Commentary

Growing Government and Slowing Growth — Obama’s Contradiction

With unemployment still hovering near 8 percent, President Obama has made it a second term priority to increase economic growth. Yet the president’s own policies, which have lead to a significant growth in the size and cost of government, may make it difficult, if not impossible, for the United States to grow at the rate necessary to significantly increaseemployment.

Much attention recently has been focused on the ongoing struggle between President Obama and Republicans in Congress over the budget deficit. And, of course, the deficit is indeed significant. This year will mark the fifth consecutive year that budget deficits will exceed $1 trillion, and our national debt exceeded $16.4 trillion as of January 2013. The need to increase the debt ceiling in February or March of this year is expected to provoke another painful legislative battle.

Certainly, the deficit and debt are barriers to economic growth. For example, the International Monetary Fund looked at the relationship between federal debt levels and economic growth, concluding that from 1890-2000, countries with high debt levels consistently grew their economies at slower rates than those with low debt levels (Abbas et al.).Similarly,Carmen Reinhardt of the University of Maryland and Harvard’s Kenneth Rogoff conclude that countries with debt ratios above 90 percent of their GDP have median growth rates one percent lower than countries with lower debt, and average growth rates nearly four percent lower (Reinhardt and Rogoff). Our debt currently exceeds 102 percent of GDP, if one considers both debt held by the public and intragovernmental debt. (Bureau of the Public Debt; Bureau of Economic Analysis)

By increasing the size and cost of government the president is actually slowing economic growth and reducing the number of  jobs available.”

Worse, that likely understates the true size of our indebtedness. If one includes the unfunded liabilities of Social Security and Medicare and the total future debt of the United States, this country’s real total indebtedness could run as high as $129 trillion (in current present value). Even under the most optimistic scenarios, our real debt approaches $80 trillion. Measuredas a percentage of GDP, our total debt exceeds the total debt of Greece or Spain (Tanner). And, as we move forward, much of that debt is liable to be converted into new or higher taxes with even worse consequences.

This creates a devilish sequence of cause and effect. The debt burden means that economic growth will be lower in the future. This, in turn, means that without some sort of reduction in the structure of programs such as health care and retirement, the debt burden will grow as a percentage of the economy. The larger debt burden will further reduce economic growth, making the debt still larger relative to GDP, and so on. Therefore, the longer countries wait to make adjustments to these programs, the more difficult the problem of balancing long-term budgets becomes.

As frightening as the numbers discussed above may be, focusing on taxes and debt is to confuse the symptom with the disease. As Milton Friedman often explained, the real issue is not how you pay for government spending—debt or taxes—but the spending itself.

Of course, some government spending is necessary. Governments must provide certain basic services such as adjudicating disputes, maintaining police and defense functions, and, arguably, maintaining the infrastructure necessary for a functioning economy. Thus, under a scenario with zero government spending there would be little, if any, economic growth.

But beyond a certain level, nearly all economists would agree that the costs of government exceed the benefits it provides, leading to lower economic growth.For example, if governments consumed 100 percent of GDP there would be little or no economic growth. In between is a curve, with rising initial growth accompanying increased government spending, followed by declining growth once government gets too large.

As James Gwartney, Robert Lawson, and Randall Holcombe argue:

As governments move beyond these core functions [of protecting people and property], they will adversely affect economic growth because of a) the disincentive effects of higher taxes and crowding-out effect of public investment in relation to private investment, b) diminishing returns as governments undertake activities for which they are ill-suited, and c) an interference with the wealth creation process, because governments are not as good as markets in adjusting to changing circumstances and finding innovative new ways of increasing the value of resources (Gwartney, Lawson, and Holcombe).

Since World War II, the federal government has generally accounted for about 20 percent of GDP. Under Presidents Bush and Obama, that amount has increased significantly, hitting a high of 25.2 percent in 2009. Today, the federal government consumes 22.9 percent of GDP, and while that is projected to decline to 22.4 percent of GDP, it will begin rising significantly after that. Under current trend lines, CBO projects that federal spending could reach 46 percent of GDP by 2050. When one considers that state and local government spending adds an additional 15-20 percent of GDP to that level, governments at all levels will likely consume more than 60 percent of GDP, unless significant changes occur (Congressional Budget Office).

Economists debate the exact relationship between the size of government and economic growth (the slope of the curve), but few would argue that governments can consume an unlimited proportion of the national economy without it having a significant impact on that economy.

For example, Harvard’s Robert Barro found that “public consumption spending is systematically inversely related to economic growth,” and that there is a “significantly negative relation between the growth of real GDP and the growth of the government share of GDP” (Barro). In other words, as government spending goes up, economic growth goes down. Similarly, James Guseh found that every 10 percent increase in the size of government led to a 0.74 percent decline in economic growth in democratic mixed economies, and a slightly larger 1.11 percent decline in democratic market-based economies (Guseh). And a study by Stefan Folster and Magnus Henrekson of Sweden’s Research Institute for Industrial Economics came to a nearly identical conclusion: a 10 percentage point increase in government expenditure was associated with a 0.7 to 0.8 percentage point reduction in the economic growth rate (Folster and Henrekson).

A study by Prmoz Pevcin of the University of Ljubljana found an even larger impact, a decline in economic growth of 0.15 percentage points for every one percentage point increase in the size of government (Pevcin). And an older but still relevant empirical analysis of 23 OECD countries by James Gwartney and his colleagues found an effect of similar magnitude: a ten percentage point increase in government consumption as a share of GDP reduced the growth rate of real GDP by one percentage point (Gwartney et al.).

To be sure, not every study reaches the same conclusion. Perhaps the most widely cited of these contrary studies is a survey of 115 countries from 1960-1980 by Rati Ram of Illinois State University. Ram concluded that the impact of the size of government on economic output was almost always positive, though the relationship was possibly stronger in lower income countries (Ram).

However, as Eric Engen of the Federal Reserve Board and Jonathan Skinner of Dartmouth University point out in a paper for the National Bureau for Economic Research, “an obvious shortcoming with Ram’s econometric estimates is endogeneity; countries that grow fast also tend to increase government spending”(Engen and Skinner). This basically means that the direction of cause and effect cannot be properly determined from the selected variables, and raises statistical problems with the concluding claim. In addition, both Jack Carr of the University of Texas and Bhaskara Rao of MIT criticize Ram’s model for including government spending as part of GDP, which means that GDP may grow simply because government spending grows (Carr; Rao).

Finally, some studies have found ambivalent or contradictory results. A 2006 study by Marta Pascual Saez and Santiago Alvarez Garcia found that the relationship between the size of government and economic growth can be either positive or negative depending on what countries are included in the sample, the time frame involved, and how the size of the public sector is measured (Saez and Garcia). But overall, the vast majority of research concludes that big government is incompatible with economic growth.

A U.S. government that consumes 46 percent of GDP at the federal level—and more than 60 percent overall—would clearly seem to exceed any reasonable estimate for a burden of government compatible with economic growth.

President Obama seems wedded to an old-fashioned Keynesian philosophy of trying to revive the economy by using government hiring and spending to increase consumer demand, but the body of evidence suggests that those policies are self-defeating. By increasing the size and cost of government the president is actually slowing economic growth and reducing the number of jobs available.

Sources

Abbas, S.A., et al., “An Historical Public Debt Database,” International Monetary Fund Working Paper no. 10-245, 2010.

Barro, R., “Government Spending in a Simple Model of Endogeneous Growth.” Journal of Political Economy (June 16, 2011): 122.

Bureau of Economic Analysis, “National Economic Accounts: Current-dollar and “real” GDP,” Q3 2012, accessed January 8, 2013.

Carr, J., “Government Size and Economic Growth: A New Framework and Some Evidence from Cross-Section and Time Series Data, Comment” American Economic Review 76 (1986): 267-71.

Congressional Budget Office, “The 2012 Long-Term Budget Outlook: Supplemental Data” June 5, 2012.

Engen, E. and Skinner, J., “Fiscal Policy and Economic Growth,” National Bureau of Economic Research Working paper no. 4223, December 1992.

Folster, S. and Henrekson, M., “Growth Effects of Government Expenditure and Taxation in Rich Countries,” Stockholm School of Economics, Working Paper Series in Economics and Finance, 2000.

Guseh, J., “Government Size and Economic Growth in Developing Countries: A Political-Economy Framework,” Journal of Macroeconomics 19 no 1 (January 1997): 175-192.

Gwartney, J., et al, “The Size and Functions of Government and Economic Growth,” Joint Economic Committee, 1998.

Gwartney, J., Lawson, R., and Holcombe, R., “The Size and Functions of Government and Economic Growth,” Joint Economic Committee (1998).

Pevcin, P., “Does Optimal Size of Government Spending Exist,” University of Ljubljana, 2004.

Ram, R., “Government Size and Economic Growth: A New Framework and Some Evidence from Cross-Section and Time Series Data,” American Economic Review 76 (1986): 191-203.

Rao, B., “Government Size and Economic Growth: A New Framework and Some Evidence from Cross-Section and Time Series Data, Comment,” American Economic Review 76 (1986): 272-80

Reinhardt, C and Rogoff, K, “Growth in a Time of Debt,” American Economic Review Papers and Proceedings, January 7, 2010.

Saez, M.P., and Garcia, S.A., “Government spending and Economic Growth in European Union Countries: An Empirical Approach,” July 2006.

Tanner, M., “Bankrupt: Entitlements and the Federal Budget,” Cato Institute Policy Analysis, March 28, 2011.

United States Department of the Treasury Bureau of the Public Debt, “The Daily History of the Debt” accessed January 8, 2013.