What Government Spending Buys For Us

Proof: government spending hurts the economy, not helps.

The "TEA" of today's "Tea Party" movement stands for "Taxed Enough, Already."  The American Revolution, and to some extent our modern one, was triggered over excessive taxation.

Given these facts of history, it's not unreasonable for most Americans to focus their attention on tax rates.  In this election cycle, however, many Americans were equally worried about the deficit and national debt, and many of our new Representatives promised to cut spending as well as cutting taxes.

Although our tax system has interacting loopholes of mind-bending complexity, cutting taxes is relatively simple because the big debates center on tax rates.  It's easy to figure out that a tax rate of 20% lets citizens keep more of their money than a tax rate of 30%, for example.

It's much harder to talk about cutting spending for two reasons:

  1. People who benefit from government spending lobby very hard to keep it coming, whereas taxpayers have to spend time earning a living.  That's why the wind industry and the ethanol industry were able to squeeze their subsidies into the recent "tax cut" bill, for example - they worked very hard at it and spent much money promoting their point of view.
  2. Some government spending is actually beneficial and a good idea.  It may come as a surprise to regular readers that we actually believe this, but in the abstract, it is a fact worthy of mention.

We can't do much about (1), but we can provide a guide to help you think about whether government spending does any good or not.

Government Spending 1.01

Economists have argued for years whether government spending boosts the economy or not.  Keynesians argue that government borrowing leads to more spending than there would be without it; others, particularly the Austrian school of economics, claim that government borrowing crowds out private borrowing and so reduces overall economic activity.

This question is difficult to answer because modern economies are so complex and it's hard to do experiments.  We can't re-run the last two years with bigger or smaller stimulus to see what would have happened, for example, so the argument goes on.

The Economist discussed a recent Harvard study which suggests a way to answer this question:

When American politicians become chairmen of congressional committees, they are able to direct federal spending to their home states. To take one example, Richard Shelby, a Republican from Alabama, became chairman of the Senate intelligence committee in 1997. Before that Alabama averaged $6m less in annual federal earmarks, or specific funding, than other states. After his appointment the state received $90m more than the average.

Our seniority-based system means that individual states get more or less money as their senators achieve and lose political power.  This gives an opportunity to compare results between states which get a lot of federal money and states that don't, so we can see how the individual state economies behave.

The academics examined 232 appointments across 42 years. They found the average state receives a 40-50% boost in earmarks in the year following a chairman’s appointment, an increase that persisted for the rest of his tenure. Private firms reacted by reducing capital expenditure (by 8-15%) and research and development (by 7-12%); employment and sales growth also suffered. This test appears fairly robust, as it covered a wide variety of states and was also reversed when the chairman stood down.

Harvard found that extra federal money reduces private investment and private employment.

The Harvard study didn't argue that federal spending actually reduces overall spending, but another study showed that it does:

It [The Impact of Government Spending on the Private Sector: Crowding-out versus Crowding-in Effects] found that a 1% rise in government consumption as a share of GDP eventually reduced private-sector consumption by 1.9%. Temporary spending to pick up economic slack may be useful but the long-term benefits of austerity seem clear.  [emphasis added]

In other words, when the government spent an extra dollar, private consumption went down by $1.90.  Instead of being built up, the economy loses more than the total amount of government stimulus spending.

The Wall Street Journal agrees that the benefits of government spending are short-term at best:

Using powerful statistical methods to separate these effects in U.S. data, Andrew Mountford of the University of London and Harald Uhlig of the University of Chicago conclude that the small initial spending multiplier turns negative by the start of the second year. In a new cross-national time series study, Ethan Ilzetzki of the London School of Economics and Enrique Mendoza and Carlos Vegh of the University of Maryland conclude that in open economies with flexible exchange rates, "a fiscal expansion leads to no significant output gains."  [emphasis added]

In other words, there might be a short-term economic boost, but in the long term, all we have is more debt for no overall economic gain.  The Journal also argues that tax cuts are much more effective in boosting growth:

Former Obama adviser Christina Romer and David Romer of the University of California, Berkeley, estimate a tax-cut multiplier of 3.0, meaning $1 of lower taxes raises short-run output by $3. Messrs. Mountford and Uhlig show that substantial tax cuts had a far larger impact on output and employment than spending increases, with a multiplier up to 5.0[emphasis added]

In other words, a dollar of government spending costs us $1.90 whereas a dollar of tax reduction buys $3 to $5 in growth.  Even worse, the Journal goes on to point out that if the cost of deficit financing is taken into account, a dollar of deficit spending costs $3.40 in economic growth.

Your tax dollars at work.

The Obama Stimulus Impact?  Zero, At Best

The Wall Street Journal points out that the Obama stimulus had essentially zero positive impact and explains why:

The bottom-line is the federal government borrowed funds from the public, transferred these funds to state and local governments, who then used the funds mainly to reduce borrowing from the public. The net impact on aggregate economic activity is zero, regardless of the magnitude of the government purchases multiplier.  [emphasis added]

The difficulty was that the federal government sent the Obama stimulus money to the states instead of spending it - they borrowed money to subsidize state spending.

This saved some union jobs which helped repay the unions for supporting Mr. Obama's presidential campaign, but ended up with no net spending.  Even if government spending could boost the economy, the Obama stimulus didn't increase spending, it reduced state borrowing at federal expense and overall spending didn't change much.

We know that Mr Obama simply hates the idea of letting taxpayers keep the money they earn; he wants to take it away in the name of fairness.  Now that it's known that his stimulus plans can't work and now that he's lost his majority in the House, we'll see if he figures out how to boost the economy by cutting taxes and by cutting regulations.  If not, he's unlikely to be re-elected.

The Truth Will Out

These economic studies, facts, and arguments are so contrary to the constant pro-big-government drumbeat from basically every mainstream media mouthpiece that we can understand if you might not wish to take Scragged's word against Nobel-laureate Paul Krugman who says the exact opposite with mind-numbing repetitiveness.  Fortunately, there's no need to take our word for it: you can read the studies:

Do Powerful Politicians Cause Corporate Downsizing?” by Lauren Cohen, Joshua Coval and Christopher Malloy, Harvard Business School

The Impact of Government Spending on the Private Sector: Crowding-out versus Crowding-in Effects”, by Davide Furceri and Ricardo Sousa

If you'd rather not plow through pages of heavy-duty academese, The Market Ticker has illustrated the effect via revealing charts and graphs, and the Wall Street Journal has summarized it as well.

There will always be politicians who'll argue the false virtues of government spending because it's in their interest to do so.  Unless you're one of them - in which case, welcome to Scragged! - there's no excuse.

Will Offensicht is a staff writer for Scragged.com and an internationally published author by a different name.  Read other Scragged.com articles by Will Offensicht or other articles on Economics.
Reader Comments

The Economist agrees with you at least with respect to cars:


An electric car in Britain today, for instance, produces around 20% less in CO2 emissions than a car with a petrol engine. Even if the generating mix gets greener, electric vehicles are so expensive to produce, that they will still be a relatively costly way of abating CO2 emissions. Sceptics therefore doubt that the subsidy is a good use of public money. According to Richard Pike, chief executive of the Royal Society of Chemistry, replacing all of Britain’s cars with subsidised electric cars would cost the taxpayer £150 billion and, with Britain’s current fuel mix, cut CO2 emissions from cars by about 2%. For the same money, Britain could replace its entire power-generation stock with solar cells and cut its emissions by a third.

The only efficient way to cut greenhouse-gas emissions is to impose a carbon tax. If electric cars are a good way of reducing emissions, a carbon tax will enable them to flourish. Taxes, of course, are not as popular as subsidies. But subsidies are almost always a waste of public resources. At this particular time, throwing more taxpayers’ money at the car industry seems a daft thing to do.

December 29, 2010 3:17 PM
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