Government is an expense, not an income

I wrote here and here about why we should view government spending as an expense for the economy, rather than an income, as it is treated in the formula for Gross Domestic Product (GDP = Consumer Spending + Investment Spending + Government Spending).

In the latest issue of Forbes magazine, Amity Schlaes points to research that may confirm my view in her column, Tax Summit for Growth:

Scholars Andreas Bergh and Magnus Henrekson found a negative correlation between government size and economic growth. When government increases by 10%, annual growth decreases by up to one percentage point. So if the U.S. were to cut its income or dividend tax rates the cut might not take us all the way to a 5% growth rate, but it might get us to at least 3%.

I’m always skeptical of statistical studies, even those that confirm my own views. Here, my skepticism is in the magnitude of the correlation, where a 10% growth in government leads to only a 1% point reduction in economic growth.

But, then again, there’s a couple of things to consider here.

First, since government doesn’t usually make up the entire GDP of an economy, this effect may be larger than it appears at first glance.

For example, consider an economy of size 100, with government spending making up 20 of that. A 10% increase in government moves it from 20 to 22. A 1% reduction in the economy moves it from 100 to 99. So a 2 unit increase in government translates into a 1 unit decrease in the economy. That’s a big effect.

Second, the effect of government spending now is spread out over time, so Bergh and Henrekson’s study may only capture the cost in the current period . Government, like you and I, can only spend wealth that was created in the past or will be created in the future.

Governments that borrow heavily to fund their current spending, may reduce the economy by 1 unit now and more units in the future.

Schlaes makes some other great points in her column and I recommend reading the whole thing.

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