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CF&P Foundation Prosperitas

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April 2007, Vol. VII, Issue III

The Economic Case for Limited Government

The burden of government spending in the United States has grown considerably since 2000, but this is just the calm before the storm. Thanks to unchecked entitlement programs, America is at risk of becoming an uncompetitive European-style welfare state. Total government spending already consumes about one-third of national economic output, with the federal government spending $2 for every $1 spent by state and local governments. If left unchecked, however, the federal government's budget will metastasize, growing from about 21 percent of GDP today to nearly 40 percent of national economic output after the baby-boom generation retires.

Instead of allowing government to grow, policy makers should focus on how best to shrink the public sector. Academic research clearly shows that government spending - once it reaches above the level needed to finance core responsibilities such as the rule of law - hinders economic growth by misallocating labor and capital. Indeed, there is even a well-established relationship, illustrated by the Rahn Curve, showing how larger levels of government spending are associated with slower growth and economic stagnation. Researchers do not agree on the precise number, but there is general agreement that the growth maximizing level of government is between 15 percent of GDP and 25 percent of GDP, far below current levels.

Most federal spending is unjustified. To cite just a few examples, the Departments of Energy, Education, Commerce, Housing and Urban Development, and Agriculture engage in activities that are not legitimate functions of the federal government. They should be shut down. A substantial share of federal spending is consumed by entitlement programs such as Social Security and Medicare. These programs should be shifted to the private sector. The transition may be lengthy, but the ultimate objective is more freedom and greater prosperity. This requires smaller government.

By Sven R Larson, Ph.D.

For much of its history, America had a tradition of limited government. And even though government has expanded dramatically in the past 70-plus years, America still has a relatively small public sector by international standards.1 As a result of having a lower burden of government, taxes are less onerous and the standard of living is higher here than in most other nations - especially countries in highly-taxed Europe. But even America's government has become too large. Moreover, the United States is in jeopardy of becoming an uncompetitive, high-tax welfare state.  As Figure 1 indicates, total government spending in the U.S. (including state and local government) is now above one third of GDP, more than three times its size (as a share of national output) as recently as 100 years ago. Moreover, government spending is projected to climb to European levels unless entitlement programs are reformed.2

[Link to larger figure]

Indeed, entitlement programs are substantially responsible for the expansion of the public sector that already has occurred. An entitlement program, in plain English, creates an unlimited obligation to dole out money to anyone who meets eligibility requirements. For the two biggest programs, Social Security and Medicare, age is the biggest criterion. For Medicaid, the third-biggest program, eligibility generally is based on income and assets.

As Table 1 shows, these so-called mandatory spending programs have come to dominate the federal budget. Rising entitlements mean a growing burden of government. The White House's Office of Management and Budget estimates that the federal budget will consume ever-larger shares of GDP until, by 2070, the federal budget devours about 40 percent of GDP.3 Theoretically, because of rising health care costs, the trend could continue until the private sector is entirely consumed by the government.

[Link to larger table]

Bigger government almost certainly imposes a high cost on economic performance. A major review of the academic literature published by the Heritage Foundation4 shows that limited government is more conducive to economic growth.

A particularly important point in the Heritage paper, written by Daniel Mitchell, is the "Rahn Curve," which measures the relationship between different levels of government spending and economic performance. This curve was popularized by Richard Rahn, the former chief economist of the U.S. Chamber of Commerce,5 and defines a largely negative relationship between economic growth and the burden of government spending. As shown in Figure 2, the Rahn Curve's message is that growth is maximized when government spending is modest - and presumably allocated for core public goods like protection of life, liberty and property - but that growth deteriorates when government expands beyond this limited level.

[Link to larger figure]

The growth-maximizing point on the Rahn Curve is the subject of considerable research. Academic experts generally conclude that this point is somewhere between 15 percent of GDP and 25 percent of GDP, though it is likely that these estimates are too high since the statistical studies are constrained by a lack of data for countries with limited governments. In the past, as shown in Figure 1, most nations in Europe and North America had modest levels of government, oftentimes only consuming only about 10 percent of GDP. Today, by contrast, even jurisdictions such as Hong Kong have governments that consume nearly 20 percent of GDP, and this influences the results of cross-country research. For all intents and purposes, today's research measures the downward-sloping portion of the Rahn Curve.

Not surprisingly, America is on the "wrong" side of the curve.6 Bluntly stated, government is too big and is hampering economic growth by consuming resources that could be more productively allocated by the private sector.7 Figure 3 sheds more light on the Rahn curve: using 1993-2002 data for OECD countries. The findings show that, as the government share of GDP rises, the growth of the economy slows. Interestingly, Figure 3 shows that government is too big in all countries and that higher spending leads to less growth in all cases. In other words, every nation is on the downward-sloping portion of the Rahn Curve.

[Link to larger figure]

To be sure, economic performance is not solely a function of fiscal policy. Trade policy, labor policy, regulatory policy, and monetary policy are just a few of the other important economic issues. But putting a limit on government spending surely is a necessary condition of a free and prosperous society. This is why spending limits rather than deficits limits are the key to sound fiscal policy. It is much more destructive for the economy to have a balanced budget when government spending is above 50 percent of GDP than it is to have a deficit when government spending is at or below, say, 30 percent of GDP.

Prioritizing government spending and shrinking the size of the state

What would a limited government actually look like? One way to approach this hypothetical exercise is to compare today's government with the one America had 100 years ago.8 Total federal outlays for FY 2007 are projected to be $2.784 trillion, with the Department of Health and Human Services topping the spending list with $672.9 billion, followed by the Social Security Administration at $625 billion and the Department of Defense at $548.9 billion (see Table 2).

[Link to larger table]

With GDP expected to reach $13.5 trillion in 2007, the current federal budget almost surely is above the growth-maximizing point on the Rahn Curve. And when state and local government expenditures are added, total government spending in America greatly exceeds the growth-maximizing point of the Rahn curve.

When added together, federal, state and local government outlays exceed one third of GDP. Reducing the burden of government spending so that America is at the growth-maximizing point on the Rahn Curve would require cutting away about two trillion dollars worth of spending. This should, of course, be done at all levels of government, but the federal budget is a good place to start since the Constitution - as originally written - presumably does not give the federal government authority for many of its current activities.

Limited government has two purposes: individual freedom and economic prosperity. Individual economic freedom is instrumental to economic prosperity because it facilitates incentives for productive behavior. The federal budget therefore should be constrained only to those activities that protect life, liberty, and property.

Not many of the Departments and programs from Table 2 fulfill government's legitimate role of protecting life, liberty, and property. And even the Departments that are necessary almost surely are too big and operated inefficiently. But even if one assumes that government operates efficiently, only the departments and agencies listed in Table 2B are - at least theoretically - necessary for the protection of the life, liberty, and property of Americans.

Additionally, some limited functions of the Treasury and State departments belong under the realm a limited government. Deleting a whole range of foreign aid programs from the State department's budget reduces its budget to $10.5bn, 36.6% of its actual budget for 2007.  A similar operation with the Treasury department (including, for all intents and purposes, closing the Internal Revenue Service) reduces its budget by 98.6% to $861 million.

Adding the downsized State and Treasury departments to Defense, Justice and Veterans' Affairs produces a limited federal government budget of $706.1 billion (Table 2B). Almost three quarters of every dollar in the '07 budget has been excised, leaving a federal government that consumes barely 5 percent of GDP. This level is below the Rahn curve's growth-maximizing range (at least based on data-constrained academic research), but state and local governments currently consume 11.5 percent of GDP9 and state and local policy makers might be expected to pick up some of the activities formerly handled by the federal government.

[Link to larger table]

At the very least, total government outlays will consume a bit more than 16 percent of GDP - a good approximation of the growth-maximizing level of spending according to econometric estimates of the optimal size of government.10

This hypothetical exercise obviously sidesteps the challenge of how to get from here to there. Some programs could - and should - be immediately abolished. Others, such as entitlements, would be phased-out as part of reforms such as personal retirement accounts. The purpose of this paper is to explain why the destination is desirable, not to provide a road map.

Limited Government: An American Tradition

While a very small government would be a very unpopular notion in most parts of Washington, DC, it actually is very much part of America's history. Since the Great Depression the federal government has gradually expanded its spending beyond the constraints imposed by the Constitution. As Figure 1 illustrated, the burden of government spending used to be very modest.

Equally important, the federal government was just a minor part of overall government. For much of America's history, state and local governments overshadowed the federal government. Indeed, as recently as 1930, federal spending was just 3.4 percent of gross domestic product. Sadly, that quickly began to change. The burden of the federal government more than doubled by 1940, thanks in part to misguided policies during the Great Depression. It did not take long for federal spending to climb closer to 20 percent of GDP, though it has remained somewhat constant in recent decades. It is a great historic irony that government policy mistakes (such as tax rate increases, misguided monetary policy, and trade protectionism) have caused economic downturns, including the Great Depression, that have then been used as an excuse by those wanted bigger government, to greatly expand the size and scope of government.

A European Future?

As shown in this paper, the relationship between limited government and growth is reinforced by economic data, and that link is likely to become even stronger because of globalization. It is increasingly easy for labor and capital to cross national borders, so nations with bigger governments are likely to suffer even worse economic consequences.

Competition among nations already has generated very positive results. Top tax rates have dropped dramatically since 1980. Triggered by the tax rate reductions of Margaret Thatcher and Ronald Reagan, the average top tax rate on personal income in OECD nations has fallen by 25 percentage points. A similar story can be told for the corporate tax. The average corporate tax rate in the developed world has dropped by nearly 20 percentage points.

It remains to be seen, however, if nations will begin to compete more aggressively to reduce the burden of government spending.

Unfortunately, America seems more likely to move in the wrong direction. Table 3 indicates that in 2007 total government spending claimed almost 37 percent of America's national economic output. The good news is that this represents a slight decline since 1993 (though the burden of government was even smaller in 2000 and has climbed since that year). The bad news - at least from a competitiveness standpoint - is that other nations are moving in the right direction at a faster rate.

[Link to larger table]

In several nations, government spending has dropped by more than 10 percentage points or more as a share of GDP. As a result, the average burden of government today in other developed nations is down to 43.5 percent of economic output, just 6.5 percentage points higher than the US level. In 1993, by contrast, the gap was 11.2 percentage points. While it certainly is good news that many nations are reducing the burden of government spending, this means America is slowly losing an important economic advantage. Furthermore, in 1993 only a couple of countries had government spending burdens below that of the United States. In 2007 a larger group of nations enjoys spending burdens below the American level.

Conclusion

To promote growth and boost freedom, government should be a small fraction of its current size. The question is not what to do, but how to get there. The entire Social Security system should be privatized, for instance, and safety net programs operated at the state and local level. A privatization of Social Security would take several decades to accomplish and require political consensus and commitment paralleled only by the construction of the system itself. Similarly, replacing Medicare and Medicaid with private health insurance also take enduring effort and legislative dedication.

However, such obstacles should not lie in the way of a serious discussion of what it actually means - and takes - to limit the burden of government. Those who built Social Security, Medicare, Medicaid and other vast federal spending programs did so with dedication, commitment and patience. It took at least half-a-century for Social Security to mature into the full-scale program it is today. Rolling back government must - and can - demand similar amounts of dedication, commitment and patience.

This long-term trend in the American economy is a strong reason to take note of the Rahn Curve. As this paper has shown, the curve is not merely a theoretical construct, but contains tangible proof that the philosophy of limited government has a harsh economic reality to back it up. Small governments are more beneficial to growth than big governments.

___________________________

Dr. Sven R Larson served as a research fellow with the Center for Freedom and Prosperity Foundation.

The Center for Freedom and Prosperity Foundation is a public policy, research, and educational organization operating under Section 501(C)(3). It is privately supported, and receives no funds from any government at any level, nor does it perform any government or other contract work. Nothing written here is to be construed as necessarily reflecting the views of the Center for Freedom and Prosperity Foundation or as an attempt to aid or hinder the passage of any bill before Congress.

Center for Freedom and Prosperity Foundation, the research and educational affiliate of the Center for Freedom and Prosperity (CFP), can be reached by calling 202-285-0244 or visiting our web site at www.freedomandprosperity.org.


Endnotes

1 See Gwartney et al: The Size and Functions of Government and Economic Growth, Exhibit 1, Testimony before the Joint Economic Committee, U.S. Congress, April 1998. Available at: http://www.house.gov./jec/growth/function/function.pdf.

2 Although the same trends are apparent, the OECD's methodology is slightly different that the federal government's methodology for measuring the aggregate burden of government. For figures from the Office of Management and Budget on total government spending as a share of GDP, see http://www.whitehouse.gov/omb/budget/fy2008/sheets/hist15z3.xls.

3 http://www.whitehouse.gov/omb/budgetcharts/2007_budget/current_
trends.pdf.

4 Mitchell, Daniel J: The Impact of Government Spending on Economic Growth, Backgrounder #1831, March 15, 2005, The Heritage Foundation. Available at: http://www.heritage.org/Resarch/Budget/bg1831.cfm.

5 http://www.ewtn.com/library/BUSINESS/ANTOUTWK.HTM

6 Brimelow, Peter: Why the Deficit is the Wrong Number, Forbes Magazine, March 15, 1993.

7 http://hsgac.senate.gov/_files/102505Mitchell.pdf.

8 http://www.whitehouse.gov/omb/budget/fy2007/budget.html. The discussion of the '07 budget is in no way an endorsement of it, either in its entirety or parts thereof. Nor is it an endorsement of any competing budget proposals in U.S. Congress. The discussion is meant exclusively as an experiment in limited government.

9 Budget of the United States Government, FY 2008, Historical Tables, February 2007. Available at http://www.whitehouse.gov/omb/budget/fy2008/sheets/hist15z3.xls.

10 The most compelling evidence is provided by:  Peden, E.A., Productivity in the United Sates and Its Relationship to Government Activity: An Analysis of57 Years, 1929-1986, Public Choice, Vol. 69 (1991), pp. 153-173. Some evidence in this direction is also found in: Folster, S. and Henrekson, M., Growth Effects of Government Expenditure and Taxation in Rich Countries, European Economic Review, Vol. 45, No. 8 (August 2001), pp. 1501-1520; and: Hansson, P. and Henrekson, M., A New Framework for Testing the Effect of Government Spending on Growth and Productivity, Public Choice, Vol. 81 (1994), pp. 381-401. Another study that indicates a top of the Rahn curve significantly below 20 percent of GNP is: Carlstrom, C T, and Gokhale, J, Government Consumption, Taxation and Economic Activity, Federal Reserve Bank of Cleveland Economic Review, 3rd Quarter, 1991.


Bibliography

Brimelow, Peter: Why the Deficit is the Wrong Number, Forbes Magazine, March 15, 1993.

Bureau of Economic Analysis, National Income and Product Accounts, Tables 1.1.5 (Gross Domestic Product, current prices) and 3.3 (State and Local Current Receipts and Expenditures, current prices)

Bureau of Economic Analysis, National Income and Product Accounts, Table 3.3. Available at: http://www.bea.gov

Carlstrom, C T, and Gokhale, J, Government Consumption, Taxation and Economic Activity, Federal Reserve Bank of Cleveland Economic Review, 3rd Quarter, 1991

Folster, S. and Henrekson, M., Growth Effects of Government Expenditure and Taxation in Rich Countries, European Economic Review, Vol. 45, No. 8 (August 2001), pp. 1501-1520

Gwartney et al: The Size and Functions of Government and Economic Growth, Exhibit 1, Testimony before the Joint Economic Committee, U.S. Congress, April 1998. Available at:
http://www.house.gov./jec/growth/function/function.pdf.

Hansson, P. and Henrekson, M., A New Framework for Testing the Effect of Government Spending on Growth and Productivity, Public Choice, Vol. 81 (1994), pp. 381-401

Mitchell, Daniel J: The Economic Consequences of Government Spending; U.S. Senate Committee Hearing. Available at:
http://hsgac.senate.gov/_files/102505Mitchell.pdf.

Mitchell, Daniel J: The Impact of Government Spending on Economic Growth, Backgrounder #1831, March 15, 2005, The Heritage Foundation. Available at: http://www.heritage.org/Research/Budget/bg1831.cfm

Office of the Management of the Budget: Budget chart; FY 2007 budget and current budget trends. Available at: http://www.whitehouse.gov/omb/budgetcharts/2007_budget/current_trends.pdf

Peden, E.A., Productivity in the United Sates and Its Relationship to Government Activity: An Analysis of57 Years, 1929-1986, Public Choice, Vol. 69 (1991), pp. 153-173

St Antoninus Institute: Out of Work: Unemployment, Government & Bishops; Applied Economics File 6/2a. Available at: http://www.ewtn.com/library/BUSINESS/ANTOUTWK.HTM


Additional Issues of Prosperitas:

22) March 2007, Vol. VII, Issue II, "The Hong Kong Tax System -- Key Features and Lessons for Policy Makers,"  by Professor Michael Littlewood. Web page link below:
http://www.freedomandprosperity.org/Papers/hongkong/hongkong.shtml

21) February 2007, Vol. VII, Issue I, "The Swiss Tax System: Key Features and Lessons for Policy Makers," by Pierre Bessard. Web page link below:
http://www.freedomandprosperity.org/Papers/swiss/swiss.shtml

20) September 2006, Vol. VI, Issue VI, "The Slovakian Tax System: Key Features and Lessons for Policy Makers," by Martin Chren, Web page link below:
http://www.freedomandprosperity.org/Papers/slovakia/slovakia.shtml

19) June 2006, Vol. VI, Issue V, "Making Section 911 Universal is Good Economic Policy and Good Tax Policy, " by Yesim Yilmaz, Web page link below:
http://www.freedomandprosperity.org/Papers/sec911-2006/sec911-2006.shtml

18) June 2006, Prosperitas Volume VI, Issue IV, "The Health Care Choice Act: Restoring Competition in the Individual Insurance Market," by Sven Larson, Web page link below:
http://www.freedomandprosperity.org/Papers/hc-choice/hc-choice.shtml

17) June 2006, Prosperitas Volume VI, Issue III, "Tax Havens, Tax Competition and Economic Performance," by Yesim Yilmaz, Web page link below:
http://www.freedomandprosperity.org/Papers/taxhavens/taxhavens.shtml

16) June 2006, Prosperitas Volume VI, Issue II, "The Swedish Tax System -- Key Features and Lessons for Policy Makers," by Sven Larson, Web page link below:
http://www.freedomandprosperity.org/Papers/sweden/sweden.shtml

15) January 2006, Prosperitas Volume VI, Issue I, "The Paris-Based Organization for Economic Cooperation and Development: Pushing Anti-U.S. Policies with American Tax Dollars," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/oecd-funding/oecd-funding.shtml

14) November 2005, Prosperitas Volume V, Issue II, "The OECD's Anti-Tax Competition Campaign: An Update on the Paris-Based Bureaucracy's Hypocritical Effort to Prop Up Big Government," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/oecd-hypocrisy/oecd-hypocrisy.shtml

13) May 2005, Prosperitas Volume V, Issue I, "Territorial Taxation for Overseas Americans: Section 911 Should Be Unlimited, Not Curtailed," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/section911/section911.shtml

12) August 2004, Prosperitas Volume IV, Issue II, "The Threat to Global Shipping from Unions and High-Tax Politicians: Restrictions on Open Registries Would Increase Consumer Prices and Boost Cost of Government," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/shipping/shipping.shtml

11) June 2004, Prosperitas Volume IV, Issue I, "The OECD's Dishonest Campaign Against Tax Competition: A Regress Report," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/oecd-dishonest/oecd-dishonest.shtml

10) October 2003, Prosperitas Volume III, Issue IV, "The Level Playing Field: Misguided and Non-Existent," by Dan Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/lpf/lpf.shtml

9) July 2003, Prosperitas Volume III, Issue III, "How the IRS Interest-Reporting Regulation Will Undermine the Fight Against Dirty Money," by Daniel J. Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/irsreg-dm/irsreg-dm.shtml

8) April 2003, Prosperitas Volume III, Issue II, "Markets, Morality, and Corporate Governance: A Look Behind the Scandals," by Daniel J. Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/corpgov/corpgov.shtml

7) February 2003, Prosperitas Volume III, Issue I, "Who Writes the Law: Congress or the IRS?," by Daniel J. Mitchell, Web page link below:
http://www.freedomandprosperity.org/Papers/irsreg/irsreg.shtml

6) April 2002, Prosperitas Volume II, Issue II, "The Case for International Tax Competition: A Caribbean Perspective," by Carlyle Rogers, Web page link below:
http://www.freedomandprosperity.org/press/p03-25-02/p03-25-02.shtml

5) January 2002, Prosperitas Vol. II, Issue I, "U.S. Government Agencies Confirm That Low-Tax Jurisdictions Are Not Money Laundering Havens," by Daniel J. Mitchell. Web page link below:
http://www.freedomandprosperity.org/Papers/blacklist/blacklist.shtml

4) November 2001, Prosperitas, Vol. I, Issue IV, "The Adverse Impact of Tax Harmonization and Information Exchange on the U.S. Economy," by Daniel J. Mitchell. Web page link below:
http://www.freedomandprosperity.org/Papers/taxharm/taxharm.shtml

3) October 2001, Prosperitas, Vol. I, Issue III, "Money Laundering Legislation Would Discourage International Cooperation in the Fight Against Crime," by Andrew F. Quinlan. Web page link below:
http://www.freedomandprosperity.org/Papers/kerry-levin/kerry-levin.shtml

2) August 2001, Prosperitas, Vol. I, Issue II, "United Nations Seeks Global Tax Authority," by Daniel J. Mitchell. Web page link below:
http://www.freedomandprosperity.org/Papers/un-report/un-report.shtml

1) August 2001, Prosperitas, Vol. I, Issue I, "Oxfam's Shoddy Attack on Low-Tax Jurisdictions," by Daniel J. Mitchell. Web page link below:
http://www.freedomandprosperity.org/Papers/oxfam/oxfam.shtml

Complete List of Prosperitas Studies, including summaries:
http://www.freedomandprosperity.org/fpf/prosperitas/prosperitas.shtml

_______________________________
Center for Freedom and Prosperity Foundation
P.O. Box 10882, Alexandria, Virginia 22310
Phone: 202-285-0244
www.freedomandprosperity.org

 

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