Spending and Growth - David Howarth
Transcript of Spending and Growth - David Howarth
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A response to David Laws
David Howarth
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David Laws has recently received much favourable publicity in the Conservative
press for advocating further spending cuts and tax cuts. He wrote:
Future UK governments should consider a further substantial real rise in the
personal tax allowance, along with lower marginal rates of tax at all income
levels. This can be paid for over time by continuing to reduce the share of
public spending in GDP [E]ven after the existing fiscal consolidation, state
spending will account for some 40% of GDP, a figure that would have shocked
not only Adam Smith, Gladstone and J.S. Mill, but also Keynes and Lloyd
George. The implication of the state spending 40% of national income is that
there is likely to be too much resource misallocation and too much waste and
inefficiency. (David Laws, The Orange Book: Eight Years On, Economic
Affairs 32:2 (June 2012) 31 at 34).
Perhaps the enthusiasm of readers of the Tory press might have been dampened iftheir journalists had allowed them to read some of the other things Laws wrote, for
example:
If economic liberalism has proved itself over time as the best guarantor of
wealth creation, it has proved rather less successful in delivering the society of
opportunity that many liberals would like to see. Too often, free market
capitalism has been associated with gross inequalities of wealth, income and
opportunity. No liberal can be content to live in a society where life chances
are determined more by family background and parental income than by
natural ability.
Milton Friedman claimed in his famous book Capitalism and Freedom(1962)
that capitalist societies would be meritocracies, in which social mobility would
be high and in which everyone would enjoy opportunity. While it is true that
most liberal societies are increasingly meritocracies where people are judged
on their personal worth and not on their race, class, creed, sex or sexuality,
the sad fact is that the chances of acquiring merit are grossly unequal. (ibid.)
But leaving to one side the ideological debate about meritocracy, Laws assertion
that public spending at 40% of GDP leads to too much resource misallocation and
inefficiency, although itself rather imprecise and politically calibrated for serious
analysis (too much for what and compared to what?), does prompt the question of
what we know, as a matter of empirical fact, about the relationship between public
spending and economic growth. Is Laws right to imply that reducing the overall
share of public spending in GDP will lead to greater prosperity?
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In 2007, I wrote:
Despite much research effort, the fundamental position is still as Jonathan
Temple stated it in 1999: In political discussion it is common to hear claims
that a high ratio of social security transfers to GDP and a high level of
government consumption can be damaging to growth prospects. The
evidence is not strong. Some researchers find a negative link between
government consumption and growth, but overall studies disagree, and it
would be wrong to argue that a correlation between small government and
fast growth leaps out from the data. Work continues on whether particular
types of government expenditure are likely to have positive or negative
effects on conventional economic growth, but industrial subsidies seem to be
a more likely source of economic failure than social security payments.
(Duncan Brack and Ed Randall (eds), Dictionary of Liberal Thought(2007) at
103)
The research in the area has moved on since then. The overall assessment that the
correlation between reducing public expenditure and encouraging economic growth
is not as clear as the political right would have us believe still stands, but there is
more to say, and some emerging themes of the research, especially that of Norman
Gemmell, Richard Kneller and Ismael Sanz in their so far unpublished study Does
the composition of government expenditure matter for economic growth?, is worth
reporting to a wider audience.
The first point is that, although the relationship between higher public spending and
lower growth rates remains weak and not statistically significant, stronger
relationships appear if we differentiate between different ways of funding higher
spending. Roughly speaking, if higher spending is funded by taxes on consumption,
no adverse effect on long term growth rates can be demonstrated, but if it is funded
by direct taxes an adverse relationship does appear. Deficit funding, significantly for
present political purposes, also has an adverse long-term effect, but a much lower
one than that of direct taxation.
Clearer results are also starting to emerge about different forms of public spending.Again roughly speaking, public expenditure on transport and communications
infrastructure raises long term growth rates, as does expenditure on education. That
much has been suspected for a while, but researchers are now starting to find
evidence that public expenditure on health is also associated with higher long term
growth, although the effect is only about a third of that of expenditure on education.
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Spending on housing and defence, however, has no statistically significant long-term
effect. The only statistically significant negative relationship for a category of public
spending found by Gemmell, Kneller and Sanz is for welfare spending (as we have
been browbeaten into calling social security spending, in obeisant imitation of the
US Right), but it is interesting that the effect is quite small a loss, they estimate, of0.04% in annual growth of GDP for every additional percentage point of GDP spent
on social security, assuming that spending on all other functions falls proportionately
by an equal amount.
Some work has also been done on breaking down the categories of expenditure into
more specific types. For example, the work of Vandenbussche, Aghion and others
seems to show that education spending works better for countries operating at the
boundaries of existing technology (that is to say, highly developed countries) if it is
spent on higher education and research, whereas for countries that are not so
technologically advanced, and which aim to grow through imitating the innovationproduced by others rather than through innovating themselves, expenditure is best
directed at lower levels of the education system.
What are the policy implications of these emerging themes? Economic policy is not,
of course, only about economic growth. Other policy goals such as the
environment and social justice are important, and GDP itself is far from a perfect
measure of welfare. But even if we look only at the growth issue, although some of
these results reinforce David Laws position, in particular his desire to reduce direct
taxation, they suggest that he is not right to imply that public spending itselfnecessarily kills off growth. Some forms of public expenditure are good for growth,
regardless of the theoretical objection that public expenditure not guided by the
market risks misallocation. Those forms of expenditure include not only transport
and communications infrastructure a form of spending both David Laws and David
Cameron seem to favour and not only education spending of which Laws also
approves but also health spending, a result that gives more comfort to a different
strand of Liberal Democrat politics.
Another problem with Laws position is that the policy he has promoted of reducing
spending on higher education in favour of raising it on school education especiallythrough the pupil premium turns out to be just the kind of misallocation of
resources he denounces. In a developed country such as Britain, it amounts to
redistributive spending that will eventually cut economic growth.
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If we want to finance redistributive spending such as the pupil premium without
adversely affecting growth, the options should be restricted to reducing other forms
of redistributive spending, reducing spending on relatively economically
unproductive functions, such as defence, or by raising expenditure taxes. Unless his
long-term strategy is to move Britain back from the frontiers of technology andtowards developing country status, the idea that higher education spending is
merely a subsidy for the middle-class makes no economic sense.
Instead of the rather odd strategy of cutting overall public expenditure while
increasing the purely redistributive elements of education spending we might start
to think about a different strategy for the period beyond the current era of austerity.
That strategy would start with determinedly shifting the composition of public
spending towards those forms of spending that tend to produce growth, which
includes not only transport and communications infrastructure and higher education,
but also health. We could fund increases in spending on those areas withoutdamaging growth, and without increasing the deficit, by increasing consumption
taxes. We could further enhance the positive impact of such a financing strategy by
concentrating on expenditure taxes that promote other important policy goals, for
example environmental taxes.
Another option for financing increases in spending on growth-enhancing functions
would be to reduce spending on other, less economically productive, areas. The
current government is targeting social security spending, and we should
acknowledge that the evidence shows that such reductions would probably enhancegrowth. The question, however, is whether one could justify their effects in terms of
poverty and inequality in the light of the size of the gains available in long-term
economic growth rates. If 1% of GDP off social security brings in only 0.04% on the
growth rate, we are not being confronted by an overwhelmingly impressive return.
On those numbers, even if the whole of the budget of the Department of Work and
Pensions were to be cut, even assuming, contrary perhaps to reality, that the effects
on growth would the same for the last billion as for the first, the long-term rate of
growth in GDP would rise by no more than 0.4%. More realistically, the extra 10bn
in welfare cuts demanded by George Osborne would change the annual growthrate by an imperceptible 0.027%.
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If, by the time the country is in a position once again to consider a long-term
economic policy, there remain any growth-strangling non-environmental subsidies
for production (perhaps there might be some in defence), they should, of course, go.
We should also finally ditch Britains imperial pretensions and face down the defence
industry lobby. Defence spending is not good for long-term growth and thoseexpenditures would be better directed elsewhere. There might also be specific
examples of redistributive spending that we might want to suppress, either because
they do not work or, more importantly, because they redistribute in an irrelevant way
for example, as in the case of some general benefits, to people who are
comfortably off anyway, or, as in the case of some benefits for pensioners, from the
working poor to the retired upper middle class. But in the end, if we are to spend to
enhance long-term growth without starting another cycle of debt, the choice will
come down to cutting redistributive spending or raising indirect taxes. Liberals
should choose the latter.
David Howarth is a Reader in Private Law in the Department of Land Economy and a
Fellow of Clare College at the University of Cambridge. He was the Liberal Democrat
Member of Parliament for Cambridge between 2005 and 2010.