Why Government

Spending Hinders
Economic Growth
Freedom, Commerce and Peace: A Regional
Agenda Tbilisi, Georgia October 2006
Key Premises of Eurasian Growth Paradox
East European nations experienced strong
growth in the 1990s due to market
liberalization.
CIS nations have experienced strong growth
more recently due to reductions in the burden
of government.
EU membership is a mixed blessing.
Perhaps some evidence for convergence, but
only if the right policies are in place.
Issues to Contemplate
Why are the Baltic countries different?
How reliable are economic statistics?
Would long-run data tell a different
story?
Why do per capita output numbers
seemingly tell a different story?
 OECD Per Capita GDP Statistics
$16,000

$14,000
Estonia

$12,000

$10,000

All Others
$8,000

$6,000

$4,000

$2,000

Eight ex-Soviet Republics and Romania

$0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: Angus Maddison, Historical Statistics for the World Economy
World Bank Gross Natl Income Statistics
$12,000

$10,000

$8,000

$6,000

Visegrad nations and Baltics

$4,000

Russia, Romania, Bulgaria, Kazakhstan, and Belarus

$2,000

Remaining ex-Soviet Republics

$0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: World Bank, Gross National Income Per Capita

 Share of GDP
G

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10%
20%
30%
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70%
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Source: Friedrich Schneider, Shadow Economies and Corruption All Over the World: What Do We Really Know?
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Underground Economy is Large

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Government Spending and Growth
If government spending is zero, presumably
there will be very little economic growth because
enforcing contracts, protecting property, and
developing an infrastructure would be very
difficult. Some government spending is
necessary to uphold the rule of law.
Government spending reduces growth, however,
when the public sector becomes too large,
leading to punitive tax rates and misallocation of
labor and capital.
The Rahn Curve
There is a Rahn
Curve relationship
between government
spending and
economic growth
similar to the Laffer
Curve relationship
between tax rates
and tax revenue.
Empirical Estimates of the Rahn Curve
Academic studies generally find that the
growth-maximizing level of government is 17
percent-23 percent, though a European
Central Bank study put the figure as high as
30 percent.
Every single western nation and every
single transition nation spends above the
growth-maximizing level in these studies.
Because of data limitations, the actual
growth-maximizing level of spending
presumably is lower than shown in the
studies.
Burden of Government Used to be Small
50

45
Expenditures as a percent of GDP

40 Sweden
UK
35
US
30 Japan

25 Germany
France
20

15

10

0
1870 1913 1920 1937 1960

Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"

Why Big Government Hurts Growth
The Extraction Cost: The federal government
cannot spend money without first taking that
money from someone else. All of the options
used to finance government spending have
adverse consequences.
The Displacement Cost: Government
Spending Displaces Private Sector Activity.
Every dollar that the government spends
necessarily means that there is one less dollar
in the productive sector of the economy.
Why Big Government Hurts Growth
The Negative Multiplier Cost: Government
Spending Finances Harmful Intervention.
Many regulatory agencies have relatively
small budgets, but they impose large costs on
the economys productive sector.
The Behavioral Subsidy Cost: Many
government programs subsidize economically
undesirable decisions. Welfare programs
encourage people to choose leisure over
work. Unemployment insurance programs
provide an incentive to stay unemployed.
Why Big Government Hurts Growth
The Behavioral Penalty Cost: Government
programs discourage economically desirable
decisions. The incentive to save has been
undermined by government programs that
subsidize retirement, housing, and education.
The Market Distortion Cost: Government
programs interfere with competitive markets.
In both health care and education,
government efforts to reduce out-of-pocket
expenses have resulted in higher prices
because of third-party payer issue.
Why Big Government Hurts Growth
The Inefficiency Cost: Government Spending
is a Less Effective Way of Delivering Services.
A voucher system would yield better
education for less money. Privatized airports
and postal service would be more efficient.
The Inertia Cost: Government programs
inhibit innovation. Lacking a profit motive,
bureaucracies do not seek better ways of
achieving goals. This can create huge costs,
as demonstrated by Americas old welfare
system.
What Should Government Do?
There are certain core functions of government
- including national defense, legal system, and
public safety.
These core functions create conditions that
encourage people to create wealth and improve
their living standards.
These core functions preserve and enhance
liberty so people can enjoy freedom.
Limited Government Makes
Good Tax Policy More Feasible
Tax Income at one low rate, ideally no more
than 20 percent.
Define the tax base correctly, taxing Income
only one time.
Tax all income alike, since neutrality ensures
economic criteria rather than tax provisions
determine resource allocation.
Tax only income earned inside national
borders, the common-sense notion of
territorial taxation.
Fiscal Competitiveness
Todays global economy makes good
economic policy much more important.
Capital and labor (brain drain) are migrating
to the United States.
This is another reason why a lower burden of
government is helping the U.S. grow faster
and create more jobs than the EU.
Ireland is another success story.
Jurisdictional competition is a powerful force
for economic liberalization, one that should
be celebrated rather than persecuted.
More on Competitiveness
OECD economists have written that the ability to
choose the location of economic activity offsets
shortcomings in government budgeting processes,
limiting a tendency to spend and tax excessively.
Gary Becker observed that competition among
nations tends to produce a race to the top rather
than to the bottom by limiting the ability of
powerful and voracious groups and politicians in
each nation to impose their will at the expense of
the interests of the vast majority of their
populations.
Conclusion
Very few if any nations have inadequate
levels of government.
Every nation in the Eurasian Growth Paradox
paper has too much government spending
according to Rahn Curve research.
The Eurasian Growth Paradox paper shows
the economic benefits of climbing the right
side of the Rahn Curve somewhat akin to
Laffer Curve research showing the benefit of
lowering tax rates when they are so high that
government loses revenue.