More Government Spending Is No Solution

Around the world, the pandemic has wreaked havoc with government finances. On one side of the fiscal equation, politicians have increased spending – by staggering amounts in some cases. On the other side of the fiscal equation, tax revenues have dropped because more people are out of work, and many businesses are losing money rather than earning profits.

That’s the bad news.

The good news is that some of the fiscal damage is temporary. As more people are vaccinated and as economies come back to life, there won’t be as much pressure for coronavirus-related emergency spending. Moreover, tax revenues will rebound as people go back to work and more businesses begin to make money again.

That being said, there will be two big ongoing fiscal issues.

First, there probably won’t be a full economic recovery. Some businesses have disappeared, forever. And some jobs are permanently lost. We will see, of course, some new businesses spring to life, of course, and there also will be new jobs, but it’s quite likely that the economy’s output won’t return to the pre-pandemic trendline.

This means continuing pressure for politicians to approve more spending – even if there’s no longer an emergency. And there will also be a continuing loss of tax revenue – at least compared to that pre-pandemic trendline.

Second, nations will be dealing with unprecedented levels of red ink. Government debt has soared in almost every nation, and annual deficits – which were already significant in most nations before the crisis – presumably will be even higher in the future.

What does this mean and what should be done?

To answer those questions, this presentation can be divided into three sections.

First, we’ll augment the grim pandemic-driven fiscal news with even-worse demographic fiscal news.

Second, we’ll discuss how the real problem in the western world is the size of government, not red ink.

Third, we’ll conclude with some analysis of spending caps, which are the only feasible solution to the fiscal mess impacting most nations.

There’s been a big population shift in almost all developed nations.

We used to have population pyramids, which is how a nation’s population profile looks when there are a few old people, lots of working-age people, and then even larger numbers of children.

But now we’re living longer and having fewer kids. In some sense, population pyramids are becoming population cylinders.

And this creates major fiscal challenges because there will be more spending for entitlement programs such as old-age benefits and health care for the elderly.

But at the same time, there are fewer and fewer workers, at least relatively speaking, to finance all that spending.

To use the jargon of budget wonks, you wind up with “old-age dependency ratios” that require very onerous tax burdens (or very high levels of government borrowing), or both.

This is a big problem for the United States.

Long-run forecasts from the Congressional Budget Office in Washington show that government spending will consume an additional 10-percentage points of GDP over the next several decades.

Japan is also in serious trouble. Government is projected to become a bigger burden – so we can only imagine what will happen to debt levels in that country.

Now let’s look at some recent data to show that Europe is another part of the world where this problem is especially acute.

The European Commission published its 2021 Ageing Report late last year and there are three visuals that deserve attention.

First, take a look at the European Union’s population profile. Except it’s not a pyramid. It’s more like a cylinder (or maybe an upside-down pyramid).

And then, compare the number of old people with the working-age population in 2019, 2045, and 2070.

From the perspective of fiscal policy, these are horrific numbers.

But there are numbers that are even worse, such as, for example, the economic dependency ratio, which the European Commission defines as “… the ratio between the total inactive population and employment. It gives a measure of the average number of individuals that each employed person ‘supports’ economically.”

The bottom line is that most European nations already have a stifling fiscal burden, yet it’s all but certain that there will be even higher taxes, even higher debt, and even more government spending in the near future.

Which means more economic stagnation for Europe (and those of us in America face that possibility as well).

Almost everyone agrees we should be worried. The fiscal effects of the pandemic and the fiscal effects of demographic change are a potent one-two punch.

But there isn’t necessarily agreement on why we should be worried.

Is the long-run fiscal problem too much red ink? In other words, high deficits and ever-accumulating debt?

Or is an ever-increasing burden of government spending the long-run fiscal problem?

According to a lot of scholarly research, the latter option – excessive spending – is the real problem.

There is nothing wrong with fretting about deficits and debt, incidentally. Nations such as Greece demonstrate that it is possible to accumulate so much debt that it leads to a fiscal crisis. But the key thing to understand is that excessive spending over a long period of time is the reason that Greece had a meltdown.

The bottom line is that most types of government spending are bad for an economy, regardless of whether they are financed by taxes or borrowing.

So while most of us instinctively don’t like government borrowing, never forget that replacing debt-financed spending with tax-financed spending is like jumping out of the frying pan and into the fire. Or the fire into the frying pan, if you prefer. In either case, politicians are ignoring the real problem.

We know we have a massive fiscal problem, but how do we solve the problem?

Many people think the answer is some sort of balanced budget requirement. Many states in America have such policies. Nations in the European Union supposedly have to comply with the Maastricht rules limiting deficits and debt.

But these rules limiting red ink are not very successful. Many American states – such as Illinois, New York, California, and New Jersey – have enormous levels of debt and bloated public sectors.

Balanced budget requirements didn’t stop bad fiscal policy in these states. Indeed, they may have helped push policy in the wrong direction by giving politicians an excuse the raise taxes.

Similarly, the Maastricht rules in Europe have not stopped politicians in countries such as Greece and Italy from imposing more spending, more taxes, and more debt on their nations.

That’s why it is much better to directly tackle the problem of excessive spending with an annual spending cap.

The underlying principle of this approach is very simple. Simply impose some type of limit on how fast politicians can increase spending from one year to the next.

A spending cap tells politicians they can increase spending by, say, 2 percent each year. They can do that even when the economy is in recession. They can also do it when the economy is growing quickly.. But a spending cap also tells politicians they can increase spending by only 2 percent when the economy is growing quickly and revenues are rapidly increasing.

Progress will be possible so long as the spending cap limits spending so that government budgets grow slower than the private economy.

There’s a very practical reason to focus on capping long-run spending rather than trying to balance the budget every year. Simply stated, the “business cycle” makes the latter very difficult.

Here’s why: when a recession occurs and revenues drop, a balanced-budget mandate requires politicians to make dramatic changes at a time when they are especially reluctant to either raise taxes or impose spending restraint. Then, when the economy is enjoying strong growth and producing lots of tax revenue, a balanced-budget requirement doesn’t impose much restraint on spending.

All of which creates an unfortunate cycle. Politicians spend a lot of money during the good years, creating expectations of more and more money for various interest groups. When a recession occurs, the politicians suddenly have to slam on the brakes. But even if they actually cut spending, it is rarely reduced to the level it was when the economy began its upswing. Moreover, politicians often raise taxes as part of these efforts to comply with anti-deficit rules.

When the recession ends and revenues begin to rise again, the process starts over—this time from a higher base of spending and with a bigger tax burden. Over the long run, these cycles create a ratchet effect, with the burden of government spending always reaching new plateaus.

Let’s look at some real-world evidence.

The bad news is that very few governments have imposed spending caps. The good news is that there have been very positive results when such policies are in effect.

In Hong Kong, Article 107 of the Basic Law (the jurisdiction’s constitution) states, “The Hong Kong Special Administrative Region shall . . . keep the budget commensurate with the growth rate of its gross domestic product.”

This sensible policy helps explain why total government spending averages less than 20 percent of GDP, significantly lower than the total burden of spending in America and far lower than in Europe’s welfare states.

In Switzerland, voters used a referendum in 2001 to impose a so-called debt brake, which operationally functions as a spending cap. Outlays have expanded by only about 2 percent annually since the constitutional reform was implemented. That restraint has led to a modest reduction in the burden of spending relative to GDP and a big reduction in government debt as a share of economic output.

By the way, spending caps do have emergency opt-out provisions. So if something happens, – such as a war – or a pandemic – the spending cap can be set aside. But there should be strict rules to make sure politicians can’t turn an emergency opt-out into a regular loophole.

Let’s conclude with a warning. With the exception of a tiny handful of jurisdictions that don’t have welfare states – such as Hong Kong and Singapore, the world’s developed nations have big long-run fiscal challenges.

Those challenges existed before the pandemic, and the pandemic has made a bad situation even worse.

The core problem in these countries is government growing faster than the private sector. That’s happened in the past, it’s happening now, and it’s projected to happen in the future.

A spending cap is the only approach that can successfully fix this problem.

If you deal with the underlying disease of government growing that is too fast, you solve the symptom of government red ink.

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• More Government Spending Is No Solution by Daniel J. Mitchell