In the lead-up to the federal budget the government has made it clear it sees the long-term task of fiscal management in terms of cutting expenditure rather than raising revenue.

We’ve been repeatedly told the Rudd-Gillard government let spending get out of control, and that we must now rein in outlays and “repair” the budget to avoid a Mediterranean-scale disaster.

The reality is that Australia’s public expenditure, as a percentage of GDP, has shown no discernible upward trend for the last 35 years, and that out of comparable high-income developed countries, we have about the smallest public sector (and the lowest taxes).

Containing the size of government is a worthy objective only if one sees government as an unproductive overhead, but government is a vital partner in the economy. As economist Paul Samuelson pointed out in his Pure theory of public expenditure there is an optimum public/private mix in any economy, and Australia seems to be a long way from that optimum, which almost certainly lies in the direction of a larger public sector rather than a smaller one.

Public spending – bumpy but not going up

The diagram below shows Commonwealth outlays over the last 45 years. They peaked in the mid 1980s, and have risen and fallen as governments have applied fiscal boosts in response to downturns and economic shocks (such as the global financial crisis) and as they have let the private sector take up the slack as the economy recovers. There has been no upwards trend.

Source: Commonwealth Budget Papers and 2014-15 MYEFO

That diagram covers only Commonwealth outlays. We lack a robust time series consolidating data for all levels of government, but national accounts data suggest the same pattern holds for Australia as a whole, although the peak came later, in 1992. Over the same 45-year period there has been a rise in government transfer payments (pensions and other cash benefits) offsetting a fall in government “own purpose” outlays (education, defence, health care and so on), with no aggregate change. The rise in transfers reflects an ageing population, more persistent unemployment, and widening inequality.

Over the last year Miriam Lyons (former executive director of the Centre for Policy Development) and I have been researching the countervailing pressures on public budgets – the “small government” ideology (strongest in English-speaking countries) contrasting with economic pressures for upward re-balancing of the public-private mix. Our conclusion is in our book Governomics: can we afford small government?, published last week by Melbourne University Press. The title hints at our conclusions – we pay a high price for “small government”.

Our main finding is that Australia is seriously out of step with similar countries. We looked at 18 comparable prosperous OECD countries (those with per-capita GDP > $US35,000 in 2012), and found that at 34% of GDP we have the smallest public sector of all, well below the 45% average of those other 17 countries, and that the size of government has no correlation with countries’ economic performance. Standing out are northern European countries that have gone for efficient and effective government, rather than “small” government.

Our difference with those other countries - 11% of GDP - is huge. It’s around A$180 billion a year applied to our A$1.6 trillion economy. It’s enough to provide free university education (as in many mainland European countries), to implement the Gonski reforms, and to cope with our infrastructure backlog in a few years.

The case for public goods

In Australia the “small government” ideology has seen many functions transferred to the private sector. With technological and market changes there will be shifts each way of various functions, but our governments have pushed to the private sector functions that, in the interests of technical and allocative efficiency, should best be left with government. Small savings in tax have been offset by larger private outlays for toll roads, private health insurance and private school fees, to name some of the main examples.

This is in spite of three economic trends that should be seeing a larger, not a smaller, public sector.

The first is an ageing population, already acknowledged in documents like the Intergenerational Report.

The second arises because many government services, particularly education, health care, policing, and some social services are necessarily labour-intensive. (They are the big expenditure items for state governments). These public goods have experienced labour-productivity improvements, but not to the extent that private goods have. While prices of televisions, foreign travel and motor vehicles have tumbled, prices of public services have remained comparatively high. (Economists know this phenomenon as the Baumol effect.)

The third is a demand-side response to the Baumol effect. Oxford economist Avner Offer shows that as we become satiated with low-cost private goods, we seek more satisfaction (“utility”) from public goods. When you have a $35,000 car with satellite navigation, stability control, dynamic cruise control and climate control – accessories once found only on $100,000 cars – you’d like the potholes in the road fixed.

When Treasurer Hockey presents the budget next week it’ll will be worth remembering that long-term fiscal policy is about revenue collection, not only to close the budget deficit, but also to provide Australia with those public services necessary for our prosperity.

This article was co-authored by Miriam Lyons.