversion to - certain tax policy instruments for their own sakes, without reference to their effects on what really matters. We indulge in these fetishes to our material cost. But as David Dodge pointed out over the weekend, we can't afford to do so much longer. It's long past time that we had an adult discussion about tax policy.