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