Supplement to "The Impact of Government Spending on Economic Growth"

This paper is a supplemental appendix to "The Impact of Government Spending on Economic Growth," Heritage Foundation Backgrounder No. 1831

The academic evidence catalogued below strongly supports the hypothesis that government spending has a generally adverse effect. This does not mean that statistical studies invariably confirm a negative relationship between government spending and economic performance, but the preponderance of research certainly suggests that economic growth will be higher if government spending is lower.

Recent scholarship has been especially persuasive, both because of improvements in statistical research techniques and because more data become available with each passing year. As the Organisation for Economic Co-operation and Development (OECD) explains, “The empirical growth literature has developed substantially over the past two decades, drawing on larger and richer databases and exploiting better econometric tools to explain cross-country differences in growth performance.”[1]

The academic literature does not provide all of the answers. Isolating the precise effects of one type of government policy—such as government spending—on aggregate economic performance is probably impossible. Moreover, the relationship between government spending and economic growth quite possibly depends on factors that can change over time.

Another important element of the academic research is methodology. When scholars attempt to measure a relationship between government spending and economic performance, they can pursue this research in a number of ways. They can conduct a statistical test to ascertain a relationship between two or more variables, but this still leaves many questions unanswered. Are they testing to find a relationship over a period of time? Are they testing to find a relationship using cross-country data?

Academics can also build complete economic models and then try to determine whether the evidence supports that model. But what kind of model? What are the assumptions in that model? Will the model be based on the Keynesian theory or on incentive effects of changes in relative prices? Will a model be self-limiting by assuming that an economy has a maximum growth rate? These are very important issues:

[In] the traditional Solow [neoclassical] model…increased taxation as well as increased saving and investment only have transitory effects on the rate of growth, while the economy moves toward the new higher steady-state equilibrium. In this type of model growth depends solely on exogenous technological change, leaving no role for changing economic policies and institutions in explaining changing long-run growth rates. In contrast, the rapidly expanding literature on endogenous growth highlights the fact that if productivity is to increase year after year, the economy must continuously provide the workforce with more “tools.” By tools the theorists mean a very broad concept of reproducible capital including physical capital, human capital, and knowledge capital (technology).… [E]ndogenous growth theory directs our attention to the only way by which government can affect long-run growth, namely via its impact on investment in machines, skills and technology. To the extent that capital and labor taxation deter such investments they reduce growth. Similarly, public expenditures that deter such investments by creating additional marginal tax wedges over and beyond those induced by the taxes required to finance these programs, or that reduce incentives to save and accumulate capital in other ways, reduce growth in these models.[2]

Translated into everyday language, the economics profession is split between those who believe that good fiscal policy can cause the level of gross domestic product (GDP) to climb and those who believe that good fiscal policy can cause the growth rate of GDP to climb. In other words, endogenous growth models “tend to transform the temporary growth effects of fiscal policy implied by the neoclassical model into permanent growth effects.”[3] Both approaches have their own sets of assumptions. For instance, the neoclassical model “assumes perfect competition, constant returns to scale, and the absence of externalities. All three assumptions have been questioned, often convincingly, by new growth theorists.”[4]

Other important methodological issues include whether the model assumes a closed economy or allows international flows of capital and labor. Does it measure the aggregate burden of government or the sum of the component parts? These are all critical questions, and the answers to those questions help drive the results of various studies. As one research paper noted:

Clearly, it would be preferable to base conclusions on microeconomic evidence concerning, for example, how taxes affect the choice between household work and market work or how saving is affected by the design of the social security system. For the time being, however, there does not exist a coherent framework for summing up the growth effects of such bottom-up investigations. Until such a framework is developed, we believe that top-down studies will remain an important source of knowledge enhancement in the field.[5]

The effort is further complicated by the challenge of identifying the precise impact of government spending. Is spending hindering economic performance because of the taxes used to finance government? Would the economic damage be reduced if government had some magical source of free revenue? How do academic researchers measure the adverse economic impact of government consumption spending versus government infrastructure spending, or the difference between military and domestic spending, or purchases versus transfers?

There are no “correct” answers to these questions. Indeed, this is why Greg Mankiw, who served as chairman of the Council of Economic Advisers, wrote that:

Using these regressions to decide how to foster growth is also most likely a hopeless task. Simultaneity, multicollinearity, and limited degrees of freedom are important practical problems for anyone trying to draw inferences from international data.[6]

This is an important caveat. In the words of another economist, “presenting the results of a single model is misleading,”[7] which is why the growing consensus in the academic literature is persuasive. Regardless of the methodology or model, it appears that government spending is associated with weaker economic performance.

Extraction Costs

Not surprisingly, many researchers have determined that government spending has an adverse impact on economic growth because of the taxes that are imposed to finance the budget. This research focuses on the “extraction costs” of government spending.

An article in Public Choice concluded: “[B]ig governments imply large income tax rates. Large tax rates presumably affect work-leisure decisions and could lengthen search time between bouts of unemployment.”[8]
Public Finance Review published an article that stated: “[T]axes negatively affect economic growth, even when they finance certain types of nontransfer spending.”[9]
Another Public Choice article explained: “On the revenue side, when government gets too big, high tax rates discourage whatever activity the tax is on (work, saving, consumption, etc.).”[10]
A study by the European Commission (EC) noted: “[A] first reason for expecting non-Keynesian effects of fiscal policy emerges…when a current expenditure cut is expected to be offset by a reduction in future distortionary taxes.”[11]
A Joint Economic Committee (JEC) report explained: “Like taxes, borrowing will crowd out private investment and it will also lead to higher future taxes. Thus, even if the productivity of government expenditures did not decline, the disincentive effects of taxation and borrowing as resources are shifted from the private sector to the public sector, would exert a negative impact on economic growth.”[12]
A Federal Reserve Bank of Cleveland study found: “Output, however, is lower due to the decrease in the capital stock. The charts show that the convergence to the new steady state is gradual. The new steady-state capital stock is reduced by 7.7 percent, and output by 1.2 percent. Private consumption is 7.3 percent lower than it was before government spending rose. Increases in government expenditure cause output to decline because an income tax is distortionary.”[13]
The study from the Cleveland Federal Reserve also concluded: “In the new long-run steady state, the capital stock is lower by 25.2 percent, and output is reduced by 7.3 percent. This crowding-out effect is much larger than the effect of the balanced-budget increase in government expenditure considered earlier. It reflects the greater distortionary effect of the higher tax rates under deficit financing that are imposed on young and future generations to pay for the redistribution toward the initial older generations.”[14]
An article in the Journal of Money, Credit, and Banking noted: “In the more realistic case, when spending is financed by an income or wage tax, we find a negative effect on long-run growth rates.”[15]
The same study also reported: “When government spending can be financed with few distortions, labor supply rises and growth is higher. When government must finance spending with income or wage taxes, labor supply and growth fall.”[16]
A National Tax Journal article explained: “The appropriate size and role of government depend on how costly it is to transfer funds from taxpayers to the government. That cost includes more than the administrative cost of the government and the time spent by taxpayers to keep records and complete forms. It also includes the loss of real income that occurs because taxes distort economic incentives. Recent econometric work implies that the deadweight burden caused by tax increases may exceed one dollar for every dollar of additional tax revenue that is raised. Such estimates imply that the true economic cost of each extra dollar of government spending is more than two dollars. That is, individuals lose the equivalent of more than two dollars of additional consumption for every extra dollar of government spending.”[17]
Even the International Monetary Fund (IMF) agreed: “This tax induced distortion in economic behavior results in a net efficiency loss to the whole economy, commonly referred to as the ‘excess burden of taxation,’ even if the government engages in exactly the same activities—and with the same degree of efficiency—as the private sector with the tax revenue so raised.”[18]
Equally surprising, the Paris-based OECD also admitted “negative impacts on growth stemming from a too-large government sector (with associated high tax pressure to finance high government expenditure).”[19]

Displacement Costs

Other academic studies focus more on the displacement effects of government spending. “Displacement effects” occur because government spending necessarily uses up resources that otherwise would be available in the productive sector of the economy.

An article in the Journal of Monetary Economics found: “[T]here is substantial crowding out of private spending by government spending.… [P]ermanent changes in government spending lead to a negative wealth effect.”[20]
Public Choice published an article that explained: “[G]overnment spending crowds out private spending, most notably investment spending that would have raised productivity and encouraged technical change.”[21]
The IMF acknowledged: “The financing of any level of public expenditure, whether through taxation or borrowing, involves the absorption of real resources by the public sector that otherwise would be available to the private sector.”[22]
A JEC report noted: “Government spending reduces productivity as resources are withdrawn from the private sector and placed in the unproductive public sector.”[23]
A working paper from the National Bureau of Economic Research (NBER) concluded: “Perhaps more surprisingly, we consistently find a considerable crowding out of investment both by government spending and to a lesser degree by taxation; this implies a strong negative effect on investment of a balanced-budget fiscal expansion.”[24]
A study from the Centre for Economic Policy Research in London noted: “The effects of government spending on economic activity derive from the fact that the government absorbs resources and thus has a negative effect on the representative agent’s wealth.”[25]
A Federal Reserve Bank of Dallas study explained: “Taken as a whole, the three policy cases support two broad conclusions. First, growth in government stunts general economic growth. Regardless of how it is financed, an increase in government spending leads to slower economic growth.”[26]
The OECD recognized “both a ‘size’ effect of government intervention as well as specific effects stemming from the financing and composition of public expenditure. At a low level, the productive effects of public expenditure are likely to exceed the social costs of raising funds. However, government expenditure and the required taxes may reach levels where the negative effects on efficiency and hence growth start dominating.”[27]
An article in Metroeconomica noted: “Assuming that labour is supplied in-elastically a reallocation of public resources from productive to non-productive uses always reduces the balanced growth rate.”[28]
The Congressional Budget Office explained: “Many federal investment projects yield net economic benefits that are small, or even negative. Others yield high returns that would be forgone in the absence of federal involvement, but the number of such projects appears to be limited, and hence their potential impact on growth is small. Increases in federal investment spending that are not targeted toward cost beneficial projects can reduce growth. Federal investment spending can displace investments by state and local governments and the private sector. Displacement is likely to be substantial in some cases, such as roads and bridges, which state and local governments have a strong incentive to fund because the benefits accrue primarily to local users. Federal spending that displaces other investment is unlikely to have a positive effect on growth.”[29]

Measuring the Economic Impact of Government Spending

While some academic studies focus on specific adverse effects of particular government programs, the bulk of research seeks to measure the relationship between the size of government and economic performance. This scholarship is quite convincing, showing that economic growth suffers as government expands.

An article from the Quarterly Journal of Economics stated: “The basic message of our model is that there will be a strong demand for redistribution in societies where a large section of the population does not have access to the productive resources of the economy. Such conflict over distribution will generally harm growth.”[30]
The JEC published a report noting: “Economic growth is created over the long run by a labor force which possesses the incentive to work and produce, and by entrepreneurs who have incentives to invest in capital stock. Through excessive spending, the government negatively affects the long-run economic growth rate of a free economy. Government spending reduces labor force participation, increases unemployment, and reduces productivity.”[31]
The IMF acknowledged: “[T]he IMF has had a bias towards expenditure reductions rather than tax increases, particularly for more advanced economies with already high tax burdens. Moreover, with a concern to minimize adverse allocative effects and to instill an investment and growth-supporting environment, the IMF often advises countries to both reduce expenditures shares and reduce the overall tax burden.”[32]
A study from the Federal Reserve Bank of Dallas concluded: “Tax increases that reduce the deficit are contractionary whereas spending cuts that accomplish the same goal are expansionary.”[33]
The study from the Dallas Fed also noted: “[G]rowth in government stunts general economic growth. Increases in government spending or taxes lead to persistent decreases in the rate of job growth.”[34]
An EC report acknowledged: “[B]udgetary consolidation has a positive impact on output in the medium run if it takes place in the form of expenditure retrenchment rather than tax increases.”[35]
The EC study also reported: “Fiscal consolidations obtained through expenditure cuts may increase short-run investments,” and “a similar effect would be obtained by means of reductions in government transfers.”[36]
Writing for the Centre for Economic Policy Research, three economists (including two from the IMF) explained: “Those countries which rely primarily on expenditures cuts…are projected to enjoy output gains from their adjustment over the long run, while those countries relying mainly on labour and capital taxes…are projected to suffer output losses.”[37]
More specifically, the same source elaborated: “The projected medium-run recovery reflects the shift of resources from (public) consumption to (private) investment and the reduced burden of taxation.”[38]
An IMF study reached similar conclusions: “[E]pisodes of fiscal consolidation need not trigger an economic slowdown, especially over the medium term. The paper also suggests that structuring fiscal consolidation primarily around spending cuts, rather than tax increases, tends to increase the chances of success.”[39]
The IMF study comments on a specific example: “New Zealand is a recent success case that seems to confirm the policy message of this paper: an industrial country with a serious deficit problem should pursue a strict fiscal consolidation strategy, focused on expenditure cuts.”[40]
A report from the National Center for Policy Analysis noted: “By penalizing success with taxes and subsidizing failure with transfer payments, the United States and other OECD nations have lower standards of living than they would have if tax rates were lowered. The slower rise in various social indicators and the increasing societal disorder since 1960 demonstrate the consequences of higher tax rates. In terms of social progress, increased taxes have not bought very much for the United States. It is true that infant mortality and the overall death rate are down and life expectancy is up since the 1960s, but these gains are small compared with those of the previous 90 years, when government was smaller and tax burdens much less oppressive.”[41]

These conclusions are based on sound theory, but they also are supported by significant empirical evidence.

An article in the European Journal of Political Economy found: “We find a tendency towards a more robust negative growth effect of large public expenditures.”[42]
A study in Public Choice reported: “The results indicate that the level of government consumption, transfers and total spending as a share of GDP has a strongly negative effect on the growth of TFP [total factor productivity] in the nongovernment sector.”[43]
Another study, published in the Journal of Macroeconomics, concluded “that growth in government size is negatively associated with economic growth.” Interestingly, the study also found that “the negative effects are greater in nondemocratic socialist systems than in democratic market systems.”[44]
The Quarterly Journal of Macroeconomics published an article stating: “[W]e find that both increases in taxes and increases in government spending have a strong negative effect on private investment spending. This effect is consistent with a neoclassical model with distortionary taxation, but more difficult to reconcile with Keynesian theory.”[45]
A study in Public Finance Review noted: “[H]igher total government expenditure, no matter how financed, is associated with a lower growth rate of real per capita gross state product.”[46]
Even an article sympathetic to the Keynesian view, published by the Centre for Economic Policy Research in London, reported: “[W]e show that following an increase in government spending real wages decline.” The article also admitted that “expansion in government spending financed with distortionary taxes is always contractionary.”[47]
Research from the EC specifically explained that positive effects of fiscal balance are due to smaller government: “Fiscal adjustments based on expenditure cuts rather than tax increases have expansionary effects,” and “The impact on output of budgetary consolidation depends on whether it takes place on the revenue or expenditure side. Tax increases are likely to have a negative impact on output both in the short and medium run. By contrast, the short-run negative impact on output of permanent expenditure cuts is likely to turn positive in the medium to long run.”[48]

A study in Public Choice notes: “[T]he evidence supports the conclusion that the distortionary effects arising from government generated misallocation of resources are not insignificant.”[49]
A JEC report concluded: “Even after adjusting for cross-country differences in investment rates, both level of the government expenditures and change in size of government during the decade remain highly significant. This provides additional support for the hypothesis that a larger public sector reduces economic growth.”[50]
An NBER article found: “Both increases in taxes and increases in government spending have a strong negative effect on investment spending.”[51]
A Federal Reserve Bank of Dallas study discovered “that an increase in the size of federal government leads to slower economic growth, that the deficit is an unreliable indicator of the stance of fiscal policy, and that tax revenues are the most consistent indicator of fiscal policy,” and “Our analysis of the 1983–2002 period suggests that tax cuts are consistently expansionary, spending increases are consistently contractionary, and deficit increases can be either expansionary or contractionary, depending on their impact on government size.”[52]
The same study also reported: “As the upper figure shows, an increase in spending and taxes leads to a decrease in employment growth that is significant for two years. As the lower figure shows, this increase in the size of the public sector leads to a persistently slower rate of job growth.” The study also stated: “[B]oth Sims–Zha experiments confirm the joint-shock analysis. An increase in government spending and taxes persistently reduces the rate of job growth.” Moreover, “an increase in the deficit that finances a spending increase rather than a tax cut…leads to a decline in employment growth.”[53]

A German economist, writing for the Institute for German Economics, concluded: “[T]he state nowadays is oversized in many western countries. Having less state, the economic growth could be accelerated.”[54]
An NBER study found: “Empirical results using data on growth rates over the period 1970–84 suggest a significant and negative impact of government fiscal activity on output growth rates in both the short-term and the long-term.”[55]
A JEC report concluded: “Like that for the United States, the evidence from OECD countries indicates that increases in the size of government retard both investment and economic growth.”[56]
An article from the Journal of Money, Credit, and Banking explained: “A permanent increase in the share of government spending…reduces social welfare. When government spending is financed with an income tax, a permanent increase in spending reduces the long-run growth rate. The same result applies when the spending increase is financed only with wage income taxes.”[57]
An article in the Quarterly Journal of Economics reported: “[T]he ratio of real government consumption expenditure to real GDP had a negative association with growth and investment,” and “Growth is inversely related to the share of government consumption in GDP, but insignificantly related to the share of public investment.”[58]
An NBER study found: “An increase in redistribution to the retirees financed by an increase in the income tax rate leads to: an increase in the price of exportables, i.e., a decrease in competitiveness; an increase in the relative price of nontradables, provided the elasticity of substitution between goods is sufficiently high; a decrease in employment in both sectors. An increase in redistribution to the unemployed, regardless of how it is financed, leads to: the same.”[59]
A Public Choice article reported: “Economies with relatively high levels of government expenditures as a fraction of GDP in 1960 and with increases in the size of the government sector during the period experienced a decline in the efficiency in transforming inputs into outputs.” The article also explained, “The size of the government share coefficients in the regression were of sufficiently large magnitude to conclude that the rise in the size of the government has had a substantial depressing effect on economic growth.”[60]
Another NBER study concluded: “We find a sizable negative effect of public spending—and in particular of its public wage component—on business investment. The effects of government spending on investment are larger than the effects of taxes.” The study also stated: “This paper shows that in OECD countries changes in fiscal policy have important effects on private business investment. Interestingly, the strongest effects arise from changes in primary government spending and, especially, government wages.”[61]
An OECD economic study found: “There is also evidence that the ‘size’ of government may be negatively associated with the rate of accumulation of private capital.”[62]
A study in the Journal of Political Economy concluded: “[T]here is an indication that an increase in resources devoted to non-productive government services is associated with lower per capita growth.”[63]
The same article from the Journal of Political Economy contained this useful summary of statistical findings: “Grier and Tullock extended the Kormendi–Meguire form of analysis to 115 countries, using data on government consumption and other variables from Summers and Heston (1984). The concept of government spending is the same as that employed by Kormendi and Meguire. The Grier-Tullock study was a pooled cross-section, time series analysis, using data averaged over 5-year intervals. They found a significantly negative relation between the growth of real GDP and the growth of the government share of GDP, although most of the relation derived from the 24 OECD countries. Landau (1983) studied 104 countries on a cross-sectional basis, using an earlier form of the Summers-Heston data. He found significantly negative relations between the growth rate of real GDP per capita and the level of government consumption expenditures as a ratio to GDP. Barth and Bradley found a negative relation between the growth rate of real GDP and the share of government consumption spending for 16 OECD countries in the period of 1971–83.”[64]
A study published by the New Zealand Business Roundtable noted: “Economic performance, as measured by indicators such as GDP growth and unemployment levels, has been better on average in countries with small governments than in countries with big governments.”[65]
A study in Public Choice concluded: “From a sample of 19 industrialized countries, it is found that economic growth is inversely related to public sector size over the period 1960–1980. The results of this paper suggest that shrinking private sectors not only pose threats to future over-all economic growth but constrain the future ability of public sectors to consume private resources at accelerating rates.”[66]

The OECD acknowledged: “The overall tax burden is estimated to have a negative impact on output per capitaand, controlling for the overall tax burden, there is an additional negative effect coming from a tax structure focusing on direct taxes.… [T]he omitted factors on the expenditure side, i.e. public transfers, are driving the negative effects on total financing.”[67]
A National Chamber Foundation study by two George Washington University economists found: “[T]he empirical results based upon three sets of international data consistently reveal a negative and statistically significant relationship between the scale of government and economic activity. This finding holds for all levels of government as well as all types of government spending. When examining separately federal or central government spending, the same finding was also obtained.”[68]
A Southern Economic Journal article reported: “The results of this study suggest a negative relationship exists between the share of government consumption expenditure in GDP and the rate of growth of per capita GDP. The negative relationship was found for the full sample of countries, unweighted, or weighted by population, for all six time periods examined, and excluding or including the major oil exporters. It was also found for the top and middle halves of the set (sorted by per capita income) and for the third world.”[69]

Many of the academic articles statistically test the impact of government spending on the economy. The results vary, as might be expected given the challenges of trying to isolate the effect of one variable on economic performance, but they indicate that there is a large cost associated with excessive government. As noted in a Public Choice study, “The stakes are enormous. The difference in real GNP between a 3% yearly growth rate in productivity over a 1% growth rate is 48% after 20 years and 167% after 40 years.”[70] Some have argued that economic policy does not matter since nations will naturally converge so that incomes are equal, but a study in the Journal of Economic Literature found that “there is no tendency for countries to converge to a common level of per capita income.”

A study in the European Economic Review reported: “The estimated effects of GEXP [government expenditure variable] are also somewhat larger, implying that an increase in the expenditure ration by 10 percent of GDP is associated with an annual growth rate that is 0.7–0.8 percentage points lower.”[72]
The same article, using a larger sample of nations, concluded: “Quantitatively, the effect is estimated to be somewhat larger than before; a 10 percentage points increase in public sector size is associated with a reduction of the growth rate of roughly one percentage point.”[73]
An article in the European Journal of Political Economy explained: “[T]he more efficient estimation accounting for within-country variation and heteroscedasticity yields highly significant and large coefficients for the effects of the tax burden and public expenditures on growth, even after controlling for initial GDP and the demographic structure. The estimated effects are much larger, implying that an increase in the tax burden by 10 per cent of GDP is associated with an annual growth rate that is roughly 1 percentage point lower.”[74]
Interestingly, the same article also discovered that the adverse impact of government was especially severe in more developed nations: “[W]e do find a tendency toward a more robust negative growth effect of large public expenditures in rich countries.”[75]
A Public Choice study reported: “[A]n increase in GTOT [total government spending] by 10 percentage points would decrease the growth rate of TFP [total factor productivity] by 0.92 percent [per annum]. A commensurate increase of GC [government consumption spending] would lower the TFP growth rate by 1.4 percent [per annum].[76]
An article in the Journal of Development Economics on the benefits of international capital flows found that government consumption of economic output was associated with slower growth, with coefficients ranging from 0.0602 to 0.0945 in four different regressions.[77]
A Journal of Macroeconomics study discovered: “[T]he coefficient of the additive terms of the government-size variable indicates that a 1% increase in government size decreases the rate of economic growth by 0.143%.”[78]
A study in Public Choice reported: “[A] one percent increase in government spending as a percent of GDP (from, say, 30 to 31%) would raise the unemployment rate by approximately .36 of one percent (from, say 8 to 8.36 percent).”[79]
A New Zealand Business Roundtable study found: “With deadweight costs equivalent to about half of each additional dollar of government spending, a reduction in government spending from 40 to 30 percent of GDP could be expected to add about 0.5 percent to the rate of growth of GDP over about a decade. This is a conservative estimate because it does not include the dynamic benefits of reducing the size of government. An econometric analysis that allows for dynamic effects suggests that a reduction in government spending of this order would add about 0.6 percent to the annual growth rate for 15 to 25 years. In addition to these transitional effects, there are good reasons to expect that smaller government would result in an ongoing improvement in New Zealand’s economic growth performance.”[80]
A study from the Journal of Monetary Economics stated: “We also find a strong negative effect of the growth of government consumption as a fraction of GDP. The coefficient of –0.32 is highly significant and, taken literally, it implies that a one standard deviation increase in government growth reduces average GDP growth by 0.39 percentage points.”[81]
A study in Public Choice discovered: “Each one percentage point increase in government expenditures as a fraction of GDP in 1960 (GOVT60) or in the interperiod change in the fraction reduces the growth rate by roughly one tenth of a percentage point.”[82]
The OECD admitted: “Taxes and government expenditures affect growth both directly and indirectly through investment. An increase of about one percentage point in the tax pressure—e.g. two-thirds of what was observed over the past decade in the OECD sample—could be associated with a direct reduction of about 0.3 per cent in output per capita. If the investment effect is taken into account, the overall reduction would be about 0.6–0.7 per cent.”[83]
A JEC study estimated: “Over seven years, economic output would be $2.45 larger for every dollar of spending restraint enacted in the first year and sustained through the period.”[84]
Another JEC report found: “These results suggest that for each 1 percent increase in the government share of GDP, the GDP itself falls by about $30 billion. Since the numbers are expressed in 1992 dollars, the figure in current dollars would be slightly higher, perhaps $34 billion. Since a 1 percent change in GDP is currently about $80 billion, this suggests that $80 billion in federal spending has associated with it an output-reducing impact of about $34 billion, or somewhat more than 40 percent of the total—the ‘deadweight’ loss of modern government.”[85]
An NBER paper stated: “[A] 10 percent balanced budget increase in government spending and taxation is predicted to reduce output growth by 1.4 percentage points per annum, a number comparable in magnitude to results from the one-sector theoretical models in King and Robello.”[86]
Research summarized in a Wall Street Journal column estimated: “There is a striking relationship between the size of government and economic growth. When government spending was less than 25% of GDP, OECD countries achieved an average real growth rate of 6.6%. As the size of government rose, growth steadily declined, plunging to 1.6% when government spending exceeded 60% of GDP.”[87]
An NBER paper concluded: “Our results are in contrast to many of the ‘new growth’ models…in finding that government spending, rather than tax rates, have the greatest long-term negative impact on private sector productivity,” and that “government spending and taxation both reduce the productivity of labor and capital, although the interacted taxation coefficients are not jointly significant at the 5 percent level.”[88]
The NBER paper also found: “The effect of government expenditures and taxation on GDP growth rates is central to many debates in both developing and developed countries. This paper has developed a theoretical model that integrates the effects of government spending, and the distortionary effects of taxation, in a model of output growth. Using a sample of 107 countries during the period 1970–85, we found strong and negative effects of both government spending and taxation on output growth. A balanced-budget increase in government spending and taxation of 10 percentage points was predicted to decrease long-term growth rates by 1.4 percentage points. The implied behavioral parameters from the model suggest that the allocation of factor inputs are sensitive to intrasectoral tax distortions.”[89]
A JEC report estimated: “As the plot illustrates, there is a clearly observable negative relationship between size of government and long-term growth of real GDP. The line drawn through the plotted points is the least squares regression line showing the relationship that best fits the data. The slope of the line (minus 0.100) indicates that a 10 percentage point increase in government expenditures as a share of GDP leads to approximately a one percentage point reduction in economic growth. The R-squared of .42 indicates that government spending alone explains about 42 percent of the differences in economic growth among these nations during the period.”[90]
The JEC study also reported: “The reduction in the average growth rate of real GDP was 5.2 percentage points for OECD members with the largest expansion in size of government, compared to an average decline of 1.6 percentage points for those with the least increase in size of government. The reduction in the growth rate of every nation in the ‘big growth of government’ group exceeded the OECD average (bottom line of table). In contrast, each country in the top group—those with the least expansion in government—registered below average reduction in growth. Moreover, every nation in the bottom group had a larger reduction in growth than any of the nations in the top group.”[91]

An NBER paper stated: “A reduction by one percentage point in the ratio of primary spending over GDP leads to an increase in investment by 0.16 percentage points of GDP on impact, and a cumulative increase by 0.50 after two years and 0.80 percentage points of GDP after five years. The effect is particularly strong when the spending cut falls on government wages: in response to a cut in the public wage bill by 1 percent of GDP, the figures above become 0.51, 1.83 and 2.77 per cent respectively.”[95]
The NBER study also concluded: “An increase in government spending by 1 percentage point of trend GDP decreases profits as a share of the capital stock by about 1/10 of a percentage point,” and “Accounting for financial constraints, investment as a share of GDP increases approximately by 0.73 percentage points (versus 0.55 in the benchmark case) in response to permanent decrease in primary spending by 1 percent of trend GDP.”[96]
The New Zealand Business Roundtable study found: “An increase of 6 percentage points in government consumption expenditure as a percentage of GDP, (from, say 10 percent to 16 percent) would tend to reduce the annual rate of growth of GDP by about 0.8 percent,” and “The result of the studies by Barro and Commander et al. suggest that the 70 percent increase in government consumption as a percentage of GDP that occurred in New Zealand during the period of 1960 to 1980 could possibly account for a reduction in the economic growth rate of about 1 percentage point per annum.”[97]
An IMF study confirmed: “Average growth for the preceding 5-year period…was higher in countries with small governments in both periods. The unemployment rate, the share of the shadow economy, and the number of registered patents suggest that small governments exhibit more regulatory efficiency and have less of an inhibiting effect on the functioning of labor markets, participation in the formal economy, and the innovativeness of the private sector.”[98]

Not All Spending Is Created Equal

While all government spending is associated with extraction costs and displacement costs, the presence of other costs varies depending on the structure and operation of each government program or activity. Some programs and activities, such as police protection and a well-functioning legal system, actually promote economic growth by facilitating the operation of a market-based economy. Other programs and activities, such as national defense, may yield net benefits because they reduce the likelihood of external threats—a feature that has been called “wealth-maintaining defense spending.”[99]

However, most government programs fail to generate an adequate rate of return. Many, such as welfare programs, almost certainly have a negative return and unambiguously damage economic performance. Not all government spending, needless to say, should be dependent on rates of return, but legislators should fully understand that funding programs with money that the private sector could use more productively will result in less economic growth.

Policymakers should determine whether spending for a given program yields enough benefits to offset the corresponding loss of money to the private sector. For instance, a certain level of transportation spending will facilitate economic growth by permitting the efficient flow of goods and services. Of course, policymakers should debate whether the spending could be privatized or conducted at the state and local levels. To the extent they believe that it has to be conducted by Washington, they should do their best to ensure that funding is allocated according to sound guidelines rather than pork-barrel politics.

In too many cases, there is strong reason to believe that the federal government is spending money in ways that do not produce good results for the economy. Some programs, such as welfare, reduce the cost of not working and inevitably undermine productive economic behavior. Other types of spending, such as the budgets for regulatory agencies, can have significantly negative rates of return because of the heavy costs that they impose on the private sector. Regrettably, policymakers usually do not subject government programs to this type of cost-benefit analysis.

Academics have found that the composition of government spending is often just as important as the level of government spending.

An IMF paper explained: “Many public investment projects could be wasteful, for example, in the sense that their marginal net present values could be negative for the society as a whole.”[100]
A Public Choice study found: “[T]he level of government consumption appears to have a fairly robust negative effect on economic growth, in particular in the richer countries.”[101]
The same article reported: “[T]ransfer payments also appear to exercise a significantly negative effect on TFP [total factor productivity] growth. According to the 1965–82 estimate, an increase of transfers as a share of GDP by 10 percentage points would, ceteris paribus [everything else assumed constant], decrease the growth rate of TFP by 0.8 percent per year.”[102]
An article in the European Economic Review noted: “This means that 80 percent or more of public expenditures in OECD countries consists of expenditure that is not often claimed to have positive growth effects.”[103]
Public Finance Review published a sturdy that concluded: “[W]e find a negative effect of taxes on state economic growth, even if revenues finance education, and transportation and public safety.”[104]
An article in Economic Inquiry found: “[I]t is seen that private R&D is the more important determinant of productivity growth (at the aggregate national level). In fact, once private R&D is controlled for, the public variable is no longer significant at the 5 percent significance level.”[105]
The OECD noted: “The main conclusion from the literature is that there may be both a ‘size’ effect of government intervention as well as specific effects stemming from the financing and composition of public expenditure.”[106]
A study in Metroeconomica concluded: “Assuming that labour is supplied inelastically, it is shown that increases in non-productive government spending, i.e. public consumption or lump-sum transfers, always reduce the balanced growth rate, whereas there exists a growth-maximizing investment subsidy rate and income tax-rate.”[107]
A JEC study reported: “If the expansion in government continues…expenditures are increasingly channeled into less and less productive activities. Eventually, as the government becomes larger and undertakes more activities for which it is ill suited, negative returns set in and economic growth is retarded.”[108]
A separate JEC study highlighted the adverse impact of income redistribution: “This gap is more than the total gap between actual total federal government spending (as a percent of GDP)—about 20 percent—and that amount that would maximize output (17.4 percent of GDP, using the 1947–97 data and the original model). Thus, the evidence seems to suggest that the problem of excessive government growth in the postwar era is a problem relating to entitlements and income transfers.”[109]
A study at the University of North Texas explained: “[R]ecent evidence suggests that expansion in the relative size of government may reduce economic growth.… As government expands beyond its core functions of national defense, police, courts, and establishing property rights, growth-inhibiting factors may arise.”[110]
The same study elaborated: “While the size of government investment spending has a positive impact on real GDP, the size of government consumption spending has a negative impact. In all cases, labor and private investment have a positive impact on real GDP.”[111]
A Federal Reserve Bank of Cleveland article found that government consumption harms economic performance: “[A] permanent rise in government consumption leads to lower long-run output. For an increase in expenditure of the magnitude of 4 percent per year, output declines by about 2 percent. With deficit financing, output is higher in the short run, but declines considerably in the long run.”[112]
A Journal of Political Economy paper focused on the governmental activities associated with good economic performance: “[P]roductive government spending would include the resources devoted to property rights enforcement, as well as activities that enter directly into production functions.”[113]
A National Tax Journal study noted: “Government spending itself contributes significantly negatively to long-run economic growth, unless it is of the capital infrastructure variety.”[114]
A report in Economic Development and Cultural Change concluded: “Government consumption expenditure excluding military and educational expenditure (OCSA) appears to have noticeably reduced economic growth. Military and transfer expenditures do not appear to have had much impact on economic growth. Government educational expenditures seem to be inefficient at generating actual education; that is, actual education (measured by enrollment ratios) is strongly correlated with growth rates, but levels of government educational expenditure are not.” The study also “found a negative relationship between the share of government consumption expenditure in GDP and the growth of per capita GDP for a cross section of 96 LDCs [less developed countries] and developed countries over various time periods between 1961 and 1976.”[115]
The same article specifically examines the impact of government outlays other than those for defense and education, concluding: “The coefficients are all negative and highly significant; this result suggests that this type of expenditure has a marked negative impact on economic growth. The growth rates and the shares in GDP are both in percentages, so taken literally, the coefficient of –.234 for the small annual subsample says that an increase by 1% of GDP in this category of government expenditure would slow the growth rate of per capita product by .23%.”[116]
Research from the OECD discovered: “Taxes and government expenditures seem to affect growth both directly and indirectly through investment. An increase of about one percentage point in the tax pressure (or, equivalently one half of a percentage point in government consumption, taken as a proxy for government size)—e.g. two-thirds of what was observed over the past two decades in the OECD sample—could be associated with a direct reduction of about 0.3 per cent in output per capita. If the investment effect is taken into account, the overall reduction would be about 0.6–0.7 per cent.”[117]
The same OECD paper concluded: “The results suggest that for a given level of taxation, higher direct taxes lead to lower output per capita, while on the expenditure side transfers as opposed to government consumption, and especially as opposed to government investment, could lead to lower output per capita.”[118]
An American Economic Review paper found: “To the extent that government spending is on investment-type goods yielding future goods and services that are perceived as substitutes for future privately provided consumption goods, there will be a relatively smaller reduction in private sector consumption.”[119]
Even outlays that are necessary for a country’s survival impose an economic burden according to research cited by the IMF: “As regards more specific categories of public consumption, Knight, Loayza, and Villanueva (1996) found a significant adverse impact of military spending on growth.”[120]

Is There an Optimal Size of Government?

There is ample evidence that government spending hinders economic growth and that government is spending money on the wrong things. The research in these two areas is augmented by studies seeking to ascertain the “right” level of government spending. In other words, certain forms of government spending are necessary to sustain a well-functioning market economy, but spending beyond that level hinders economic performance.

Scholars have tried to determine the point at which government spending becomes economically counterproductive.

Looking at U.S. evidence from 1929–1986, an article in Public Choice estimated: “This analysis validates the classical supply-side paradigm and shows that maximum productivity growth occurs when government expenditures represent about 20% of GDP.”[121]
Using a different approach, this Public Choice article concluded that “the growth in government economic activity has a positive effect on productivity growth when government expenditures are less than 17 percent of GNP, but that when government expenditures are greater than 17 percent of GNP this effect is negative. Maximum long-run productivity growth thus occurs when government expenditures are about half of their 1986 percentage.”[122]
An article in Economic Inquiry estimated: “We conclude that the optimal government size for the representative country in our sample is approximately 20 percent.”[123]
The same author updated his research, and a new article in Economic Inquiry discovered: “The optimal government size is 23 percent (+/– 2 percent) for the average country. This number, however, masks important differences across regions: estimated optimal sizes range from 14 percent (+/– 4 percent) for the average OECD country to…16 percent (+/– 6 percent) in North America.”[124]
A Public Choice article estimated: “[R]educing the U.S. government’s share of GDP from 36.7 to 23% would lower the reported unemployment rate by approximately 2.9%.”[125]
Another economist reported in Public Choice: “Estimates indicate that the 1983 level of government expenditures exceeds by 87 percent the level that would maximize private sector output,” and “Reducing government output to the optimal level and reallocating the excess labor to the private sector would expand private output by 22 percent.”[126]
A JEC paper concluded: “[G]overnment expenditures of 20 percent of GDP are associated with a decade-long average annual growth rate of approximately 5 percent, while government expenditures of about 45 percent are associated with only half as much economic growth. Among these countries, a 25 percent increase in the size of government as a share of GSP [gross state product] retarded the annual rate of economic growth by approximately 2.5 percent.”[127]
Another JEC study found: “The Curve peaks where government spending equals 17.45 percent of GDP. Since federal spending in recent years has been between 20 and 22 percent of GDP, the results suggest that the federal government is 12–20 percent too large from the standpoint of growth optimization. The last year in which federal spending was below 17.5 percent of GDP was 1965.”[128]
The same study also stated: “The data here suggest that a further reduction in government size to 17.45 percent of GDP would be growth enhancing. The positive impact of government downsizing at the margin gets smaller as we approach the optimum. Nonetheless, the results from (1) would suggest that reducing federal spending by about 2.75 percent of GDP (or by about $225 billion) would raise GDP by slightly more than $30 billion a year.” Among other findings: “Moreover, government spending in every case except Canada in the last year observed was dramatically larger than what the results suggest would optimize the rate of economic growth. In each of the European cases, spending reductions of 40 to 50 percent would seem desirable from the standpoint of growth optimization.”[129]
In earlier work for the JEC, the same two economists wrote: “The optimal level of federal government spending is about 17.6 percent of GDP. Beyond this point, the resources consumed by government impose more costs on the economy than benefits.”[130]
An article in the Journal of Monetary Economics produced geographic estimates: “In Africa and the Americas, government growth is significantly negatively correlated with GDP growth, and though the coefficients are smaller than what we observe for the OECD, government growth is more variable in these countries so that a one standard deviation increase in government growth reduces GDP growth by 0.58 points in Africa and 0.25 points in the Americas. In Asia, a one standard deviation increase in government growth corresponds to a 0.38 percentage point increase in the real GDP growth.”[131]

A Federal Reserve Bank of Cleveland study reported: “A simulation in which government expenditures increased permanents from 13.7 to 22.1 percent of GNP (as they did over the last four decades) led to a long-run decline in output of 2.1 percent. This number is a benchmark estimate of the effect on output because of permanently higher government consumption.”[132]
A National Center for Policy Analysis study found: “We use data on the real rate of growth of GDP for the 46-year period from 1950 through 1995 and on federal, state and local taxes as a share of GDP for that period. The resulting calculations suggest that: The estimated growth-maximizing tax rate for the United States is 21 percent of GDP.”[133]
A later study by the same author explained: “[G]overnment spending on such things as roads, education and criminal justice positively affects per capita GDP. But beyond some level—21 percent of GDP in the United States, for instance—the tax burden necessary to finance this spending slows economic growth and thus reduces per capita GDP below what it otherwise would be. Today, total government spending in the United States and other developed countries far exceeds the level at which it increases national income.”[134]
Looking at all developed nations, the NCPA study concluded: “Advanced countries can achieve maximum social progress, in the sense of marginal benefit equal to zero, with ‘maximum’ per capita government consumption spending in the range of $3,970 to $4,380—20.2 percent to 22.3 percent of GNP, or ‘minimum’ expenditures of $2,300 to $3,980—11.7 percent to 20.3 percent of GNP.”[135]
A study by the former chief economist of the U.S. Chamber of Commerce estimated: “In order to maximize economic growth, the average rate for federal, state, and local taxes combined should be between 21.5 percent and 22.9 percent of gross national product (GNP). Taxes as a share of GNP have not been in this range since 1949.”[136]
An IMF study concluded: “Perhaps the level of public spending does not need to be much higher than, say, 30 percent of GDP to achieve most of the important social and economic objectives that justify government intervention. Achieving this expenditure level would require radical reforms, a well functioning private market, and an efficient regulatory role for the government.”[137]
Even the OECD recognized that government spending could exceed an optimal size: “The main conclusion from the literature is that there may be both a ‘size’ effect of government intervention as well as specific effects stemming from the financing and composition of public expenditure. At a low level, the productive effects of public spending are likely to exceed the social costs of raising funds. However, government expenditure and the required taxes may reach levels where the negative effects on efficiency and hence growth start dominating.”[138]

Academic Evidence That Government Does Not Work Very Well

With a wealth of evidence that government is too big and that it spends too much, it should come as no surprise that scholars also have discovered that the fundamental differences between private markets and political decision-making may explain in part why federal spending undermines economic performance.