The Economic Impact of Federal Spending on State Economic Performance: A South Carolina Perspective

The South Carolina Policy Council in cooperation with Arduin, Laffer & Moore Econometrics.

By Donna Arduin
Arthur B. Laffer, Ph.D
Wayne H. Winegarden, Ph.D.
Ian McDonough

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Federal government spending comes with costs; it should not be accepted as the free-lunch it is frequently considered to be. Every dollar the government spends must first be removed from the pocket of the private sector through higher taxes today, or higher borrowing today implying higher taxes tomorrow. Either way, government spending crowds-out private sector spending, diminishing the private economy’s rate of growth.

Properly accounting for the impact from higher government expenditures illustrate the negative economic impacts high or increasing expenditures have. Total government expenditures relative to the private economy (the government expenditure wedge) appropriately measures the burden created by total government spending.

The government expenditure wedge is defined as government expenditures divided by net domestic business output. The historic relationship between the growth in the private economy, the size of the government expenditure wedge, and the change in the government expenditure wedge illustrate that increases in government spending relative to the size of the private sector causes a reduction in the overall growth of the economy.

 

Specifically:

  • Between 1950 and 1965, the government expenditure wedge was relatively low (32.4%) and grew slightly (+5.5 percentage points). Private sector expansion was a robust 3.6% per year during this period.
  • Between 1965 and 1983, the government expenditure wedge grew quickly, rising 16.6 percentage points to 49.0%. Growth in the private sector slowed to 2.5% per year.
  • Between 1983 and 1988, growth in the private sector accelerated to 5.1% per year as the government expenditure wedge fell 3.3 points back down to 45.7%.
  • The brief reversal in the government expenditure wedge between 1988 and 1992 led to a 5.2 percentage point rise in the wedge to 50.9%. Growth in the private sector economy slowed again to 1.0% per year.
  • Between 1992 and 2000, the government expenditure wedge fell 9.2 percentage points to 41.7%. Growth in the private sector economy accelerated again to 4.5% per year.
  • Finally, between 2000 and 2007, the growth in the government expenditure wedge started growing again (by 4.5 percentage points to 46.1%) and the growth rate in the private sector cooled to 2.0%.

 

 

Consequently, the costs of accepting federal dollars from the American Recovery and Reinvestment Act of 2009 will be a long-term drain on the private sector. The ARRA Act of 2009 will increase the government expenditure wedge from 49.2% to 52.4% for an overall 3.3% increase. This increase will reduce the growth in real net business output by 2.5% which translates to a reduction of 1.7 million jobs nationally and between 23,800 and 34,850 additional jobs lost in South Carolina. South Carolina is particularly sensitive to changes in government expenditures because the state already imposes a much higher government expenditure wedge than most other states. Any major increase to their present expenditure wedge will cause higher than average amounts of negative change to the state of their economy.

Allotments for unemployment insurance (UI) from the American Recovery and Reinvestment Act of 2009 (ARRA) are particularly noteworthy as well. UI expenditures increase during a recession which often drains state trust funds. Historically, the federal government steps in to cover the increased costs but with strings that require expanded UI benefits. Once the temporary federal money has run dry, states have historically been forced to ramp up their collections in order to maintain the additional support previously provided by the federal government.

One of the cornerstones of good economic analysis is the realization that “there is no such thing as a free lunch.” Yet when it comes to federal money for the states, this foundation is lost. Most people equate federal dollars as manna from heaven – a free meal that should be enjoyed for as long, and often, as possible. The reaction to the Governors that questioned the efficacy of the recent stimulus package is simply the latest example of this mistaken belief.

The United States is comprised of 50 states, the District of Columbia, and a few territories. This obvious statement is somehow forgotten with respect to the economic and fiscal effects from federal government spending. All federal government tax revenues are raised by levying taxes on people (or entities) that are located in one of the states or the District of Columbia (a subset of the country). Because the vast majority of the federal budget is spent domestically, the vast majority of government spending is spent in a part (or subset) of the country. By definition then, federal government fiscal policy is taking revenues from one state and spending it in the same, or a different, state.

No magic resources are created by the federal government that did not exist in one state prior to the federal government’s fiscal policy. In order for one state to receive a net positive amount of resources from the federal government, accounting for the federal tax revenues that were levied in that state, the federal government must take a net negative amount of resources away from another state. For the country as a whole, the federal government cannot create a net injection of resources.

What the federal government can do is change the net economic incentives across each state or change the net benefits (or value) created by the federal tax dollars. A careful examination of federal spending illustrates that federal tax and spending policy is creating significant adverse impacts on state economic efficiency and despite the addition of seemingly “free money,” is actually creating a net negative for the health of state budgets across the country.

Continue reading the full study here.

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