Containing Spending

Milton Friedman

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F rom the founding of the country until 1929 total govern- ment spending federal, state, and local--never ex-

ceeded 10 percent of the national income except in the time of major war--in the Civil War and in the First World War. Of that 10 percent two-thirds was state and local spending, and about one-third was federal spending. Federal spending was about 3 percent of the national income in 1929. In the forty- five years since then total government spending has gone from 10 to 40 percent of the national income. The roles of the states and localities on the one hand, and the federal govern- ment on the other, have been reversed. Today two-thirds of total spending is federal; one-third is state and local. This number 40 percent of the national income corresponding to federal, state, and local spending--greatly understates the role which the federal government has come to play in deter- mining how we may live and what we may do with our time, our energy, and our resources.

This is the background. Both the rapid growth of the total and the shift from states and localities to the federal govern- ment raise major problems and are largely undesirable. Why are these movements undesirable? Do they not simply repre- sent a response to real problems that have arisen? Do they not simply represent a democratic society in which the public at large asks, and the government responds? I think not. It is easier to see what is wrong by starting with the shift from the state and local to the federal level.

Benefits of Local Spending

The more distant the source of power, the more difficult it is for the ordinary citizen to control it, and the more difficult it is to have truly representative and responsible government. A few years ago, when I happened to be in Miami, there was a headline in a newspaper that a local public bus transporta- tion system was finally going to be adopted. What the story said was that for three years in a row the local voters in that area of Florida had voted down propositions on the ballot to have a bond issue to finance precisely this project. Now they were going to have it because it was part of a program passed in Washington for supporting public transportation around the country. That was hardly an increase in representative government.

Nothing bothers me more, as a citizen and taxpayer of Chicago, than to have people hired by our tax money go down to Washington--on that tax money-- to persuade Con- gress to impose taxes on us, send the revenues to Washington, deduct for the turnaround, and permit some of it to return here for things we could vote for directly.

We come tar closer to the kind of representative govern- ment our founding fathers envisioned when, insofar as possi- ble, all expenditures are locally determined. There is, admit- tedly, a problem of inequality among the taxable resources and capacities of various states; there is sometimes an argu- ment for a federal program that will assist the less well- endowed states. However, if we look at all the programs that are sold under that description, they never accomplish that. Each takes money from all fifty states and sends money back to all fifty states, roughly in proportion to the amounts contri- buted.

I would like to make a general rule that no federal grant- in-aid program to local communities be adopted which pro- vides grants to all states and a/1 communities. Some selective grants can be justified. What about the growth in govern- ment? Does this expansion from 10 percent to 40 percent represent a response to grass roots demand? I do not believe so. Such growth is a bad thing because, for two very different reasons, we are not getting our money's worth.

One reason is that government is, by its nature, inefficient. The fundamental principle is simple: nobody spends some- body else's money as carefully as he spends his own. This is a fundamental principle that underlies most of the problems with trying to handle things through political mechanisms. In general, anything that would cost private enterprise a dollar would cost the federal government two dollars. That is the two-to-one rule which is an empirical generalization. The Post Office is a blatant example of inefficiency. There have also been numerous studies which have compared such things as the cost of garbage collection by municipalities and the cost by private enterprise; the cost of fire protection when it is done on a governmental basis and the cost when it is done on a private basis. The general result is a two-to-one com- parison.

A more fundamental reason why we are not getting our money's worth, particularly at the federal level, is because of a grave defect in the political system and the political struc- ture for expressing the will of the people. The problem is that when a measure is up which will benefit a small group a great deal, while imposing only small costs on a large number of people, the small group has far greater incentive to pass that measure than the large group has to avoid it.

This is, in many ways, the fundamental source of most of the bad economic measures that are taken. Our present sys- tem is one in which special interests readily prevail. This fact is so, whether they are manufacturers hoping for a tariff or the oil industry wanting percentage depletion and import curbs, whether they are shippers seeking a subsidy for building ships or the tea-importing industry wanting federally sub- sidized tea tasters.

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Achieving Objectives

We have identified the real problem. Much of the money spent by government does not achieve intended objectives. There is hardly a government program which, no matter how good the motives behind its adoption, has ended up produc- ing the results intended. An unholy coalition forms between the do-gooders on the one hand, and the special interests on the other. The do-gooders propose a program for the best of purposes to improve the conditions of groups in the commu- nity. As soon as that program is adopted, the special interests take it over and convert it into a program to promote their own interests. That situation has been true of the Interstate Commerce Commission, the Federal Communications Commission, and the Securities Exchange Commission. Pick out any other three letters and the same thing will be true.

Now, what harm does it do, outside of wasting our money? A serious harm. It threatens to produce both fiscal disaster and a loss of freedom, and we can see that in many cases around the world. We can see it in Chile in the growth of the welfare state under the former governments. Chile was one of ths earliest welfare states in the Western Hemisphere. By 1969--70 government spending in Chile reached 40 percent of national income. This is our level, but Chile is a poorer country with many fewer resources.

At that rate of government spending Chile experienced runaway inflation. This situation led first to Allende, under whose rule the inflation rates soared to over 900 percent. It then led to a takeover by the junta. There was a loss of freedom both under Allende and under the junta, but the fundamental source of that loss of freedom in both cases was growth of governmental expenditure and the runaway infla- tion to which it led.

We see the same phenomenon in Great Britain. The United Kingdom is a stronger country than Chile. Government spending is now up to 60 percent of the national income in Britain. Inflation last year was running at 25 percent. This inflation is temporarily down, but will rise again. England, too, is threatened with a loss of freedom. We had the same example close to home in New York City. The only difference between New York City on the one hand, and Chile and Britain on the other, is that New York City does not have a printing press--at least it does not have a printing press that can turn out those green pieces of paper that we call money. As a result, the financial crisis in New York City took a more obvious and direct form. New York City is as good an example as you could want of good intentions gone wild, of programs which have increased spending without achieving any of the objectives.

Cost of Government: Conservatives

Permit me to turn from this negative, broad issue and to take up more specific issues. In talking about the problem of financing government, much of the discussion is put in terms of the problem of balancing the budget. Fiscal conservatives,

in particular, tend to talk as if the harm which is done by large government spending derives primarily from the fact that the budget is not balanced, but is financed by the "Democratic debt." This is a serious mistake. The total government- funded debt is about as small, relative to our income, as it has been for a long time. The actual deficits in the conventional def'mition have been much lower than the officially an- nounced deficit because the official figures do not take into account the amount of revenue raised by inflation. The fact of the matter is that the federal government has been paying off the government debt in the simplest way possible: by re- pudiating it. Introducing an inflation has diminished the value of the debt. Those people who loaned to the govern- ment have been taken to the cleaners.

The true cost of government is what government spends, not what is labeled as " taxes ." If government were to spend in 1977 the $395 billion that former President Ford recom- mended, but were to take in in taxes only the $350 billion he recommended, who would pay the other $45 billion? Would the Arab sheiks pick up the tab? There is no one who will pay for it except you and me, and the rest of our fellow citizens.

It will be paid for either by printing money, which imposes an inflationary tax, or by borrowing on the market. If funds are loaned to the government, they are not available for other purposes, such as building houses and factories. When the government borrows it imposes a hidden tax. When the government borrows on the open market it saddles us all with higher taxes in the future.

The real issues are not at all about how much to tax and how much not to tax. The real issues are: What form of taxation shall be used? How shall we finance the total spend- ing? What part through direct, open, explicit taxes, what part through the implicit tax involved in borrowing from the public, and what part through inflation?

Just as the do-gooders have been the unwitting allies of special interests who have taken over the programs once the programs have been developed, so, in this area, the fiscal conservatives have been the front men for the big spenders. Time and again government spending has gone up, creating a deficit, and the fiscal conservatives have said, "Oh, my God! That's terrible! We have to eliminate the deficit!" and so they have cooperated in raising taxes to close the deficit. As soon as that deficit is closed, the spenders are off again and the spiral continues.

Those of us concerned about the growth of government must watch total spending, and not waste any of our efforts on budget balancing. We should welcome a reduction of taxes at any time, for any excuse, and in any way, as the only effective way of keeping spending down. Parkinson's Law holds: spending rises to meet the funds available--plus, in the government's case, a good deal more.

Cost of Government: Liberals

Having criticized the fiscal conservatives, let me turn next to the program for financing government advanced by the

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liberals. I am nonpartisan, saying a plague on both your houses.

Liberals discuss financing strictly in terms of cyclical effects. They contend that the way to promote expansion of the economy is to have the government spend more, tax less, and have a bigger deficit. Liberals argue that the way to slow down inflation is to have the government tax more, spend less, and have a smaller deficit.

This reasoning is wrong in logic and wrong empirically. Government spending or government deficits are not expan- sionary in any significant way. They have many effects, they affect the composition of spending, but they do not affect the total spending.

Let me kill two birds with one stone by giving my argument in terms of a particular government program. Consider the bill vetoed by Gerald Ford, his veto sustained in the Senate by three votes, for a so-called Jobs Creation Program that would have spent $6.2 billion. Never mind the sums involved. The argument was that the program would create jobs. That argument is false. It would not have created jobs at all.

Suppose we vote $6.2 billion, and we use that money to hire people. Where does the money come from? If govern- ment raises taxes, then taxpayers have less to spend, reducing the amount of private employment. All that is accomplished is the substitution of government jobs for private jobs. We do not increase the total number of jobs; we do not increase total spending. The government spends the money instead of the taxpayer.

Suppose, instead, that government borrowed the money on the capital markets. In that case people lend money to the government instead of lending it to people who would have built houses, factories, or machines. Once again we substi- tute government spending for private spending. We substi- tute government jobs for the jobs that would have been had by the people building the houses or building factories. There would be no net effect on total spending.

Government could also finance an expensive jobs program by printing money, which would indeed add to aggregate demand since the government spends more and no one else in the first instance has to spend less. So in the short run it would add to jobs. However, this effect can be achieved just as well by monetary policy without a change in government spend- ing. For example, the Federal Reserve can buy up preexisting debt. That action too adds to the quantity of money, and will add just as much to total spending as if the money had been printed in order to finance a government program. Please note that printing money, in either case, will sooner or later result in inflation. In the long run the printing of money does not add to jobs, but simply to an inflationary tax. So if money is printed to pay for government spending, that situation too will simply substitute government jobs for private jobs.

Consequences of Government Action This example illustrates an important point which ties in

with the earlier discussion of why the political process does

not always yield representative results. Let us focus on the distinction between the visible and invisible effects of governmental action.

The fact that certain people are hired under that $6.2 billion program is visible. The people who are hired under the program know the source of their employment. On the other hand, the people who lose their jobs because of lower spending by those who are taxed to finance the program do not know why their employment has evaporated. Those effects are invisible. In general, if we look at undesirable governmental programs, we will find that they almost always have this effect. They have visible effects which are good and invisible effects which are bad. That is the fallacy in the tariff and in many other issues.

Finally, how do we finance whatever we do spend? Few question the equity of the progressive income tax. I am one of those few.

The personal income tax is not progressive in any mean- ingful sense. It is a maze of special measures. It taxes people in the same economic circumstances very differently. It is arbitrary and inequitable in its effects. A far better form of tax would be a flat-rate tax on all income above exemption, with no deductions for anything except strict occupational ex- penses. We have an excellent model in the income tax of the state of Illinois. By accident of interpretation of the Illinois Constitution, our state tax takes exactly that more equitable form.

The worst tax we have, however, is not the personal income tax. It is, rather, the payroll tax for Social Security, a flat-rate tax on wages below a maximum. It is a tax that is undesirable and should be abolished. We should finance whatever expenditures there are in the program which are desirable by a flat-rate personal income tax.

How are we going to contain this growth in spending? Obviously, one important way is by trying to have as much local control as possible: by trying to reduce federal spending and turn programs back to communities where local citizens can have closer control. Second, under all circumstances we should be in favor ot ~ lower taxes. Third, and much more fundamental and far reaching, the right solution, the only effective solution, is likely to be an amendment to our con- stitutions, both state and federal, which sets upper limits on governrnental spending as a fraction of total income.

The Pubfic versus Special Interests

The problem today is that the ordinary citizen never has a chance to vote on how much money the government should spend on his behalf. Each measure is considered separately, and on each measure separately the special interests will overpower the general interest. When a series of special interest measures is added up, the total is an amount greater than what the citizens would vote for if called upon to approve the budget as a whole.

The right way to solve this problem, for example, is by having an amendment which limits the total spent by the

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Illinois state government to a specified percentage of the personal income of the people of Illinois. That percentage could be established at the outset on the level where taxation is now. Gradually, progressively, it would be reduced. The same system should be adopted by the federal government.

Under the status quo the special interests fight not against one another, but against the public at large. With my proposal there would be a fixed pie to be divided. The special interests would have to fight with one another, and give at least a small chance for the public interest to emerge.

There is much talk today about the eleventh, twelfth, thirteenth, and fifteenth commandments. Let me close by giving my own eleventh commandment: everybody shall be free to do good---at his own expense.H

Milton Friedman is Paul Snowden Russell Distinguished Service Professor of Economics at the University of Chicago. He was winner of the 1976 Nobel Prize in Economics and is the author of A Monetary History of the United States and Capitalism and Free- dom. He has served in various capacities in the National Bureau for Economic Research, the Tax Division of the U.S. Treasury., and the National Resources Commission.

Maximizing Welfare

Robert Eisner

W Ve need above all to shun money illusion. Instead of talking about economic quantities in nominal terms,

we should keep in sight real factors: the total volume of goods and services produced and real welfare. We should not be concerned with changes in money magnitudes, which do not involve changes in these real magnitudes. This pattern sug- gests that we should evaluate government expenditures and the way they are financed by what the effects are on real magnitudes. We may use the narrow concept of gross na- tional product to measure real welfare, or extended new measures which include not only market activity but the total of all goods and services produced by households, govern- ments, and nonprofit institutions.

Key Questions

The first major questions are "Can government expendi- tures affect this real welfare?" and "What is the effect of taxing upon the level of employment and output?" The great

body of professional economists disagree with Milton Friedman and his view that government spending has little effect upon the total level of output and employment. Fiscal policy has an effect; more government spending in a period of high unemployment does increase employment. Also, tax cuts contribute to private demand and lead producers to meet this increased demand. They hire new workers and buy additional supplies, creating increased output and employ- ment.

The next major question is "What do tax programs do to the allocation of resources?" Taxes affect the allocation of resources by affecting the demand for, and production of, goods and services. Do they lead us to produce more in one direction or in another? For example, a tax on gasoline will lead to some economizing on the use of gasoline. An increase in tuition for public education will tend to discourage public education. A third example, the payroll tax, is a tax on employment. It discourages investment in human capital, particularly the hiring of young people and other new work- ers in the labor force.

Finally, we come to the question "What are the effects upon the distribution of income?" To many analysts this is the real issue. One argument against any program of income redistribution is that the redistribution is not equitable. But government is inevitably affecting the distribution and redis- tribution of income all the time. Most people, when income redistribution is called to their attention, do not like govern- ment expenditures to benefit somebody else. The greatest conservative who supports curtailing the role of government happily accepts a big government contract to help his busi- ness. He remains opposed to government expenditures that do not benefit the group with which he identifies, the hardworking people like himself. We should face up to the question: does our screaming about the burden of taxation amount to anything more than " I want more, and I don't care if the other guy has less"?

Impact of Government Spending

We have, then, three basic criteria: the effect on employ- ment and output; the effect on allocation of resources; and the effect on the distribution in income. Let us keep these points in mind as we analyze the impact of government spending.

Friedman's argument calls for reducing the role of gov- ernment. I want to introduce figures different from his to present another picture. I will concentrate on 1975 total real expenditures. Total government spending at all levels amounted to $339 billion for goods and services, which was 22 percent of the gross national product, not the 40 percent figure Friedman cites. His figure includes many transfer payments.

Breaking down the figures, federal expenditures for goods and services in 1975 ($124 billion) represented 8.2 percent of GNP, and state and local expenditures ($215 billion) repre- sented 14.1 percent. State and local spending was 63 percent of total government spending for goods and services, not the

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