The Economic Impact of Government Spending

INESS, April 2012

What is the Goal of Economic Policy?

To create conditions that encourage people to create wealth and improve their living standards.To create a large tax base so that the legitimate functions of government can be financed at low tax rates.To preserve and enhance liberty so people can enjoy freedom.

Growth is the Best Option

You can’t redistribute without first producing.It is better to be a poor person in a rich nation than a middle-income person in a poor nation.Rich nations can afford redistribution, and the accompanying tepid growth.Poor nations will never become rich if they adopt welfare state policies.

Years Needed to Double Economic Output

1 percent growth

2 percent growth

3 percent growth

4 percent growth

5 percent growth

6 percent growth

7 percent growth

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1

Two Major Issues

What is the appropriate role of government?The classical liberal vision of small government.Or the welfare state vision of large government.

How should government be financed?Broad-base and low-rate system designed to minimize distortions.Or a tax code as a tool of social policy.

The Economics of Spending

How does government spending impact growth?Wagner’s Law and the Rahn Curve The problem is spending, not deficitsKeynesian theoryCan spending be restrained?A Greek future

Government Spending and GrowthIf government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very difficult. Some government spending is necessary to uphold the rule of law. Government spending reduces growth, however, when the public sector becomes too large, leading to punitive tax rates and misallocation of labor and capital.

How Government Can Hurt Growth

The Extraction Cost: The federal government cannot spend money without first taking that money from someone else. All of the options used to finance government spending have adverse consequences. The Displacement Cost: Government Spending Displaces Private Sector Activity. Every dollar that the government spends necessarily means that there is one less dollar in the productive sector of the economy.

How Government Can Hurt GrowthThe Negative Multiplier Cost: Government Spending Finances Harmful Intervention. Many regulatory agencies have relatively small budgets, but they impose large costs on the economy’s productive sector. The Behavioral Subsidy Cost: Many government programs subsidize economically undesirable decisions. Welfare programs encourage people to choose leisure over work. Unemployment insurance programs provide an incentive to stay unemployed.

How Government Can Hurt GrowthThe Behavioral Penalty Cost: Government programs discourage economically desirable decisions. The incentive to save has been undermined by government programs that subsidize retirement, housing, and education. The Market Distortion Cost: Government programs interfere with competitive markets. In both health care and education, government efforts to reduce out-of-pocket expenses have resulted in higher prices because of “third-party payer” issue.

How Government Can Hurt GrowthThe Inefficiency Cost: Government Spending is a Less Effective Way of Delivering Services. A voucher system would yield better education for less money. Privatized airports and postal service would be more efficient. The Inertia Cost: Government programs inhibit innovation. Lacking a profit motive, bureaucracies do not seek better ways of achieving goals. This can create huge costs, as demonstrated by America’s old welfare system.

Big Government Inevitably…

…Erodes a Nation’s Social Capital

The Right Size of GovernmentThere are certain core functions of government - including national defense, legal system, and public safety.The more governments stray from these core functions, the less likely they are to be competent in any area.The more governments stray from these core functions, the higher the tax burden.This means less growth.

The “Rahn Curve”

There is a “Rahn Curve” relationship between government spending and economic growth similar to the “Laffer Curve” relationship between tax rates and tax revenue.

Empirical Estimates of the Rahn CurveAcademic studies generally find that the growth-maximizing level of government is 17 percent-23 percent, though a European Central Bank study put the figure as high as 30 percent.Every single western nation spends above the growth-maximizing level in these studies.Because of data limitations, the actual growth-maximizing level of spending presumably is lower than shown in the studies.

What About Wealthy Welfare States?Don’t Europe’s welfare states show that big government is not an impediment to growth?No. They became rich because they used to have small public sectors and laissez-faire policy (indeed, still have laissez-faire policy).Government expanded after they became wealthy and could afford anti-growth policies.A nation (or state) can tolerate one percent growth once it is rich. But a poor nation (or state) will never become rich with one percent growth.

Burden of Government Used to be Small

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1870 1913 1920 1937 1960

Ex

pe

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itu

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as

a p

erc

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t o

f G

DP Sweden

UK

US

Japan

Germany

France

Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"

Deficits and Debt Are Symptoms “Red ink” is not the most important fiscal policy variable.Too much spending is the disease and high taxes and excessive borrowing are both symptoms.Deficits don’t stimulate an economy and in normal situations they don’t threaten an economy.A balanced budget is prudent for moral reasons.

Return of the Keynesian Rationale

Government usually expands because of “public choice” as politicians buy votes.Today, politicians are trying to make a virtue out of depravity, asserting that government spending is the only way to save the economy.Demoralized Republicans were not offering an alternative, allowing Obama to claim that everyone agreed.

Keynesianism vs. the Real World

Deficit spending did not work for Hoover and Roosevelt.So-called stimulus did not work for Ford and Bush.Keynesianism failed in Japan during the 1990s.Obama’s faux stimulus was a flop.Keynesians have theoretical models but are unable to provide any academic evidence.

The Long-Run Fiscal Outlook

Ageing populations and welfare states are an unstable combination.Pay-as-you-go systems are Ponzi schemes.Not enough future workers to support redistribution programs.Without reform, massive debt or massive tax increases.Probably both

Two Workers per Retiree

The Sovereign Debt Crisis

Greece is the tip of the icebergIreland was phase two.Spain and Portugal phase three.Italy and Belgium phase four.Japan in a special category.Almost all other industrialized nations are on this path.Rare exceptions such as Australia, perhaps Switzerland and even Sweden.

Where Is the Debt Tipping Point?

Rogoff and Reinhart say 90 percent of GDP is the danger zone.Depends on the nation.Industrialized world has breathing room.Greece got in trouble over 100 percent.Japan still doing fine at 200 percent.Spain and Portugal in trouble at less than 90 percent.

France – 400 Percent of GDP

Germany – 300-plus Percent of GDP

Greece – 400 Percent of GDP

Ireland – 300 Percent of GDP

Italy – 250 Percent of GDP

Netherlands – 400 Percent of GDP

Japan – 600 Percent of GDP

Portugal – 300 Percent of GDP

Spain – 300 Percent of GDP

U.K. – 500-plus Percent of GDP

U.S. – 450 Percent of GDP

A Closer Look at the U.S.

During the Bush-Obama years, the burden of federal spending has jumped from 18 pct of GDP to more than 24 pct of GDP.Two new health entitlements have been created.More centralization of education and other activities.Perhaps most worrisome, an erosion of social capital as dependency increases.

Source: Office of Management and Budget

The Federal Government Has Been Growing...

0%

10%

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60%

1900

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1932

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The Calm Before the Storm

Because of Social Security, Medicare, and Medicaid, federal spending is projected to jump from about 24 percent-plus of GDP today to 45 percent-67 percent of GDP after the baby boom generation is fully retired. State and local governments will consume – at a minimum – another 15 percent of GDP.America’s welfare state will be bigger than what France has today.

Source: Congressional Budget Office

…But Soon Will Explode

0%

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America’s Dismal FutureIf the projections become reality, America will become France.Instead of growing 2.5 percent-3.0 percent each year in real terms, we will grow 1.0 percent-1.5 percent, a difference that has enormous long-run implications.Per capita GDP will 30 percent-40 percent below what it otherwise would be.An unemployment rate of less than 8.0 percent will be considered a cause for celebration.

Curtailing the Welfare State

“Public Choice” makes spending restraint a political challenge.At a minimum, spending should grow slower than GDP, causing the burden of government to fall over time.This happened during the Reagan years and Clinton years.Some nations have been successful with dramatic spending restraint.

Other Nations Have Reformed

Good fiscal policy does not require miracles, just spending restraint.If spending grows slower than nominal GDP, good things happen – the Golden Rule.Greater levels of fiscal restraint mean quicker progress.If spending grows faster than nominal GDP, sooner or later a nation becomes Greece.But sometimes nations do the right thing.

Ireland Restrains Growth of Spending and...

0

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25

1985 1986 1987 1988 1989

Bill

ions

Source: Economist Intelligence Unit

...Burden of Government and Deficit Both Shrink

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1985 1986 1987 1988 1989

Def

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Source: Economist Intelligence Unit

Budget Deficit

Government Spending

New Zealand Restrains Growth of Spending and...

25

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1990 1991 1992 1993 1994 1995

Bill

ions

Source: Economist Intelligence Unit

...Burden of Government and Deficit Both Shrink

-4

-3

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-1

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1990 1991 1992 1993 1994 1995

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get D

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Source: Economist Intelligence Unit

Budget Deficit

Government Spending

Budget Surplus

Canada Restrains Growth of Spending and...

300

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1992 1993 1994 1995 1996 1997

Bill

ions

Source: Economist Intelligence

...Burden of Government and Deficit Both Shrink

-2

0

2

4

6

8

10

1992 1993 1994 1995 1996 1997

Bud

get D

efic

it as

Sha

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35

45

55

65

Gov

ernm

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pend

ing

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hare

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DP

Source: Economist Intelligence Unit

Budget Deficit

Government Spending

U.S. Success Stories

The combination of Bill Clinton and the 1994 Congress resulted in a 4-year period where annual spending increased only 2.9 percent.Ronald Reagan reduced domestic spending (including entitlements) from 15.7 percent of GDP down to 13.2 percent of GDP.In the good ol’ days, fiscal policy was never a problem since the federal government averaged only 3 percent of GDP.

Change in Burden of Domestic Spending

-2.5%

-0.8%

5.7%

-3%

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3%

6%

9%

Reagan Years Clinton Years Bush-Obama Years

Sh

are

of G

DP

Average Annual Domestic Spending Increase

$9.7

$37.7

$103.3

$0

$40

$80

$120

Reagan Years Clinton Years Bush-Obama Years$Bill

ions

, Inf

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djus

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2005

Dol

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How Do We Get There?

Three challengesCorrectly identifying the problem – big government is the disease. Deficits and debt are symptoms.Figuring out ways to “bend the cost curve” of government spending.Convincing the people that liberty is better than dependency.

Conclusion

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