How to measure the size of government

What is the right size of government? Obviously our answers vary depending on our understanding of the facts and the value we each place on different activities. It should be possible, however, to narrow the range of answers to differences in individual preferences (values). A good starting place is to agree on how to measure the size of government. My real interest in this note, however, is in how best to finance whatever government we wind up having.

The size of government should be measured by the resources it commands. This is obvious with regard to the government buying goods and services and employing people. These resources are taken from the private sector and employed for government purposes. If these purposes have greater value to us than their alternative value in private use (what economists call their “opportunity cost”), society as a whole is better off as a result. This is the economist’s famous cost benefit test.

People sometime confuse the size of government with the taxes leveled to finance it. Reducing taxes without reducing the government’s command over resources does not reduce the size of government. Rather it shifts how the resources commanded by government are paid for. But how the government gets and pays for these resources is important too because it can impose additional costs over and above the cost of just taking command of them. So what are the options? Here are the Good, the Bad and the Ugly choices. I have been indulging in a Clint Eastwood retrospective, if you haven’t noticed, and I am impressed by how many things can be conveniently partitioned this way.

When it comes to paying for government it is a bit of a stretch to talk of the Good. Almost all ways of paying for government distort private decisions and thus resource allocations to some extent, but some methods are clearly better than others. The goal should be to share the burden of government fairly and with the least disturbance and distortion to the private economy as possible. The view that the free market is generally the best allocator of resources is now so widely accepted that Democratic Presidential candidate Barak Obama said “The market is the best mechanism ever invented for efficiently allocating resources to maximize production. And I also think that there is a connection between the freedom of the marketplace and freedom more generally.”[1] I start at the top and descend to the ugly.

User fees

If the government is providing goods and services to specific individuals, they should generally be willing to pay for them especially since they value them. If the government provides a passport for an American or an entry visa for a visitor, it is both economically more efficient and fairer for those getting these services to pay for them rather than for someone else to. This mirrors the resource allocation efficiency of the private sector where prices reflect supply and demand. The same principle applies to highways, airports, schools and medical facilities. Why should those without cars pay to build highways for those who have them? And if drivers are willing to pay more than the cost of building a highway, it should be built. Taxes on gasoline are an attempt to charge user of roads for the cost of building them as are tolls on highways.

Institutions such as colleges and hospitals present a mixed case. They mix the provision of services for those who benefit individually from them and can pay for them with income transfers to those who can’t. But these two aspects can and should be separated by charging for these services and subsidizing the payments from those who can’t afford them. A different argument is generally made for primary and secondary education where the argument is that all of society benefits from this level of general education and thus everyone should help pay for it and thus a user charge is not appropriate. People without children sometimes object to this argument. Applying wage taxes on workers to pay for their social security is another example of mixing things up. Social Security is not a pension from saving while working. It is a pay-as-you go tax on the currently working to pay the pension of those already retired. My thoughts on Social Security are here: "Saving Social Security"

General taxation

Government command of resources for the general benefit of the whole country should be paid for with taxes on the whole country that are fair and that distort economic decisions of the public as little as possible. User fees are infeasible and inappropriate in these cases. A properly designed comprehensive income or consumption tax (no exemptions for favored activities) at a flat marginal rate fits these criteria. Views differ on the fairness of progressivity. For me, it is “fair” that someone with twice the income pays twice the tax, which is what a flat tax rate does. A flat tax is actually modestly progressive because the tax rate is actually zero up to the level of income from which the flat marginal rate applies. I prefer the consumption version (VAT) because it does not distort saving and consumption decisions by taxing saving but not consumption. Business income taxes found in most countries are very hard to justify (other than relative ease of collection for companies that do not operate across borders) as such income is taxed twice, once at the company level and again as income to this shareholders. For example, Moldova recently reduced its business income tax rate to zero. My slightly more developed thoughts can be found in: "The Ideal Tax System"

Debt finance

Here we descend to the “bad.” Governments can finance their activities by borrowing from the public. This has the “virtue” that those lending to the government (buying is bills and bonds) do so voluntarily because of attractive interest rates and low risk (I leave aside the now thoroughly discredited practice of some earlier governments of mandating purchases of government securities in one way or another). However, this financing tool falls almost fully on capital. The diversion of saving from financing capital to financing government “crowds out” and thus reduces private capital formation. While it is possible in principle that the resulting increase in interest rates increases saving and thus takes some of the government financing out of consumption, empirical evidence suggests that this effect is very small.

Cyclically balanced budgets are much more defensible. When the budget is balanced over the business cycle, governments save (spend less than their tax revenue) during the boom phase of the cycle and dis-save (or borrow) during the recession phase. Such behavior results from maintaining constant government spending over the cycle and has an automatic stabilizing effect on output.

Discriminatory taxes

Some taxes look a bit like user fees but are not actually linked to the provision or use of a government services to those paying these taxes. They simply fall on particular economic activities and thus increase the cost and reduce the supply of those activities. These clearly distort resource allocation. Examples are import duties and excise taxes.

If, however, an activity is taxed (or subsidized) that has social costs (or benefits) not paid for (or received) by those undertaking the activity, the tax (or subsidy) can actually improve resource allocation. In other words, to the extent a tax reduces any gap between private and social costs of an activity it will bring private decisions with regard to the activity more in line with the true cost to the economy, which will improve the efficiency of resource allocation. The classic example is a pollution tax. If, for example, activities that add carbon dioxide to the atmosphere contribute to global warming (a scientific assertion that is still under some debate), such as burning coal or gasoline (when driving a car), are taxed by the amount of that damage, the public’s decisions about whether and how much carbon fuels to use will better reflect the true cost to society of its use. This would improve the efficiency of resource allocation. Simply prohibiting the use of carbon fuels runs the strong risk of imposing a cost (in the form of the next best alternative energy sources) far greater than the benefit.

Lotteries

I am not sure whether to categorize lotteries as “ugly” or “merely “bad.” They are voluntary, which is a virtue. However, they might be said to exploit human weakness for gambling. Gambling can be an acceptable entertainment for those with the money to pay for it, but can become the desperate effort to get ahead by those who cannot. Most jurisdictions restrict or even forbid lotteries except when offered by the tax authority. This is morally odd indeed. The state grants itself a monopoly in an activity considered generally inappropriate and thus forbidden to private enterprise, on the grounds that the state puts the money to good us. Lotteries are generally regressive (raising money disproportionately from lower income families).

Mandates (outsourcing)

This is a seductive form of financing the government’s command of resources. Government regulations from banking supervision to product safety and much more reflect government command of resources a bit more indirectly. The costs of these regulations are as real as if the government bore them directly, but they are generally paid for by the regulated entities. They should be subjected to the same cost benefit assessment as any other government program. The danger of mandates is that because the costs do not appear in the government budget it is too easy and thus tempting for the government to undertake such regulations and mandates as if they had no cost at all.

Inflation

Inflation is clearing in the “ugly” category. First it is the easiest of all taxes to administer. The central bank just prints the extra money to lend to the government to cover the cost of its activities (not covered otherwise). The government spends the money thus taking the resources away from the private sector. The private sector reduces its own spending as a result of the fall in the real value (purchasing power) of the cash held by the public. Thus economists refer to inflation as a tax on the holding of central bank money (currency and bank deposits with the central bank). While seductively easy to administer, the inflation tax has two serious shortcomings. First, it is generally hard to anticipate accurately and unfolds unevenly and thus tends to distort relative prices. Distorted relative prices distort resource allocation and thus slow the pace and quality of economic growth. Second, the inflation tax is regressive and thus fails the fairness test. Cash is held disproportionately by lower income families and thus the loss of purchasing power is born regressively.

The pernicious effects of inflation and the tempting ease with which government can “borrow” from its central bank have led to a world wide movement to protect central banks and their monetary policy from government by making them “independent.” Most central bank laws now prohibit or tightly limit central bank lending to government.

The health and well being of society and the economy depend in part on getting the size and nature of government right. But it also depends on financing those activities in the fairest and least distorting ways.

[1] Quoted in David Leonhardt, "How Obama Reconciles Dueling Views on Economy," The New York Times Magazine, August 20, 2008