Government Spending and Economic Growth

Whenever I debate with people on the role government, I often hear “the government should do X” almost as though the state is an omnipotent solution to everything and can do so at no cost. I hear this mostly from the left. They essentially believe that government spending more efficiently allocates resources than a competitive market. Furthermore, they view government spending as necessarily expansionist and a correctional tool for market failures.

Proponents of government spending are short sighted and fail to see its full effect on the macro scale. Governments generate revenue in a few different ways: 1) taxes 2) borrowing money 3) printing money. The third is extremely complicated so I will focus on the first two. Regardless of how the funds are acquired, every $1 the government spends, including payments on debt, must first be forcibly taken from another. Taxes are not voluntary. The person or business losing the $1 could have invested in retirement, their family’s future, or a capital good (i.e. a home); or a business could invest in a new plant, capital equipment, product development, or labor.

With this in mind, we can draw the conclusion that government spending cannot result in an expansion of wealth. Unlike private and voluntary exchange, the government transaction (tax payer, state, and tax receiver) rarely results in a net gain for all parties. The tax payer loses a dollar, the State wastes it on their operations, and the tax receiver will get $1 less bloated administrative costs. If the free market has a demand for the tax receiver’s skill (i.e. road building), then the tax receiver would obtain an entire $1 from financiers and be expected to turn $1 into $2; the difference of which (return/profit) will be reinvested or spent. Government, however, uses that $1 as funding instead of capital investment, and there is no incentive or checks to ensure that the $1 will generate an expected return or at least be frugally spent.

There are supporters of government spending as a means to curb unemployment or jump start economic growth. In both these situations, they have again offered a short sighted solution that exacerbates the problem. As previously stated, government does not create wealth or employment. In fact, scholars have found that for every 100 public sector jobs created, about 150 private sector jobs are destroyed. There is a net loss on employment from private sector crowding and a net loss on aggregate demand from the decrease in national income. In fact, the St. Louis Federal Reserve branch concluded that states with minimal government intervention experience faster employment growth, especially when labor market policies are minimally intrusive.

Government spending as a share of GDP does not have a negative effect on unemployment. Quite to the contrary, research has found that increased government spending as part of the GDP increases unemployment and hurts growth. There is also evidence of a causal relationship between increased government outlays and increased unemployment. In other words, increases in government spending leads to a decrease in aggregate labor demand and more incentives for leaner operations.

People often believe that a $1 in taxes collected equate to $1 in public employment outlays, but this is never the case. The government must first go through the costly process of collecting the $1 and then paying what’s left to an employee. It is important to note that a public employee may not hold an equally paid position in the private market, thus capital resource has been misallocated.

Of course, despite these findings, government spenders continue to uphold that public outlays spur economic growth and kick start industries. Both of these arguments are logical fallacies that are empirically false. As I said before, every public outlay must first be taken via taxation. The fallacy here is that government can actually spend that money more economically than you or a business. As we all know, the government is subjected to special interests and personal gain that often leads to crony capitalism and poor investments. It is a dangerous premise to give so much money to those who have no interest in the capital return on investment.

Many of these “industry kick start” programs (i.e. green energy subsidies) are political handouts under convoluted premises. More often, they are make-work programs inefficiently managed and mostly unnecessary. Subsidies in green energy are often squandered because they are ahead of their time. In other words, the government becomes impatient and thinks that $X million in subsidies will suddenly result in the proliferation of solar panels. This has never been proven to work for any industry on a large scale, or at least to my knowledge. There are further examples in agriculture, but I digress.

So if government spending doesn’t spur industry growth, does it help economic growth? The research here says no and the economic logic for such a practice is weak. Swedish economists found s a negative correlation between size of government and economic growth. The common rebuttal here is that government spending has, in the short term, caused economic growth in post-recession times. This short sighted view can be partially correct, but it foregoes the long term reality of net reductions in growth.

When we ignore the redistributive nature of government spending, it is easy to forget that precisely the amount spent by government will also not be spent, invested, or saved by the private market. Rarely is the case that government spending of $1 yields a return on capital greater than would be in a private market. Even if the government borrows the money, the short term benefits may be noticeable, but that is only if we do no account the future tax revenue to make good on debts. Our current bloated long term liabilities being the case in point.

While large amounts of government spending may be bad for economic growth, it does not necessarily mean no government equates to maximum growth. There are some types of spending that are necessary to a stable economy and growing nation. With that in mind, we must decide what size of government is economically tolerable. The Fraser Institute conducted an analysis of 70 countries to determine the size of government as a share of GDP for maximum economic growth. Researchers concluded that the optimal ratio of expenditures to GDP is around 26%, which allows for a 3.1% annual GDP per capita growth.

For reference, government spending as a share of GDP in the United States was over 40% in 2012. Although such a high ratio does not cause negative growth, it certainly does not increase growth. Some European countries are over 50% and, at such a high ratio, government expenditures are likely detrimental to economic growth. There are cases when government spending supposedly increases GDP. This is because the metric used for GDP includes government spending, which does not provide for accurate analysis.

If government spending continues to increase, then economic growth will continue to slow. Recessions will become more painful and taxes will continue to increase. The government’s enormous unfunded liabilities for the next 20 years will be the biggest detriment to our economy. Instead of pushing for more central planning to “help people”, we should remove onerous regulations that tie down economic freedom. There is no government program in the world that yields stable long term economic growth and prosperity.

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