Academic journal article
By Higgs, Robert
Independent Review , Vol. 18, No. 1
In the 1930s and 1940s, when the modern system of national income and product accounts (NIPA) was being developed, the scope of national product was a hotly debated topic. No issue stirred more debate than the question, Should government product be included in gross product? Simon Kuznets (Nobel laureate in economic sciences, 1971), the most important American contributor to the development of the accounts, had major reservations about including all government purchases in national product. Over the years, others have elaborated on the reasons he gave and adduced others.
Why should government product be excluded? First, the government's activities may be viewed as giving rise to intermediate rather than final products, even if the government provides such valuable services as enforcement of private-property rights and settlement of disputes. Second, because most government services are not sold in markets, they have no market-determined prices to be used in calculating their total value to those who benefit from them. Third, because many government services arise from political rather than economic motives and institutions, some of them may have little or no value. Indeed, some commentators--including the present writer--have ultimately gone so far as to assert that some government services have negative value: given a choice, the people victimized by these "services" would be willing to pay to be rid of them.
When the government attained massive proportions during World War II, this debate was set aside for the duration of the war, and the accounts were put into a form that best accommodated the government's attempt to plan and control the economy for the primary purpose of winning the war. This situation of course dictated that the government's spending, which grew to constitute almost half of the official gross domestic product (GDP) during the peak years of the war, be included in GDP, and the War Production Board, the Commerce Department, and other government agencies involved in composing the NIPA recruited a large corps of clerks, accountants, economists, and others to carry out the work.
After the war, the Commerce Department, which carried forward the national accounting to which it had contributed during the war (since 1972 within its Bureau of Economic Analysis), naturally preferred to continue the use of its favored system, which treats all government spending for final goods and services as part of GDP. Economists such as Kuznets, who did not favor this treatment, attempted for a while to continue their work along their own different lines, but none of these economists could compete with the enormous, well-funded statistical organization the government possessed, and almost all of them eventually gave up and accepted the official NIPA (O'Brien 1994, 242; Higgs 2006, 64--68).
Thus did government spending become lodged in the definition and measurement of GDP in a way that ensuing generations of economists, journalists, policymakers, and others considered appropriate and took for granted. Nonetheless, the issues that had been disputed at length in the 1930s and 1940s did not disappear. They were simply disregarded as if they had been resolved, even though they had not been resolved intellectually but simply swept under the Commerce Department's expansive (and expensive) rug. In particular, the inclusion of government spending in GDP remained extremely problematic.
Generations of elementary economics students since World War II have come away from Economics 101 having learned, if anything, that GDP is defined as
GDP = C + I + G + (X-M).
That is, GDP for a given period, usually a year, is the sum of spending for final goods and services by domestic private consumers (C), domestic private investors (I), and domestic governments (G) at all levels, plus foreign purchases of U.S. exports (X) minus Americans' purchases of U.S. imports (M).
This sort of accounting supplies the basic framework for the Keynesian models that swept the economics profession in the 1940s and 1950s, from which a key policy conclusion was derived: that the government can vary its spending to offset shortfalls or excesses of private spending and thereby stabilize the economy's growth while maintaining "full employment. …