Austerity: Why it is Key for Both Short Term and Long Term Economic Growth
Last Updated on Sunday, 2 October 2011 12:08
Written by dbhalling
Sunday, 2 October 2011 12:03
Keynesians have continually argued that cutting government spending will kill economic growth. They point to Great Britain as showing that austerity does not work. The UK introduced an austerity package that included substantial cuts in government spending and tax increases in June of 2010. Since then the UK’s growth rate has been anemic. However, there are a number of flaws with the Keynesians argument. First, the UK raised taxes, which is not austerity. Second, the US and the West are already actuarially bankrupt so we have to cut our budgets. See US Goes Bankrupt by 2019.
It is not an austerity program when you raise taxes. This is like a family saying they were instituting an austerity program by demanding their boss give them a raise. In addition, the UK raised capital gains taxes from 18% to 28%, which is the taxes that hit business formation the most. Raising capital gains decreases the return on investing in new economic activities and investors can easily decide not to invest their capital so this tax reduces economic activity more quickly than other taxes. If the UK had not raised taxes, they would most likely now be experiencing an economic boom. The empirical data clearly shows that lower government spending results in greater economic activity. As an example of one study that clearly shows this see “The Size and Functions of Government and Economic Growth”. This study clearly shows that the lower government spending the greater subsequent growth of the economy. (see Graph)
Logically, if a government absorbs 50% of a country’s GDP then the cost of goods and services on average have to be twice as much as they would otherwise be. In order to pay the expenses of government, a private sector producer who would normally charge $1.00 for a good in the absences of any government costs will now have to charge $2 and pay $1 of it to the government. If the government consumes 25% of the economy then the average cost of goods and services has to be 33% higher than they otherwise be. The simple math to figure this out is to take the reciprocal of 1-government spending. If you want to stimulate “demand” as the Keynesians are constantly suggesting, then the way to do it is to cut government spending not increase it. Imagine the increase in demand if the US were to reduce its total government spending of about 50% of the economy down to 25% of the economy. This means that the average cost of goods and services would fall 39%. How many more cars, computers, software, etc would people purchase if they were 39% cheaper? Austerity is one of the keys to both our short term and our long term economic health.
Note that the regulatory burden government imposes is not part of the government spending but it has the same effect as government spending on the economy so that should be taken into account. For instance, the cost of complying with the federal tax system is estimated by the Heritage Foundation at $431 billion. Simplifying our tax code to say a flat or fair tax could reduce this cost by more than 90%. As a result, any intelligent austerity program would include simplifying our corrupt tax code. This is the exact opposite of what the UK did.
This is not to suggest that we do not need a government. However, ”The Size and Functions of Government and Economic Growth” study showed that even at the very low level of 15% of GDP for total government spending countries continued to have increased growth rates. People forget that it was common among Western countries for total government spending to be below 10% of GDP until around 1900. If Keynesians and Socialists really cared about people they would focus on economic growth. There is no way to make the average person wealthier without growing the economy. Charity never increased the average wealth of anyone. The only reason we ever escaped the Malthusian Trap was because of the increase in per capita wealth.
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