State government spending hits new heights

by Adam Millsap on July 30, 2015

in Balanced Budget, Economic Growth, Public Finance, Tax and Budget

There is a large literature in macroeconomics that examines the extent to which federal spending “crowds out” investment in the private sector. Basic theory and common sense lead to the conclusion that government spending must replace some private sector spending. After all, dollars are scarce – if the government taxes Paul and uses his money to build a road Paul necessarily has less money to invest in his landscaping business. In theory government spending on public goods like roads could be a net gain. This would occur if the additional value produced by spending one more dollar on roads was greater than the additional value produced by investing one more dollar in Paul’s landscaping business. But even in this scenario, Paul himself may be worse off – he’s one dollar poorer and he may not use the new road – and there is still a dead-weight loss due to the tax.

In reality, the federal government does a lot more than build roads, especially productive ones. In 2014, only 1.9% of federal income tax revenue was spent on transportation. And most of the other stuff that the government does is way less productive, like shuffling money around via entitlement programs – Medicare, Medicaid, and Social Security – and investing in businesses that later go bankrupt like Solyndra. So while it is possible that a dollar spent by the government is more productive than a dollar spent by a guy like Paul, in a country with America’s spending habits it’s unlikely to be the case.

The same crowding out that occurs at the federal level can occur at the state level. In fact, in many states state spending as a percentage of gross state product (GSP) exceeds federal spending as a percentage of GDP. The graph below shows state spending as a percentage of GSP for all 50 states and Washington D.C. in 1970, 1990, and 2012 (data). The red, dashed line is federal spending as a percentage of GDP in 2012 (21.9%).

state spending gsp graph

As shown in the graph, nearly every state increased their spending relative to GSP from 1970 – 2012 (triangles are above the X’s). Only one state, South Dakota, had lower spending relative to GSP in 2012 than in 1970. In 2012, 15 of the 50 states spent more as a percentage of GSP than the federal government spent as a percentage of GDP (states where the triangle is above the red, dashed line). In 1990 only two states, Arizona and Montana, spent at that level.

It used to be the case that state and local spending was primarily focused on classic government services like roads, water/sewer systems, police officers, firemen, and K-12 education. But state spending is increasingly looking similar to federal spending. Redistributive public welfare expenditures and pension expenditures have increased substantially since 1992. As an example, the tables below provide a breakdown of some key spending areas for two states, Ohio and Pennsylvania, in 1992 and 2012 (1992 data here, 2012 data here). The dollar per capita amounts are adjusted for inflation and are in 2009 dollars.

ohio spending table

penn spending table

As the tables show, spending on public welfare, hospitals, and health increased by 120% in Ohio and 86% in Pennsylvania from 1992 to 2012. Pension expenditures increased by 83% and 125% respectively. And contrary to what many politicians and media types say, funding for higher education – the large majority of state education spending is on higher education – increased dramatically during this time period; up 250% in Ohio and 199% in Pennsylvania. Meanwhile, funding for highways – the classic public good that politicians everywhere insist wouldn’t exist without them – has increased by a much smaller amount in both states.

The state spending increases of the recent past are being driven in large part by public welfare programs that redistribute money, pensions for government employees, and higher education. While one could argue that higher education spending is a productive public investment (Milton Friedman didn’t think so and I agree) it is hard to make a case that public welfare and pension payments are good investments. This alone doesn’t mean that society shouldn’t provide those things. Other factors like equity and economic security might be more important to some people than economic productivity. But this does make it unlikely that the marginal dollar spent by a state government today is as economically productive as that dollar spent in the private sector. Like federal spending, state spending is likely crowding out productive private investment, which will ultimately lower output and economic growth in the long run.

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