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Growth factor

How big government helps the economy take off

By Jeff Madrick
September 7, 2008
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IN LISTENING TO this year's candidates for the White House talk about their ambitions for the economy, there's no escaping one undercurrent of contemporary American thinking: the idea that minimizing government and lowering taxes will help the economy grow.

In the 1970s, with inflation and slow growth plaguing the United States, a consensus began developing among certain economists that higher taxes did not merely take too big a bite out of people's incomes, but actually restrained the nation's growth and prosperity. And over the last 30 years, that view of government's relationship to the economy has emerged as a tenet of mainstream politics.

In a 1980 presidential debate with incumbent Jimmy Carter, Ronald Reagan put it effectively: "We don't have inflation because the people are living too well. We have inflation because the government is living too well." As president, he engineered a dramatic income tax cut, reducing the top rate from 70 percent in the 1960s to 50 percent - and it was about to be cut still more. Many observers argued that the economy was reinvigorated as a result.

Since then, the Democrats have slowly but surely boarded the bandwagon. By 1996, when President Bill Clinton was declaring proudly the end of "the era of big government," the transformation of the nation was complete.

The underlying economic argument is persuasively simple: Higher taxes undermine incentives to work and invest; a bigger government pushes aside private enterprise and siphons money from private investment; social programs are inefficient and make people dependent. All these cost the nation valuable gains in productivity.

Behind these arguments is the work of economists such as Martin Feldstein of Harvard University, who claimed to supply evidence to prove the point. The problem, however, is that the evidence has not held up. In fact, economic growth during the Reagan years did not increase over the beleaguered 1970s. And the economic boom of the Clinton presidency was preceded by a substantial tax in crease on the wealthy.

Since then, a series of serious, detailed investigations of the economies of rich nations across the globe, as well as reexaminations of the economic studies that helped build the antigovernment case, have found that the size of government and high tax rates do not automatically slow a nation's economic growth. Peter Lindert, a mainstream economist from the University of California at Davis, states it straightforwardly in his 2004 book, "Growing Public:" "It is well-known that higher taxes and transfers reduce productivity. Well-known - but unsupported by statistics and history."

Lindert's work surveyed a century of data across numerous countries and found that high taxes and social spending did not slow the growth of productivity or GDP. Statistically speaking, Lindert found no relationship between the level of social spending and economic growth. High tax nations like Norway grow rapidly and produce high standards of living. Even the income per hour of work in nations like France and Germany is equal to or even exceeds America's.

Lindert also carefully examined the opposition's case and found it flawed. The University of Michigan economist Joel Slemrod, in a paper for the Brookings Institution, had earlier also investigated a wide range of earlier growth studies, as well as the work of their critics, and came to a similar conclusion. As he shows in an updated edition of his book, "Taxing Ourselves," coauthored with Jon Bakija, there is no demonstrable relationship between the size of government and growth.

This evidence has serious implications for the kind of debate Americans have about taxes and government. If the big picture case against taxes is simply wrong, it suggests that instead of competing to offer tax cuts and less government, as Senator McCain and to some degree Senator Obama are doing, America's presidential candidates and their parties would help the economy more by acknowledging that big government is a fact of life - and indeed is necessary to a healthy economy.

Rather than harm the economy, the evidence shows that government spending, when done well, contributes critically to economic growth. Americans rely on the government for the free primary and high schools that educate the workforce. The government subsidizes college education and has built the immense transportation infrastructure that moves goods across the country and gets people to work. Federal, state, and local government have been essential to the nation's health, building clean-water systems and developing vaccines that have eliminated or minimized diseases like diphtheria, tuberculosis, and polio. The government can waste money, too. But the national rhetoric about the economy needs to stop focusing on how to shrink the government, and start focusing on how best to use it.

Contrary to the romantic claims about the nation's laissez-faire past, American history is a story of government intervening, time and again, to support growth.

Early America created a national bank to maintain its finances and currency, critical to a smooth-functioning modern economy, at the instigation of Alexander Hamilton, George Washington's treasury secretary. Under Thomas Jefferson, well-known for his laissez-faire sympathies, America bought the Louisiana territories in what amounted to a large federal spending program. He thus provided cheap land to farmers at federally controlled low prices, enabling them to feed themselves and the nation, but also soon to produce surpluses to feed Britain as well, adding to America's wealth.

State and local government were also vital contributors to growth. New York State issued bonds to finance most of the Erie Canal, opened in 1825. Other states followed suit with canals of their own, creating an efficient transportation network essential to commercial development before the Civil War.

Led by Massachusetts, the states built free and mandatory primary schools based on property and other local taxes, producing a literate and able work force. After the Civil War, the federal government donated tens of thousands of acres of land to states with the express purpose of starting new technical universities, which helped launch the University of California at Berkeley, the Massachusetts Institute of Technology, and Cornell University, among others. These research centers contributed vitally to American agriculture and manufacturing.

The federal government financed much of the railroad development of the second half of the 1800s through massive provisions of land. The tens of thousands of miles of railroad created the nationwide marketplace that made possible America's first industrial revolution. Similarly, in the 20th century, the federal government built roads, dams, bridges, and, after World War II, the interstate highway system, which were the building blocks for the huge commercial growth of postwar America.

It invested in research and development through the Defense Department, accounting for most of such spending in the nation in the decades after World War II. America sent its returning GIs to college, again raising the educational level of its workforce, and provided low-interest loans for their children to go to college as well. It aggressively subsidized medical research and education.

Throughout the 1950s and 1960s, taxes rose as a proportion of GDP, and the economy only grew more rapidly. Family income doubled in two decades, adjusted for inflation, even as more new social programs were funded. This was, in fact, true of all the developed nations of the West.

But a new wave of thinking began to arise in the 1970s as America became mired in high rates of inflation and unemployment. The economic guru of the time was the Nobel laureate Milton Friedman, the nation's leading advocate of laissez-faire economics. Friedman, whose mentors included the Austrian economist F.A. Hayek, author of "The Road to Serfdom," had been arguing since the early 1950s that big government led to economic inefficiencies and slower rates of growth. For decades, the strong economy proved him wrong. But by the 1970s, America longed for an explanation of its predicament, and Friedman and his followers provided a simple and convincing answer.

Some of his followers, like Robert Lucas, another Nobel laureate from the University of Chicago, and Robert Barro at Harvard, held still more extreme antigovernment views, arguing that any and all government interference was at best neutral and at worst harmful.

Voters began to rebel against taxes, starting in 1978, when California overwhelmingly passed Proposition 13, sharply reducing property taxes. Reagan swept into office on the promise of tax cuts and reducing government, and what followed were the boom years of the 1980s. To conservatives of the time, it seemed strong proof that the arguments of Friedman and his followers were correct.

But there is also a strong case that they were wrong. In 1992, President Bill Clinton succeeded in passing legislation to raise the income tax rate on higher income Americans. Harvard's Feldstein, who had served as Reagan's chief economic adviser, claimed that the tax increase would reduce the incentives to work and therefore the incomes of the wealthy. It turned out to do nothing of the kind: the top tier of Americans, in fact, made more money.

A look at tax history suggests that this should have been no surprise. Nancy L. Stokey, of the University of Chicago, and Sergio Rebelo, of Northwestern University, looked closely at the period between 1913 - when the United States first adopted an income tax - and 1942. In that period, the federal bite from income taxes rose from 2 to 15 percent of GDP. Discounting the data for business cycles, including the sharp downturns during the Great Depression, they found that the rate of growth remained consistently strong and positive over the years, despite ever-higher tax rates.

In recent years, the underpinnings of antitax economics have been further questioned by a number of mainstream scholars. Economists like Robert Barro produced studies claiming that high taxes reduced growth. Feldstein similarly produced studies to show that high taxes undermined incentives to invest. But when Lindert, Slemrod, and many others took a closer look at the statistical methods, the results turned out to be fragile at best. Barro's early analysis, for example, was undermined by a handful of economists who found that if they simply added some new causal factors that Barro had left out, the conclusions evaporated. Even Friedman's key assertions about the relationship of the money supply to GDP were ultimately discredited, and have been discarded by the Federal Reserve. (Some of the contemporary antitax economists do acknowledge there are gaps in their analyses, but believe they will yet be proved correct.)

Today, despite the long legacy of Reagan and the antitax economists, taxes paid in America are not lower than they once were. Americans pay less in income taxes than they once did, but a lot more in Social Security taxes. The overall tax bite is about the same, and government spending, despite the Reagan rhetoric, is still 20 percent or so of GDP. Even without a real tax cut, the economy has grown steadily - although it has never again reached the levels attained in the high-tax 1960s.

Some countries provide strong counterexamples to antitax economics - nations with high taxes and generous levels of social spending where wages, productivity, and GDP are also high. A classic example is Norway, with very high tax rates, a generous welfare state, and productivity levels that exceed America's. Even Sweden, with the most luxurious of all welfare states, has been growing solidly again since its economic downturn in the early 1990s.

None of this is to say that government is automatically beneficial for the economy. An objective look at the data does not suggest that big government itself always produces faster growth. Just raising taxes, of course, won't increase rates of growth. And no doubt, at some point, government can get too big.

The question is how well the tax money is spent. America has almost given up on cultivating new manufacturing industries by, for example, investing in transportation infrastructure or alternative energy policies. Developing new roads, bridges, water systems, improved airports, and new energy technologies creates jobs at home, not overseas.

America seems paralyzed about reforming its healthcare system, which if left as is will cost the nation 20 percent of its GDP, up from the current 16 percent, in only a few years. That will come to more than another half a trillion dollars a year.

And despite the rise of the two-worker family, there is no high-quality national pre-K program in America. Such a program, we now know from contemporary research, could add substantially to prosperity by creating a still more productive workforce.

The list is not complete. But to a nation steeped in antigovernment economics, the idea that government cannot be of help - or that taxes are not worth paying - is now seriously jeopardizing its future. There is no rich nation in the world today, including America, that has grown wealthy without significant government involvement. And there will be no rich nation in the future that can stay wealthy without robust government, either.

Jeff Madrick is editor of Challenge magazine and senior fellow of the Schwartz Center for Economic Policy Analysis, The New School. His new book, "The Case for Big Government," will be published in November.

(Globe Staff photo illustration)
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