How Government Spending Harms the Economy

See Reducing Deficits by Cutting Spending by Chris Edwards of Cato (from his Senate testimony 7-26-11). Excerpt:

"There is renewed talk in Washington about further spending measures to try and stimulate the flagging economy. Yet now more than two years after passage of the $821 billion stimulus package in 2009, it seems pretty clear that that effort was a very expensive Keynesian policy failure.9

Note that the total Keynesian stimulus of recent years has been much larger than just the 2009 stimulus bill. In Keynesian theory, the total amount of deficit spending is the amount of demand-side stimulus. We've had deficit spending of $459 billion in fiscal 2008, $1.4 trillion in fiscal 2009, $1.3 trillion in fiscal 2010, and $1.4 trillion in fiscal 2011.

Yet despite that enormous deficit-spending stimulus, U.S. unemployment remains stuck at high levels and the recovery is very sluggish compared to prior recoveries. Indeed, the current recovery appears to be slower than any since World War II by various measures.10

Obama administration economists had claimed that the Keynesian "multipliers" from government spending are large, meaning that spending would give a big boost to GDP. But other macroeconomists have found that Keynesian multipliers are actually quite small, meaning that added government spending mainly just displaces private-sector activities.11Stanford University Professor John Taylor took a detailed look at GDP data over recent years, and he found little evidence of any benefits from the 2009 stimulus bill.12 Any "sugar high" to the economy from recent increases in government spending was apparently very small and short-lived.

The reality is that Washington is very poor at trying to micromanagement short-term economic performance. Its failed stimulus actions of recent years have just put the nation further into debt, which has harmed our long-term prosperity. Harvard University's Robert Barro calculated that any short term benefit that the 2009 stimulus bill may have provided from small spending multipliers is greatly outweighed by the future damage caused by higher taxes and debt.13

Let's take a look at how federal spending damages the economy over the long-run. Federal spending is financed by the extraction of resources from current and future taxpayers. The resources consumed by the government cannot be used to produce goods in the private marketplace. For example, the engineers needed to build a $10 billion government high-speed rail line are taken away from building other products in the economy. The $10 billion rail line creates government-connected jobs, but it also kills at least $10 billion worth of private jobs.

Indeed, the private sector would actually lose more than $10 billion in this example. That is because government spending and taxing creates "deadweight losses," which result from distortions to working, investment, and other activities. The CBO says that deadweight loss estimates "range from 20 cents to 60 cents over and above the revenue raised."14 Harvard University's Martin Feldstein thinks that deadweight losses "may exceed one dollar per dollar of revenue raised, making the cost of incremental governmental spending more than two dollars for each dollar of government spending."15 Thus, a $10 billion high-speed rail line would cost the private economy $20 billion or more.

The government uses a "leaky bucket" when it tries to help the economy. Former Chairman of the Council of Economics Advisors, Michael Boskin, explains: "The cost to the economy of each additional tax dollar is about $1.40 to $1.50. Now that tax dollar ... is put into a bucket. Some of it leaks out in overhead, waste, and so on. In a well-managed program, the government may spend 80 or 90 cents of that dollar on achieving its goals. Inefficient programs would be much lower, $.30 or $.40 on the dollar."16 Texas A&M Professor Edgar Browning comes to similar conclusions about the magnitude of the government's leaky bucket: "It costs taxpayers $3 to provide a benefit worth $1 to recipients."17

The larger the government grows, the leakier the bucket becomes. On the revenue side, tax distortions rise rapidly as marginal tax rates rise.18 On the spending side, funding is allocated to activities with ever lower returns as the government expands. Figure 3 illustrates the consequences of the leaky bucket. On the left-hand side, tax rates are low and the government initially delivers useful public goods such as crime reduction. Those activities create high returns, so per-capita incomes initially rise as the government grows.

As the government expands further, it engages in less productive activities. The marginal return from government spending falls and then turns negative. On the right-hand side of the figure, average incomes fall as the government expands. Government in the United States — at more than 40 percent of GDP — is almost certainly on the right-hand side of this figure. In a 2008 book on federal fiscal policy, Professor Browning concludes that today's welfare state reduces GDP — or average U.S. incomes — by about 25 percent.19 That would place us substantially to the right in Figure 3, and it suggests that major federal spending cuts would increase U.S. incomes over time.

Federal spending is soaring, and government debt is piling up at more than a trillion dollars a year. Official projections show rivers of red ink for years to come unless policymakers enact major budget reforms. Unless spending is cut, the United States is headed for economic ruin. I've proposed a detailed plan at www.DownsizingGovernment.org to cut spending on entitlements, defense, and discretionary spending over 10 years to balance the budget.20

The essays on this Cato website provide evidence that many federal programs produce very low or negative returns. Many programs — such as Medicare and the EITC — have high levels of fraud and improper payments. Other programs create economic distortions, damage the environment, or restrict individual freedom.

The federal government has expanded into hundreds of areas that would be better left to state and local governments, businesses, charities, and individuals. Reviving constitutional federalism is one important way to help reduce federal spending and debt. I also think that cutting federal spending would enhance civil liberties and improve democratic governance by dispersing power from Washington."