When Ronald Reagan said that big government undermined the economy, some people dismissed his comments because of his philosophical belief in liberty.
And when I discuss my work on the economic impact of government spending, I often get the same reaction.
This is why it’s important that a growing number of establishment outfits are slowly but surely coming around to the same point of view.
- The European Central Bank published a study showing “…a significant negative effect of the size of government on growth.”
- A study by two Harvard economists found that “large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions.”
- The Organization for Economic Cooperation and Development noted in recent research that welfare programs are economically destructive because they lure people into dependency because “net disposable income would increase despite putting in fewer hours.”
- A study from the International Monetary Fund concluded that “Cuts to pension and health entitlements had the most beneficial effect on economic growth.”
This is remarkable. It’s beginning to look like the entire world has figured out that there’s an inverse relationship between big government and economic performance.
That’s an exaggeration, of course. There are still holdouts pushing for more statism in Pyongyang, Paris, Havana, and parts of Washington, DC.
But maybe they’ll be convinced by new research from the World Bank, which just produced a major report on the outlook for Europe. In chapter 7, the authors explain some of the ways that big government can undermine prosperity.
There are good reasons to suspect that big government is bad for growth. Taxation is perhaps the most obvious (Bergh and Henrekson 2010). Governments have to tax the private sector in order to spend, but taxes distort the allocation of resources in the economy. Producers and consumers change their behavior to reduce their tax payments. Hence certain activities that would have taken place without taxes, do not. Workers may work fewer hours, moderate their career plans, or show less interest in acquiring new skills. Enterprises may scale down production, reduce investments, or turn down opportunities to innovate. …Over time, big governments can also create sclerotic bureaucracies that crowd out private sector employment and lead to a dependency on public transfers and public wages. The larger the group of people reliant on public wages or benefits, the stronger the political demand for public programs and the higher the excess burden of taxes. Slowing the economy, such a trend could increase the share of the population relying on government transfers, leading to a vicious cycle (Alesina and Wacziarg 1998). Large public administrations can also give rise to organized interest groups keener on exploiting their powers for their own benefit rather than facilitating a prosperous private sector (Olson 1982).
In other words, government spending undermines growth, and the damage is magnified by poorly designed tax policies.
The authors then put forth a theoretical hypothesis.
…economic models argue that the excess burden of tax increases disproportionately with the tax rate—in fact, roughly proportional to its tax rate squared (Auerbach 1985). Likewise, the scope for self-interested bureaucracies becomes larger as the government channels more resources. At the same time, the core functions of government, such as enforcing property rights, rule of law and economic openness, can be accomplished by small governments. All this suggests that as government gets bigger, it becomes more likely that the negative impact of government might dominate its positive impact. Ultimately, this issue has to be settled empirically. So what do the data say?
These are important insights, showing that class-warfare tax increases are especially destructive and that government spending undermines growth unless the public sector is limited to core functions.
Then the authors report their results.
Figure 7.9 groups annual observations in four categories according to the share of government spending in GDP during that year. Both samples show a negative relationship between government size and growth, though the reduction in growth as government becomes bigger is far more pronounced in Europe, particularly when government size exceeds 40 percent of GDP. …we provide new econometric evidence on the impact of government size on growth using a panel of advanced and emerging economies since 1995. As estimates can be biased due to problems of omitted variables, endogeneity, or measurement errors, it is necessary to rely on a broad range of estimators. …They suggest that a 10 percentage point increase in initial government spending as a share of GDP in Europe is associated with a reduction in annual real per capita GDP growth of around 0.6–0.9 percentage points a year (table A7.2). The estimates are roughly in line with those from panel regressions on advanced economies in the EU15 and OECD countries for periods from 1960 or 1970 to 1995 or 2005 (Bergh and Henrekson 2010 and 2011).
These results aren’t good news for Europe, but they also are a warning sign for the United States. The burden of government spending has jumped by about 8-percentage points of GDP since Bill Clinton left office, so this could be the explanation for why growth in America is so sluggish.
Last but not least, they report that social welfare spending does the most damage.
Governments are big in Europe mainly due to high social transfers, and big governments are a drag on growth. The question is whether this is because of high social transfers? The answer seems to be that it is. The regression results for Europe, using the same approach as outlined earlier, show a consistently negative effect of social transfers on growth, even though the coefficients vary in size and significance (table A7.4). The result is confirmed through BACE regressions. High social transfers might well be the negative link from government size to growth in Europe.
The last point in this passage needs to be emphasized. It is redistribution spending that does the greatest damage. In other words, it’s almost as if Obama (and his counterparts in places such as France and Greece) are trying to do the greatest possible damage to the economy.
In reality, of course, these politicians are simply trying to buy votes. But they need to understand that this shallow behavior imposes very high costs in terms of foregone growth.
To elaborate, this video discusses the Rahn Curve, which augments the data in the World Bank study.
As I argue in the video, even though most of the research shows that economic growth is maximized when government spending is about 20 percent of GDP, I think the real answer is that prosperity is maximized when the public sector consumes less than 10 percent of GDP.
But since government in the United States is now consuming more than 40 percent of GDP (about as much as Spain!), the first priority is to figure out some way of moving back in the right direction by restraining government so it grows slower than the private sector.
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[…] You don’t have to take my word for it. Even research from establishment organizations like the European Central Bank find that smaller governments are more efficient. And the normally left-leaning World Bank even acknowledged that the evidence is strong about bigger governments harming growth. […]
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[…] off” the masses. They’ll privately admit the policies are destructive (both to the economy and to poor people), but they think there’s no […]
[…] such as the Organization for Economic Cooperation and Development, International Monetary Fund, World Bank, and European Central Bank. And since most of those organizations lean to the left, these results […]
[…] I’ve posted hundreds of charts over the past several years, including on favorite topics such as tax code corruption and counterproductive government spending. […]
[…] I’ve posted hundreds of charts over the past several years, including on favorite topics such as tax code corruption and counterproductive government spending. […]
[…] I’ve posted hundreds of charts over the past several years, including on favorite topics such as tax code corruption and counterproductive government spending. […]
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[…] Regular readers know that I get very excited when I see signs that more and more people are realizing that the real fiscal problem is big government. Even if the sound analysis comes from foreigners or international bureaucracies. […]
[…] such as the Organization for Economic Cooperation and Development, International Monetary Fund, World Bank, and European Central Bank. And since most of those organizations lean to the left, these results […]
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[…] Regular readers know that I get very excited when I see signs that more and more people are realizing that the real fiscal problem is big government. Even if the sound analysis comes from foreigners or international bureaucracies. […]
[…] is too big in Europe, I invite you to peruse this research from the European Central Bank, World Bank, and National Bank of […]
[…] Regular readers know that I get very excited when I see signs that more and more people are realizing that the real fiscal problem is big government. Even if the sound analysis comes from foreigners or international bureaucracies. […]
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[…] that government spending, in general, undermines prosperity. Hold on, the European Central Bank and World Bank already have produced such research. And the Organization for Economic Cooperation and Development […]
[…] that government spending, in general, undermines prosperity. Hold on, the European Central Bank and World Bank already have produced such research. And the Organization for Economic Cooperation and Development […]
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[…] Regular readers know that I get very excited when I see signs that more and more people are realizing that the real fiscal problem is big government. Even if the sound analysis comes from foreigners or international bureaucracies. […]
[…] not claiming, by the way, that the VAT is the only reason why the burden of government spending expanded in Europe. The Europeans also impose harsher payroll taxes and higher energy taxes. And their income taxes […]
[…] not claiming, by the way, that the VAT is the only reason why the burden of government spending expanded in Europe. The Europeans also impose harsher payroll taxes and higher energy taxes. And their income taxes […]
[…] Regular readers know that I get very excited when I see signs that more and more people are realizing that the real fiscal problem is big government. Even if the sound analysis comes from foreigners or international bureaucracies. […]
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[…] Second, I’ll offer a prediction that’s about as controversial as asserting that the sun will rise in the east and set in the west. I predict that government will get even bigger over the next four years, which will mean more corruption and weaker economic performance. […]
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“…leading to a vicious cycle.”
That is the key. The elephant of decline in the room.
“dabbling in a little more redistribution, a little more along the European model, will not hurt production much” thinks the naive American…
“Besides, if we make a mistake, we can always reverse course. An irreversible catch22 of dependence will not happen here. American continued success is preordained by ethereal forces bordering on the divine — even if we copy Europe.”
In such thoughts, Americans are proving their world renowned naïveté
This is where your intellectual talents should be.