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Executive Summary #1979 on Federal Budget

October 25, 2006

Executive Summary: Fiscal Policy Lessons from Europe

By

The federal government spends an enormous amount of money. Measured as a share of national economic output, budgetary outlays are near a peacetime high, consuming almost 21 percent of gross domestic product (GDP). Whether it is mea­sured in nominal dollars, in inflation-adjusted (real) dollars, or on a per household basis, federal spending in America is at record levels.

Moreover, this is just the calm before the storm. Left on autopilot, the burden of federal spending will increase dramatically because of both demo­graphic forces and reckless policy choices, such as the creation of a new prescription drug entitle­ment. In a worst-case scenario, the Congressional Budget Office (CBO) estimates that government outlays could consume as much as 55.8 percent of GDP by 2050. Even a more optimistic scenario shows that the burden of federal spending will still nearly double, climbing to more than 37 per­cent of GDP.

Cautionary Lessons from Europe

Many European nations have already allowed the burden of government to climb to these levels. Government spending consumes more than 50 percent of GDP in France and Sweden and more than 45 percent in Germany and Italy. These nations provide useful lessons about the economic consequences of bigger government, and these les­sons suggest strongly that America is on the wrong track. Even a cursory review of European economic performance shows that excessive government has serious adverse effects: slower growth, higher unemployment, lower living standards, and a bleak future. For instance:

Per capita economic output in the U.S. in 2003 was $39,700, almost 40 percent higher than the $28,700 average for EU-15 nations.

Over the past 10 years, the U.S. economy has grown at an average annual rate of 3.3 percent in real terms, 50 percent faster than the EU-15's growth rate of 2.2 percent.

A comparative study by Timbro, a Swedish think tank, found that European Union countries would rank with the very poorest American states in terms of living standards, roughly equal to Arkansas and Montana and only slightly ahead of West Virginia and Mississippi, the two poorest states.

In August 2006, unemployment in the European Union was 8.0 percent, including a 7.9 percent unemployment rate in the group of nations that use the euro. The U.S. unemployment rate in the same month was only 4.7 percent.

A study by Eurochambres estimated how long it would take Europe to catch up to America, assuming no more growth in the U.S. It would take Europe 18 years to reach U.S. income lev­els, 14 years to reach U.S. levels of productivity per employee, 24 years to reach U.S. levels of research and development investment, and 26 years to reach U.S. employment levels.

In 1980, foreign direct investment in the United States totaled $127 billion, according to the Bureau of Economic Analysis. Today, it totals more than $1.7 trillion. In 1980, there was $90 billion of foreign portfolio investment (just counting holdings of government and pri­vate securities) in the United States. Today, there is more than $4.6 trillion. Much of that money-capital that finances new invest­ment-comes from Europe and at least partly reflects the more market-oriented policy envi­ronment in the United States.

Americans enjoy more leisure than Europeans because they can afford to purchase labor and goods that reduce the amount of time spent working at home. According to one German study, "overall working time is very similar on both sides of the Atlantic. Americans spend more time on market work but Germans invest more in household production." The report further notes that "these differences in the allo­cation of time can be explained by differences in the tax-wedge and wage differentials."

A special competitiveness panel of the Euro­pean Commission acknowledged that "many young scientists continue to leave Europe on graduating, notably for the U.S. Too few of the brightest and best from elsewhere in the world choose to live and work in Europe."

Conclusion

One of the most important lessons to be learned is that GDP is linked to policy. For instance, the CBO's long-run forecasts assume that inflation-adjusted GDP will grow by about 2 percent annu­ally, regardless of whether government consumes 21 percent of economic output or 56 percent of economic output. The dismal performance of the European economies shows that this is a deeply flawed assumption and indicates that America's future is at even greater risk than the CBO estimates suggest.

If the United States is saddled with a French-sized government, it will inevitably suffer from French-style economic stagnation. This means higher un­employment, lower living standards, and a loss of upward mobility. The economic malaise in Europe is tragic, but the dark cloud could have a silver lining if policymakers learn the right lesson and protect Americans from that fate by reducing the burden of government-both today and in the future.

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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