Very basic politics #2: what is government spending for?

Many thanks to all who have commented on part 1 of this series: very interesting discussion. Also to Millennium Elephant for fact-checking my statements about LibDem policies.

Today, I want to look at what government spending is for, and why we have it. The reason that’s important is that lots of people resent taxes, and feel that the government is taking their money away. That’s the means, not the end. It would be more true to say that the government is spending money on your behalf. Why does it do that? Is it a good thing?

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Very, very roughly speaking, the answer to “is it a good thing” is what defines the difference between “left wing” and “right wing” parties. The right wing, which in the UK traditionally means the Conservative party, thinks that you should get to choose how to spend the money you earn, so the government should tax as little as possible, which means it has to spend as little as possible*. At the extreme end of this ideology (and to be fair, you don’t really get this in the UK, only in America), you have libertarians who think there should be no taxes, and that governments should not spend at all.

As superficially attractive as this idea is, it’s perfectly clear that a functioning country needs at least some collective spending. We need roads: no individual is going to pay for a motorway, but everyone benefits from it. So the way to fund infrastructure is to get everyone to chip in some money, build the thing, and let everyone use it. “Getting everyone to chip in” is called tax. There are other things that pretty uncontroversially have to paid for this way. Armed forces (assuming we want to keep them, which most people do); power stations; in short, anything too expensive for regular people to buy for themselves. So any realistic government needs to collect taxes, and spend them on things for the common good.

So far, so good. Now the question becomes, what things should a government spend money on (and therefore how much tax does it need to raise)?

Being a civilised country, we in the UK believe that everyone should be educated, irrespective of whether their parents have enough money to send them to private schools. So the state provides education.

We also believe that everyone has the right to health-care, and that it should be free at the point of use (so that being ill doesn’t cost you money)**. (That is a surprisingly recent idea — it’s shocking to think that the National Health Service only dates from 1948, three years after the War.)

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So: infrastructure, armed forces, education, health. What else?

Welfare for out-of-work people? Pensions for people who have reached the end of their working lives? Training for people transitioning to new careers? Housing benefit for people who don’t earn enough to pay the rent? Subsidies for the arts? The list can go on. One can understand why almost anyone can object to something that their tax-money is spent on. High earners might resent what they perceive as lazy people scrounging benefits instead of working; working-class people might resent subsidies for opera-houses that put on productions they have no interest in seeing.

While we might quibble, perhaps legitimately, with any of the specific things the government spends money on, the broader picture is that by participating in a country, we are implicitly entrusting collective spending to the government that we elect. Which is why one of the most important aspects of choosing a government is its attitude to spending.

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Now I want to explore the important distinction between spending and investment. When you spend money, it’s gone; but when you invest it, you expect to get that money back, and more.

  • As a private individual, I can spend money on a sports car; or I can invest it in a house.
  • A small business can spend money on a fancy office; or it can invest it in new staff.
  • A government can spend money on Olympic stadiums; or it can invest it in education.

The line between spending and investment is not always a clear one: for example, the business that buys a fancy office may, depending on what line of work it’s in, find that the new office attracts more business. Nevertheless, the distinction exists and it’s an important one.

Now I am not necessarily saying that we should not have built Olympic stadiums. Sport is a legitimate part of British culture, and it’s arguably just as entitled to government subsidies as opera is. It’s good for governments to be about more than just money. But in purely economic terms, money spent on stadiums is essentially money down the drain. It doesn’t earn money back. Whereas money spent on educating kids pays back into the economy, over the long term, in enabling them to do better work in a broader variety of fields.

So when we talk about cutting government spending — which, remember, has been one of the main things that the coalition has done over the last five years — it’s desperately important to consider whether what it’s cutting is actually spending (which gets no return) or investment (which does get a return). Because even if you’re evaluating in purely economic terms and ignoring human cost, it makes no long-term sense to cut government investment.

Utpwon Sushi new storefront

I said before that the distinction between spending an investment is not a binary one. In fact, you can quantify the degree to which a given outflow of money brings money back in. The measure is our old friend Return On Investment, or ROI for short. It is, very simply, how much money you get back divided by how much you put in. So if I buy a house for £150,000 and sell it for £300,000, my ROI is 200%. But if I spend my £150,000 on a Ferrari and sell it for £15,000, my ROI is only 10%.

Now for some reason, when we’re talking about government spending rather than individual or company spending, we call ROI figures fiscal multipliers instead. This trick of nomenclature has the very harmful effect of making a simple thing sound complicated. Most people hear “fiscal multipliers” and switch off. But in principle at least there is nothing complicated about them.

When the government pays for something whose fiscal multiplier is less than 1.0, it’s spending (i.e. getting back less than it puts in). When it pays for something whose fiscal multiplier is greater than 1.0, it’s investing (i.e. getting back more than it put in).

Note that cutting tax costs a government money, just as spending does. Tax cuts are a form of spending. If we reduce net tax income by a billion pounds, and the economy benefits to the tune of two billion, then that was a good investment with a fiscal multiplier of 2.0. But if the economy benefits only by £500 million, then it was a bad investment with a fiscal multiplier of 0.5.

So: what actually are the values of fiscal multipliers for various ways of spending government money?

OYa, Japanese, Asian, Boston, Sushi

The answer, depressingly, is that it’s hard to know with any certainty. That makes sense, because these are big, complicated systems that run for a long time, and which it would be unethical to experiment on. But we do have some data. In testimony given before the U.S. House Committee on Small Business in 2008, Mark Zandi, chief economist of Moody’s Economy.com, gave the figures he had calculated for various government measures. The headline numbers are as follows:

  • Various spending increases: 1.36-1.73
  • Various temporary tax-cuts: 0.27-1.29
  • Various permanent tax-cuts: 0.29-0.48

This suggests, perhaps surprisingly given our own government’s rhetoric, that tax cuts, especially permanent ones, are very ineffective way to stimulate economic growth; and that spending on things like infrastructure and unemployment benefits is much more effective.

There are two caveats here: first, speaking as a fully paid-up scientist, I’d like to see the the working behind these numbers. Actually, even if I did I see working I wouldn’t understand it, so it would be better to say I’d like a range of competent economists to see how these numbers were arrived at, and verify that they’re at least in the right ballpark. The second caveat is that these are figures for the USA, which may not translate directly to the UK.

But even with those caveats in mind, we seem to be drawn to the following conclusion: most government spending is in fact investment; and most tax-cuts cost the economy money (i.e. they are spending!)

All of which raises the question of why the Conservative party in particular is so keen to cut taxes, when economists predict that the economy will do better if we increase spending (i.e. investment). We could speculate on what the reasons might be, but I don’t think we need to do that at the moment.

I want to finish the post with this observation: last time I concluded that it’s more moral to increase taxes (which hurts the rich) than it is to cut spending (which hurts the poor). Simple utilitarianism tells us it’s less bad to hurt a few people than to hurt many; and the many in this case are hurt more badly by losing the little that they have, then the few are by losing a little of the much that they have. If you don’t care for utilitarianism, then perhaps you prefer to hear it from Spock: the needs of the many outweigh the needs of the few.

And this time I seem to be concluding that it’s also more pragmatic to increase taxes than to cut spending. It yields a better outcome when evaluated in purely economic terms.

So the more I write on this, the more I convince myself that both morally and economically, spending cuts are the wrong solution to the problem of the deficit.

[Read on to #3: where has all the money gone?]


* An aside: during the first televised debate on ITV, David Cameron several times said that Labour wanted to “tax more, spend more, borrow more”. That’s just silly. You don’t do all three of those things, and no-one advocates that you should. If you tax more to fund your increased spending, you don’t need to borrow more. If you borrow more, you don’t need to tax more. I’m surprised no-one called him on this malformed soundbite.

** For some reason, “free at the point of use” doesn’t seem to apply to NHS dentists. I’ve never understood this. My taxes pay for my ears, hands, kidneys, skin and duodenum to be taken care of, but not my teeth.

18 responses to “Very basic politics #2: what is government spending for?

  1. Government spending isn’t really for paying for things that people can’t afford individually. You used as examples roads, which are paid for by government in most places, and power stations, which are often paid for by government but are not, for example, in the UK. But I can’t afford to build a supermarket for myself, the government is not building them, and nevertheless supermarkets exist. The private sector is also capable of providing things that no one person can afford. Broadly speaking, government spending is for paying for things that we don’t want the private sector to provide, either because it would be inefficient (roads), you can’t prevent freeloaders (national defence, policing) or we don’t want anyone to do without just because they can’t afford them (health care, education, welfare, housing to an extent).

  2. “If you tax more to fund your increased spending, you don’t need to borrow more. If you borrow more, you don’t need to tax more.”

    And if you borrow *and* tax more, you can spend *even more*. I don’t think the soundbite is malformed.

  3. Thanks for the correction/clarification, drpokta — that is a better formulation than mine of what government spending is about.

  4. “The deficit” – so much harm in so little a pronoun! One of the more amusing features of the last few years has been the way those most insistent on the importance of “paying down” the deficit have been least willing to talk about what caused the thing in the first place. It’s just assumed to be there. The Tories endlessly recycle tales of Labour’s “there is no money” note, like its some dirty little secret which got exposed upon their sober-minded arrival in Downing Street. While Mike, you’re written a two-part piece which asks this salient question not once!
     
    While Futilelaneswapper states “the fundamental reason for the problems we are facing [is that] we are now living way beyond our means”. This has become a commonplace, it gets repeated by rote. But who are the we? I wasn’t living beyond mine, were you living beyond yours? Rather than our leading increasingly gold-plated lives, the wealth gap had actually been widening every decade since the Eighties. Where I work, in the public sector, the value of our wages has fallen by almost a fifth. In such circumstances “we” becomes nothing but a meaningless mean.
     
    Despite the way its now being used as a scare-word, there is nothing inherently problematic about countries running deficits. Many countries have run deficits for years… for decades, even… without suffering ill effects, including the one usually seen as a beacon of free-market economics – the United States. It’s as plain as day. The deficit did not cause the economic crisis. The economic crisis caused the deficit. Both Spain and Ireland ran budget surpluses before the crisis, yet were two of the European countries worst hit by it.
     
    And there’s a clear-cut explanation for what did cause the crisis – it was financial deregulation.  Iceland and Finland are in many ways similar countries. Yet Iceland had embarked upon a barn sale of deregulation and a wholesale embrace of high finance, with consequences so drastic they caused unprecedented riots on the streets of Reykjavik. While the effects on Finland, who had more or less continued life as they had been before, were much more minor. In real life there’s almost never a smoking gun. This time there’s a smoking cannon.

    And what happens if you don’t look for causes? Imagine a drunk incapably fell over in the street and you picked him up and set him off on his way. What would you expect to happen next? He’s just going to pratfall again, right? Yet we picked up the drunk-on-power bankers by cushioning them with bales of our own money, then did nothing but set them on their way. What happens next is inevitable.
     
    The reason you almost never hear anyone mention the presence of this smoking cannon is because the two main parties, from whom most people get their political cues, are committed to continue the crappy free-market economics that got us in the shit in the first place. The Tories quite ludicrously accuse Labour of causing the crisis. How they’d be capable of causing a global event which started in the United States escapes me, but the Tories keep saying this regardless. Yet Labour would rather take this hit than defend themselves, and risk having talked themselves out of an excuse for further neoliberal “reforms”.
     
    Of course, as anyone who’s been paying attention will have noticed, after five years the Tories’ tactics have been disastrous even on their own terms. Osborne has missed all his self-set targets, like a footballer allowed to decide where the goal is and then still can’t manage to kick a ball through it. But then the deficit was only ever a decoy, an excuse to bring in their spending cuts. Many of their ‘cuts’ were clearly going to cost money rather than save it. Cuts to Legal Aid, for example, would cut legal representation, increase self-representation and thereby logjam court time. Virtually all the independent experts said this would wind up being more expensive. They went ahead anyway. Simply because it suits them if poor people have poorer access to the legal system.
     
    My attitude to the post-crisis deficit is a simple one – let those who caused it pay for it. Why should I let a table of fine diners put their tab on me, particularly when I’m sitting outside nibbling yesterday’s sandwich? My attitude to the pre-crisis (ie the ‘structural’) deficit is equally simple – who cares? The cost of borrowing’s at a record low anyway. But I don’t think either of them are the most pressing question. That’s to ask when we’re finally going to get rid of these rubbish free-market economics which have proved so disastrous for so many of us.

    This is quite a good article on what the author calls “the austerity delusion”, and how it’s mostly just the British political system left clinging to it.

  5. Those fiscal multiplier numbers are for the US, where taxes are, in general, lower.

    Obviously at 0% tax, increasing it a little is OK, and at 100% tax you get a huge multiplier from tax cuts, and there’s a minimum somewhere in the middle. Trouble is, no-one knows where that is.

    Those numbers claim that the US is too far towards the low-tax end, but you don’t know if we are too, or if we’re on the other side of the minimum and the correct answer is somewhere in between.’

    (The definition of ideal tax levels here would be that the fiscal multiplier of tax cuts would be exactly 1. Calculus and all that.)

  6. The trouble with the argument that “it’s more moral to increase taxes (which hurts the rich) than it is to cut spending (which hurts the poor)” (without any additional qualifiers) is that you can use induction to arrive at the conclusion that you should tax everyone until their after-tax income is the same, no matter their pre-tax income. Half of the last century was occupied with showing that that doesn’t work (in the form of communism) because then no-one has any incentive to try and make money.

    Obviously that’s not what anyone is proposing. But the argument needs more fleshing out, essentially with the ratio of “good done via giving money directly to the poor” vs “harm done indirectly by disincentivizing work and harming the economy”.

  7. The trouble with the argument that “it’s more moral to increase taxes (which hurts the rich) than it is to cut spending (which hurts the poor)” (without any additional qualifiers) is that you can use induction to arrive at the conclusion that you should tax everyone until their after-tax income is the same, no matter their pre-tax income. […] Obviously that’s not what anyone is proposing.

    No, it’s not :-)

    You are of course right that much more could be said regarding the nuances of the arguments in these posts. But I want to keep them simple (A) because I want them to digestible for people who aren’t in the habit of thinking about these things, and (B) because I am very, very far from an expert myself. In short, I want to deal with principles rather than details. But it’s great that commenters on these posts are supplying some of the details that I’m omitting.

  8. “you should tax everyone until their after-tax income is the same, no matter their pre-tax income. Half of the last century was occupied with showing that that doesn’t work (in the form of communism)”

    Chris, do you seriously believe that Stalin and Brezhnev were on the same take-home pay as some guy working at a factory in Siberia?

  9. Interesting points again!

    I’m pretty sure the estimates of ROI (or whatever we call it) are quite difficult to do precisely. For instance, the ROI on a heart op depends on how much you think a human life is worth. Economists try clever ways to estimate this (20 years ago it was around £1m but I guess life’s cheaper now – I think NICE uses abour £20k a year?), but really they are only assumptions. As you say, without at least knowing what the assumptions are you can’t really argue or agree with the conclusions on specifics…

  10. Gavin, I’m sure Chris doesn’t believe any such thing. He was making a reductio ad absurdum argument; to which (as he realised) the answer is that we don’t need to reduce the argument to an absurdity.

    BTW., thank you for your long earlier comment, which I am inclined to be sympathetic to, but I don’t know enough economics to know whether it’s right. At the very least, we have to admit that the idea we should spend our way out of recession through further borrowing is controversial. I hear arguments both ways, and wish I’d learned enough to have an informed opinion of my own.

    Jason, yes, of course the fiscal multipliers can only ever be estimates, and may be fairly imprecise; not only that but, but they will likely be somewhat different in the UK from their values in the USA. But even with all those caveats, the implication of that testimony before congress is that spending increases are dramatically better value than tax cuts in the present environment. We could legitimately argue about whether they’re three times better value or merely twice as good. But they’re better: that much is clear.

  11. “we have to admit that the idea we should spend our way out of recession through further borrowing is controversial. “

    The cause of the deficit is controversial in the same way intelligent design is controversial – one side keeps shouting that it is, but they’re using repetition rather than evidence, and relying on the general public’s hazy understanding of the subject, I suppose theoretically they could try to uncouple the cause from the fix. But I don’t think that’s what is being argued, in the main.

  12. Gavin, do you really think that that analogy holds? No-one who works in the relevant sciences denies evolution. Yet plenty of people who work in politics, or even economics, believe that austerity is the right response to a recession. Now, understand, I’m not saying that I agree with them (as noted I’m not qualified to agree or disagree); just that it’s not a tiny minority that no-one of significance pays attention to. At the very least, it’s an idea that Cameron, Milliband and Clegg all buy into. (As I noted in the first post in this series, the great contribution that the Greens have made in this election, to my mind, is introducing the notion that austerity is a choice. But the very fact that that that’s news shows that the converse notion, whether true or not, is far from being a fringe opinion.)

  13. Mike, please note I’m specifically talking about the cause of the deficit here. Most of those who try to suggest it was all to do with too high public spending (the “living beyond our means” thing), try to imply it, rather than say it outright as its so impossible to substantiate.

    In retrospect, climate change denial may be a better denial. Intelligent design plays more to people’s ideological persuasions, whereas climate change is more pushed by those whose vested interests it suits.

    Did you have the chance to read the link I posted? There’s quite a lot of info in there…

  14. (Interim response to Gavin: Labour overspending did not trigger financial crash, says senior civil servant. This has emerged at a convenient time for our discussion :-))

  15. “The irony is that Labour gets a lot of criticism for a crime of which they are innocent (spending too much) and hardly any at all for one of which they are guilty (not regulating the banks).”
    http://www.independent.co.uk/voices/comment/the-myth-excessive-government-borrowing-got-us-into-this-mess-8601390.html

  16. Pingback: A final thought on the election | The Reinvigorated Programmer

  17. Pingback: Very basic politics #1: three ways to deal with the deficit | The Reinvigorated Programmer

  18. Pingback: On using nuclear deterrents | The Reinvigorated Programmer

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