Lessons on How NOT to Stimulate the Economy

Confronting the prospect of a serious recession, Members of Congress are split over whether the economic stimulus package should mostly include tax cuts or spending increases, or some combination of both. The direction Congress chooses will have profound implications for the well-being of all Americans because, as past efforts in the United States and other countries demonstrate, strategies that rely on increased spending will fail. Indeed, lessons from past experience and economic studies suggest that spending strategies could very well make things worse by diverting scarce resources away from productive use in the private sector toward wasteful uses that pander to the interests of influential constituencies.

Instead of increasing spending, a much sounder economic strategy--based on proven experiences both here and abroad--would be to restrain or shrink government and utilize broad-based tax rate cuts that encourage work, savings, and investment.

COMPETING VISIONS

The September 11 terrorist attacks caused many to fear that an economy already showing signs of weakness would slide into a full-fledged recession. With hundreds of thousands of workers laid off within the first few weeks following the terrorist assault, both the President and many in Congress acknowledged a need for some sort of government-sponsored stimulus to deter the decline and spur commerce.

As was often the case during the past 70 years when government embarked upon an exercise to promote economic revitalization, the effort to find a solution often divides public officials into opposing camps with competing visions: increasing spending or cutting taxes. Some in Congress and many lobbyists want to do the former, while President George W. Bush and others in Congress advocate cutting taxes.

The President, building on the success that followed President John F. Kennedy's broad-based income tax rate cuts in the early 1960s and President Ronald Reagan's in 1981 (which led to the then-longest peacetime expansion in history), has proposed a package of tax cuts and worker relief that totals as much as $75 billion. Many in Congress have endorsed the effort in principle, and the House Ways and Means Committee has responded by reporting out a tax reduction bill containing $99.5 billion in tax cuts and relief.1

Opposing this approach are a variety of budget-busting spending proposals--from Congress, governors, and business lobbyists--to stimulate select sectors of the U.S. economy by substantially increasing and targeting federal spending that benefits them. Senator Harry Reid (D-NV), for example, has proposed a $40 billion stimulus package that includes $22 billion in transportation spending.2 More than half of that spending, about $12 billion, is to go to Amtrak, which carries one-half of 1 percent of inter-city passengers. Moreover, $1 billion of this would be dedicated to help fund three magnetic levitation trains,3 including a new train connecting Los Angeles and Las Vegas.

Representative James Oberstar (D-MN), ranking member of the House Committee on Transportation and Infrastructure, wants $50 billion in new infrastructure spending, including $23 billion for Amtrak and other rail purposes. His colleague, committee Chairman Don Young (R-AK), wants a $70 billion loan and grant package for railroads. A substantial increase in infrastructure spending is also sought by a bipartisan group of Senators on the Environment and Public Works Committee. And New York Governor George Pataki is pressing Congress for a $54 billion spending package for his state. Reflecting the rail vogue that has smitten elected officials this year, the package includes a proposal for a high-speed rail line connecting Schenectady, above Albany, with New York City.

Before Congress commits itself to a budget-busting porkfest in the belief that it would help the economy and put people to work, it is instructive to review the experience of the United States and other countries with such spending programs.

A WEALTH OF EXPERIENCE

As the findings of comprehensive government-sponsored studies show,4 efforts to achieve prosperity through more government spending invariably yield greater poverty instead.

The U.S. Experience with Spending v. Tax Cuts

The 1930s. Perhaps the classic failures in government spending to boost the U.S. economy were the pump-priming efforts conducted during the 1930s to ameliorate the effects of the Great Depression after the stock market crash of October 1929. From 1930 to 1940, federal spending tripled in volume as new programs were created and old ones expanded in a costly effort to revive the collapsing economy. As a share of the gross domestic product (GDP), federal spending rose from 3.4 percent in 1930 to 9.8 percent in 1940.5 Yet, despite this unprecedented surge in spending, America's GDP fell by 27 percent part way through the decade and by 1938 was less than two percent above its 1929 level.6

For American workers, the failure of this spending spree to do anything more than expand the deficit and bureaucracy was devastating. The number of unemployed more than doubled from 2.8 million at the beginning of the decade to 6.9 million in 1940.7

The 1960s. Inheriting a sluggish economy when he took office in 1961, President Kennedy learned from these lessons and instead relied on a massive tax cut to get the economy going again. It worked; inflation-adjusted GDP grew by 50.5 percent during the 1960s, a postwar record for decade-over-decade growth rates.

The 1980s and 1990s. The 1981 tax cuts of President Reagan led to what then became the longest peacetime economic expansion in U.S. history--a record that was broken during the 1990s when economic expansion was accompanied by a shrinkage in government spending relative to the size of the economy.

The federal government's share of GDP fell from 22.3 percent in 1991 during the brief recession that marked the beginning of the decade to 18.2 percent by 2000.8 Because of the restraint on federal spending, which allowed resources to shift to the more productive private sector, the economy boomed and a new American record was set for the duration of an expansion that only an outrageous act of terrorism could end.

Japan's Sad Experience in the 1990s

The United States was not the only country to experience an economic downturn in 1991 as the Gulf War and its impact on energy prices and business confidence depressed commerce worldwide. Although the negative impact on the U.S. economy was brief and shallow, the effect in Japan was much more severe, exacerbated by that country's highly leveraged and overextended financial system and inefficient service, agriculture, and distribution sectors.

Increased Infrastructure Spending. Whereas the United States responded to this downturn with a sustained program of fiscal discipline, which eliminated budget deficits and reduced government's share of GDP by more than 18 percent over the decade, the Japanese government pursued a contrary tack to economic stimulation--increased spending.

Beginning in 1991-1992, Japan adopted the spending approach now advocated by many in the U.S. Congress when it embarked on a massive nationwide program of infrastructure investment. Between 1992 and 2000, Japan implemented 10 separate spending stimulus packages in which public infrastructure investment was a major component.9 Excluding the 2000 program, for which final costs are not yet available, additional spending on the infrastructure component alone amounted to 30.4 trillion yen, or $254 billion at the current exchange rate.10

Rising Government Share of GDP.
Combined with increases in other government spending programs, Japan's efforts to spend its way to prosperity led to substantial increases in government spending as a share of GDP. Chart 1 illustrates this trend in comparison to fiscal trends in the United States over the same period.

Historically, the Japanese government maintained a share of GDP that was smaller than that of the United States; at the same time, both the Japanese and U.S. governments had significantly smaller shares of GDP than was typical of most other industrialized countries. Whereas the U.S. governments' GDP share was 29.3 percent in 2000, Sweden's share of 53.9 percent was the highest among the world's advanced countries, followed by France at 51.2 percent.11

Beginning in 1991 and in response to a weak economy, government spending in Japan rapidly increased. The relative positions of GDP share between the U.S. and Japan reversed in 1993 as Japan's program of fiscal stimulus crossed paths with America's program of fiscal restraint. In the years following, the gap widened as the countries pursued strikingly different fiscal policies.

As a result, Japan's growth of government during the past decade may very well have been the fastest of any country in the postwar period, in marked contrast not only to the U.S. experience, but to that of virtually every industrialized country during the decade. Indeed, between 1995 and 2000, Japan was only one of two in the top 16 nations in the Organisation for Economic Co-operation and Development (OECD) to experience an increase in government spending as a share of GDP.12

Slow Growth. Japan's failed policies had severe negative consequences for its economy and citizens. As Chart 2 illustrates, measured in inflation-adjusted GDP growth, Japan went from being a high-growth country in the 1980s to a slow-growth country during the 1990s.

Low Industrial Production. At the same time, Japan's much-vaunted industrial powers began to wane, as Chart 3 reveals. Between 1992 and 1999, industrial production in Japan increased by just 0.7 percent, while in the United States it increased by 39.6 percent. France, which each year surrenders half of its GDP to government, saw an increase in industrial production of only 15 percent, which closely matched the average performance of most other countries in Europe where big government is the norm, not the exception.13

Decline in the Standard of Living. For the average Japanese citizen, the chief consequence of this economic underperformance has been both a relative and an absolute decline in the nation's standard of living, defined by per capita GDP as measured by the World Bank and adjusted for differences in purchasing power parity (PPP).14 Chart 4 illustrates trends in the Japanese standard of living, as so measured, compared with that of the United States, which to serve as a benchmark is set at 100 (as defined by U.S. per capita GDP, adjusted for PPP).

Japan began gradually to close the gap beginning in the late 1970s, when its standard of living was about 72 percent of that of the United States. By 1991, its standard of living had risen to nearly 90 percent of that of the United States.15 During this period, Japan's level of government spending in proportion to its economy, while rising, was still the lowest of the major industrial countries.

Had Japan continued with this policy of fiscal restraint and low taxes, its per capita income (adjusted for PPP) would likely have overtaken America's by the mid-1990s. But 1991 was also the beginning of the Japanese government's spending spree and the country's relative, and then absolute, decline.

After coming within 12 percentage points of matching U.S. per capita GDP, Japan's relative performance began its inexorable decline and fell to a 78 percent share by 1999, a milestone it had surpassed--on the way up--only 12 years earlier. More important, the standard of living also fell in absolute terms. After reaching a per capita, PPP-adjusted GDP of $25,373 in 1997, that measure fell to $24,314 in 1998 and remained below $25,000 in 1999. Significantly, this was the first decline experienced by the Japanese since this data series began in 1975.

Other Nations' Experience

It should be noted that while the Japanese-U.S. contrast is one of the most striking because of the dramatic policy differences that occurred during the period under review, U.S. performance vis-à-vis most other leading countries follows similar patterns.

France, for example, which experienced steady growth in government's share for most of this period, also saw steady but slow deterioration in its GDP compared with that of America. Registering a 78 percent share in 1975 (when Japan's was 72 percent), it never got higher than 82 percent and now stands at just 71.8 percent, reflecting the bloated government (which, again, spends more than 50 percent of national income) that burdens the nation.

Sweden, whose government is the largest at 53.9 percent (down from its lofty perch of 62 percent in 1995), has seen its standard of living decline as well compared with that of the United States. From 79 percent of the U.S. standard of living in 1985, Sweden's level fell to 71 percent in 1999. Reflecting a relatively bigger government than any other advanced country's, over the same period Sweden also fell from being slightly more prosperous than the French and Japanese to being poorer than both.

As Ireland's experience shows, the United States is not alone in reaping the economic benefits of less government. Ireland reduced the government share of national spending in a dramatic fashion over the 1990s and now has the distinction of being the only Western European member of the OECD that has a government smaller than America's, as measured by spending share of GDP. In 2000, government spending in Ireland was at 27.7 percent of GDP, compared with 29.3 percent for the United States.16 Significantly, this government spending share reflects a marked decline for Ireland from 36.4 percent in 1995 and over 50 percent in the early 1980s.

As Ireland's government has shrunk proportionately, its standard of living has soared. Once one of the poorest countries in Europe, Ireland is now one of the richest. In 1975, per capita income in Ireland was half as much as it was in France and 42 percent as much as it was in the United States. By 1999, Ireland's per capita income had reached 81 percent of America's and exceeded that of every other leading European country except Norway (whose GDP is boosted by high oil production compared to its small population) and Switzerland, whose government's share is also small.

These relationships between government spending and economic performance have been confirmed in a December 1998 study produced by the Joint Economic Committee of the United States Congress. Using sophisticated econometric models to examine data from the U.S. and other countries, the study concluded:

The evidence suggests that large transfer payments in particular have negative consequences for growth. The results for the federal government are confirmed for state and local governments and several other countries. The findings suggest that a federal budget strategy of constraining spending below output growth, with particular attention paid to constraining transfer payments, would have positive effects on economic growth.17

CONCLUSION

Although Congress is split over whether the stimulus package should be comprised of tax cuts or spending increases or some combination of both, lessons derived from such past efforts at home and abroad demonstrate that strategies relying on increased spending will fail. Indeed, such lessons also suggest that such strategies make things worse by diverting scarce resources away from productive use in the private sector.

Instead, a sounder strategy to advance economic activity and prosperity, based on proven performance in countries around the world, is to restrain or shrink government and to utilize broad-based tax rate cuts to encourage work, savings, and investment.

Dr. Ronald D. Utt, is Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Endnotes