State spending

A particularly controversial example of the law of diminishing returns is in the area of state, or public, spending. Some recent studies indicate that diminishing returns have been very much in evidence in developed countries in recent decades, with returns even being negative in some cases. An example is the IMF paper by Tanzi and Schuknecht, which examined the growth in public spending in industrial economies over the past 125 years and assessed its social and economic benefits.

At the beginning of this period, 1870, governments confined themselves to a limited number of activities, such as defence and law and order. Public spending was only an average of 8% of GDP in these countries at this time. The higher taxes that were introduced to pay for the First World War allowed governments to maintain higher spending afterwards. Public spending rose to an average of 15% of GDP by 1920. This spending increased again in the years after 1932 in the surge of welfare spending to combat the Great Depression. By 1937 the average for industrial countries had reached nearly 21% of GDP.

The three decades after the Second World War witnessed the largest increase in public spending, mainly reflecting the expansion of the welfare state. By 1980 the proportion of GDP accounted for by state spending was 43% in industrial countries, and by 1994 this had risen to 47%. By this time there were large variations between countries: the EU average was 52%, in the UK it was 43%, in the USA 33%. In the newly industrializing countries (NICs) the average was only 18%. These variations over time and area allow some interesting comparisons regarding the benefits of additional spending.

Tanzi and Schuknecht found that before 1960 increased public spending was associated with considerable improvements in social welfare, such as in infant-mortality rates, life expectancy, equality and schooling. However, since then, further increases in public spending have delivered much smaller social gains, and those countries where spending has risen most have not performed any better in social or economic terms than those whose spending has increased least. In the higher-spending countries there is much evidence of 'revenue churning': this means that money taken from people in taxes is often returned to the same people in terms of benefits. Thus middle-income families may find their taxes returned to them in child benefits. Furthermore, in many of those countries with the lowest increase in public spending since 1960, efficiency and innovation appear to be greater; they have lower unemployment and a higher level of registered patents.

Another study found a similar pattern in Canada specifically. In the 1960s public spending, at modest levels, helped the development of Atlantic Canada. Most of the money went into genuinely needed roads, education and other infrastructure. Later large increases in spending not only had a smaller effect, but in general had a negative effect. For example, generous unemployment insurance reduced the supply of labour and impeded private investment. Subsidized industries, like coal, steel and fishing, involved using labour that could have been employed in more productive areas, as well as in the last case decimating the cod stocks. Even the roads eventually deteriorated, as local politicians had little incentive to spend public funds wisely, and voters felt unable to discipline them.

Questions

1. In what areas of public spending do there appear to be increasing returns?

2. In what areas of public spending do there appear to be diminishing or negative returns?

3. Explain the difference between diminishing and negative returns in the context of public spending, giving examples.

4. Explain what is meant by 'revenue churning', giving examples.

5. Why do local politicians have little incentive to spend public money wisely?

6. Is it possible to talk about an optimal level of public spending? How might this level be determined?

I want answer of this six questions in brief