Government Spending as a Percent of GDP

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Much of the past seventy years in the United States has seen a debate about "how big" government should be.  Should we have a small government that intrudes little on our lives ("that government is best which governs least"), or should it provide a broad safety net to smooth out the shocks and problems of life?

While I have a philosophical opinion on which of these extremes I'd prefer, it isn't particularly relevant to the situation in which we find ourselves.  Both Democrats and Republicans have done nothing but expand the scope of government for scores of years.  One thing that has not been well-analyzed by either side is the theoretical limit of the size of the government.  While Republicans have tended to chant doom-and-gloom about the growth of government, it has tended to be in vague "someday this is going to cause a problem" terms.

One thing that is becoming very clear is that we are nearing the limit of how big government can get (again, leaving aside any question of how big it should) - and we have probably already exceeded it.  My personal opinion is that a much smaller government than this would mean higher growth and greater net human happiness; but such a thing is so far from the political reality that it seems unlikely to be worth much time analyzing.

What are the limits to government growth?

In the United States, from 1950 - 2010, Federal tax receipts have never exceeded 21% of GDP.  As the economy grows and shrinks, revenues grow and shrink with them.  There seems to be a natural governor on the economy and taxes - as taxes exceed that rate, people become better (and more motivated) at tax evasion; or earn less; or do less; or some combination of those items.  Over the long haul, the average rate has been more like 18% - and it's never exceeded 19% for any length of time.

We therefore can set a theoretical sustained maximum size for income of 19% of GDP.  In 2011, that's about $2.8T.  Again, I'll reiterate - I think it would be better for us to take less money from our citizens.  However, we are talking here about the real world, and the natural constraints on how big the Federal government possibly can get.

We can borrow money to increase what the government can spend.  If our borrowing is in line with GDP growth, in fact, it might be essentially infinitely sustainable.  3% seems like a reasonable guess as to a long-term GDP growth rate.  It might be a little bit on the conservative side (if things go at all well, we'll grow faster), but when we're thinking about borrowing against future earnings it seems reasonable to be conservative about them.

Taking 2011 as an example year, if we take expected GDP of $14.7T, and we figure it'll grow 3% (which I frankly find unlikely in these particular circumstances, but we're building a model, here), we'd expect to add $441B to the economy next year and have a total GDP next year of $15.14.  So, if we borrowed 19% of that this year, we could add another...$80 billion to the Federal expenditures for 2011 in a fairly sustainable fashion.  It's not a lot of money, but it could help smooth things out a bit.

We also can borrow unsustainably.  There is a limit to how much we can do.  How much of a limit?  Frankly, no one knows.  Clearly it's more than 70% of GDP, since we're there and we're still borrowing money just fine.  Japan is currently at nearly 200% - but they have a uniquely stable economy, and, as recent credit ratings downgrades have shown, the markets will not have infinite patience with them.

A reasonable limit for us to imagine for ourselves - given the market's horror at the continuing political strife in Washington - is 120% of GDP.  Maybe the real number is lower; maybe it's higher, but that gives us a good, reasonable target for the point at which interest rates begin to rise.

Putting all this together, for a long-term sustainable US government, the Feds need to spend no more than $2.8T/yr, but they can borrow up to a total of $17.6T total on top of that to spend more.  As of November, 2011, total debt outstanding is $10T, so we have another $7.6T of headroom. Of course, we're not currently taxing at 19% of GDP - we're only going to bring in something like $2.2T, this year in reality.  We're going to spend $3.8T, meaning we'll need to borrow approximately $1.6T, so we'll only have $6T left on our account, this time next year.  We'll (hopefully) increase that by about 3% per year, too, but we're running out of funds to borrow at an alarming rate.  A trivial model would show this running out in a little under four years; the more complex model actually gives us ten, assuming some GDP growth and some short-term cuts in spending as we finish up TARP and pull out of the Middle East.

It is theoretically simple to chart a path through this that isn't terrible for the country.  If we slowly lower expenditures, while slowly raising taxes, we could get the two to cross at $2.8T/year.  That would require a roughly 25% cut in expenditures, coupled with a roughly 25% increase in taxes, all relative to the economy that would be growing at the same time (thus making it easier).

Phased in over a decade - even two, as the initial reductions would buy us more time - this could be done with a relatively small disruption to the economy. However, the lesson we learned from Europe is that the incentives are not there for the politicians to do either of these things.  

In summary - the biggest government the US can sustain indefinitely is about 19% of GDP, which was $2.8T in 2011.  To do that, we'll also need to increase taxes from $2.2T (15% of GDP) to $2.8T (19% of GDP).  If you desire lower taxes, expenditures need to be lowered further, as well.  If you desire more spending, you're going to be long-term stuck, because we haven't yet been able to raise more than 19% of GDP over the long haul.

Finally, we have about $7.6T left on our "credit account" before the bank (probably) starts refusing to lend us more.

Tomorrow, we'll look at ways we could improve this situation by cutting spending - and why, regardless of who is in power, this isn't going to happen.

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This page contains a single entry by Brett Thomas published on November 27, 2011 10:00 AM.

The End of the Euro was the previous entry in this blog.

Cutting Our Way to Balance is the next entry in this blog.

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