March 15, 2005 | Backgrounder on Federal Budget
For more on government spending, read Brian Reidl's new paper "Why Government Does Not Stimulate Economic Growth"
For more information, see the supplemental appendix to this paper.
Policymakers are divided as to whether government expansion helps or hinders economic growth. Advocates of bigger government argue that government programs provide valuable "public goods" such as education and infrastructure. They also claim that increases in government spending can bolster economic growth by putting money into people's pockets.
Proponents of smaller government have the opposite view. They explain that government is too big and that higher spending undermines economic growth by transferring additional resources from the productive sector of the economy to government, which uses them less efficiently. They also warn that an expanding public sector complicates efforts to implement pro-growth policies-such as fundamental tax reform and personal retirement accounts- because critics can use the existence of budget deficits as a reason to oppose policies that would strengthen the economy.
Which side is right?
This paper evaluates the impact of government spending on economic performance. It discusses the theoretical arguments, reviews the international evidence, highlights the latest academic research, cites examples of countries that have significantly reduced government spending as a share of national economic output, and analyzes the economic consequences of those reforms.1 The online supplement to this paper contains a comprehensive list of research and key findings.
This paper concludes that a large and growing government is not conducive to better economic performance. Indeed, reducing the size of government would lead to higher incomes and improve America's competitiveness. There are also philosophical reasons to support smaller government, but this paper does not address that aspect of the debate. Instead, it reports on-and relies upon-economic theory and empirical research.
Economic theory does not automatically generate strong conclusions about the impact of government outlays on economic performance. Indeed, almost every economist would agree that there are circumstances in which lower levels of government spending would enhance economic growth and other circumstances in which higher levels of government spending would be desirable.
If government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very difficult if there were no government at all. In other words, some government spending is necessary for the successful operation of the rule of law. Figure 1 illustrates this point. Economic activity is very low or nonexistent in the absence of government, but it jumps dramatically as core functions of government are financed. This does not mean that government costs nothing, but that the benefits outweigh the costs.
Costs vs. Benefits. Economists will generally agree that government spending becomes a burden at some point, either because government becomes too large or because outlays are misallocated. In such cases, the cost of government exceeds the benefit. The downward sloping portion of the curve in Figure 1 can exist for a number of reasons, including:
Spending on a government program, department, or agency can impose more than one of these costs. For instance, all government spending imposes both extraction costs and displacement costs. This does not necessarily mean that outlays-either in the aggregate or for a specific program-are counterproductive. That calculation requires a cost-benefit analysis.
The Keynesian Controversy. The Economics of government spending is not limited to cost-benefit analysis. There is also the Keynesian debate. In the 1930s, John Maynard Keynes argued that government spending-particularly increases in government spending-boosted growth by injecting purchasing power into the economy. According to Keynes, government could reverse economic downturns by borrowing money from the private sector and then returning the money to the private sector through various spending programs.
This "pump priming" concept did not necessarily mean that government should be big. Instead, Keynesian theory asserted that government spending-especially deficit spending-could provide short-term stimulus to help end a recession or depression. The Keynesians even argued that policymakers should be prepared to reduce government spending once the economy recovered in order to prevent Inflation, which they believed would result from too much economic growth. They even postulated that there was a tradeoff between Inflation and unemployment (the Phillips Curve) and that government officials should increase or decrease government spending to steer the economy between too much of one or too much of the other.
Keynesian economics was very influential for several decades and dominated public policy from the 1930s-1970s. The theory has since fallen out of favor, but it still influences policy discussions, particularly on whether or not changes in government spending have transitory economic effects. For instance, some lawmakers use Keynesian analysis to argue that higher or lower levels of government spending will stimulate or dampen economic growth.
The "Deficit Hawk" Argument. Another related policy issue is the role of budget deficits. Unlike Keynesians, who argue that budget deficits boost growth by injecting purchasing power into the economy, some economists argue that budget deficits are bad because they allegedly lead to higher interest rates. Since higher interest rates are believed to reduce investment, and because investment is necessary for long-run economic growth, proponents of this view (sometimes called "deficit hawks") assert that avoiding deficits should be the primary goal of fiscal policy.
While deficit hawks and Keynesians have very different views on budget deficits, neither school of thought focuses on the size of government. Keynesians are sometimes associated with bigger government but, as discussed above, have no theoretical objection to small government as long as it can be increased temporarily to jump-start a sluggish economy. By contrast, the deficit hawks are sometimes associated with smaller government but have no theoretical objection to large government as long as it is financed by Taxes rather than borrowing.
The deficit hawk approach to fiscal policy has always played a role in economic policy, but politics sometimes plays a role in its usage. During much of the post-World War II era, Republicans complained about deficits because they disapproved of the spending policies of the Democrats who controlled many of the levers of power. In more recent years, Democrats have complained about deficits because they disapprove of the tax policies of the Republicans who control many of the levers of power. Presumably, many people genuinely care about the impact of deficits, but politicians often use the issue as a proxy when fighting over tax and spending policies in Washington.
Economic theory is important in providing a framework for understanding how the world works, but evidence helps to determine which economic theory is most accurate. This section reviews global comparisons and academic research to ascertain whether government spending helps or hinders economic performance.
Worldwide Experience. Comparisons between countries help to illustrate the impact of public policy. One of the best indicators is the comparative performance of the United States and Europe. The "old Europe" countries that belong to the European Union tend to have much bigger governments than the United States. While there are a few exceptions, such as Ireland, many European governments have extremely large welfare states.
As Chart 1 illustrates, government spending consumes almost half of Europe's economic output-a full one-third higher than the burden of government in the U.S. Not surprisingly, a large government sector is associated with a higher tax burden and more government debt. Bigger government is also associated with sub-par economic performance. Among the more startling comparisons:
Blaming excessive spending for all of Europe's economic problems would be wrong. Many other policy variables affect economic performance. For instance, over-regulated labor markets probably contribute to the high unemployment rates in Europe. Anemic growth rates may be a consequence of high tax rates rather than government spending. Yet, even with these caveats, there is a correlation between bigger government and diminished economic performance.
The Academic Research. Even in the United States, there is good reason to believe that government is too large. Scholarly research indicates that America is on the downward sloping portion of the Rahn Curve -- as are most other industrialized nations. In other words, policymakers could enhance economic performance by reducing the size and scope of government. The supplement to this paper includes a comprehensive review of the academic literature and a discussion of some of the methodological issues and challenges. This section provides an excerpt of the literature review and summarizes the findings of some of the major economic studies.
The academic literature certainly 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 may depend on factors that can change over time.
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 help drive the results of various studies.
The effort is further complicated by the challenge of identifying the precise impact of government spending:
There are no "correct" answers to these questions, but the growing consensus in the academic literature is persuasive. Regardless of the methodology or model, government spending appears to be associated with weaker economic performance. For instance:
Both economic theory and empirical evidence suggest that government should be smaller. Yet is it possible to translate good economics into public policy? Even though many policymakers understand that government spending undermines economic performance, some think that special-interest groups are too politically powerful and that reducing the size of government is an impossible task. Since the burden of government has relentlessly increased during the post- World War II era, this is a reasonable assumption.
Moreover, there is a concern that the transition to smaller government may be economically harmful. In other words, the economy may be stronger in the long run if the burden of government is reduced, but the short-run consequences of spending reductions could make such a change untenable. This Keynesian analysis is much less prevalent today than it was 30 years ago, but it is still part of the debate.
There are examples of nations that have successfully reduced the burden of government during peacetime. They show that it is possible to reduce government spending-sometimes by dramatic amounts. In all of these examples, policymakers enjoyed political and economic success. For instance:
Reagan's track record on entitlements was also impressive. When he took office, entitlement spending was on a sharp upward trajectory, peaking at 11.6 percent of GDP in 1983. By the time he left office, entitlement spending consumed 9.8 percent of economic output.
As a result of these dramatic improvements, Reagan was able to reduce the total burden of government spending as a share of economic output during his presidency while still restoring the nation's military strength. Table 1 shows Reagan's impressive performance compared to other Presidents, measured by the real (inflation-adjusted) growth of federal spending.
These were modest reductions compared to Ronald Reagan, and many of them evaporated during Clinton's second term once a budget surplus materialized and undermined fiscal discipline. Nonetheless, when combined with reasonable economic growth and the "peace dividend" made possible by President Reagan's victory in the Cold War, the total burden of federal spending fell as low as 18.4 percent of GDP in 2000, the lowest level since 1966.
The reductions in government were especially impressive. A Joint Economic Committee report explained: "This situation was reversed during the 1987-96 period. As a share of GDP, government expenditures declined from the 52.3 percent level of 1986 to 37.7 percent in 1996, a reduction of 14.6 percentage points." As Chart 2 illustrates, Ireland has been able to keep government from creeping back in the wrong direction. Little wonder that a writer for the Financial Post wrote that "Ireland's biggest export was people until the country adopted enlightened trade, tax and education policies. Now it is the Celtic Tiger."
When we started this process with the Department of Trans-portation, it had 5,600 employees. When we finished, it had 53. When we started with the Forest Service, it had 17,000 employees. When we finished, it had 17. When we applied it to the Ministry of Works, it had 28,000 employees. I used to be Minister of Works, and ended up being the only employee.… We achieved an overall reduction of 66 percent in the size of government, measured by the number of employees.
It is especially amazing that New Zealand was able to accomplish so much is such a short period of time. In the first half of the 1990s, "Real spending per capita fell by 12 percent." This fiscal reform, combined with other free-market policies, helped New Zealand recover from economic stagnation.
Policymakers in the United States should seek to replicate these successes. A smaller government will lead to better economic performance, and it also is the only pro-growth way to deal with the politically sensitive issue of budget deficits.
Even a modest degree of discipline can quickly generate a balanced budget. As Chart 4 illustrates, a spending freeze balances the budget in two to three years, and limiting the growth of spending to the rate of Inflation balances the budget in four to five years. Even if spending is allowed to grow by 4 percent each year, the budget deficit quickly shrinks-even if the Bush tax cuts are made permanent.
The size of government has a major impact on economic performance, but it is just one of many important variables. The Index of Economic Freedom, published annually by The Heritage Foundation and The Wall Street Journal, thoroughly examines the factors that are correlated with prosperity, finding that the following policy choices also have important effects independent of the level of government spending:
These five factors are certainly not an exhaustive list. Other factors that determine a nation's economic performance include the level of corruption, openness of capital markets, competitiveness of financial system, and flexibility of prices. The 2005 Index of Economic Freedom contains a thorough analysis of the role of all these factors in promoting economic growth.
Government spending should be significantly reduced. It has grown far too quickly in recent years, and most of the new spending is for purposes other than homeland security and national defense. Combined with rising entitlement costs associated with the looming retirement of the baby-boom generation, America is heading in the wrong direction. To avoid becoming an uncompetitive European-style welfare state like France or Germany, the United States must adopt a responsible fiscal policy based on smaller government.
Budgetary restraint should be viewed as an opportunity to make an economic virtue out of fiscal necessity. Simply stated, most government spending has a negative economic impact. To be sure, if government spends money in a productive way that generates a sufficiently high rate of return, the economy will benefit, but this is the exception rather than the rule. If the rate of return is below that of the private sector-as is much more common-then the growth rate will be slower than it otherwise would have been. There is overwhelming evidence that government spending is too high and that America's economy could grow much faster if the burden of government was reduced.
The deficit is not the critical variable. The key is the size of government, not how it is financed. Taxes and deficits are both harmful, but the real problem is that government is taking money from the private sector and spending it in ways that are often counterproductive. The need to reduce spending would still exist-and be just as compelling-if the federal government had a budget surplus. Fiscal policy should focus on reducing the level of government spending, with particular emphasis on those programs that yield the lowest benefits and/or impose the highest costs.
Controlling federal spending is particularly important because of globalization. Today, it is becoming increasingly easy for jobs and capital to migrate from one nation to another. This means that the reward for good policy is greater than ever before, but it also means that the penalty for bad policy is greater than ever before.
This may be cause for optimism. A study published by the IMF, which certainly is not a free-market institution, has stated:
As the international economy becomes more competitive, and as capital and labor become more mobile, countries with big and especially inefficient governments risk falling behind in terms of growth and welfare. When voters and industries realize the long-term benefits of reform in such an environment, they and their representatives may push their governments toward reform. In these circumstances, policymakers find it easier to overcome the resistance of special-interest groups.
For most of America's history, the aggregate burden of government was below 10 percent of GDP. This level of government was consistent with the beliefs of the America's founders. As the IMF has explained, "classical economists and political philosophers generally advocated the minimal state-they saw the government's role as limited to national defense, police, and administration." America's policy of limited government certainly was conducive to economic expansion. In the days before income tax and excessive government, America moved from agricultural poverty to middle-class prosperity.
Reducing government to 10 percent of GDP might be a very optimistic target, but shrinking the size of government should be a major goal for policymakers. The economy certainly would perform better, and this would boost prosperity and make America more competitive.
Daniel J. Mitchell, Ph.D. , is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
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Spending reductions following a war are quite common but tend not to be very instructive since government is almost always bigger after a war than it was before hostilities began.
Office of Management and Budget, Budget of the United States Government, Fiscal Year 2005: Historical Tables (Washington, D.C.: U.S. Government Printing Office, 2004), p. 128, Table 8.4, at www.gpoaccess.gov/usbudget/fy05/pdf/hist.pdf (February 2, 2005).
 Ibid., p. 23, Table 1.2.
Benjamin Powell, "Markets Created a Pot of Gold in Ireland," Cato Institute Daily Commentary, April 21, 2003, at www.cato.org/dailys/04-21-03.html (February 2, 2005). This article was previously published by Fox News on April 15, 2003.
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See U.S. Department of Commerce, Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970 (Washington, D.C.: U.S. Government Printing Office, 1975).
Tanzi and Shuknecht, "Reforming Government in Industrial Countries."