Which is better for the economy: a large public sector or a small one?
This is a debate that has continued for decades but is now even more pertinent given the current government's zealous attack on public spending. For while "Slasher" Osborne and his colleagues may continue to claim publicly that their spending cuts are driven by a need to reduce the deficit, the reality is that for many in the coalition this course of action is driven more by ideology than economic reason. They are cutting the size of government because they want too, not because they believe they have to.
For many Thatcherites, neoliberals and old-fashioned Gladstonian Liberals, it is not just about the size of the current budget deficit, or even about the current budget deficit at all. It is about implementing measures that they believe will unleash a tsunami of entrepreneurial dynamism. In fact in both the Conservative Party and in the Liberal Democrats there exists a dominant strand of economic ideology that sees the move towards a small state as a necessary prerequisite for delivering higher levels of economic growth. Of course it is just a coincidence that reducing the size of the state necessarily involves reducing taxes, thereby allowing the rich to retain an even greater proportion of their wealth and income.
At the heart of this debate is the Rahn curve. Like its paramour the Laffer curve which argues that there is an optimal tax rate that maximizes government tax revenues and is therefore used by neoliberals to justify tax cuts for the rich, the Rahn curve claims a similar relation between GDP growth and the size of the public sector. But there are other supposed justifications for a smaller state that are regularly wheeled out by the neoliberal Right. One is the concept of "crowding out" (the squeezing of supply to the private sector by excessive government demand), while the other comes from the various quotes of eminent historical economists (including some seen as being more on the left like John Maynard Keynes and Hyman Minsky) that "in their opinion optimal government spending should be less than 25%".
Of course in the case of eminent opinion context is everything. Keynes may have believed that an economy with 25% of GDP under the control of the State was bordering on excessive, but at the time there was no NHS, and manufacturing, mining and agriculture accounted for over 50% of GDP. Now that these sectors account for less than 20% of GDP can we really cling to the same old certainties or prejudices? Of course not!
A more realistic analysis would be to recognize that the size of the state is inextricably linked to the overall size of the services sector of which it is a major part. Thus as the relative size of production in the economy decreases, the size of services must increase and with it also the size of the State. Not only that, but as the means of production is concentrated into the hands of fewer and fewer workers, so the importance of the State will increase as a necessary means of redistributing the earnings from that production amongst the wider populace. Without it inequality would be greater, and as we are finding now, recessions would be deeper and more frequent.
In the case of the Rahn curve the justification is based on a logic that is derived from the Laffer curve. Yet there is a fundamental difference between the two curves when it comes to the veracity of the theory that underpins their underlying reasoning.
In the case of taxation and thus the Laffer curve, any level or rate of tax yields positive revenues for the government. But if the tax rate is zero, then the revenues collected must clearly be zero. However, if the tax rate is 100% then the revenues collected are also likely to be close to zero as there is no incentive for anyone to work, at least that is the theory (see below for a counter-argument). Thus in the case of the Laffer curve, the revenue curve must be zero when the tax rate is at either 0% or 100% and as the tax revenue must always be positive, the curve must be positive at all points in between. Therefore the curve must have a maximum somewhere in this region. The question that is continually being debated is, where exactly is that maximum? While the neoliberal Right claim it to be as low as possible (20% or less), there is a growing body of evidence to suggest it is much higher and may even be as high as 70%.
The proponents of the Rahn curve try to make an identical argument for GDP growth. Unfortunately their logic is flawed. They try to claim that when there is no government (i.e. government spending is zero), growth must be zero, but there is no reason why this should be true. If as the neoliberals claim, it is the private sector and only the private sector that can deliver economic growth, then they cannot at the same time demand a residual of government spending to make it happen. All that is required for a functioning capitalist economy is a well-defined currency and the rule of law, not government spending.
They also try to claim that when there is no private sector (i.e. government spending is 100% of GDP) growth must be zero again, but there is no reason why this should be true either. Even communist countries can have positive growth rates even if they are generally much lower.
Nor is it the case that growth rates must always be positive for all intermediate sizes of government between the two limits described above. Unlike tax revenues, GDP growth is not restricted to positive quantities.
Thus the Rahn curve is fundamentally flawed, but in truth so is the Laffer curve. As hinted at above, the upper tax limit of 100% will not discourage all work as the neoliberals claim. In practice most people will continue to work even when all their income is taken in tax as they know that the taxes they pay must be returned to them in the form of services and transfer payments, and thus the more they work the more that will be returned. So while a "nationalization of income" will reduce incentives to work harder, it will not completely remove them. Somewhat counter-intuitively, a tax rate of 100% is more likely to kill growth rather than government tax revenues as it removes the incentive for each individual to work harder than his neighbour.
Of course the attempts to intellectually justify the drive for a smaller state do not come purely from Rahn curve analysis. There are other macroeconomic justifications, the primary one being the concept of "crowding out".
The argument is that if the State hogs too much of the nation's resources, then this increases the demand for those resources and so increases their price. This then puts additional costs on the private sector which leads to reductions in growth. And the two resources for which the State has the greatest appetite are labour and capital.
Thus if the State employs too many people, or too many of the most skilled people, then the cost of labour should increase. But if this happens we should see evidence of it in excessive growth in wages and subsequently in inflation and high interest rates. Yet for most of the past twenty years we have seen neither.
Similarly, if the State absorbs too much capital through borrowing or taxing, the effects would be seen in the growing cost of borrowing for business. Again the last twenty years show little evidence of this. It is therefore difficult to justify any claim that crowding out has impeded growth over the last few decades.
So much for the theory behind the Rahn curve and the principle of crowding out. As is we have seen, the curve itself has no mathematical integrity, while the economic data from the last two decades provides no substance to the claim that the State has been too big, or that it has had a detrimental impact on other economic indicators like wages, inflation and interest rates. But what about the comparative evidence with other similar economies, or for economies with different levels of government spending?
In my next post I will show that contrary to the claims of the neoliberal Right, both the USA and the UK have experienced higher growth-rates in the post-war period where their government spending exceeded 25% than they did in earlier periods where government spending was much less than 25%. Not only that, but the increase in government size has contributed to greater economic stability and fewer recessions. In short: Big Govt. = Higher Growth!