Feeds:
Posts
Comments

Archive for the ‘Rahn Curve’ Category

What’s the relationship between the Rahn Curve and the Laffer Curve?

For the uninitiated, the Rahn Curve is the common-sense notion that some government is helpful for prosperous markets but too much government is harmful to economic performance.

Even libertarians, for instance, will acknowledge that spending on core “public goods” such as police protection and courts (assuming, of course, low levels of corruption) can enable the smooth functioning of markets.

Some even argue that government spending on human capital and physical capital can facilitate economic activity. For what it’s worth, I think that the government’s track record in those areas leaves a lot to be desired, so I’d prefer to give the private sector a greater role in areas such as education and highways.

The big problem, though, is that most government spending is for programs that are often categorized as “transfers” and “consumption.” And these are outlays that clearly are associated with weaker economic performance.

This is why small-government economies such as Hong Kong and Singapore tend to grow faster than the medium-government economies such as the United States and Australia. And it also explains why growth is even slower is big-government economies such as France and Italy.

The Laffer Curve, for those who don’t remember, is the common-sense depiction of the relationship between tax rates and tax revenue.

The essential insight is that taxable income is not fixed (regardless of the Joint Committee on Taxation’s flawed methodology).

When tax rates are low, people will earn and report lots of income, but when tax rates are high, taxpayers figure out ways of reducing the amount of taxable income they earn and report to government.

This is why, for instance, the rich paid much more to the IRS after Reagan lower the top tax rate from 70 percent to 28 percent.

So why am I giving a refresher course on the Rahn Curve and Laffer Curve?

Because I’ve been asked on many occasions whether there is a relationship between the two concepts and I’ve never had a good answer.

But I’m happy to call attention to the good work of other folks, so here’s a very well done depiction of the relationship between the two curves (though in this case the Rahn Curve is called the Armey Curve).

I should hasten to add, by the way, that I don’t agree with the specific numbers.

I think the revenue-maximizing rate is well below 45 percent and I think the growth-maximizing rate is well below 30 percent.

But the image above is spot on in that it shows that a nation should not be at the revenue-maximizing point of the Laffer Curve.

Since I’m obviously a big fan of the Rahn Curve and I also like drawing lessons from cross-country comparisons, here’s a video on that topic from the Center for Freedom and Prosperity.

Well done, though I might quibble on two points, though the first is just the meaningless observation that the male boxer is not 6′-6″ and 250 lbs.

My real complaint (and this will sound familiar) is that I’m uneasy with the implication around the 1:45 mark that growth is maximized when government spending consumes 25 percent of economic output.

This implies, for instance, that government in the United States was far too small in the 1800s and early 1900s when the overall burden of government spending was about 10 percent of GDP.

But I suppose I’m being pedantic. Outlays at the national, state, and local level in America now consume more than 38 percent of economic output according to the IMF and we’re heading in the wrong direction because of demographic changes and poorly designed entitlement programs.

So if we can stop government from getting bigger and instead bring it back down to 25 percent of GDP, even I will admit that’s a huge accomplishment.

Libertarian Nirvana would be nice, but I’m more concerned at this point about simply saving the nation from becoming Greece.

P.S. I’ve shared numerous columns from Walter Williams and he is one of America’s best advocates of individual liberty and economic freedom.

Now there’s a documentary celebrating his life and accomplishments. Here’s a video preview.

Given Walter’s accomplishments, you won’t be surprised to learn that there’s another video documentary about his life.

Read Full Post »

I’ve shared lots of data and evidence about the harmful economic impact of government spending.

Simply stated, budgetary outlays divert resources from more productive uses. And this results in labor and capital being misallocated, leading to less economic output.

The damage is even more pronounced when you look at how politicians finance the budget. Whether they use taxes or borrowing (or even printing money), there are additional distortions that hinder the private sector.

Today, we’re going to look at the economic impact of a particular type of government spending. A new working paper by two academics at the University of Miami has revealed a negative relationship between government consumption spending and economic growth.

But before digging into the details, what do public finance economists mean when they talk about “consumption spending”? At the risk of over-simplifying, it’s the part of the budget used to purchase goods and services. Everything from soldiers to housing and from jails to education.

It’s basically the so-called discretionary portion of the federal budget, minus “investment spending” (which would be things like roads).

Anyhow, here are some of the key findings.

This paper tests the Mundellian hypothesis that too much government spending reduces economic growth… In this paper, we analyze annual panel data from 1999 to 2011 for 31 OECD countries to examine the role of government spending in determining economic growth. In particular, we will focus our attention on government consumption spending on non-market goods such as defense and justice for collective consumption and its effect on growth in real GDP growth. …We find that government consumption spending on non-market goods signifi cantly reduces economic growth. A one percentage point increase in government consumption of non-market goods as a percent of GDP is associated with a 0.86 percentage lower growth rate in GDP. …This result is compatible with Barro (1990)’s fi nding for the Summers and Heston database, but suggests a stronger negative eff ect of government consumption on economic growth.

That’s a big number, which implies that we’re definitely on the downward-sloping portion of the Rahn Curve.

By the way, just in case you’re wondering why Obama’s “stimulus” was such a flop, the study also notes that “the 2009 American Reinvestment and Recovery Act envisaged less than 5% spending on public investment, and over 95% on consumption.”

In other words, Obama increased the type of government spending with the worst impact on the economy. Something to keep in mind when politicians, lobbyists, interest groups, and other insiders argue that there’s no need to cut back on discretionary spending.

But it’s also important to note that the study has some findings that may distress libertarians and small-government conservatives. It finds, for instance, that “government investment spending is positively related to growth.”

Also, it’s important to realize that the study is limited to only certain forms of discretionary spending. As the authors explain, they examine, “the impact of government consumption spending net of health, education and housing service.”

But even with those caveats, we have another strong piece of evidence that our economy would grow much faster if we reduced the burden of government spending.

And if you need more evidence on the harmful effect of government spending (either generally or specific types of outlays), allow me to call your attention to research even from normally left-leaning international bureaucracies such as the Organization for Economic Cooperation and Development, International Monetary Fund, World Bank, and European Central Bank.

And you can find similar findings in the work of scholars from all over the world, including the United States, Finland, Australia, Sweden, Italy, Portugal, and the United Kingdom.

Read Full Post »

There’s an old saying that there’s no such thing as bad publicity.

That may be true if you’re in Hollywood and visibility is a key to long-run earnings.

But in the world of public policy, you don’t want to be a punching bag. And that describes my role in a book excerpt just published by Salon.

Jordan Ellenberg, a mathematics professor at the University of Wisconsin, has decided that I’m a “linear” thinker.

Here are some excerpts from the article, starting with his perception of my view on the appropriate size of government, presumably culled from this blog post.

Daniel J. Mitchell of the libertarian Cato Institute posted a blog entry with the provocative title: “Why Is Obama Trying to Make America More Like Sweden when Swedes Are Trying to Be Less Like Sweden?” Good question! When you put it that way, it does seem pretty perverse.  …Here’s what the world looks like to the Cato Institute… Don’t worry about exactly how we’re quantifying these things. The point is just this: according to the chart, the more Swedish you are, the worse off your country is. The Swedes, no fools, have figured this out and are launching their northwestward climb toward free-market prosperity.

I confess that he presents a clever and amusing caricature of my views.

My ideal world of small government and free markets would be a Libertopia, whereas total statism could be characterized as the Black Pit of Socialism.

But Ellenberg’s goal isn’t to merely describe my philosophical yearnings and policy positions. He wants to discredit my viewpoint.

So he suggests an alternative way of looking at the world.

Let me draw the same picture from the point of view of people whose economic views are closer to President Obama’s… This picture gives very different advice about how Swedish we should be. Where do we find peak prosperity? At a point more Swedish than America, but less Swedish than Sweden. If this picture is right, it makes perfect sense for Obama to beef up our welfare state while the Swedes trim theirs down.

He elaborates, emphasizing the importance of nonlinear thinking.

The difference between the two pictures is the difference between linearity and nonlinearity… The Cato curve is a line; the non-Cato curve, the one with the hump in the middle, is not. …thinking nonlinearly is crucial, because not all curves are lines. A moment of reflection will tell you that the real curves of economics look like the second picture, not the first. They’re nonlinear. Mitchell’s reasoning is an example of false linearity—he’s assuming, without coming right out and saying so, that the course of prosperity is described by the line segment in the first picture, in which case Sweden stripping down its social infrastructure means we should do the same. …you know the linear picture is wrong. Some principle more complicated than “More government bad, less government good” is in effect. …Nonlinear thinking means which way you should go depends on where you already are.

Ellenberg then points out, citing the Laffer Curve, that “the folks at Cato used to understand” the importance of nonlinear analysis.

The irony is that economic conservatives like the folks at Cato used to understand this better than anybody. That second picture I drew up there? …I am not the first person to draw it. It’s called the Laffer curve, and it’s played a central role in Republican economics for almost forty years… if the government vacuums up every cent of the wage you’re paid to show up and teach school, or sell hardware, or middle-manage, why bother doing it? Over on the right edge of the graph, people don’t work at all. Or, if they work, they do so in informal economic niches where the tax collector’s hand can’t reach. The government’s revenue is zero… the curve recording the relationship between tax rate and government revenue cannot be a straight line.

So what’s the bottom line? Am I a linear buffoon, as Ellenberg suggests?

Well, it’s possible I’m a buffoon in some regards, but it’s not correct to pigeonhole me as a simple-minded linear thinker. At least not if the debate is about the proper size of government.

I make this self-serving claim for the simple reason that I’m a big proponents of the Rahn Curve, which is …drum roll please… a nonlinear way of looking at the relationship between the size of government and economic performance. And just in case you think I’m prevaricating, here’s a depiction of the Rahn Curve that was excerpted from my video on that specific topic.

Moreover, if you click on Rahn Curve category of my blog, you’ll find about 20 posts on the topic. And if you type “Rahn Curve” in the search box, you’ll find about twice as many mentions.

So why didn’t Ellenberg notice any of this research?

Beats the heck out of me. Perhaps he made a linear assumption about a supposed lack of nonlinear thinking among libertarians.

In any event, here’s my video on the Rahn Curve so you can judge for yourself.

And if you want information on the topic, here’s a video from Canada and here’s a video from the United Kingdom.

P.S. I would argue that both the United States and Sweden are on the downward-sloping portion of the Rahn Curve, which is sort of what Ellenberg displays on his first graph. Had he been more thorough in his research, though, he would have discovered that I think growth is maximized when the public sector consumes about 10 percent of GDP.

P.P.S. Ellenberg’s second chart puts the U.S. and Sweden at the same level of prosperity. Indeed, it looks like Sweden is a bit higher. That’s certainly not what we see in the international data on living standards. Moreover, Ellenberg may want to apply some nonlinear thinking to the data showing that Swedes in America earn a lot more than Swedes still living in Sweden.

Read Full Post »

Last month, I shared a very interesting video from Canada’s Fraser Institute that explored the link between economic performance and the burden of government spending.

There’s now an article in the American Enterprise Institute’s online magazine about this research.

The first half of the article unveils the overall findings, explaining that there is a growth-maximizing size of government (which, when put onto a graph, is shaped like a hump, sort of a spending version of the Laffer Curve).

One recent addition to the mounting evidence against large government is a study published by Canada’s Fraser Institute, entitled “Measuring Government in the 21st Century,” by Canadian economist and university professor Livio Di Matteo. Di Matteo’s analysis confirms other work showing a positive return to economic growth and social progress when governments focus their spending on basic, needed services like the protection of property. But his findings also demonstrate that a tipping point exists at which more government hinders economic growth and fails to contribute to social progress in a meaningful way. …Government spending becomes unproductive when it goes to such things as corporate subsidies, boondoggles, and overly generous wages and benefits for government employees. …Di Matteo examines international data and finds that, after controlling for confounding factors, annual per capita GDP growth is maximized when government spending consumes 26 percent of the economy. Economic growth rates start to decline when relative government spending exceeds this level.

This is standard Rahn Curve analysis and it shows that the public sector is far too large in almost all industrialized nations.

And if you happen to think that 26 percent overstates the growth-maximizing size of government (as I argued last month), then it’s even more apparent that significant fiscal restraint would be desirable.

But I’m more interested today in the specific topic of Canada and the Rahn Curve. The article has some very interesting data.

For a real-life example of how scaling back government has led to positive and practical economic benefits, Americans should look north. …total government spending as a share of GDP went from 36 percent in 1970 (just over 2 percentage points higher than in the United States) to 53 percent when it peaked in 1992 (14 percentage points higher than in the United States). Spending Canada v US…the federal and many provincial governments took sweeping action to cut spending and reform programs. This led to a major structural change in the government’s involvement in the Canadian economy. The Canadian reforms produced considerable fiscal savings, reduced the size and scope of government, created room for important tax reforms, and ultimately helped usher in a period of sustained economic growth and job creation. This final point is worth emphasizing: Canada’s total government spending as a share of GDP fell from a peak of 53 percent in 1992 to 39 percent in 2007, and despite this more than one-quarter decline in the size of government, the economy grew, the job market expanded, and poverty rates fell dramatically.

Simply stated, none of this should be a surprise.

The Canadian economy had the breathing room to expand when the burden of spending was reduced. Why? Because more labor and capital were available to be allocated by market forces.

This is one of the reasons why Canada now ranks higher than the United States in both Economic Freedom of the World and the Index of Economic Freedom.

And it’s also worth noting that spending restraint has facilitated significant tax cuts in Canada. Indeed, some American companies are moving north of the border!

Here’s my video that includes a discussion of Canada’s dramatically successful period of spending restraint in the 1990s.

P.S. You won’t be surprised to learn that Paul Krugman would rather misrepresent supposed austerity in the United Kingdom rather than address the real success story of Canada.

P.P.S. More generally, I’ve challenged all Keynesians to explain why Canada’s economy enjoyed good growth when there was genuine spending restraint.

P.P.P.S. While I’m a big fan of Canada, I’m not fully confident about the nation’s long-term outlook.

Read Full Post »

I feel a bit like Goldilocks.

No, this is not a confession about cross-dressing or being transsexual. I’m the boring kind of libertarian.

Instead, I have a run-of-the-mill analogy. Think about when you were a kid and your parents told you the story of Goldilocks and the Three Bears.

You may remember that she entered the house and tasted bowls of porridge that were too hot and also too cold before she found the porridge that was just right.

And then she found a bed that was too hard, and then another that was too soft, before finding one that was just right.

Well, the reason I feel like Goldilocks is because I’ve shared some “Rahn Curve” research suggesting that growth is maximized when total government spending consumes no more than 20 percent of gross domestic product. I think this sounds reasonable, but Canadians apparently have a different perspective.

Back in 2010, a Canadian libertarian put together a video that explicitly argues that I want a government that is too big.

Now we have another video from Canada. It was put together by the Fraser Institute, and it suggests that the public sector should consume 30 percent of GDP, which means that I want a government that is too small.

My knee-jerk reaction is to be critical of the Fraser video. After all, there are examples – both current and historical – of nations that prosper with much lower burdens of government spending

Singapore and Hong Kong, for instance, have public sectors today that consume less than 20 percent of economic output. Would those fast-growing jurisdictions be more prosperous if the burden of government spending was increased by more than 50 percent?

Or look at Canadian history. As recently as 1920, government outlays were 16.7 percent of economic output. Would Canada have grown faster if lawmakers at the time had almost doubled the size of government?

And what about nations such as the United States, Germany, France, Japan, Sweden, and the United Kingdom, all of which had government budgets in 1870 that consumed only about 10 percent of GDP. Would those nations have been better off if the burden of government spending was tripled?

I think the answer to all three questions is no. So why, then, did the Fraser Institute conclude that government should be bigger?

There are three very reasonable responses to that question. First, the 30 percent number is actually a measurement of where you theoretically maximize “social progress” or “societal outcomes.” If you peruse the excellent study that accompanies the video, you’ll find that economic growth is most rapid when government consumes 26 percent of GDP.

Second, the Fraser research – practically speaking – is arguing for smaller government, at least when looking at the current size of the public sector in Canada, the United States, and Western Europe. According to International Monetary Fund data, government spending consumes 41 percent of GDP in Canada, 39 percent of GDP in the United States, and 55 percent of GDP in France.

The Fraser Institute research even suggests that there should be significantly less government spending in both Switzerland and Australia, where outlays total “only” 34 percent of GDP.

Third, you’ll see if you read the underlying study that the author is simply following the data. But he also acknowledges “a limitation of the data,” which is that the numbers needed for his statistical analysis are only available for OECD nations, and only beginning in 1960.

This is a very reasonable point, and one that I also acknowledged when writing about some research on this topic from Finland’s Central Bank.

…those numbers…are the result of data constraints. Researchers looking at the post-World War II data generally find that Hong Kong and Singapore have the maximum growth rates, and the public sector in those jurisdictions consumes about 20 percent of economic output. Nations with medium-sized governments, such as Australia and the United States, tend to grow a bit slower. And the bloated welfare states of Europe suffer from stagnation. So it’s understandable that academics would conclude that growth is at its maximum point when government grabs 20 percent of GDP. But what would the research tell us if there were governments in the data set that consumed 15 percent of economic output? Or 10 percent, or even 5 percent? Such nations don’t exist today.

For what it’s worth, I assume the author of the Fraser study, given the specifications of his model, didn’t have the necessary post-1960 data to include small-state, high-growth, non-OECD jurisdictions such as Hong Kong and Singapore. If that data had been available, I suspect he also would have concluded that government should be closer to 20 percent of economic output.

I explore all these issues in my video on this topic.

The moral of the story is that government is far too large in every developed nation.

I suspect even Hong Kong and Singapore have public sectors that are too large, causing too many resources to be diverted from the private sector.

But since I’m a practical and moderate guy, I’d be happy if the burden of government spending in the United States was merely reduced back down to 20 percent of economic output.

P.S. Though I would want the majority of that spending at the state and local level.

P.P.S. Since I’m sharing videos today, here’s an amusing video from American Commitment about the joy of being “liberated” from employment.

And if you like snarky videos about Obamacare, here are some based on sex and mockery, and there’s even a Hitler parody.

P.P.P.S. This has nothing to do with public policy, but I got a good chuckle from this news out of Iraq.

A group of Sunni militants attending a suicide bombing training class at a camp north of Baghdad were killed on Monday when their commander unwittingly conducted a demonstration with a belt that was packed with explosives, army and police officials said. …Twenty-two ISIS members were killed, and 15 were wounded, in the explosion at the camp.

One of the reasons I laughed is that I recalled a cartoon that was sent to me many years ago. And when I dug into my humor folder, it was still there.

I think you’ll see the obvious connection.

Terrorist School

And since we’re venturing into humor about self-detonating terrorists, here’s another joke from my treasure trove.

===================================

Guy goes into a sex shop and asks for an inflatable doll.

Guy behind the counter says, “Male or female?”

Customer says, “Female.”

Counter guy asks, “Black or white?

Customer says, “White.”

Counter guy asks, “Christian or Muslim?”

Customer says, “What the hell does religion have to do with it?”

Counter guy says, “The Muslim one blows itself up.”

===================================

And here’s another joke that’s worth sharing.

Garfield Terrorist

If this isn’t enough terrorism-related humor for you, we also have this collection of stereotypes I received from an English friend.

This image, meanwhile, doubtlessly has caused a few nightmares in certain quarters.

And this Jay Leno joke is one of the best examples of anti-political correctness I’ve ever seen.

Read Full Post »

My goal in life is very simple. I want to promote freedom and prosperity by limiting the size and scope of government.

That seems like a foolish and impossible mission, perhaps best suited for Don Quixote. After all, what hope is there of overcoming the politicians, interest groups, bureaucrats, and lobbyists who benefit from bigger government?

But I don’t think I’m being totally irrational. I’ve pointed out, for instance, that we can make progress if we simply restrain the growth of government so that it expands slower than the private sector. Surely that’s not asking too much, right? Heck, we’ve done that for the past two years!

Moreover, while much of Washington is a fact-free zone, I’m encouraged by the wealth of evidence showing that big government is bad for growth.

I’ve cited research on the negative impact of excessive government spending from 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 should be particularly persuasive.

I’ve also cited the work of scholars from all over the world, including the United States, Finland, Australia, Sweden, Italy, and the United Kingdom.

And I share additional compelling data in this video, including a comparison of the United States and Europe.

Now we have some more evidence to add to our collection. Here are some excerpts from a study by two European economists. We’ll start with a blurb from the abstract that tells you everything you need to know.

The aim of this paper is to analyze the impact of government spending on the private sector, assessing the existence of crowding-out versus crowding-in effects. Using a panel of 145 countries from 1960 to 2007, the results suggest that government spending produces important crowding-out effects, by negatively affecting both private consumption and investment.

But if you want to understand how they did their research, here are some methodological details.

While most of the tests of the “crowding-out” versus “crowding-in” hypothesis that have been carried in previous papers focus on a time series or cross-country approach, this work extends such analysis to a panel data set of 145 countries from 1960 to 2007. The results show that government spending produces important crowding-out effects, by negatively affecting both private consumption and investment. …In addition, we analyze possible asymmetries of the effect of government consumption on private consumption and investment. In particular, we test: i) whether the effect varies among regions; and ii) whether it depends on to the phase of the economic cycle. We find that the effect varies substantially among regions, but it does not seem to depend on the phase of the economic cycle. …we study the impact of changes in the ratio of government spending to GDP on the growth of real per capita private consumption and private investment.

Here are some of the key results, starting with how government spending impacts consumption.

Starting with the analysis of the effect of government consumption on private consumption (Table 5a), we can immediately see that it is negative and statistically significant. The results also suggest that not only contemporaneous changes in the government consumption-GDP ratio matter, but also its past lags (specifically, the 2nd and 3rd ones). In particular, the cumulative effect of government spending on private consumption is about 1.9 %, of which about 1.2% captured by contemporaneous changes in the government consumption-GDP ratio and 0.7 % by its lags. This result can be interpreted as follows: an increase of government consumption by 1 % of real GDP immediately reduces consumption by approximately 1.2%, with the decline continuing for about four years when the cumulative decrease in consumption has reached approximately 1.9 %.

And here’s the data on how government spending affects investment.

Similarly to what we obtained for private consumption, both current and lagged changes in government consumption-GDP ratio have a negative and significant effect on private investment, with a cumulative effect of approximately 1.8%. The main difference between the effect on consumption and investment is that, while contemporaneous change in the government consumption-GDP ratio seems to have a bigger effect on consumption, lagged changes are more detrimental for investment.

Interestingly, the economists find that the harmful impact of government spending varies by region and country.

But is the effect similar for different regions and countries? To answer this question, we replicate the estimations for specific geographical areas and countries. …The results show that the effect varies substantially between areas. In particular, while we find statistically significant crowding-out effects in Africa, Europe and South America, government spending does not seem to have (statically) significant affects in the other areas considered. We also assess whether the effect is different between developed (OECD) and developing countries. The results suggest that the impact of government spending on both private consumption and investment is more detrimental in the OECD group. …it emerges that the “crowding-out” effects of government consumption are largest in relatively less developed countries (such as Mexico and Turkey) and in those countries with a high share of government spending (such as Finland, Sweden and Norway).

While I’m always cautious about drawing sweeping conclusions from any single piece of empirical research, these results make a lot of sense.

Rahn CurveThe Rahn Curve (which is sort of a spending version of the Laffer Curve) is based on the theory that a very modest level of government, focusing on providing core public goods, is associated with better economic performance. But once government gets too big, than the relationship is reversed and higher levels of spending are associated with weaker performance.

So it’s no surprise that bigger government has particularly bad effects in nations that already have bloated public sectors. Here’s the video I narrated on the Rahn Curve, which provides additional analysis.

Last but not least, it also makes sense that bigger government has a pronounced negative effect in less-developed nations. Those are countries that generally have serious problems with corruption, cronyism, and the rule of law (i.e., Argentina), so the budget often is simply a tool for transferring funds to those with power and political connections.

For all their flaws, the Nordic nations at least are reasonably honest and well run. That being said, the fact that they can endure a larger level of government doesn’t mean it’s a good idea.

P.S. Someone did a video attacking my analysis of the Rahn Curve. Except it isn’t really an attack since I agree with the criticism.

P.P.S. For those who want to argue that the relative prosperity (by global standards) of Western Europe is evidence that big government is good for growth, I invite you to look at this chart. Simply stated, Western Europe became rich when government was very small.

P.P.P.S. Just as there’s lots of evidence about the damaging impact of government spending, there’s also a lot of research showing that high tax rates are economically destructive.

P.P.P.P.S. While I sometimes myopically focus on fiscal policy, remember that there are many other policies that determine economic performance.

Read Full Post »

The fiscal policy debate often drives me crazy because far too many people focus on deficits.

The Keynesians argue that deficits are good for growth and this leads them to support more government spending.

The “austerity” crowd at places such as the International Monetary Fund, by contrast, argues that deficits are bad for growth and this leads them to support higher taxes.

Then you have institutions such as the Congressional Budget Office that want the worst of all worlds, supporting Keynesian spending in the short run while advocating higher taxes in the long run.

But since I don’t like higher spending or higher taxes, you can see why I want to pull my hair out.

With this in mind, I’m pleased that economists at the European Central Bank have released some new research on “Fiscal Composition and Long-Term Growth” which doesn’t reflexively assume that red ink is the key variable. Instead, they dispassionately look at how several fiscal policy variables impact economic performance.

Here is the general conclusion.

In this study we use a large panel of developed and developing countries for the period 1970-2008. …Specifically, we examine the following issues: the influence of which budgetary components have a stronger influence in affecting (positively or negatively) per capita GDP growth rates… Our evidence suggests that for the full sample…government expenditures appear with significant negative signs.

This makes sense. Whether financed by taxes or borrowing, excessive government expenditures hurt an economy by diverting resources from productive uses.

But not all government spending is created equal. Here are some of the specific findings.

In a nutshell, our results comprise notably: i) for the full sample revenues have no significant impact on growth whereas government expenditures have significant negative effects; ii) the same is true for the OECD sub-sample with the addition that total government revenues have a negative impact on growth; iii) taxes on income are less welcome for growth; iv) public wages, interest payments, subsidies and government consumption have a negative effect on output growth; v) expenditures on social security and welfare are less growth enhancing.

It’s noteworthy that government spending is negatively correlated with economic performance for both developing and advanced nations.

It’s also interesting that taxes on income are bad for growth everywhere, and overall revenue is bad for growth in advanced nations (both of these findings, incidentally, suggest that Obama’s class-warfare tax agenda is quite misguided).

The authors of the study also find that some forms of government spending are particularly harmful for growth. That also makes a lot of sense since I’ve explained in my video on the Rahn Curve that core public goods can be good for growth while other types of government spending undermine prosperity.

So what does all this mean? Simply stated, the fiscal problem in virtually all nations is not red ink. It’s big government. Large deficits aren’t desirable, to be sure, but they’re best understood as side effects of too much spending.

In other words, entitlements need to be reformed and discretionary spending needs to be reduced. Solve these underlying problems and you fix the symptoms of red ink and sluggish growth.

Read Full Post »

Older Posts »

Follow

Get every new post delivered to your Inbox.

Join 2,513 other followers

%d bloggers like this: