Prof. Bryan Caplan

Econ 311

Fall, 1999

Week 7: Government Spending, Taxation, Levels, and Growth

  1. Government Spending, Taxation, Regulation, and AS-AD
    1. Suppose the government increases taxes and then spends those taxes on something. Does AD increase? Not clear why it would.
    2. Suppose the government borrows more and then spends what it borrowed on something. Does AD increase? Not clear why it would.
    3. Suppose the government prints new money and then spends the newly printed money on something. Does AD increase? Yes, definitely. The key variable for AD, though, remains the quantity of money. The same would hold if the government printed up new money and gave it to the students in this class.
    4. If government spending by itself does not affect AD, does it affect AS?
    5. GDP counts government spending as productive by definition.
    6. But if we measure result rather than effort, this is a harder question.
    7. If the spending has few or no results desired for their own sake (digging ditches and re-filling them), increases in government spending reduce AS.
    8. If the spending has results, but the private sector can produce the same item more efficiently, increases in government spending reduce AS (though not by as much as pure waste).
    9. If the spending has results, and government and private production are equally efficient, increase in government spending have no effect on AS.
    10. If the spending has results, and government production is more efficient than private production, increases in government spending increase AS.
    11. Bastiat on "What Is Seen and What Is Not Seen": People tend to count all government spending as productive, when a great deal of it is either pure waste or could be produced more efficiently by the private sector.
    12. A similar point applies to government regulation: If it makes production more costly, it reduces AS. Only if regulation produces something more efficiently than the private sector (clean air?) could it actually increase AS.
  2. Deficit vs. Tax Finance of Government Expenditure
    1. Suppose government increases taxes to pay for more spending. How is the market for loanable funds affected? It might be affected, but it is not clear that it would be.
    2. Suppose in contrast that government borrows to pay for more spending? How is the market for loanable funds affected? Demand for present goods increases, raising interest rates.
    3. This rise in interest rates "crowds out" private borrowing for both investment and consumption.
  3. The Theory of Public Goods vs. the Practice of Government Expenditure
    1. Slight oversimplification: "Public goods" are goods that government can produce more efficiently than the private sector, for one reason or another.
    2. Ex: National defense.
    3. Many economists think that most government spending is in fact dedicated to the production of public goods.
    4. In fact, a great deal of government spending is either pure waste, or takes over the supply of items the private sector can more efficiently produce. It isn't enough to point out the results of government spending; they must be compared to what would have happened if the government had reduced taxes or borrowed less. ("What Is Seen and What Is Not Seen" again).
    5. What is the key difference between markets and government? For-profit structure means incentives to satisfy consumer demand.
    6. Take the case of education.
      1. A great deal of education is pure waste: it does not improve worker productivity, and has little or even negative consumption value.
      2. For the remainder, government production remains less efficient than private production.
      3. What would be done instead? Apprenticeships.
  4. The Theory of Market Failure vs. The Practice of Government Regulation
    1. Similarly, a common justification of regulation is that it corrects for "market failures" - goods that the market system does not take into account.
    2. Ex: Pollution controls.
    3. But again, most regulation either focuses on other areas. It isn't enough to point out that regulation accomplishes something; you must also consider what would have happened if the government did nothing.
    4. Take the case of worker safety regulation.
      1. Much worker safety regulation does not seem to increase worker safety.
      2. More importantly, even if regulations increase safety, they also reduce worker productivity. Why make workers "buy" more safety than they actually want?
      3. What would be done instead? One amenity employers offer workers is more safety; also insurance companies have an incentive to monitor job safety.
  5. Government, the Level of Wealth, and the Rate of Growth
    1. Government spending and regulation thus often reduces AS at a given moment of time. People could be richer right away by privatizing and deregulating.
    2. More important over the long-run, though, is the rate of growth. Higher levels of government involvement also tend to reduce long-term growth. Why?
    3. The bigger the government sector is, the larger a percentage of the economy lacks profit incentives for innovation.
    4. Ex: Consumer products in the USSR.
    5. Regulation of new and innovative products tends to be stricter than regulation of old, familiar products.
      1. Could the automobile receive safety approval today?
    6. "What Is Seen and What Is Not Seen," again.
  6. The Fallacy of the Multiplier
    1. Whenever someone mentions the benefits of a government program, they rarely hesitate to mention all of the indirect effects. Government spending supposedly has a "multiplier" effect.
    2. Ex: "Funding for George Mason not only supports the faculty, programs, and student center. It also creates customers for the Giant across the street, the University Mall, the 7-Eleven. It provides income for book publishers, and thus authors. Construction firms in the area receive generous contracts from George Mason, and in turn spend their incomes on other local products..."
    3. The fallacy: ALL spending has secondary effects! Thus, if you cut taxes and spending, people would also spend more on, say, home audio equipment. This would provide income for audio retailers, and music companies, the musicians, and instrument manufacturers...
    4. "What Is Seen and What Is Not Seen," one last time.