Would Cutting Federal Spending Slow the Economy?

Right now federal spending is consuming 24 percent of national income. At the same time, the amount of tax revenue the government is receiving is 14 percent of national income. In the event economic growth fails to increase at rates to close this spending-revenue gap, then cutting spending or raising taxes become the policy options.

Since the end of World War II, government revenues have averaged about 18 percent of GDP. If we assume the mix of tax policy and economic growth achieves this historic average, then the focus shifts to cutting government spending from 24 percent of GDP to 18 percent.

Yet, there exists a viewpoint that cutting government spending by this much will do great harm to economic growth. The belief is that this reduction will affect aggregate demand too severely, especially if the cuts happen in a matter of a few years.

There are examples internationally, particularly in New Zealand in the 1980s and Canada in the 1990s, where sustained and substantial reductions in government spending led to the opposite: an economic rebound.

But, what about the United States? Are there patterns similar to New Zealand and Canada? There is one important historical example that not only reduced spending in a short period of time but where the reductions were massive.

The period is the aftermath of World War II. Between 1945 and 1947 federal spending in nominal dollars and as a percent of GDP fell steeply:

If we assume one dollar of federal spending equates to one dollar of GDP (a multiplier of 1), then we should expect a reduction of $58.2 billion in GDP. But, in fact GDP rises 9 percent or $21.4 billion.

What about unemployment? 10 million servicemen returned and there was concern that double-digit unemployment rates would return. During this time period the total civilian labor force increased by seven million while the total number employed rose by five million. The result was a doubling in the unemployment rate (14 years and older). But, note these peacetime levels were under four percent and between two and four times less than Great Depression levels.

Who would not want a four percent unemployment rate today?

If the large and swift reductions in government spending failed to trigger a commensurate drop in economic growth, then what variable moved to take its place?

The answer is private domestic investment. Reducing both federal spending and controls over the private economy (e.g., price controls and rationing) not only freed up resources but increased the freedom to engage in these risk-taking activities.

The positive effect private domestic (read: business) investment has on GDP and employment should not be lost on us today. Effective federal policies should not only focus on a reduction in federal spending, but also on promoting a set of rules that reduce risk and uncertainty and improve the reward structure.

Author: This blog entry was written by Dr. Jim Granato, Director of the Hobby Center for Public Policy.