Tag: Rahn Curve

Goldilocks, Canada, and the Size of Government

I feel a bit like Goldilocks.

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.

Question of the Week: What’s the Right Point on the Laffer Curve?

Back in 2010, I wrote a post entitled “What’s the Ideal Point on the Laffer Curve?

Except I didn’t answer my own question. I simply pointed out that revenue maximization was not the ideal outcome.

I explained that policy makers instead should seek to maximize prosperity, and that this implied a much lower tax rate.

But what is that tax rate, several people have inquired?

The simple answer is that the tax rate should be set to finance the legitimate functions of government.

But that leads to an obvious follow-up question. What are those legitimate functions?

According to my anarcho-capitalist friends, there’s no need for any public sector. Even national defense and courts can be shifted to the private sector.

In that case, the “right” tax rate obviously is zero.

But what if you’re a squishy, middle-of-the-road moderate like me, and you’re willing to go along with the limited central government envisioned by America’s Founding Fathers?

That system operated very well for about 150 years and the federal government consumed, on average, only about 3 percent of economic output. And even if you include state and local governments, overall government spending was still less than 10 percent of GDP.

Moreover, for much of that time, America prospered with no income tax.

But this doesn’t mean there was no tax burden. There were federal excise taxes and import taxes, so if the horizontal axis of the Laffer Curve measured “Taxes as a Share of GDP,” then you would be above zero.

Or you could envision a world where those taxes were eliminated and replaced by a flat tax or national sales tax with a very low rate. Perhaps about 5 percent.

So I’m going to pick that number as my “ideal” tax rate, even though I know that 5 percent is just a rough guess.

For more information about the growth-maximizing size of government, watch this video on the Rahn Curve.

There are two key things to understand about my discussion of the Rahn Curve.

First, I assume in the video that the private sector can’t provide core public goods, so the discussion beginning about 0:33 will irk the anarcho-capitalists. I realize I’m making a blunt assumption, but I try to keep my videos from getting too long and I didn’t want to distract people by getting into issues such as whether things like national defense can be privatized.

Second, you’ll notice around 3:20 of the video that I explain why I think the academic research overstates the growth-maximizing size of government. Practically speaking, this seems irrelevant since the burden of government spending in almost all nations is well above 20 percent-25 percent of GDP.

But I hold out hope that we’ll be able to reform entitlements and take other steps to reduce the size and scope of government. And if that means total government spending drops to 20 percent-25 percent of GDP, I don’t want that to be the stopping point.

At the very least, we should shrink the size of the state back to 10 percent of economic output.

And if we ever get that low, then we can have a fun discussion with the anarcho-capitalists on what else we can privatize.

P.S. If a nation obeys Mitchell’s Golden Rule for a long enough period of time, government spending as a share of GDP asymptotically will approach zero. So perhaps there comes a time where my rule can be relaxed and replaced with something akin to the Swiss debt brake, which allows for the possibility of government growing at the same rate as GDP.

New Study from UK Think Tank Shows How Big Government Undermines Prosperity

It seems I was put on the planet to educate people about the negative economic impact of excessive government. I must be doing a bad job, because the burden of the public sector keeps rising.

But hope springs eternal. To help make the case, I’ve cited research from international bureaucracies such as the Organization for Economic Cooperation and Development, International Monetary Fund, World Bank, and European Central Bank. Since most of those organizations lean to the left, these results should be particularly persuasive.

I’ve also cited the work of academic scholars from all over the world, including the United States, Australia, and Sweden. The evidence is very persuasive that big government is associated with weaker economic performance.

Now we have some new research from the United Kingdom. The Centre for Policy Studies has released a new study, authored by Ryan Bourne and Thomas Oechsle, examining the relationship between economic growth and the size of the public sector.

The chart above compares growth rates for nations with big governments and small governments over the past two decades. The difference is significant, but that’s just the tip of the iceberg. The most important findings of the report are the estimates showing how more spending and more taxes are associated with weaker performance.

Here are some key passages from the study.

Using tax to GDP and spending to GDP ratios as a proxy for size of government, regression analysis can be used to estimate the effect of government size on GDP growth in a set of countries defined as advanced by the IMF between 1965 and 2010. …As supply-side economists would expect, the coefficients on the tax revenue to GDP and government spending to GDP ratios are negative and statistically significant. This suggests that, ceteris paribus, a larger tax burden results in a slower annual growth of real GDP per capita. Though it is unlikely that this effect would be linear (we might expect the effect to be larger for countries with huge tax burdens), the regressions suggest that an increase in the tax revenue to GDP ratio by 10 percentage points will, if the other variables do not change, lead to a decrease in the rate of economic growth per capita by 1.2 percentage points. The result is very similar for government outlays to GDP, where an increase by 10 percentage points is associated with a fall in the economic growth rate of 1.1 percentage points. This is in line with other findings in the academic literature. …The two small government economies with the lowest marginal tax rates, Singapore and Hong Kong, were also those which experienced the fastest average real GDP growth.

The folks at CPS also put together a short video to describe the results. It’s very well done, though I’m not a big fan of the argument near then end that faster growth is a good thing because it generates more tax revenue to finance more government. Since I’m a big proponent of the Laffer Curve, I don’t disagree with the premise, but I would argue that additional revenues should be used to finance lower tax rates.

Since I’m nit-picking, I’ll also say that the study should have emphasized that government spending is bad for growth because it inevitably and necessarily leads to the inefficient allocation of resources, and that would be true even if revenues magically floated down from heaven and there was no need for punitive tax rates.

This is my message in this video on the Rahn Curve.

When the issue is government, size matters, and bigger is not better.

New Study from Swedish Economists Allows Us to Quantify the Cost of the Bush-Obama Spending Binge

The United States has been on a decade-long spending binge. Thanks to the profligate policies of both Bush and Obama, the burden of federal spending has climbed to about 25 percent of economic output, up from 18.2 percent of GDP when Bill Clinton left office.

The political class tells us that more government is good for the economy since it an “investment” and/or a “stimulus.”

The academic research, however, tells a different story. Here are some brief excerpts from a recent study by two Swedish economists, including a critically important observation about the impact of bigger government on economic performance.

…most recent studies typically find a negative correlation between total government size and economic growth. …the most convincing studies are those most recently published. …In general, research has come very close to a consensus that in rich countries there is a negative correlation between total government size and growth. It appears fair to say that an increase in total government size of ten percentage points in tax revenue or expenditure as a share of GDP is on average associated with an annual lower growth rate of between one-half and one percentage point.

Let’s focus on the last sentence of the excerpt and contemplate the implications. The research cited above tells us that annual growth is 0.5 percentage point-1.0 percentage point lower if the burden of government rises by 10 percentage points of GDP. Well, the burden of federal spending has jumped by more than 5 percentage points of GDP during the Bush-Obama years, indicating that annual growth in America is now 0.25 percentage point-0.5 percentage point lower than it otherwise would be.

Now let’s take the best-case scenario, and assume that annual growth has only dropped by 0.25 percentage points, and consider what that means. It may not sound like much, but even small differences in growth rates become very important over time. For an average household over a 25-year period, the loss of 0.25 percentage points of growth means annual income will rise, but the total increase will be about $5,000 smaller by the 25th year.

The budgetary implications of growth also are rather important. According to the Congressional Budget Office, the economy’s performance has a large impact on tax receipts (more growth means higher incomes and more taxpayers) and a small effect on government spending (more growth means fewer people at the public trough). CBO even publishes a “sensitivity table” with specific estimates (Table B-1).

If we once again use the best-case scenario and assume the Bush-Obama spending binge has reduced annual growth by only 0.25 percentage points, the CBO numbers show this means more than $750 billion of additional red ink. This is something to keep in mind as the White House argues that job-killing class-warfare tax hikes will somehow improve the budget situation.

Let’s now return to the academic research. The authors included a very helpful table showing the results of recent studies on the relationship between the size of government and economic performance. Click on the image for a full-size look at how the majority of scholarly research this century confirms that big government is bad for prosperity.

For all intents and purposes, all this research shows that developed nations are on the downward-sloping portion of the Rahn Curve. Named after my Cato colleague Richard Rahn and explained in the video below, the Rahn Curve is sort of a spending version of the Laffer Curve.

It shows that growth is maximized by small governments that focus on core “public goods” like rule of law and protection of property rights. But when governments expand beyond a certain growth-maximizing level (the research says about 20 percent of GDP, by I explain in the video why the right number is probably much smaller), the result is slower growth and less prosperity.

With the exception of high-growth Hong Kong and Singapore, all developed nation have public sectors that consume at least 30 percent of economic output. This means that government spending is undermining prosperity all around the world. And since the burden of government spending is close to 40 percent of GDP in the United States…well, you can fill in the blanks.

It’s Simple to Balance the Budget without Higher Taxes

John Podesta of the Center for American Progress had a column in Politico yesterday asserting that “closing the budget gap entirely on the spending side would require draconian programmatic cuts.” He went on to complain that there are some people who “refuse to look at the revenue side of the ledger – while insisting that we dig the hole $830 billion deeper over the next decade by extending the Bush tax cuts.”
 
Not surprisingly, Mr. Podesta is totally wrong. It’s actually not that challenging to balance the budget. And it doesn’t even require any spending cuts, though it would be a very good idea to dramatically downsize the federal government. Here’s a chart showing this year’s spending and revenue totals. It then shows the Congressional Budget Office’s estimate of how much revenues will grow, assuming all the 2001 and 2003 tax cuts are made permanent and assuming that the alternative minimum tax is adjusted for inflation. As you can see, balancing the budget is a simple matter of limiting the annual growth of federal spending.

So how is it that Mr. Podesta can spout sky-is-falling rhetoric about “draconian” cuts when all that’s needed is fiscal restraint? The answer is that politicians in Washington have concocted a self-serving budget process that automatically assumes that all previously-planned spending increases should occur. So if the politicians put us on a path to make government 8 percent bigger next year and there is a proposal to instead limit spending growth to 3 percent, that 3 percent increase gets portrayed as a 5 percent cut.
 
This is a great scam, at least for the political class. They get to buy more votes by boosting the burden of government spending, but they get to tell voters that they’re being fiscally responsible. And they get to claim that they have no choice but to raise taxes because there’s no other way to balance the budget. In the real world, though, this translates into bigger government and puts us on a path to a Greek-style fiscal nightmare.
 

The goal of fiscal policy should be smaller government, not fiscal balance. Deficits are just a symptom of a government that is too large, as I have explained elsewhere. But the good news is that spending discipline is the right answer, regardless of the objective. I explained this in more detail for a piece in today’s Philadelphia Inquirer. Here’s an excerpt.

According to the Congressional Budget Office, the federal government this year is spending almost $3.5 trillion. Tax receipts are estimated to be less than $2.2 trillion, which means a projected deficit of about $1.35 trillion. So can we balance the budget when there is that much red ink? And is it possible to eliminate deficits while also extending the 2001 and 2003 tax cuts? The answer is yes. …It’s a simple matter of mathematics. The Congressional Budget Office estimates that tax revenue will grow by an average of 7.3 percent annually over the next 10 years. Reducing the budget deficit is easy - so long as politicians increase overall spending by less than that amount. And with inflation projected to be about 2 percent over the same period, this is an ideal environment for some long-overdue fiscal discipline. If spending is simply capped at the current level with a hard freeze, the budget is balanced by 2016. If we limit spending growth to 1 percent each year, the budget is balanced in 2017. And if we allow 2 percent annual spending growth - letting the budget keep pace with inflation, the budget balances in 2020. …Interest groups that are used to big budget increases will be upset if spending growth is limited to 1 or 2 percent each year. It means entitlements will need to be reformed. It means we might need to get rid of programs and departments that are not legitimate functions of the federal government. You better believe that these changes will cause a lot of squealing by lobbyists and other insiders. But that complaining will be a sign that fiscal policy is finally heading in the right direction. The key thing to understand is that there is no need for tax increases. Politicians might not balance the budget if we say no to all tax increases. But the experience in Europe shows that oppressive tax burdens are not a recipe for fiscal balance either. Milton Friedman was correct many years ago when he warned that, “In the long run government will spend whatever the tax system will raise, plus as much more as it can get away with.”