Taxes and Government Spending Undermine Economic Growth

With stimulus spending one of the most contentious issues in a very contentious political year, politicians of all stripes have argued about whether government spending boosts or hinders economic growth. It is beyond debate, however, that the spending will have to be paid for by taxpayers either now or in the future. Those taxes cause the economy to grow slower, according to a new study released by the Show-Me Institute, “Taxes and Economic Growth: A Review of the Evidence.” Written by Mark Skidmore and Nicole Bradshaw — both professors at Michigan State University’s Department of Agricultural, Food, and Resource Economics — the study shows that stimulus spending may not prove to be very stimulating, because only spending on highly demanded government services appears to boost economic growth.

In a review of the academic literature, Skidmore and Bradshaw find a general agreement among researchers that higher taxes lead to lower economic growth, and therefore lower standards of living for American workers. The exact size of taxation’s effect on growth is not firmly established, but the consensus range is that for a 10-percent tax cut, there will be an additional rise in economic activity of 1.5 percent to 8.5 percent. When the bills for our current spending binge eventually come due, taxes will be raised and economic growth will fall. However, when confronted with these facts, supporters of the stimulus will likely argue that the economic growth generated by current spending will more than offset the drop in growth that will follow the tax hikes. This is theoretically possible, but Skidmore and Bradshaw provide good reasons to doubt the idea.

The professors divide government spending into two categories, which they call general fund expenditures and fund transfer payments. The former involves spending on core government services like security and necessary infrastructure, and the latter are government payments made to a group of people who provide no good or service in return, a classification that includes food stamps or government provided health insurance. From their review of the literature, Skidmore and Bradshaw conclude that transfer payments have either a negligible or negative impact on government growth, which is unfortunate because transfer payments have made up the bulk of stimulus spending so far. According to a CNN analysis of the first year of the $787 billion stimulus package, only $31 billion has been spent on projects like infrastructure and high-speed rail, while the remaining $148 billion spent during the past year has gone to states and individuals for purposes such as funding Medicaid and extending unemployment insurance. That spending will directly benefit those hit hardest by the recession, by helping them weather the storm, but it will not cause the economy to recover any faster.

Even that portion of stimulus spending used for infrastructure and other government purchases, an amount projected to more than double to $84 billion for the next year, may not have the positive impact that stimulus supporters expect. Government spending on infrastructure and expanded government services usually, but not always, has a small positive effect on growth. Skidmore and Bradshaw argue that this puzzle can be solved by using a cost-benefit analysis of specific government projects. If the project is demanded by a large number of people, it will probably lead to higher economic growth, but if it is simply a pork barrel project designed to benefit relatively few people, the spending will likely have no (or even a negative) impact on economic growth. For example, spending $3.4 million on an underground animal crossing in Florida and $1.15 million to replace the guard rail around an empty lake in Oklahoma is unlikely to generate any economic growth.

Probably the most efficient part of the stimulus in terms of generating economic growth is the $119 billion in tax cuts, because the literature shows that a new job is generated by the private sector for every $1,906 to $10,800 of taxes that the government cuts from its yearly budget. Still, if tax cuts are not balanced with a corresponding decrease in spending, those gains will be at least partially wiped out by future tax increases that go toward paying off current deficits.

Skidmore and Bradshaw’s study shows that government efforts to revive the economy through greater spending and higher taxes are doomed to fail. The best prescription for reviving the economy of Missouri and the entire United States involves lowering taxes and balancing the budget.

John Payne is a research assistant at the Show-Me Institute, a Missouri-based think tank.