Lower spending would deliver stronger economic growth

May 22, 2012 10:40 AM

Some of the criticisms of the 2020 Tax Commission have argued that we are wrong to claim that lower taxes and spending are associated with higher growth. In particular, Nick Pearce - Director of the IPPR - argues that "the empirical evidence doesn’t support" that view. Unfortunately he hasn't seen fit to address the mountains of evidence that we included in the report looking at exactly that issue. In just one table in the report we included eighteen reputable studies that show a negative effect of higher taxes or spending on the level or growth of income. That's a lot of empirical evidence.

Nick Pearce fudges the point about the Scandinavian economies by citing tax revenue as a share of national income when, for a whole load of reasons, spending is a much more reliable variable in this instance. Lower taxes can produce better than expected tax revenues, after all, and public sector deficits can also crowd out private investment. The overall tax burden is very important in some ways, but he is just using it to play down a genuine and substantial cut in the total burden on the private economy in this case.

The same goes for his comparison of per capita growth rates between the Nordic countries and the United States since the 1960s, which ignores about a billion other things going on. It is also worth bearing in mind that, if he really wants to emulate economic policy in those countries he will also need to introduce a less progressive tax system. The comparison over time with the UK is just as weak, and appears to have perilously few data points.

The only systematic evidence he cites is from Peter Lindert, who he describes as the "world's leading authority on the development of welfare states and public services since the 18th century" and quotes as saying - in a 2004 book - that across "countries and over time, the coefficients linking growth to total government size are not negative, even in sophisticated multivariate analysis."

Peter Lindert is indeed a distinguished man, the 1,494th most influential economist in the world. But plenty of other researchers before and since he published his book have come to different conclusions. In 1997, Robert Barro - the 4th most influential economist in the world if you want to play "my economist's more important than yours"  - found that a 1 per cent increase in government consumption as a share of national income reduces growth by 0.136 per cent. More recently, Afonso and Furceri at the European Central Bank found that a 1 per cent increase in government spending as a share of national income reduces growth by 0.13 per cent. That is just two examples. You can see the others in Table 3.4 on page 133 of our full report, or in this timeline.



The weight of empirical evidence is clearly on the side of the view that higher spending is associated with lower economic growth and that isn't some kind of accident. Taxes create deadweight costs because they drive a wedge between the price signals perceived by consumers and those received by producers. That means work that isn't done, so the level of national income is lower. It also means investments that don't take place, so technological progress isn't embodied in new capital equipment and national income doesn't grow as quickly.

Of course, some public spending will also increase growth. It depends how valuable that spending is though and, as the reports cited above show the overall effect is normally negative. To give a further example, an OECD study in 2003 found that if you count them separately spending increases growth by 0.19 per cent, taxes reduce it by 0.44 per cent for an overall effect of higher taxes and spending on growth of 0.25 per cent less growth for every additional percent of spending in national income.

The lessons of history, and the empirical evidence, clearly support the claim that lower spending and lower taxes will tend to mean higher economic growth.Some of the criticisms of the 2020 Tax Commission have argued that we are wrong to claim that lower taxes and spending are associated with higher growth. In particular, Nick Pearce - Director of the IPPR - argues that "the empirical evidence doesn’t support" that view. Unfortunately he hasn't seen fit to address the mountains of evidence that we included in the report looking at exactly that issue. In just one table in the report we included eighteen reputable studies that show a negative effect of higher taxes or spending on the level or growth of income. That's a lot of empirical evidence.

Nick Pearce fudges the point about the Scandinavian economies by citing tax revenue as a share of national income when, for a whole load of reasons, spending is a much more reliable variable in this instance. Lower taxes can produce better than expected tax revenues, after all, and public sector deficits can also crowd out private investment. The overall tax burden is very important in some ways, but he is just using it to play down a genuine and substantial cut in the total burden on the private economy in this case.

The same goes for his comparison of per capita growth rates between the Nordic countries and the United States since the 1960s, which ignores about a billion other things going on. It is also worth bearing in mind that, if he really wants to emulate economic policy in those countries he will also need to introduce a less progressive tax system. The comparison over time with the UK is just as weak, and appears to have perilously few data points.

The only systematic evidence he cites is from Peter Lindert, who he describes as the "world's leading authority on the development of welfare states and public services since the 18th century" and quotes as saying - in a 2004 book - that across "countries and over time, the coefficients linking growth to total government size are not negative, even in sophisticated multivariate analysis."

Peter Lindert is indeed a distinguished man, the 1,494th most influential economist in the world. But plenty of other researchers before and since he published his book have come to different conclusions. In 1997, Robert Barro - the 4th most influential economist in the world if you want to play "my economist's more important than yours"  - found that a 1 per cent increase in government consumption as a share of national income reduces growth by 0.136 per cent. More recently, Afonso and Furceri at the European Central Bank found that a 1 per cent increase in government spending as a share of national income reduces growth by 0.13 per cent. That is just two examples. You can see the others in Table 3.4 on page 133 of our full report, or in this timeline.



The weight of empirical evidence is clearly on the side of the view that higher spending is associated with lower economic growth and that isn't some kind of accident. Taxes create deadweight costs because they drive a wedge between the price signals perceived by consumers and those received by producers. That means work that isn't done, so the level of national income is lower. It also means investments that don't take place, so technological progress isn't embodied in new capital equipment and national income doesn't grow as quickly.

Of course, some public spending will also increase growth. It depends how valuable that spending is though and, as the reports cited above show the overall effect is normally negative. To give a further example, an OECD study in 2003 found that if you count them separately spending increases growth by 0.19 per cent, taxes reduce it by 0.44 per cent for an overall effect of higher taxes and spending on growth of 0.25 per cent less growth for every additional percent of spending in national income.

The lessons of history, and the empirical evidence, clearly support the claim that lower spending and lower taxes will tend to mean higher economic growth.

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