The Economic Impact of Government Spending INESS, April 2012

What is the Goal of Economic Policy? To create conditions that encourage people to create wealth and improve their living standards. To create a large tax base so that the legitimate functions of government can be financed at low tax rates. To preserve and enhance liberty so people can enjoy freedom.

Growth is the Best Option You cant redistribute without first producing. It is better to be a poor person in a rich nation than a middle-income person in a poor nation. Rich nations can afford redistribution, and the accompanying tepid growth. Poor nations will never become rich if they adopt welfare state policies.

Two Major Issues What is the appropriate role of government? The classical liberal vision of small government. Or the welfare state vision of large government. How should government be financed? Broad-base and low- rate system designed to minimize distortions. Or a tax code as a tool of social policy.

The Economics of Spending How does government spending impact growth? Wagners Law and the Rahn Curve The problem is spending, not deficits Keynesian theory Can spending be restrained? A Greek future

Government Spending and Growth 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. Some government spending is necessary to uphold the rule of law. Government spending reduces growth, however, when the public sector becomes too large, leading to punitive tax rates and misallocation of labor and capital.

How Government Can Hurt Growth The Extraction Cost: The federal government cannot spend money without first taking that money from someone else. All of the options used to finance government spending have adverse consequences. The Displacement Cost: Government Spending Displaces Private Sector Activity. Every dollar that the government spends necessarily means that there is one less dollar in the productive sector of the economy.

How Government Can Hurt Growth The Negative Multiplier Cost: Government Spending Finances Harmful Intervention. Many regulatory agencies have relatively small budgets, but they impose large costs on the economys productive sector. The Behavioral Subsidy Cost: Many government programs subsidize economically undesirable decisions. Welfare programs encourage people to choose leisure over work. Unemployment insurance programs provide an incentive to stay unemployed.

How Government Can Hurt Growth The Behavioral Penalty Cost: Government programs discourage economically desirable decisions. The incentive to save has been undermined by government programs that subsidize retirement, housing, and education. The Market Distortion Cost: Government programs interfere with competitive markets. In both health care and education, government efforts to reduce out-of-pocket expenses have resulted in higher prices because of third-party payer issue.

How Government Can Hurt Growth The Inefficiency Cost: Government Spending is a Less Effective Way of Delivering Services. A voucher system would yield better education for less money. Privatized airports and postal service would be more efficient. The Inertia Cost: Government programs inhibit innovation. Lacking a profit motive, bureaucracies do not seek better ways of achieving goals. This can create huge costs, as demonstrated by Americas old welfare system.

Big Government Inevitably…

…Erodes a Nations Social Capital

The Right Size of Government There are certain core functions of government - including national defense, legal system, and public safety. The more governments stray from these core functions, the less likely they are to be competent in any area. The more governments stray from these core functions, the higher the tax burden. This means less growth.

The Rahn Curve There is a Rahn Curve relationship between government spending and economic growth similar to the Laffer Curve relationship between tax rates and tax revenue.

Empirical Estimates of the Rahn Curve Academic studies generally find that the growth-maximizing level of government is 17 percent-23 percent, though a European Central Bank study put the figure as high as 30 percent. Every single western nation spends above the growth-maximizing level in these studies. Because of data limitations, the actual growth-maximizing level of spending presumably is lower than shown in the studies.

What About Wealthy Welfare States? Dont Europes welfare states show that big government is not an impediment to growth? No. They became rich because they used to have small public sectors and laissez-faire policy (indeed, still have laissez-faire policy). Government expanded after they became wealthy and could afford anti-growth policies. A nation (or state) can tolerate one percent growth once it is rich. But a poor nation (or state) will never become rich with one percent growth.

Burden of Government Used to be Small

Deficits and Debt Are Symptoms Red ink is not the most important fiscal policy variable. Too much spending is the disease and high taxes and excessive borrowing are both symptoms. Deficits dont stimulate an economy and in normal situations they dont threaten an economy. A balanced budget is prudent for moral reasons.

Return of the Keynesian Rationale Government usually expands because of public choice as politicians buy votes. Today, politicians are trying to make a virtue out of depravity, asserting that government spending is the only way to save the economy. Demoralized Republicans were not offering an alternative, allowing Obama to claim that everyone agreed.

Keynesianism vs. the Real World Deficit spending did not work for Hoover and Roosevelt. So-called stimulus did not work for Ford and Bush. Keynesianism failed in Japan during the 1990s. Obamas faux stimulus was a flop. Keynesians have theoretical models but are unable to provide any academic evidence.

The Long-Run Fiscal Outlook Ageing populations and welfare states are an unstable combination. Pay-as-you-go systems are Ponzi schemes. Not enough future workers to support redistribution programs. Without reform, massive debt or massive tax increases. Probably both

Two Workers per Retiree

The Sovereign Debt Crisis Greece is the tip of the iceberg Ireland was phase two. Spain and Portugal phase three. Italy and Belgium phase four. Japan in a special category. Almost all other industrialized nations are on this path. Rare exceptions such as Australia, perhaps Switzerland and even Sweden.

Where Is the Debt Tipping Point? Rogoff and Reinhart say 90 percent of GDP is the danger zone. Depends on the nation. Industrialized world has breathing room. Greece got in trouble over 100 percent. Japan still doing fine at 200 percent. Spain and Portugal in trouble at less than 90 percent.

France – 400 Percent of GDP

Germany – 300-plus Percent of GDP

Greece – 400 Percent of GDP

Ireland – 300 Percent of GDP

Italy – 250 Percent of GDP

Netherlands – 400 Percent of GDP

Japan – 600 Percent of GDP

Portugal – 300 Percent of GDP

Spain – 300 Percent of GDP

U.K. – 500-plus Percent of GDP

U.S. – 450 Percent of GDP

A Closer Look at the U.S. During the Bush-Obama years, the burden of federal spending has jumped from 18 pct of GDP to more than 24 pct of GDP. Two new health entitlements have been created. More centralization of education and other activities. Perhaps most worrisome, an erosion of social capital as dependency increases.

Source: Office of Management and Budget

The Calm Before the Storm Because of Social Security, Medicare, and Medicaid, federal spending is projected to jump from about 24 percent-plus of GDP today to 45 percent-67 percent of GDP after the baby boom generation is fully retired. State and local governments will consume – at a minimum – another 15 percent of GDP. Americas welfare state will be bigger than what France has today.

Source: Congressional Budget Office

Americas Dismal Future If the projections become reality, America will become France. Instead of growing 2.5 percent-3.0 percent each year in real terms, we will grow 1.0 percent-1.5 percent, a difference that has enormous long-run implications. Per capita GDP will 30 percent-40 percent below what it otherwise would be. An unemployment rate of less than 8.0 percent will be considered a cause for celebration.

Curtailing the Welfare State Public Choice makes spending restraint a political challenge. At a minimum, spending should grow slower than GDP, causing the burden of government to fall over time. This happened during the Reagan years and Clinton years. Some nations have been successful with dramatic spending restraint.

Other Nations Have Reformed Good fiscal policy does not require miracles, just spending restraint. If spending grows slower than nominal GDP, good things happen – the Golden Rule. Greater levels of fiscal restraint mean quicker progress. If spending grows faster than nominal GDP, sooner or later a nation becomes Greece. But sometimes nations do the right thing.

U.S. Success Stories The combination of Bill Clinton and the 1994 Congress resulted in a 4-year period where annual spending increased only 2.9 percent. Ronald Reagan reduced domestic spending (including entitlements) from 15.7 percent of GDP down to 13.2 percent of GDP. In the good ol days, fiscal policy was never a problem since the federal government averaged only 3 percent of GDP.

How Do We Get There? Three challenges Correctly identifying the problem – big government is the disease. Deficits and debt are symptoms. Figuring out ways to bend the cost curve of government spending. Convincing the people that liberty is better than dependency.

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