economic effects of reductions in defense outlays, cato policy analysis no. 706

7/31/2019 Economic Effects of Reductions in Defense Outlays, Cato Policy Analysis No. 706

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Executive Summary

This study examines the prospective economiceffects of a reduction below the current baselinein defense outlays of $100 billion per year over 10years.

Several recent studies have attempted to esti-mate the supposedly adverse economic and em-ployment effects of reductions in governmentspending generally, and defense outlays in partic-ular. Such studies have tended to exaggerate the

harmful effects of spending cuts and have ignoredor understated the beneficial effects associatedwith redirecting resources to more productiveuses.

A reduction in defense consumption and in-vestment shifts resources among economic sec-tors and thus has economic effects analogous tothose caused by changes in demand and supply inany industry. The unemployment (or underem-ployment) of labor and other resources during theadjustment process can be politically significantbut has only temporary economic effects; however

painful for some, this process of resource reallo-

cation is economically beneficial in the aggregateover time. Moreover, the data suggest stronglythat the adverse effects of spending cuts would besmall in the aggregate because defense spending isa small component of GDP (less than 5 percent),and because estimates of the multiplier effects ofdefense expenditures reported in the scholarly lit-erature are relatively low.

The reduction in defense spendingand thus

in federal spending in totalwould reduce as wellthe economic costs of the excess burden that thetax system imposes upon the economy, in theform of distortions that reduce aggregate output.A conservative estimate of that effect is 35 percentof the reduction in defense spending. Accordingly,a reduction in defense outlays of $100 billion peryear can be predicted, conservatively, to reduceeconomic costs by a total of $135 billion per year.

These potential savings in real resources aresufficiently large to justify a detailed analysis ofU.S. national security needs and the outlays re-

quired to defend them.

Economic Effects of Reductions inDefense Outlays

by Benjamin Zycher

No. 706 August 8, 2012

Benjamin Zycher is a senior fellow at the Pacific Research Institute, a visiting scholar at the American EnterpriseInstitute, and the president of Benjamin Zycher Economics Associates, Inc.


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The changinglong-term threatenvironmentfacing the Unite

States, at leastarguably, willyield an optimalforce structuresmaller thanthat currentlysupported.

of cuts and increases in various defense func-tions: Active-duty ground manpower, fighteraircraft, Navy surface combatants, and per-haps domestic bases would be reduced, whileunmanned aircraft, cyber security, special

operations, and submarine cruise missile ca-pacity would be increased.9 As noted above,the Friedman/Preble proposal would be areduction in outlays of roughly 18 percent,yielding spending totals somewhat smallerthan the BCA budget cap/sequestration fig-ures shown in Table 1 if the FY 2013 baselineshown in the table is assumed to be unbiasedas an estimate of future defense outlays be-fore implementation of the BCA budget cap/sequestration limits.

In the next section, I discuss the nature of

defense services as a good that protects hu-man, physical, and social capital from external

threats. In brief, defense services are similar tomost other goods and services in an analyticsense, so that the unemployment and othereconomic effects resulting from a decline inthe need for (or value of) defense services are

irrelevant in terms of the appropriate levelof defense spending. After that, I discuss therecent evidence on the relationship betweendefense outlays and GDP growth and exam-ine some peer-reviewed literature on the GDPgrowth effects of changes in governmentspending, whether for defense or nondefense.The central focus of the following section isthe economic cost of the tax system neededto finance all federal outlays, including thosefor defense. Because of the tax system, the eco-nomic cost of federal spending is greater than

the spending itself. The final section offersconcluding observations.

Table 1Defense Budget Authority in FY 2013 Budget Proposal, Fiscal Years 20112017(billions of nominal dollars)

Fiscal Year

2011 2012 2013 2014 2015 2016 2017

Defense Totala 717.4 676.7 647.4 566.3 579.0 589.4 601.3

OCOb 158.8 115.1 88.5 26.2 39.5 42.5 43.4

Defense Baseline 558.6 561.6 558.9 540.1 539.5 546.9 557.9

Change from FY2012 3.9 62.6 55.4 102.4 102.2 104.8 n.a.

BCA budget cap/

sequestrationn.a. n.a. 472.0 482.0 491.0 502.0 515.0

Change from FY2013

baselinen.a. 86.9 58.1 48.5 44.9 42.9 n.a.

Sources: FY2013 Budget, Historical Tables, Table 5.1, http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/hist.pdf; FY2012 Budget, Historical Tables, Table 5.1, http://www.gpo.gov/fdsys/pkg/BUDGET-2012-TAB/pdf/BUDGET-2012-TAB.pdf; FY2013 Budget, http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/defense.pdf, pp. 83-84; Todd Harrison, $trategy in a Year of FiscalUncertainty, Center for Strategic and Budgetary Assessments, February 2012, http://www.csbaonline.org/publications/2012/02/trategy-in-a-year-of-fiscal-uncertainty/, Table 1; and author computations.Notes: n.a.=not available or not applicable. aDefense total is outlay function 050 (total); FY20122017 are esti-mates. bOCO: Overseas Contingency Operations. Figures for 20142017 are placeholders from FY2013 budget.


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To the extentthat the defense

sector is toolarge, aggregate

resource usewould be less

productive thanotherwise might

be the case.

Defense Services asEconomic Output

As a crude generalization, the ongoing de-bate over the size of the U.S. defense budget

comprises two distinct focuses. The first isthe nature and seriousness of the threat en-vironment facing the United States prospec-tively, and thus the appropriate magnitudeand allocation of resources for defense. To theextent that defense services protect human,physical, and social capital from destructionor confiscation by foreign aggressors, suchservices protect life, liberty, property, and thebenefits of civil society and encourage invest-ment and thus higher economic output (de-fined broadly) over the longer term.10 To the

extent that the defense sector is too small or isallocated poorly across functions, or to the ex-tent that the defense budget is implementedinefficiently, external threats may loom toolarge and investment and the economy writlarge are likely to be too small.11 To the extentthat the defense sector is too large, aggregateresource use would be less productive thanotherwise might be the case, and it is possiblethat the threat environment actually mightgrow as a foreign response to perceptions ofan aggressive United States. The opposite ef-

fect also is possible: by maintaining an over-whelming force structure, potential aggres-sors might be discouraged from the militarycompetition. That type of model lies outsidethe scope of this paper. The optimal size andcomposition of the defense sector are shuntedaside here; again, we assume cuts of $1 trillionor $100 billion per year for purposes of eco-nomic analysis.12

The second focus of the public debatethe topic of this paperis on the economiceffects of reductions in defense spending; the

usual parameters discussed are direct em-ployment losses, and the indirect multipliereffects in related economic sectors.13 Exceptperhaps for purposes of short-run analysisof narrow economic shifts across sectors orindustries, that general approach is prob-lematic because it ignores the benefits of aneconomic system that reallocates resources

to more productive uses as economic condi-tions change. Consider the market for anyfamiliar good; the demand and supply ofprivate security services is a good analogueIf the threat of crime declines we would ex-

pect a decline in the demand for private se-curity services. A reduction in the quantityof security services, and perhaps a decline inthe market price of such services, would re-flect this decline in demand.

This hypothetical reduction in the mar-ket size and price of private security servicesis a signal that such services have lost value.Value is the goods and services that a givendemander (or the market as a whole) is will-ing to forgo to obtain security services. Thedeclining value of security services means

that the resources used in the productionof those serviceslabor, buildings, vehiclescapital, and so onnow yield less (marginal)value when used in the production of se-curity services relative to their value in theproduction of other goods and services.14

Imagine a continuum of such resources, in-cluding labor, previously used to producesecurity services: some would be relativelybetter (more efficient) than others in pro-ductive activities in alternative economicsectors. The decline in the market price of se-

curity services would induce those resourcesrelatively more productive in alternativeusesand therefore relatively more costly toemploy in the private security sectorto exitthat sector and enter others earlier.

During the adjustment process, resourc-es, including labor, become unemployed (orperhaps underemployed). Some resourcesmight be highly specialized in the produc-tion of security services; it may be difficultand time-consuming for the owners of theseinputs to find new employment. Other re-

sources might be less specialized but diffi-cult to move: they are specialized geographi-cally, and therefore also may find it difficultto find new employment quickly. Some re-sourceslabor is a good examplemay bemore mobile than others, but the process ofchanging locales also might take substan-tial time. Even given that some of these re-


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The movementof resources

from less tomore profitablesectors increasesthe aggregateproductivity ofthe economy.

sources might find alternative employmentquickly, increased unemployment of laborand other resources previously occupied inthe production of private security services iscertain for some period of time.

This shift of resources, including labor,across economic sectors is an example ofwhat economists call structural unemploy-ment. It is the result of changes in the un-derlying economic conditions of demandand supply that yield shifts in the relativeprice signals inducing resources to flowtoward and away from various sectors. Inother words, as demand and supply condi-tions change, the structure of the economychanges as well: some industries grow whileothers decline, either absolutely or in a rela-

tive sense. Structural unemployment is afundamental feature of any dynamic econ-omy driven by constant changes in individ-ual preferences, individual choices, techno-logical shifts, and a myriad other factors.15Any owner of an input, including workerssuffering from unemployment caused by achange in market conditions, is worse off, atleast temporarily. But the process of allow-ing market forces to redirect resource useincreases aggregate output and wealth, thusmaking virtually all individuals better off

over time on net. The movement of resourcesfrom less to more profitable sectors increasesthe aggregate productivity of the economy.16Therefore, the increased unemployment andother adverse effects of the decline in the de-mand for private security services, howeverunpleasant for those bearing the brunt ofthe economic shifts, are not an adverse effectfor the economy as a whole. To put it a bitdifferently, the short-term adverse effect ofresources unemployed because of a shift ineconomic conditions is outweighed by the

longer term benefit of a process in which re-sources are allocated and reallocated amongalternative employments so as to increase theoverall productivity or value of resource use,that is, aggregate wealth.17

There is one analytic difference betweenthe simple example of a decline in the de-mand for private security services and a de-

cline in the demand for defense services: thelatter is reflected in collective choices emerg-ing from democratic institutions and politi-cal processes rather than prices determinedby market processes. A change in the aggre-

gate demand for defense services is moredifficult to measure (or to perceive) than isthe case for goods and services traded in theprivate sectorvalue in the public sector is agood deal murkierand public decisionmak-ers may have weaker incentives to respondto such changes in demand conditions.18Nonetheless, if the threat environment haschanged in ways yielding a perceived declinein the value of defense services, it is appropri-ate for some resources previously employedin the production of defense to become

unemployed temporarily as they search fortheir most valuable uses under changed cir-cumstances.

Recent Research on DefenseOutlays and the Economy

Only rarely, if ever, do we ask in a policycontext about the unemployment effects of adecline in the rates of serious crimes, particu-larly with respect to such given sectors as pri-

vate security services. Notwithstanding thestraightforward standard analysis of struc-tural economic shifts, a substantial bodyof literature has attempted to estimate thesupposedly adverse economic and employ-ment effects of reductions in governmentspending generally and defense outlays inparticular. One recent estimate of the latteris presented by Stephen S. Fuller, professorof public policy with the Center for Region-al Analysis at George Mason University.19Fullers analysis projects that a reduction in

procurement spending of $45 billion in 2013would yield the following impacts:

About $164 billion in direct and indi-rect lost sales;20

$59.4 billion in wage and salary reductions; About $27 billion in lost sales by sub-

contractors and other suppliers;


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A multipliereffect less than1.0 suggestsstrongly that

increases indefense spendin(and governmenspending moregenerally) haveeffects on GDPthat are offsetby reductions inother economicactivity.

terest is at zero.29 Parlow finds no effect ofdefense expenditures on the level or growthrate of GDP for the United States.30 In a newpaper, Ramey finds a GDP multiplier from allgovernment spending of about 0.5.31

Note that a GDP multiplier from changesin defense spending of approximately 0.6 to0.8 is in the range reported in most of thescholarly literature.32 Table 2 presents theempirical findings summarized above.

That most of the empirical estimates ofthe multiplier effect are less than 1.0 suggestsstrongly that increases in defense spending(and government spending more generally)have effects on GDP that are offset by reduc-tions in other economic activity.

This conclusion is corroborated by compar-

isons of defense spending and GDP growth.Consider Figure 1, below, which displays quar-terly data (at annual rates) on the defense con-tribution to GDP growth for 20002011.33The defense contribution is zero statistically:the mean figure for the 48 quarters is 0.15 per-cent, with a standard deviation of 0.45. More-over, the mean in this case does not obscure

wide variation. The defense contribution toGDP growth is close to zero for virtually theentire period. This is not surprising. Defensespending as a proportion of GDP was 3 per-cent in fiscal year 2000, rising to 4.8 percent in

FY2010, and then 4.7 percent in FY2011.

34

Inother words, even shunting aside the correctanalysis of structural shifts, the defense sectoris too small a part of the economy for changesin defense spending to have large aggregateeffects on GDP. A proposal to reduce defenseoutlays by $100 billion annually would haveamounted to only about 0.66 percent of GDPin 2011, a proportion that would decline eachyear thereafter as GDP grows.35 It is not plau-sible that a cut of that magnitude would havelarge aggregate effects, and the adverse short-

term effects felt by particular individuals andcommunities properly are viewed as shortrunstructural shifts, as discussed above. Moreover,even apart from the conceptual difficultieswith the commonly assumed relation betweenGDP growth and shifts in defense spending,the simple correlation between quarterly (atannual rates) percent changes in real GDP and

Table 2Estimated Multiplier Effects

Author Estimate Notes

Fuller 1.92 defense procurement

Cogan et al. 0.65 large stimulus

Mountford and Uhlig 0.65 spending shock

Barro and Redlick 0.60.9 increases in defense spending

Ramey (2011) 0.60.8 defense spending after WW2

Hall 0.71.0 all government purchases

Parlow 0 defense spending

Ramey (2012) 0.5 all government spending

Sources: See text above for sources.


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The defense sectoris too small a part

of the economyfor changes in

defense spendingto have large

aggregate effectson GDP.

percent changes in real defense spending is lessthan 0.09 for the period 20002011; that is, itis not far from zero economically, and in any

event is not statistically significant at a 5 per-cent significance level.36

As noted above, insufficient investmentin defense services in a world with significantexternal threats might result in reduced in-vestment in human and physical capital andthus might have a depressing effect on long-run GDP growth. But that is not the con-ceptual experiment offered in the literaturetypified by the Fuller analysis; instead, thatanalysis attempts to estimate the structuraleconomic impacts of reductions in defense

outlays, without consideration of the under-lying economics of resource shifts.

Consider the years 1981 through 2000, a pe-riod during which real GDP growth was posi-tive in all but two years (1982 and 1991). Realdefense expenditures grew every year from 1981through 1989 and then fell in 8 of the subse-quent 11 years. These data for real GDP and real

defense outlays are displayed in Figure 2.37

Table 3 shows the average annual com-pound growth rates for real GDP and for de-

fense outlays, for 19812000, for 19811989,and for 19902000. The compound growthin defense outlays differed by over 6.7 per-centage points between the 19811989 and19902000 periods, but GDP growth was ef-fectively the same for the two periods. For theentire period, the simple correlation betweenreal GDP and real defense outlays was -0.43For 19811989, it was 0.95, while it was -0.87for 19902000. These data do not controlfor the other myriad factors that determineGDP and GDP growth. But it is difficult to

conclude from the data in Figures 1 and 2and Table 1 that defense spending growthhas a significant impact on GDP growth.

The same is true for Figure 3, which dis-plays the percent changes in annual realGDP and real defense spending for 1981through 2000. Real economic growth wasgreater than zero for all but two years (1982

-10

-8

-6

-4

-2

0

2

4

6

8

10

Real GDP Growth Defense Contribution

AnnualPercent

Year: Quarter

Figure 1Defense Contribution to Real U.S. GDP Growth, 20002011

Source: Bureau of Economic Analysis, http://www.bea.gov/iTable/index_nipa.cfm, Table 1.1.2.


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Changes in thegrowth rate of readefense outlays

have little or noeffect on changesin GDP growth.

and 1991); the growth of real defense spend-ing was greater than zero every year through1989, and then was negative every year there-

after except 1991, 1997, and 2000. The sim-ple correlation for the entire 20-year periodbetween percent changes in GDP and per-cent changes in defense outlays was -0.17; for

19811989 it was -0.60, and for 19902000it was 0.02.38 None of these correlations issignificant statistically at a 5 percent sig-

nificance level. These data suggest strongly,again, that changes in the growth rate of realdefense outlays have little or no effect onchanges in GDP growth.

F

300

400

500

600

5,000

10,000

15,000

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

GDP Defense Outlays

Figure 2Real GDP and Defense Outlays, 19812000

BillionsofYear2011

Dollars

Year

Source: Office of Management and Budget, http://www.whitehouse.gov/omb/budget/Historicals, Table 8.2

Table 3Real GDP and Real Defense Outlays:Average Annual Compound Growth Rates (percent)

Period GDP Defense Outlays

19812000 3.32 0.43

19811989 3.40 4.25

19902000 3.26 2.47

Source: Office of Management and Budget, http://www.whitehouse.gov/omb/budget/Historicals, Table 8.2.


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-10

-8

-6

-4

-2

0

2

4

6

8

10

Real GDP Growth Private Investment Contribution

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

GDP Defense Outlays

Figure 3Precent Changes in Real GDP and Defense Outlays, 19812000

Source: Office of Management and Budget, http://www.whitehouse.gov/omb/budget/Historicals, Table 8.2plus author computations.

Year

Year: Quarter

PercentChange

AnnualPercent

Figure 4Private Investment Contribution to Real U.S. GDP Growth, 20002011



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Gross domesticprivateinvestment is thmost important

contributor toGDP growth.

To reiterate, increases in governmentspending, including spending for defense,have economic effects that are offset by re-ductions elsewhere, private investment inparticular.39 Figure 4 illustrates why this ef-

fect is important.

40

GDP is the sum of privateconsumption, private investment, net ex-ports, and government purchases (for whichvalue is assumed in the GDP accounts tobe equal to spending). Figure 4 shows a cor-relation between GDP growth and privateinvestment contribution of 0.843. Table 4presents these correlations, derived fromthe Bureau of Economic Analysis quarterlydata for 2000 through 2011.41 It is obvi-ous that gross domestic private investmentis the most important contributor to GDP

growth. Reductions in such investment en-gendered by increases in defense outlayswould reduce the aggregate multiplier effectof the latter.

In short, the scholarly literature does notsupport a premise that a decline in defenseoutlays would create sustained or substan-tial downward pressures on U.S. GDP. Theshort-run structural shifts yield increasedshort-run unemployment of labor and otherresources as part of a standard resource real-

location process, a process that is economi-cally advantageous in the aggregate.

The Economic Cost of

Financing DefenseExpenditures

The federal government must acquire theresources needed for all of its spending pro-grams through the tax system, either contem-poraneously with spending or in the future aspast debts are serviced or retired. The tax sys-tem imposes two classes of costs that are a real(but hidden) cost of defense and, indeed, of allfederal programs. The first is the cost of oper-

ating the tax revenue system itself; these costsare captured in the general government func-tions reported by the Office of Managementand Budget.42 This cost is largely fixedthatis, it does not vary greatly with changes in rev-enues or spending, whether in total or for suchindividual programs as defenseand relativelysmall.43 Accordingly, it is ignored here. Thesecond type of cost, however, appears nowherein government budgets but is both substantialand unavoidable in the context of federal rev-

Table 4Simple Correlations of Real GDP Growth and Contributions by Economic Sectors(quarterly, 20002011)

Sector Correlation

Personal consumption expenditures 0.712

Gross private domestic investment 0.843

Net exports of goods and services 0.227

Government consumption expenditures and gross investment

Federal

Defense

Non-defense

State and local

0.087

0.057

0.052

0.025

0.074



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The economiccost of financingdefense takes the

form of a GDPthat is smaller

than otherwisewould be the

case.

enue operations. It is the real economic costof the distortions created by the tax system, orthe excess burden of that system, which takesthe form of a GDP that is smaller than other-wise would be the case.

Federal tax instruments are applied toincome of various classifications, to transac-tions, to capital assets, and the like. Thosewho bear the economic burdens of such tax-es attempt, ceteris paribus, to avoid them inwhole or in part, and so, particularly in thelong run, the taxes affect economic behav-iorfor example, work effort, saving and in-vestment, and transactions. Such distortionshave the effect of lowering aggregate outputbelow levels that would prevail in the absenceof the taxes; that reduction in aggregate out-

put, however hidden, is termed the excessburden of taxation.44

These actions have nothing to do with taxevasion. Instead, because of the tax system,some transactions that would yield net ben-efits for the economywork, investment, andso forthare avoided, so that the private sectorbears a cost greater than a dollar to send a dol-lar to the federal government.

This adverse economic effect of variousfederal tax instruments has been recognizedbroadly for many years, although there is a

range of estimates on the magnitude of the ef-fect. Martin Feldstein has noted that

the traditional method of analyzingthe distorting effects of the income taxgreatly underestimates its total dead-weight loss as well as the incrementaldeadweight loss of an increase in incometax rates. . . . The true deadweight lossesare substantially greater than [prior]conventional estimates because the tra-ditional framework ignores the effect of

higher income tax rates on tax avoid-ance through changes in the form ofcompensation . . . and through changesin the patterns of consumption45

That excess burden is a real economic costof all federal spending, including that for de-fense, and therefore should be included as a

cost of defense programs (and, indeed, all fed-eral spending).46 Feldstein finds that highermarginal tax rates used to finance additionalfederal spending would impose upon theeconomy an excess burden of $0.76 per dollar

of revenue; that is, that it would cost the pri-vate sector $1.76 (the dollar of tax paymentsplus $0.76 of economic losses) to send anadditional dollar to the federal government,other things held constant.

Because that is a measure of the incremen-tal cost of federal spending, it is reasonableto assume that the average excess burden ofexisting spending is less than $0.76, becausethe incremental distortion is very likely torise as spending and tax rates increase.47 Inother words, the taxes needed to fund exist-

ing spending impose an excess burden small-er than the taxes needed to fund increasedspending. Therefore, it is reasonable to as-sume an excess burden figure smaller thanthe Feldstein estimate as part of the true costof defense services.

The lowest, barely plausible assumptionabout the excess burden of the federal taxsystem is 20 percent; that is, the economiccost of a dollar of federal spending is at least$1.20 in terms of the resulting reduction inthe size of the private sector.48 A more rea-

sonable estimate of 35 percent is still con-servative given the scholarly estimates of theexcess burden of the federal tax system avail-able in the literature.49 For all federal taxesacross a number of studies, the mean weight-ed average is about 4550 percent.

In short, the tax system imposes an excessburden on the economy by distorting the al-location of resources in ways that reduce ag-gregate output; accordingly, the private sec-tor becomes smaller by more than a dollarwhen it is forced to send a dollar to Washing-

ton. The cost of federal spending, thereforeis greater than the spending itself. In the nar-row context of the defense budget and thetax system required to fund it, a reduction inannual defense outlays of $100 billion can bepredicted with high confidence to increasethe size of the private sector by at least $135billion per year.


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Stimson Center, http://stimson.org/images/up-loads/builddown_one_pager.pdf; Todd Harrison,$trategy in a Year of Fiscal Uncertainty, Centerfor Strategic and Budgetary Assessments, February2012, http://www.csbaonline.org/publications/2012/02/trategy-in-a-year-of-fiscal-uncertainty/;and Mackenzie Eaglen and Diem Nguyen, Super

Committee Failure and Sequestration Put at RiskEver More Military Plans and Programs, HeritageFoundation Backgrounder 2625, December 5,2011, http://www.heritage.org/research/reports/2011/12/debt-ceiling-deal-puts-at-risk-ever-more-military-plans-and-programs. See also Christo-pher Preble, Being a Global Power on $469 bna Year, http://www.cato-at-liberty.org/being-a-global-power-on-469-bn-a-year/print/. For a briefdiscussion of the ongoing debate over the de-fense budget, see Elisabeth Bumiller and ThomShanker, Panetta to Offer Strategy for CuttingMilitary Budget, New York Times, January 2,2012, http://www.nytimes.com/2012/01/03/us/pentagon-to-present-vision-of-reduced-military.html?pagewanted=all. Because nondefense spend-ing lies outside the topic at hand, it is ignoredhere; but the focus in this paper on defense out-lays should not be interpreted to imply a view thatnondefense spending should be immune from

very substantial reductions.

6. Note that current budget proposals for fiscalyear 2013 reflect some of the reductions in defenseoutlays that Friedman and Preble recommended in2010, totaling $1.2 billion over 10 years. Accordingly,for the purposes of this study, the savings against thenew baseline are assumed to be $1 trillion, or $100billion per year. See Benjamin H. Friedman and

Christopher Preble, Budgetary Savings from MilitaryRestraint, Cato Institute Policy Analysis no. 667,September 23, 1010, http://www.cato.org/pub_display.php?pub_id=12151.

7. The dollar figures are nominal (unadjusted forexpected inflation). See FY 2013 Budget, Histori-cal Tables, Table 5.1, http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/hist.pdf.

8. See Department of Defense, Fact Sheet: TheDefense Budget, http://www.defense.gov/news/Fact_Sheet_Budget.pdf.

9. See Department of Defense, Defense BudgetPriorities and Choices.

10. The term social capital is used here in abroad sense to comprise the large benefits of civilsociety and its institutions, individual freedom,democratic processes, the rule of law, and the otherprotections and benefits of U.S. constitutional andpolitical institutions. For an analysis of the eco-nomic effects of differences in the level of social

capital, see Stephen Knack and Philip Keefer, DoesSocial Capital Have an Economic Payoff? A Cross-Country Investigation, Quarterly Journal of Economics 112, no. 4 (November 1997): 125188, https://hec.unil.ch/docs/files/21/280/knack_keefer_1997.pdf.

11. If society deems a certain level of defense services (or outlays) to be necessary, those servicesmight not be obtained even with the correspond-ing defense budget if there is inefficiency in theallocation of defense spending or in the imple-mentation of defense programs. One second-bestmechanism with which to compensate for this, ifthe inefficiencies cannot be corrected, say, becauseof institutional constraints, would be a defensebudget larger than the efficient one. This possibil-ity is ignored here.

12. See Friedman and Preble.

13. A substantial body of literature is available

with a wide range of findings of economic effectsnegative, positive, and insignificant attributableto (changes in) defense spending. See, e.g., Michael P.Gerace, U.S. Military Expenditures and EconomicGrowth: Some Evidence from Spectral Methods,

Defence and Peace Economics 13, no. 1 (2002): 111Uk Heo, The Relationship between DefenseSpending and Economic Growth in the UnitedStates, Political Research Quarterly 63, no. 4 (2010)76070; H. Sonmez Atesoglu, Defense SpendingPromotes Aggregate Output in the United StatesEvidence from Cointegration Analysis,Defence and

Peace Economics 13, no. 1 (2002): 5560; Jesus Cre-spo Cuaresma and Gerhard Reitschuler, A Non-

Linear Defence-Growth Nexus? Evidence from theUS Economy,Defence and Peace Economics 15, no. 1(2004): 7182; John Dunne, Ronald Patrick Smith,and Dirk Willenbockel, Models of Military Ex-penditure and Growth: A Critical Review, Defenceand Peace Economics 16, no. 6 (2005): 44961; andUk Heo and Robert J. Eger III, Paying for SecurityThe Security-Prosperity Dilemma in the UnitedStates,Journal of Conflict Resolution 49, no. 5 (Octo-ber 2005): 792817.

14. Note that the decline in the demand for security services must be accompanied by an increase inthe demand for other goods and services, other fac-tors held constant.

15. Note the implicit value judgment inherent inthis brief analysis: The productivity or value of agiven resource in a particular employment is deter-mined by the aggregated preferences of individuals,as reflected in market prices. Shifts in such prefer-ences determine shifts in those values. The struc-tural unemployment resulting from these shiftstherefore, is an effect of the freedom of individualsto change their consumption decisions.


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16. In other words, a given individual may beworse off as a result of a particular economic shift;but that individual is very likely to be better off inthe broader context as a result of an economy thatis larger, and because of the freedom to make choic-es in a competitive market.

17. Again, the fundamental normative judg-ment is that value is determined by individualpreferences.

18. Note that because most government servicesare not traded in marketstypically, Congressoffers agencies a lump-sum budget in exchangefor a lump-sum basket of outputsit is difficultto place a value on government services. Accord-ingly, the value of government services in the na-tional income accounts usually is assumed to bethe number of dollars spent on them respectively.This is a longstanding methodology fraught withproblems, the analysis of which lies outside thescope of the issues addressed here.

19. Stephen S. Fuller, The U.S. Economic Im-pact of Approved and Projected DOD SpendingReductions on Equipment in 2013: Summary ofResearch Findings, http://armedservices.house.gov/index.cfm/files/serve?File_id=33a3bd4e-fcaa-4eef-bea6-12bd39265f9a. In an e-mail dated Janu-ary 4, 2012, Fuller stated that only the summarypaper has been distributed, in that the remainderof the analysis comprises the respective discussionsof over 700 economic sectors analyzed in an input/output model. I criticize the Fuller analysis herenot because it is necessarily more flawed than mostsuch analyses, but instead because it is quite typi-

cal of that body of literature, and is the most recentthat I have found. See, e.g., Atesoglu, pp. 55-60.

20. These are losses in sales throughout thesupply chain and . . . through the broader econo-my . . . [substantially] as a result of decreased con-sumer spending by workers directly and indirect-ly affected by these DOD spending reductions.

21. Fuller argues in a separate interview that aten year defense budget cut will be felt in terms oflayoffs starting in 2012, escalate and conclude by2014. See PR Newswire, Analysis Projects One Mil-lion Jobs at Risk from Defense Cuts, October 25,2011, http://www.prnewswire.com/news-releases/

analysis-projects-one-million-jobs-at-risk-from-defense-cuts-132545243.html. That essentially is adescription of a structural shift in which labor is re-allocated from the defense sector to other unspeci-fied sectors, over some adjustment time perioddifficult to predict. Fuller does not delve into thelarger productivity implications of this structural shift.

22. Perhaps a bit more rigorously, the lost produc-tivity of the resources idled during the adjustmentprocess is an economic cost of that process itself,

one that is productive for the economy as a whole.

23. Any such shift would imply a decline in thevalue of defense services relative to that of othergovernment services, as determined by competi-tion under political and democratic institutions.

24. The Fuller analysis yields an estimate of$86.5 billion in reduced GDP for 2013.

25. John F. Cogan et al., New Keynesian versusOld Keynesian Government Spending Multipli-ers,Journal of Economic Dynamics and Control34, no.3 (March 2010): 28195.

26. Andrew Mountford and Harald Uhlig, WhatAre the Effects of Fiscal Policy Shocks?Journal ofApplied Econometrics 24, no. 6 (September/October2009): 96092.

27. See Robert J. Barro and Charles J. Redlick,Macroeconomic Effects from Government

Purchases and Taxes, National Bureau of Eco-nomic Research Working Paper no. 15369, rev.December 5, 2011, http://www.nber.org/papers/w15369.

28. Valerie A. Ramey, Identifying GovernmentSpending Shocks: Its All in the Timing, Quarterly

Journal of Economics126, no. 1 (February 2011): 150.

29. Robert E. Hall, By How Much Does GDP RiseIf the Government Buys More Output? Brookings

Papers on Economic Activity, Fall 2009, pp. 183231.

30. Anton Parlow, Economic Growth, DefenseSpending and Conflict: A Case Study of the U.S.,working paper, Department of Economics, Univer-sity of Wisconsin, Milwaukee, https://pantherfile.uwm.edu/aparlow/www/papers/conflict_1.pdf.

31. Valerie A. Ramey, Government Spending andPrivate Activity, National Bureau of EconomicResearch Working Paper no. 17787, January 2012,http://www.nber.org/papers/w17787.

32. See Valerie A. Ramey, Can Government Pur-chases Stimulate the Economy?Journal of Econom-ic Literature 49, no. 3 (September 2011): 67385.

33. See Bureau of Economic Analysis, http://www.

bea.gov/iTable/index_nipa.cfm, at Table 1.1.2.

34. See Office of Management and Budget, http://www.whitehouse.gov/omb/budget/Historicals,Table 8.4.

35. See FY 2013 Budget, Historical Tables.

36. See Bureau of Economic Analysis, http://www.bea.gov/iTable/index_nipa.cfm at Table 1.1.6.This correlation means that a 1 percent change in


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one of the parameters is associated statistically (butnot necessarily in a causal sense) with less than a0.09 percent change in the other, in the same direc-tion. The correlations for 19812000 are discussedbelow.

37. See Office of Management and Budget, http://

www.whitehouse.gov/omb/budget/Historicals, atTable 8.2.

38. Recall from the discussion above that thecorrelation for 20002011, based upon the quar-terly data, was less than 0.09. See the discussion ofFigure 1.

39. Barro and Redlick, fn. 51.

40. See Bureau of Economic Analysis, http://www.bea.gov/iTable/index_nipa.cfm, Table 1.1.2.

41. Ibid. Obviously, expected GDP growth drivesprivate investment also; but the contributions data

belie the assertion that shifts in defense spendinggrowth are an important source of shifts in GDPgrowth.

42. See Office of Management and Budget, http://www.whitehouse.gov/omb/budget/Historicals,Table 3.2.

43. The total general government function es-timated for fiscal year 2012 is $31.8 billion, outof total federal outlays of about $3.8 trillion. Thebudget proposed for the Internal Revenue Ser-

vice for fiscal year 2013 is about $12.8 billion.See, respectively, Office of Management andBudget, http://www.whitehouse.gov/omb/budget/Historicals, Table 3.2, and the Internal RevenueService at http://www.irs.gov/newsroom/article/0,,id=254281,00.html.

44. Strictly speaking, the excess burden (ordeadweight loss) is the difference between ag-gregate output under the existing tax systemand aggregate output under a different systemof lump-sum taxes that would yield the samerevenues without distorting economic activity.Because government output is not worthless, azero-tax, zero-outlay, zero-excess burden environ-ment in principle might yield aggregate output

lower than that observed under the existing taxsystem even though, again, the excess burden oftaxation would be zero. See also Jonathan Gru-ber, Public Finance and Public Policy (New YorkWorth Publishers, 2005), p. 547.

45. Martin Feldstein, Tax Avoidance and the

Deadweight Loss of the Income Tax, Review ofEconomics and Statistics 81, no. 4 (November 1999)674. See also Jon Gruber and Emmanuel SaezThe Elasticity of Taxable Income: Evidence andImplications,Journal of Public Economics 84, no. 1(April 2002): 132.

46. Martin Feldstein, The Effect of Taxes on Efficiency and Growth, National Bureau of EconomicResearch Working Paper no. 12201, May 2006; Mar-tin A. Feldstein, The Effect of Taxes on Efficiencyand Growth, Tax Notes, May 8, 2006, pp. 679684;and Christopher J. Conover, Congress Should Ac-count for the Excess Burden of Taxation, Cato In-stitute Policy Analysis no. 669, October 13, 2010. See

also William A. Niskanen, The Economic Burdenof Taxation, in Mark Wynne, Harvey Rosenblumand Robert Formaini, eds., The Legacy of Milton and

Rose Friedmans Free to Choose: Economic Liberalism at theTurn of the 21st Century, Dallas: Federal Reserve Bankof Dallas, 2004; and the Report of the Presidents

Advisory Panel on Federal Tax Reform, November 12005, p. 36, www.taxreformpanel.gov/final-report/See also Benjamin Zycher, A Preliminary Benefit/Cost Framework for Counterterrorism Public Expen-ditures, Rand Corporation MR-1693-RC, May 2003

47. A crude rule of thumb is that the excess bur-den of a tax increases as the square of the tax rate

48. The Office of Management and Budget since1992 has directed federal agencies to include a25 percent adjustment for the excess burden ofthe federal tax system in benefit/cost analyses ofpublic investment. See Office of Managementand Budget Circular no. A-94 rev., Guidelinesand Discount Rates for Benefit-Cost Analysis ofFederal Programs, October 29, 1992, http://wwwwhitehouse.gov/omb/circulars_a094#11.

49. For a good summary of the various excessburden estimates for several federal tax instru-ments, see Conover, Table 1.

economic effects of reductions in defense outlays, cato policy analysis no. 706

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