Size of Government - A Perspective on the Fundamental Washington Divide

8/22/2019 Size of Government - A Perspective on the Fundamental Washington Divide

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Hamilton Place Strategies | 1

Janurary28, 2012

Size of Government:A Perspective on the Fundamental

Washington Divide

President Obama, in his second inaugural address, made a forcefuldefense of government's role in our lives and our economy, arguing

that the private sector alone cannot provide the necessary services tostrengthen the nation, and that the government must play a largerpart. Opponents were quick to argue the merits of a limited state. At

the heart of this ongoing debate is one question: What is the propersize of government?

Government spending has reached recordlevels and is projected to increase around

4 percent per year for the next 10 years.1Since the growth in revenues has not keptpace with outlays, a large amountof spending has been paid for by theaccumulation of debt. Budget deficits areexpected to reach 100% of GDP within a

decade a level last seen just after WorldWar II. These record levels are projected tokeep growing. According to the CBO'sAlternative Fiscal Scenario, debt-to-GDP will exceed 200% by 2038(Exhibit 1).

By definition, two things must happen if spending continues to

outpace revenue growth either America will continue to increase itsdeficit or taxes must be raised. Neither of these approaches aresustainable in the long run. At some point the United States' debtburden will increase to a level where we cannot afford to service our

1Congressional Budget Office, "Historical Budget Data," January, 2012

Matt McDonald

Robert Terra

Hamilton Place Strategies805 15th St NW, Suite 700

Washington, DC 20005

(202) 822-1205

At the heart

of thisongoing

debate is one

question:

What is the

proper size ofgovernment?


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debt, or investors stop lending to the federal government. Simply raising taxesrepeatedly as the government needs funding will not work either, as these rates willreach a point that negatively impacts growth and employment.

Ultimately, the current budget battles are about finding a sustainable budget policygoing forward. Everyone understands the United States government plays an

important part in the lives of American citizens, and this role comes at a cost. Thispaper outlines some ways to think about striking that balance.

Government Spending in Relation to Optimal Growth

One way to evaluate government spending is through the lens of economic growth.A robust economy can lead to greater wealth, higher employment rates, betterstandards of living, and a host of other benefits that people value. A rationalapproach to government spending is to seek the level that will maximize growth.

There is, of course, debate over the optimal amount of government spending

needed to create the highest level of growth. Although point estimates are difficultto calculate, a recent study cited by many economists (Chobanov and Mladenova,2009) estimated that 25 percent of GDP is the upper bound of spending for state,local, and federal government combined in order to optimize growth. Thiscalculation used data from OECD countries and found that as total governmentspending exceeds the 25 percent ceiling, the negative impact on GDP growth gets

Exhibit!1 !

Unsustainable

Spending

Interest paymentsare expected to

more than double

in 10 years to $1

trillion, which will

crowd out popular

programs! You would have to

tax everyone

making over $500K

a year at an

effective rate of

100% to close the

deficit!0

50

100

150

200

2030!2020!2010!2000!1990!1980!1970!1960!1949!

GOVERNMENT SPENDING CONTINUES TO BE

PAID FOR BY MASSIVE PUBLIC DEBT!

Source: Congressional Budget Office, Internal Revenue Service!

%G

DP

Projected!Debt!

Debt-to-GDP Ratio


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exponentially stronger.2 The United States has exceeded this level since the late1950's (Exhibit 2). Recently, overall government spending has reached record levelsand is projected to further increase.

If this theory holds, we may be in a tipping point scenario where the drag on

growth at projected levels of spending will result in a "new normal" lower level ofgrowth going forward.

Accounting for Income Inequality

Gauging the size of government based on economic growth alone may be a logicalexercise, but it does not account for the entire role of the government. Without aperception of economic fairness, high GDP may not last or may not be tolerated byvoters. Optimal growth is difficult to sustain if there are riots in the streets.

A modification to the first approach would be to say that we want to maximizeGDP subject to the constraint of stability and fairness. This is necessarily a subjective

approach, but there are indicators we can look at to gauge where things stand. TheDepartment of Commerce's Gini Coefficient is a tool to determine the level of

inequality that exists in the U.S. an increasing coefficient signals an increase inincome inequality. The Gini Coefficient has been steadily increasing since the late1960s, and income growth has been volatile but continuously trending downward(Exhibit 3). Recently, the ratio experienced a sharp rise as the country went into

2

Dimitar Chobanov and Adriana Mladenova, "What Is The Optimum Size Of Government," Institute for Market Economics, August, 2009

Exhibit!2 !

Difference Between Actual !Spending And Preferred Limit!

0

5

10

15

20

25

30

35

40

1980! 1990! 2010!

Optimal Spending Limit!

Government Spending!

2000!1950! 1960! 1970!Source: Office of Management and Budget!

%G

DP

HIGHER LEVELS OF GOVERNMENT SPENDING

COULD INHIBIT GROWTH

Total Government share of GDP

Federal, State and Local! The U.S. has perhapsreached levels that spending

is now a drag on GDP

growth

Government Spending has been

over the limit since the late

1950s, but there have been

sustained periods of growth


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economic recession. With the state of the economy still in flux, this trend couldpersist for years to come.

There are two general ways that policy-makers try to decrease income inequalitythrough encouraging private sector growth or through public sector intervention.The belief that income equality is driven by the private sector rests on the fact that

the majority of jobs are created by businesses. If businesses are allowed to innovatein a free market system with low taxes and regulation, then they will expand anddemand a greater supply of workers. This environment lifts wages and thereforedecreases inequality.

Public sector intervention, on the other hand, is the belief that the governmentmust step in to promote equality. This implies that businesses' focus on profit is atodds with the goal of wage growth. Since the government is not bound by thispressure, it can focus more on the income gap. The government can provide bettereducation and training programs to provide workers with the tools to achievehigher-paying jobs. If needed, it can also act as a buffer to provide subsistence to

those in the lower income bracket through programs such as welfare and incomeassistance.A Changing Economy

Whether we're looking at spending from the perspective of GDP growth orincome equality,the central argument is about the role people want thegovernment to play in our lives. This role tends to evolve with economic demands.

Exhibit!3 !

Source: U.S. Department of Commerce: Census Bureau!

0.30

0.32

0.34

0.36

0.38

0.40

0.42

0.44

0.46

0.48

1 96 5 1 97 0 1 97 5 1 98 0 1 98 5 1 99 0 1 99 5 2 00 0 2 00 5 2 01 0 2 01 5

-4

-2

0

2

4

6

8

Historical Gini Ratio trend in the United States !Disposable Income Growth !Per Capita!GINI Coefficient!

GiniRatio

DisposableIncomeGrowthperCapita(%)

U.S INCOME INEQUALITY HAS INCREASED ASDISPOSABLE INCOME HAS DECREASED

Methods to address

income inequality:

Foster strong businessenvironment!

Improve education! Workforce training! Government

assistance!


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The government's two general purposes are defense, as the federal government issolely in charge of our armed forces, and as a service provider in amultitude of areas that range from healthcare to transportation. The balance of thesecore functions has shifted over time. Exhibit 4

depicts the government's historical spendingon defense and major service programs. Italso gives a projection by the Office ofManagement and Budget on what to expectin the coming years.

As the chart points out, major publicservices (Health Care, Medicare, SocialSecurity, Income Assistance, Transportation, Education, and Veterans Benefits) havecontinued to grow at a much faster pace than defense as a percentage of overallspending. Essentially, the American people are using comparatively moregovernment services, and this trend is expected to increase in the long-term.

This trend is in the contex of significant growth in overall services, both private andpublic, in the American economy. Total services account for approximately 65

percent of GDP today almost double than what it was in 1962 just before thegovernment started providing Medicare. Although government service programshave steadily increased their share of overall public spending, this proportion hasremained relatively flat as a percentage of the entire service sector over the past

three decades(Exhibit 5).

Exhibit!4 !

Source: Office of Management and Budget!

Shareoffederalbud

get(%)

MORE AMERICANS RELY ON FEDERAL SERVICES,

LEADING TO A SHIFT IN SPENDING PRIORITIES

70!60!50!40!30!20!10!0!

100!90!80!

2017!2006!1995!1984!1973!1962!

National Defense!

Other Federal Spending!

Federal Services!

Components of Federal Spending over Time!The role of the federal

government is changing

National defense continuesto take on a smaller share

of the federal budget! Over 60% of the budget is

comprised by major

government services

(Health Care, Medicare,

Social Security, Income

Assistance, Transportation,

Education, and Veterans

Benefits)! This trend is projected to

continue in the long-term!

The American people

are using

comparatively moregovernment services,

and this trend is

expected to increase

in the future.


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This increasing demand in overall services is relevant to the way in which oneperceives the future of government spending. If you believe there are services thegovernment should provide thengovernment should grow as thereis more demand for services in oureconomy even if the its share of

overall services stays stable.

Conclusion

It is clear from the President's inauguration speech that the government's spendinghabits will continue to be a contested topic. As long as this debate remains in the"more versus less" dynamic, little progress will be made. A more productive focus

would be working toward an agreement on common goals. This may not in theend produce agreement, but it might generate understanding.

Exhibit!5 !

0

10

20

30

40

50

60

70

1960 1970 1980 1990 2000 2010 2020

Private services are

contributing to the

increase in overall GDP

makeup!!It will continue to cost

the public more if

government services

continue to maintain or

increase its current

portion of the overallservice sector!

Source: Federal Reserve Of St. Louis!

GOVERNMENT SHARE OF OVERALL SERVICE

SECTOR HAS REMAINED STABLE

Government services as a!share of all services!Services as a share of GDP!

%!

Service Sector Trends in the United States!

if you believe there are

services the government

should provide then it makessense that government should

grow as there is more demand

for services in our economy

Size of Government - A Perspective on the Fundamental Washington Divide

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