Federal Government Must Revamp Spending To Maximize Economic Growth
Given Congress’s lack of budget discipline, House Majority Leader Kevin McCarthy and other congressional fiscal hawks are considering a “rescission” bill to cut up to $15 billion in federal spending. This would be a welcome start, but Washington must overhaul its thinking on spending altogether.
The time has come to finally impose a hard budget constraint. Constraining federal spending to 15% of national income — that is, GDP less depreciation — would eliminate the negative impact that overspending has on growth and make the coming fiscal crises easier to manage.
This is the 15% solution. Its premise is that government spending is no different from any other economic good. If the right public services are provided, then initially these services will be highly valued relative to the cost of financing them — think building a firehouse in a town that has none.
However, as the government spends more — as it builds more firehouses — the benefits from additional expenditures diminish. Ultimately, there is a spending level where the value of additional government spending is essentially equivalent to the cost of financing that spending. This level of spending maximizes the government’s beneficial impact on the economy and represents the affordable size of government.
This contrasts with the popular view that more government spending stimulates the economy, regardless of how much we are spending or how we are spending those dollars.
The federal government will spend around $4.2 trillion in 2018 — around 24% of national income. In a recent Pacific Research Institute study, I estimated that the federal government’s growth-maximizing spending level is significantly smaller — closer to 15% of national income.
Since public expenditures are above 15% of national income, the additional federal government spending is reducing economic growth. The long-term consequences of this excessive spending are significant. Had government spending followed the 15% solution, the median family income as of 2016 could be 34% higher than it was — $97,185, rather than the actual value of $72,707.
The 15 Percent Solution
As these numbers indicate, implementing the 15% solution would require steep expenditure reductions relative to national income. Consequently, a gradual approach should be taken, capping the growth in government spending to less than the average growth in national income.
If annual federal spending growth were restricted to 3% per year — assuming 2% inflation — then the budget would be balanced within a decade and would be affordable within two decades. Once federal expenditures are at an affordable level, federal expenditures should then grow at the average growth in national income.
Establishing the affordable level of government is only the beginning. How government spends tax dollars also matters.
While overall expenditures are too high, there’s no reason to believe that the budget restrictions necessary for one type of public good — like defense — are the same as the restrictions necessary for others — say, education. The value gained from additional defense expenditures may be less than the additional costs necessary to fund those services, while the net value gained from additional education expenditures may exceed those costs.
Unlike the sequester, effective budget caps force Congress to prioritize spending programs against their goals and against other spending priorities. In addition, waste, fraud, or abuse never contribute to economic growth — and so must be eliminated.
Recognizing that government spending must be affordable also illustrates the futility of stimulus spending. For example, the 2009 Obama-era stimulus was supposed to accelerate the economic recovery from the Great Recession but was destined to detract from economic growth because federal government spending was already above the affordability level.
Simply put, the value of the public goods provided by the Obama stimulus was far less than the value of those resources if they’d remained in the private sector.
In the 1980s, President Reagan correctly identified government spending as the problem. But it does not have to be. If implemented, the 15 percent solution would make government more affordable for taxpayers and more efficient for all citizens. While Congress shows little inclination for such common-sense reforms, large and growing tax and debt burdens demand it.