The Heritage Foundation

Executive Summary #1831 on Federal Budget

March 15, 2005

March 15, 2005 | Executive Summary on Federal Budget

Executive Summary: The Impact of Government Spending on EconomicGrowth

A growing government is contrary to America's economic interests because the various methods of financing government-taxes, borrowing, and print­ing money-have harmful effects. This is also true because government spending by its very nature is often economically destructive, regardless of how it is financed. The many reasons for the negative relationship between the size of government and economic growth include:

  • The extraction cost. Government spending requires costly financing choices. The federal government cannot spend money without first taking that money from someone. 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 means one less dol­lar in the productive sector of the economy. This dampens growth since economic forces guide the allocation of resources in the private sector.
  • The negative multiplier cost. Government spending finances harmful intervention. Por­tions of the federal budget are used to finance activities that generate a distinctly negative effect on economic activity. For instance, many regulatory agencies have comparatively small budgets, but they impose large costs on the economy's productive sector.
  • The behavioral subsidy cost. Government spending encourages destructive choices. Many government programs subsidize eco­nomically undesirable decisions. Welfare encourages people to choose leisure. Unem­ployment insurance programs provide an incentive to remain unemployed.
  • The behavioral penalty cost. Government spending discourages productive choices. Government programs often discourage eco­nomically desirable decisions. Saving is impor­tant to help provide capital for new investment, yet the incentive to save has been undermined by government programs that subsidize retirement, housing, and education.
  • The market distortion cost. Government spending hinders resource allocation. Compet­itive markets determine prices in a process that ensures the most efficient allocation of resources. However, in both health care and education, government subsidies to reduce out-of-pocket expenses have created a "third-party payer" problem.
  • The inefficiency cost. Government spending is a less effective way to deliver services. Gov­ernment directly provides many services and activities such as education, airports, and postal operations. However, there is consider­able evidence that the private sector could pro­vide these important services at higher quality and lower costs.
  • The stagnation cost. Government spending inhibits innovation. Because of competition and the desire to increase income and wealth, individuals and entities in the private sector constantly search for new options and oppor­tunities. Government programs, however, are inherently inflexible.

The common-sense notion that government spending retards economic performance is bol­stered by cross-country comparisons and aca­demic research. International comparisons are especially useful. Government spending consumes almost half of Europe's economic output-a full one-third higher than the burden of government in the U.S. This excessive government is associated with sub-par economic performance:

  • Per capita economic output in the U.S. in 2003 was $37,600-more than 40 percent higher than the $26,600 average for EU-15 nations.
  • Real economic growth in the U.S. over the past 10 years (3.2 percent average annual growth) has been more than 50 percent faster than EU-15 growth during the same period (2.1 percent).
  • Job creation is much stronger in the U.S., and the U.S. unemployment rate is significantly lower than the EU-15's unemployment rate.
  • Living standards in the EU are equivalent to living standards in the poorest American states-roughly equal to Arkansas and Mon­tana and only slightly ahead of West Virginia and Mississippi, the two poorest states.

The global evidence is augmented by dozens of academic research papers. Using varying method­ologies, academic experts have found a clear nega­tive relationship between government spending and economic performance. For instance, a National Bureau of Economic Research paper found: "A reduction by one percentage point in the ratio of primary spending over GDP [gross domes­tic product] 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." According to a New Zealand Business Roundtable study, "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."

An International Monetary Fund study con­firmed that "Average growth for the preceding 5-year period…was higher in countries with small governments in both periods." Even the Organi­sation for Economic Co-operation and Develop­ment 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.

This is just a sampling of the academic research presented in the main paper. While no single research paper should be viewed as definitive, given the difficulty of isolating the impact of one policy on overall economic performance, the cumulative find­ings certainly bolster the theoretical and real-world arguments in favor of smaller government.

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Federal Budget