If government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very diffi*cult if there were no government at all. In other words, some government spending is necessary for the successful operation of the rule of law. Figure 1 illustrates this point. Economic activity is very low or nonexistent in the absence of government, but it jumps dramatically as core functions of govern*ment are financed. This does not mean that gov*ernment costs nothing, but that the benefits outweigh the costs.
Costs vs. Benefits. Economists will generally agree that government spending becomes a bur*den at some point, either because government becomes too large or because outlays are misallo*cated. In such cases, the cost of government exceeds the benefit. The downward sloping por*tion of the curve in Figure 1 can exist for a number of reasons, including:
The extraction cost. Government spending requires costly financing choices. The federal government cannot spend money without first taking that money from someone. All of the options used to finance government spending have adverse consequences. Taxes discourage productive behavior, particularly in the current U.S. tax system, which imposes high tax rates on work, saving, investment, and other forms of productive behavior. Borrowing consumes capital that otherwise would be available for private investment and, in extreme cases, may lead to higher interest rates. Inflation debases a nation’s currency, causing widespread eco*nomic distortion.
The displacement cost. Government spend*ing displaces private-sector activity. Every dol*lar that the government spends necessarily means one less dollar in the productive sector of the economy. This dampens growth since economic forces guide the allocation of resources in the private sector, whereas politi*cal forces dominate when politicians and bureaucrats decide how money is spent. Some government spending, such as maintaining a well-functioning legal system, can have a high “rate-of-return.” In general, however, govern*ments do not use resources efficiently, resulting in less economic output.
The negative multiplier cost. Government spending finances harmful intervention. Por*tions of the federal budget are used to finance activities that generate a distinctly negative effect on economic activity. For instance, many regulatory agencies have comparatively small budgets, but they impose large costs on the economy’s productive sector. Outlays for inter*national organizations are another good exam*ple. The direct expense to taxpayers of membership in organizations such as the Inter*national Monetary Fund (IMF) and Organisa*tion for Economic Co-operation and Development (OECD) is often trivial com*pared to the economic damage resulting from the anti-growth policies advocated by these multinational bureaucracies.
The behavioral subsidy cost. Government spending encourages destructive choices. Many government programs subsidize economically undesirable decisions. Welfare programs encourage people to choose leisure over work. Unemployment insurance programs provide an incentive to remain unemployed. Flood insur*ance programs encourage construction in flood plains. These are all examples of government programs that reduce economic growth and diminish national output because they promote misallocation or underutilization of resources.
The behavioral penalty cost. Government spending discourages productive choices. Government programs often discourage eco*nomically desirable decisions. Saving is impor*tant to help provide capital for new investment, yet the incentive to save has been undermined by government programs that subsidize retirement, housing, and education. Why should a person set aside income if gov*ernment programs finance these big-ticket expenses? Other government spending pro*grams—Medicaid is a good example—gener*ate a negative economic impact because of eligibility rules that encourage individuals to depress their incomes artificially and misallo*cate their wealth.
The market distortion cost. Government spending distorts resource allocation. Buyers and sellers in competitive markets determine prices in a process that ensures the most effi*cient allocation of resources, but some govern*ment programs interfere with competitive markets. In both health care and education, government subsidies to reduce out-of-pocket expenses have created a “third-party payer” problem. When individuals use other people’s money, they become less concerned about price. This undermines the critical role of com*petitive markets, causing significant ineffi*ciency in sectors such as health care and education. Government programs also lead to resource misallocation because individuals, organizations, and companies spend time, energy, and money seeking either to obtain special government favors or to minimize their share of the cost of government.
The inefficiency cost. Government spending is a less effective way to deliver services. Gov*ernment directly provides many services and activities such as education, airports, and postal operations. However, there is evidence that the private sector could provide these important services at a higher quality and lower cost. In some cases, such as airports and postal services, the improvement would take place because of privatization. In other cases, such as education, the economic benefits would accrue by shifting to a model based on competition and choice.
The stagnation cost. Government spending inhibits innovation. Because of competition and the desire to increase income and wealth, individuals and entities in the private sector constantly search for new options and oppor*tunities. Economic growth is greatly enhanced by this discovery process of “creative destruc*tion.” Government programs, however, are inherently inflexible, both because of central*ization and because of bureaucracy. Reducing government—or devolving federal programs to the state and local levels—can eliminate or mitigate this effect.
Spending on a government program, depart*ment, or agency can impose more than one of these costs. For instance, all government spending imposes both extraction costs and displacement costs. This does not necessarily mean that out*lays—either in the aggregate or for a specific pro*gram—are counterproductive. That calculation requires a cost-benefit analysis.