September 13, 2010

The Negative Consequences of Government Expenditure

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The U.S. national debt currently stands at 62 percent of GDP, its highest level since WWII (CBO 2010, p.xii). Under plausible assumptions, this ratio will rise to at least 80 percent and possibly 185 percent of GDP by 2035 and continue increasing thereafter (CBO 2010, pp.x-xi). As the debt-ratio increases, the U.S.’s creditors will demand higher and higher interest rates to continue financing this debt. This means ever larger deficits and ultimately a U.S. default.

The U.S. can try to avoid this fate by raising taxes, but that approach faces both political and economic obstacles. Raising taxes is rarely popular with either voters or politicians, especially in a weak economy. Both macroeconomic and microeconomic perspectives, moreover, suggest that taxes slow economic growth, thereby limiting the scope for revenue gains. And since projected fiscal gaps are growing, the tax increases necessary to stabilize debt relative to GDP will generate escalating evasion and avoidance. This means the U.S. will reach a point where further tax increases reduce rather than increase tax revenue.

If tax increases cannot restore fiscal balance, then the U.S. must slow the path of expenditure to avoid fiscal Armageddon. Yet this approach also faces substantial opposition, for two reasons.

Many economists oppose expenditure cuts in the short to medium term based on the Keynesian claim that expenditure boosts the economy. According to this view, it does not matter whether the spending is productive, only that government spending offset the recession-induced decline in private demand for the economy’s goods and services. The Keynesian perspective does not oppose spending cuts over the long haul but argues these must wait until the economy is at or near full employment.

The second objection to expenditure cuts holds that the current level is crucial to a well functioning economy and supports key government functions such as national defense, education, and provision of retirement and health benefits. According to this view, most government is beneficial independent of the need to moderate the recession, so cuts are undesirable even in the longer term.

If these views of government expenditure are correct, the U.S. faces an unhappy economic future. The nation must either suffer higher and higher tax rates, which will slow growth and ultimately reduce rather than increase revenue, or it must cut government functions that are allegedly vital for economic productivity and the quality of life.

This paper argues that current U.S. expenditure is far greater than necessary to support an efficient economy or an equitable society, so expenditure should be cut regardless of the fiscal outlook. Certain expenditure, to be sure, is vital to a country’s success and survival, but much current expenditure actually lowers the economy’s productive capacity. Thus expenditure cuts can simultaneously improve fiscal balance while enhancing economic growth.

The remainder of the paper is organized as follows. Section II presents basic facts about the historical and projected behavior of expenditure and the national debt. Section III outlines the economic principles that determine whether government expenditure is good for the economy. Section IV evaluates key components of federal expenditure, while section V examines state and local expenditure. Section VI addresses the Keynesian argument that expenditure reduces recessions. Section VII concludes.