Magazine article Insight on the News

Government Overspending Hurts Output

Magazine article Insight on the News

Government Overspending Hurts Output

Article excerpt

The notion that nations can spend their way to economic prosperity has found new respectability among the leaders of the world's industrialized economies.

President Clinton views government as an unambiguously positive force for "growing the economy." His original economic "stimulus" package had called for a $19.5 billion boost in government spending. Similarly, Japan's ruling party, faced with that nation's most severe economic problems since the 1940s, recently unveiled a spending stimulus package totaling about $50 billion. And the European Community has jumped on the stimulus bandwagon, approving a plan that includes increased spending on government projects.

Before the world rushes to worship at the altar of Lord Keynes and demands management policies again, let's look at the body of evidence concerning the economic effects of increases in government spending.

In 1986, Richard Rahn, then the chief economist for the U.S. Chamber of Commerce, charted an inverse relationship between government spending and economic growth for the seven major industrialized countries in the form of a curve, not unlike the "Laffer Curve," which focused on the incentive effects of taxation.

The theory behind the "Rahn Curve" is that, at first, low levels of government spending on basic public services -- such as law and order and a judicial system to enforce contracts -- stimulate growth in the economy. But as spending rises as a share of the economy, its contribution to economic growth diminishes. Government spending eventually reaches a point where it actually retards economic growth.

There are several reasons for this. First, the growing public sector "crowds out" private sector activity, and it often uses the economy's resources far less efficiently. Second, as government grows bigger, it tends to accept broader responsibilities such as reducing poverty. This increased spending on welfare and income transfer programs, however, creates severe work disincentives. Third, an expanding government bureaucracy usually is accompanied by more complicated and burdensome regulation that stifles innovation and productivity. Fourth, the higher tax burdens necessary to finance bigger government at some point damage incentives to work, save and invest. The weakened economy fails to generate enough tax revenue to finance the ever-growing spending share, resulting in increased public sector borrowing and debt service burdens.

The accompanying table charts the experience of the Group of Seven major industrialized countries and a selected group of four smaller European countries representing the extremes in size of government sectors beginning in the 1960s.

From then to the 1980s, the public sector as a share of gross domestic product increased in all these countries. All of them also experienced a reduction in the rate of economic growth. However, economic growth fell the least in those countries that had the smallest growth in government share (the United States and the United Kingdom) and the most in those that had the fastest growth in government share (Spain, Greece, the Netherlands, Sweden, Italy and Japan). In general, the economies with smaller government shares outperformed those with bigger government shares.

By the 1980s, most of Europe and Canada had experienced a substantial public sector boom, with government shares averaging almost 50 percent of GDP for the decade. Only Japan and the United States restrained government spending share at the relatively low levels of 35.9 percent and 32.8 percent of GDP, respectively. …

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