Martin Tod recently drew my attention to a short publication from David Howarth published over the summer about levels of public spending: Spending and Growth – a response to David Laws.
As the title suggests, it is primarily a response to someone else’s views on appropriate levels of public spending:
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?
David Howarth argues that the evidence does not stack up for the Laws view:
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.’ …
[That] 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.
So far, so unsurprising for anyone familiar with the views of these two Davids. However, as David Howarth continues his tour of the evidence, he draws out some lessons that do not fit so neatly into ideological slots:
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.
Many who like the idea that higher spending does not damage growth are also far from keen on consumption taxes, especially when you remember that VAT is a consumption tax.
What’s more, Howarth goes on to point out that,
Deficit funding, significantly for present political purposes, also has an adverse long-term effect, but a much lower one than that of direct taxation.
Hence his conclusion that,
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.
That’s a pretty controversial conclusion and a combination of higher state spending, lower deficit and increases in taxes such as VAT is a trio almost custom designed to have something in it to put off everyone. So the full paper is well worth a read: