Government spending is no free lunch

In the 1980s, many commentators ridiculed the extreme supply-side view that across-the-board cuts in income tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called "multiplier" effect of government spending on economic output is greater than 1, says Robert Barro, a senior fellow at the Hoover Institution.

What does the data show about multipliers? Since it's not easy to separate movements in government purchases from overall business fluctuations, the best evidence comes from large changes in military purchases. A particularly good experiment is the massive expansion of U.S. defence expenditures during World War II, says Barro:

He estimates that WWII raised U.S. defence expenditures by $540 billion and real gross domestic product (GDP) by $430 billion (1996 dollars) from 1943-44.

Thus, the multiplier was .8.

The main declines were in private investment, non-military parts of government purchases and net exports.

Wartime production siphoned off resources from other economic uses.

Yet, there are reasons to believe that the war-based multiplier of .8 substantially overstates the multiplier that applies to peacetime government purchases:

People would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot).

The use of the military draft in wartime has a direct, coercive effect on total employment.

Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays.

Much more focus should be on incentives for people and businesses to invest, produce and work, says Barro. On the tax side, the U.S. should avoid programs that throw money at people and emphasise instead reductions in marginal income-tax rates. On the spending side, the U.S. should not be considering massive public-works programmes that do not pass muster from the perspective of cost-benefit analysis.

Source: Robert J. Barro, Government Spending Is No Free Lunch, Wall Street Journal, January 22, 2009.

For text: http://online.wsj.com/article/SB123258618204604599.html

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

FMF Policy Bulletin/ 27 January 2009