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."
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.
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."
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."
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.
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.
This is an important caveat. In the words of another economist,
"presenting the results of a single model is misleading,"
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."
- Public Finance Review published an article that stated:
"[T]axes negatively affect economic growth, even when they finance
certain types of nontransfer spending."
- 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.)."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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)."
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."
- 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."
- 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."
- A JEC report
noted: "Government spending reduces productivity as resources are
withdrawn from the private sector and placed in the unproductive
public sector.
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- An NBER article
found: "Both increases in taxes and increases in government
spending have a strong negative effect on investment spending."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
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."
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."
In other
words, economic policy matters. Moreover, the evidence certainly
indicates that a larger public sector diminishes economic
growth.
- 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."
- 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."
- 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."
- 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."
- 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].
- 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.
- 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%."
- 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)."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
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."
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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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%."
- 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."
- 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."
- 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."
- 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."
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."
-
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."
-
An
article in
Economic Inquiry estimated: "We conclude that the
optimal government size for the representative country in our
sample is approximately 20 percent."
-
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."
-
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%."
-
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."
-
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."
-
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."
-
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."
-
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."
-
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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
- 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."
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.
-
An
article in
Economic Inquiry stated: "The marginal
productivity of government services is negatively related to
government size; the public sector is more productive when
small."
-
A
Public Choice study explains: "[T]he level of government
spending may proxy other governmental intrusions into the workings
of the private sector, especially regulations which restrain
economic growth and efficiency."
-
A
Public Choice article reveals: "Value added in the
government sector is lower than in the private sector. Resources
are not allocated to highest valued use but on political
(bureaucratic) criterion. High taxes, tax progressivity, and the
substitution in consumption of politically priced public goods for
market priced private goods reduces the incentives of economic
actors."
-
Two
Stanford University economists note: "[T]he suppression of
diversion [obtaining unearned wealth] is a central element of a
favorable social infrastructure.… Diversion takes the form
of rent seeking in countries of all types, and is probably the main
form of diversion in more advanced economies.… Potentially
productive individuals spend their efforts influencing the
government. At high levels, they lobby legislatures and agencies to
provide benefits to their clients. At lower levels, they spend time
and resources seeking government employment."
-
A JEC
report explained: "By way of comparison with markets, the required
time for the weeding out of errors (for example, bad investments)
and adjustments to changing circumstances, new information and
improved technology is more lengthy for governments."
-
An IMF
paper noted: "There is a widespread belief that, absent
externalities, public production tends to be less efficient than
private production. Hence, on account of this effect alone, the
higher the level of public expenditure, the greater the
inefficiency and the lower the level of output."
-
Even the
Congressional Budget Office acknowledged: "Many federal investments
are motivated primarily by noneconomic policy goals (such as
equality of opportunity, national security, and the advance of
scientific knowledge). Others are influenced by political
considerations. For those reasons, one cannot expect that federal
funds will always be directed toward the most cost beneficial use,
even within those classes of projects that have an economic
rationale."
-
An
article in the
Journal of Law and Economics explained:
"Economists, journalists, and others have often pointed out that
many government spending programs are inefficient-including farm
price supports, government administration of schools, and 'in-kind
transfers.' It would appear that taxpayers would benefit if these
programs became more efficient-if farmers received monetary
payments rather than acreage restrictions or if students received
vouchers rather than free tuition at public schools. But our
analysis raises doubts about the validity of this partial political
equilibrium analysis. Taxpayers might prefer inefficient spending
programs because subsidy recipients would exert less political
pressure to expand inefficient programs."
-
The OECD
acknowledged: "[L]ess than 20 per cent of public expenditure in
OECD countries consists of expenditure that could be classified as
directly 'productive' (
e.g. schooling, infrastructure and
R&D). And in a number of countries, the share of 'productive'
expenditure declined over the past decade."
-
A
Public Choice study noted: "[T]he influence of bureaucrats
and special interest groups increases as the size of government
increases. When government is small, its scope of activity is
limited and the benefits and burdens are relatively universal."
-
A JEC
report found: "Government spending reduces productivity growth
rates by inhibiting innovation and capital accumulation.…
Government spending creates uncertainty that reduces the return of
long-term investments.… Government spending reduces
labor-force participation by creating disincentives to work.
Government spending makes labor markets more rigid by hampering the
efficient flow of workers from declining industries to expanding
industries."
-
A study
of "New Zealand's Flawed Growth Strategy" noted: "As government
grows relative to the market sector, the returns to government
activity diminish. The larger the government, the greater is its
involvement in activities it does poorly. More government means
higher taxes. As taxes take more earnings from citizens, the
incentive to invest, develop resources and engage in productive
activities declines. Compared to the market sector, government is
less innovative and less responsive to change. Growth is a
discovery process. In the market sector, entrepreneurs have strong
incentives to discover new and improved technologies, introduce
better methods of doing things, and exploit opportunities that were
previously overlooked. Also, they are in a position to act quickly
as new opportunities arise. In government, the nature of the
political process lengthens the time required to modify bad choices
(such as ending ineffective programmes) and adjust to changing
circumstances. As the size of government expands, the sphere of
innovative behavior shrinks. As government grows, it becomes more
heavily involved in redistributing income and in regulatory
activism. Redistribution blunts incentives for wealth creation. It
also induces people to spend more time seeking favours from the
government and less time producing goods and services for
consumes."
-
An
article in
Public Choice concluded: "[T]he public
decision-making process can result in an inefficient quantity of
public goods. The likelihood of this outcome increases with the
size of government. Further negative effects are created by the
revenue raising and spending mechanisms of the government, and the
increasing diversion of resources into 'unproductive' rent-seeking
activities. The magnitude of these effects is likely to increase
with the relative size of the government."
-
An
article in
The Public Interest made a similar observation:
"As more business is done with the state, relationships develop
between government agencies and corporations. Within the business
sector, groups develop that see their interests joined to those of
the political bureaucracy."
-
Another
Public Choice article echoes these findings: "[T]he revenue
raising and spending mechanisms of government and the
'unproductive' activities of rent-seeking interest groups introduce
distortions into the allocation of resources."
-
A JEC
report also echoed this point: "Government spending creates
opportunities for rent-seekers to waste resources to curry
political favor. Rent-seeking distorts economic markets, reduces
economic growth, and destroys the free market ethic."
Federal
spending also has an adverse impact because certain programs
discourage good behavior and/or reward bad behavior.
-
A
Public Choice article found: "On the expenditure side,
greater government economic activity discourages activities that
lead to greater growth by enticing people, who otherwise would be
creative and energetic in an economic sense, to be dependent on the
government."
-
A
National Tax Journal article discusses how government-run
social security systems hinder economic performance: "The simplest
answer is that such state pensions do indeed reduce the rate of
growth, but consideration has to be given to the alternative form
that pension provision would take."
-
A
Public Choice article noted: "[B]ig governments are more
likely to finance, for example, public health insurance and
lucrative unemployment insurance schemes thereby lowering the cost
of unemployment to the individual."
-
A
Journal of Political Economy study explained: "[S]ocial
insurance programs with means tests based on assets discourage
saving by households," and "the impact of social insurance programs
on saving behavior extends to saving behavior of potential, as well
as actual, recipients."
-
The same
study also revealed: "[A] Medicaid program reduced precautionary
saving against uncertain medical expenses," and "the presence of
asset-based means testing of welfare programs can imply that a
significant fraction of the group with lower lifetime income will
not accumulate wealth."
-
A study
in
Economic Policy found that government industrial
subsidies hindered performance: "[A] large share of European
countries' industrial policy has been directed towards schemes to
help declining firms and industries.… [T]his policy of
supporting declining industries has actually contributed to higher
unemployment."
-
The same
study further comments: "Any incentive to moderate wage demands is
reduced by the prospect that a troubled firm will receive
government subsidies and its workers will be offered subsidized
early retirement. Once the government's reputation is established,
it affects wages not only at subsidized firms but at all potential
subsidy recipients," and "the interaction of a number of separate
government policies can turn the insult of low employment growth
into the injury of unemployment."
-
A New
Zealand Business Roundtable report discusses research on how
entitlement programs reduce saving: "[T]he costs involved are
significant relative to GDP: Even a conservative estimate that each
dollar of Social Security wealth displaces only 50 cents of private
wealth accumulation implies that the annual loss of national income
would exceed 4 percent of GDP."
-
The same
report discusses how unemployment programs increase joblessness:
"[A] 10 percent increase in benefits would reduce employment
propensity (total employment as a proportion of the working age
population) by 1.67 percentage points if wages remain unchanged.
The effect of an increase in unemployment benefits on the level of
real wages has implications both for the quantity of labor supplied
and demanded. Using Maloney's estimate of the elasticity of supply
of labor with respect to the wage rate (0.486) and assuming
elasticity of demand for labor of -0.7, a 10 percent increase in
the level of benefits would result in a reduction in employment."
-
A
Journal of Economic Literature study estimates the overall
adverse impact of income transfers: "They conclude that the
cumulative effect of income transfers in the United States, at that
time, had been to reduce the total supply of labor by 4.8
percent."
-
An OECD
paper concluded that research and development does not yield a good
return unless it is conducted in the private sector: "[R]egressions
including separate variables for business-performed R&D and the
R&D performed by other institutions (mainly public research
institutes) suggest that it is the former that drives the positive
association between total R&D intensity and output
growth.… [T]his result suggests publicly performed R&D
crowds out resources that could be alternatively used by the
private sector, including private R&D. There is some evidence
of this effect in studies that have looked in detail at the role of
different forms of R&D and their interaction between them. In
particular, it is found that defence research performed by the
public does indeed crowd out private R&D, partly by raising the
cost of research."
-
An NBER
paper found a clear negative relationship between government
handouts and jobs: "Employment drops abruptly once individuals
become eligible for the higher social assistance benefits. As
expected, the decline in employment measured at census week happens
between age 29 and 30, while the decline in employment measured
over the previous year mostly happens between 30 and 31."
-
The same
paper also reported: "We find strong evidence that more generous
social assistance benefits reduce employment, and more suggestive
evidence that they affect marital status and living arrangements,"
and "the range of estimates suggests that the counterfactual
elimination of welfare would increase hours worked by 10 to 50
percent."
-
The NBER
study also noted: "Our main finding is that more generous social
assistance benefits substantially reduce the employment probability
of less-educated men without dependent children. The employment
rate for this group of men drops by three to five percentage points
in response to the higher benefits. Perhaps more surprisingly, we
also find that higher benefits also reduce the employment rate of
all men by about one percentage point," and "that, as expected, the
take-up of social assistance increases when benefits rise."
-
Another
NBER study found an adverse link between government and private
savings: "What is interesting about this formulation is that both
present and future taxes will tend to reduce savings. This means
that, to the extent that the government is subject to an
intertemporal budget constraint, it will not matter whether
increases in government consumption are financed by higher taxes or
by issuing government bonds.… If the public does not value
government consumption, savings will decline; this will be the case
independently of the way in which the expansion of government
expenditures is financed."
-
The same
NBER study specifically acknowledges: "[P]rivate savings will be
affected by the extent and coverage of government-run social
security programs. If individuals perceive that when they retire
they will get high social security benefits, they will tend to
reduce the amount saved during their active days."
-
Even the
OECD admitted: "[U]nemployment benefits provide needed support to
individuals and households experiencing job losses. However, high
replacement rates can raise the structural unemployment rate by
lowering the gap between the income from work and the income
received on support. This is particularly the case if high
replacement rates are accompanied by a lengthy entitlement period.
An extended benefit period can contribute to lengthening the
average unemployment spell, thus leading to a loss of human
capital."
-
Another
OECD article noted: "[G]overnment expenditure and the required
taxes may reach levels where the negative effects on efficiency and
hence growth start dominating. This may reflect an extension of
government activities into areas that might be more efficiently
carried out in the private sector; or perhaps misguided or
inefficient systems of transfers and subsidies. These negative
effects may be more evident where the financing relies more on
so-called 'distortionary' taxes and where public expenditure
focuses on so-called 'unproductive' activities."
-
Similarly, the IMF has written: "Concern for high levels of
unemployment may lead the IMF to support policies that reduce
excessively generous unemployment benefit schemes that imply high
implicit negative tax rates for unemployed workers."
-Daniel J. Mitchell, Ph.D., is a McKenna Senior Research Fellow
in the Thomas A. Roe Institute for Economic Policy Studies at The
Heritage Foundation.
Appendix
1
The Keynesian Stimulus
Myth
Until the 1970s, some economists
believed that government spending-especially debt-financed
increases in government spending-boosted growth by "injecting"
purchasing power into the economy. This ostensibly occurred by
putting money into people's pockets. According to Keynesian theory,
people would then spend the money, thereby spurring growth.
Politicians understandably liked Keynesianism since it provided a
rationale for spending more money.
Some researchers even estimated that
larger levels of government were associated with higher levels of
economic output, but these studies often contained severe
methodological errors. As explained in an article in Public
Choice, "A major problem with this approach is that a large
part of government spending is also part of measured GDP, which
implies that GDP may grow just because government spending grows."
This is why, as an article in the Quarterly Journal of
Economics explained, "evidence from large scale econometric
models has been largely dismissed on the grounds that, because of
their Keynesian structure, these models assume rather than document
a positive effect of fiscal expansions on output."
More sophisticated analysis avoids
this measurement problem and, not surprisingly, finds that
government spending does not stimulate growth. In simple terms,
Keynesian theory overlooks the fact that government does not have
some magic source of money. The government cannot inject money into
the economy without first taking it out of the economy through
taxes or borrowing. The Keynesian theory fell into disrepute once
it became apparent that spending increases were associated with
economic stagnation in the 1970s and that lower tax rates and
spending restraint triggered an economic boom in the
1980s.
Even though it has lost favor among
economists, however, the Keynesian mindset is still alive among
politicians and journalists, who commonly comment on the need to
boost spending to enhance growth. Interestingly, John Maynard
Keynes would probably be aghast at how his theories have been used
to support bigger government. Before his death, he stated that
economic performance would be undermined if government spending
exceeded 25 percent of GDP.
Since the burden of government is over
50 percent in some European nations and more than 30 percent in the
United States (including state and local government spending),
Keynes would probably be a vigorous advocate of smaller government
today.
Even Europeans increasingly realize that excessive government is
undermining economic growth. In a 2003 paper, the European
Commission noted:
The idea
that fiscal policy may have short-run effects opposite to those
predicted by the Keynesian model was first suggested by Giavazzi
and Pagano who, looking at the fiscal consolidation experiences of
Denmark and Ireland in the mid-1980s, documented in both cases an
acceleration of growth just after the governments put in place
measures that drastically reduced budget deficits.
However, the paper did not just say that lowering the budget
deficit was desirable. It specifically acknowledged that the
pro-growth effect was caused by spending reductions:
[I]t is not
the simple fact that an adjustment is carried out that really
matters, rather it is the composition of the adjustment which
explains its expansionary effect… Fiscal adjustments based
on expenditure cuts are more likely to be expansionary.
The key issue is the size of government,
not how it is financed. As Milton Friedman, probably the world's
greatest living economist, succinctly explained: "Our country would
be far better off with a federal budget of $1 trillion and a
deficit of $300 billion than with a fully balanced budget of $2
trillion."
Appendix
2
The Deficit-Interest
Rates-Investment-Growth
Myth
During the past 50
years, both Republicans and Democrats have argued that reducing the
budget deficit is an elixir for economic growth.
The theory works as follows: A lower
budget deficit leads to lower interest rates, lower interest rates
lead to more investment, more investment leads to higher
productivity, and higher productivity means more growth.
All other things being
equal, these are all reasonable assertions, but fiscal policy
should focus on the deficit only if the aforementioned
relationships are robust. Simply stated, all other things are
not equal. For instance, if policymakers reduced government
spending and this led to fiscal balance, would the resulting
economic benefits be due to lower spending or less borrowing? If
policymakers raised taxes and this led to fiscal balance, is there
any reason to believe that the economy would perform better simply
because spending was being financed by taxes rather than by
borrowing?
There are many reasons
to believe that the debt-interest rates-investment-growth
hypothesis is overstated. Interest rates are
determined in world capital markets in which trillions of dollars
change hands every day. Even a large shift in the U.S. government's
fiscal balance is unlikely to have any noticeable impact on
interest rates. This is why economists have failed to find a
meaningful link between deficits and interest rates.
In 2000, the federal government had a record budget surplus of
$236 billion. The same year, according to the Federal Reserve
Board, the average interest rate on 10-year government bonds was
6.03 percent.
By contrast, recent projections show a deficit of more than $400
billion in 2004-a shift of more than $600 billion.
Yet, instead of rising, as critics of tax cuts argue should have
happened, interest rates have declined. The Federal Reserve Board
reported that the 10-year government bond rate in 2004was only 4.27
percent.
This decline does not mean that larger deficits cause interest
rates to fall, but it does demonstrate that it is incorrect to
claim that rising budget deficits will cause interest rates to
increase.
Moreover, it is not clear that interest rates are the main
determinant of investment. Demand for credit is a key factor, which
is why higher interest rates are correlated with periods of
stronger economic growth. Financial institutions and other lenders
make funds available to borrowers because that is how they make
money. For these lenders to earn a profit, the interest rate
charged on loans and other investments must be high enough to
compensate for factors such as projected inflation rates and
likelihood of default.
Taxes also affect interest rates. When tax rates are high,
investors must charge a higher interest rate.
The different interest rates charged on tax-free municipal bonds
and high-quality taxable corporate bonds illustrate this
relationship. For instance, over the past 24 years, interest rates
for taxable AAA corporate bonds have averaged nearly 2 percentage
points higher than interest rates for tax-free municipal bonds-a
large difference given the low level of expected default for both
bonds.
This means that a tax
increase-particularly an increase in marginal income tax
rates-would be likely to increase interest rates because the
increase in interest rates caused by the higher tax burden would be
likely to more than offset any theoretical reduction in interest
rates caused by a lower deficit. Furthermore, this analysis
implausibly assumes that a tax rate increase would generate
additional revenue and that the new revenue would be used for
deficit reduction rather than for new spending.
Walter
G. Park, "International R&D Spillovers and OECD Economic
Growth,"
Economic Inquiry, Vol. 33, No. 4 (1995).
Bassanini
and Scarpetta, "The Driving Forces of Economic Growth."