Optimal Spending Expands Public Revenues

Commentary, Taxation, Peter Holle

The new year promises to be a pivotal one for the country, and for Manitoba in particular. We will likely face both federal and provincial elections, in that order. It is no longer fantastic to argue that both could provide a much-needed sea change in public policy.

We need it. Despite chirpy commentary about our amazingly diversified economy – “which never grows too fast but also never grows too slow” – a recent Statistics Canada report confirms another sign of our relative decline: Manitobans now have the third lowest rate of pay in the country. Slow growth eventually hits the pocketbook.

It’s not complicated. Manitoba grows slowly because its economy is too heavily skewed towards government spending
– exceeding half the provincial GDP – the largest in western Canada. Old policy models rumble along on a cushion of federal subsidies and high taxation, crowding out job-creating private investment, and ensuring an out migration of educated young people with little interest in a public sector career path of docile seniority. Meanwhile Manitoba as the only western “have not” province plunges ever deeper into the equalization trough.

A new Frontier Centre Charticle comparing private investment across the prairie provinces in 2005 confirms the crowding out effect with another low. Manitoba now has the lowest private investment levels in Canada. Private investment per capita in Alberta is 3.2 times the level of Manitoba. Private investors in Saskatchewan, still frequently seen as Manitoba’s poor cousin, invest 1.5 times the Manitoba level.

It’s not hopeless, however. With some leadership, there are interesting precedents that show a straightforward, surprisingly uncomplicated way to a more dynamic future.

Ireland’s story is worth revisiting. Like Manitoba, that country had chosen a policy path that saw it lagging the curve, except it had no federal transfer payments to paper over the policy decay. An easy reliance on public spending reached a crisis point by the mid-1980s. Rising government expenditure crowded out the real economy, choked out private investment and bid up the price of land, labour and capital. By 1986 years of deficit spending had lifted government debt to a crisis point where interest payments consumed 94% of government revenues. Amid declining wages and vanished profits, thousands of jobs disappeared while thousands emigrated.

Then a remarkable thing happened. Displaying impressive economic sophistication, unions agreed to a 3-year Program for National Recovery which moderated labour costs and increased profits. Big cuts in public spending were exchanged for tax cuts to boost take-home pay. Ireland witnessed what policy wonks called an “expansionary fiscal contraction.” In two years, government spending declined from 50% of the economy to 40%, an unprecedented contraction far more dramatic than anything witnessed in the so-called Thatcher and Reagan revolutions of the same time.

The “Celtic tiger” legend was born. Massive public sector spending cuts and low corporate taxes combined to launch the Irish economy onto an investment-led growth path that’s made it the second richest country in Europe. Income levels surpassed Canada’s in 1996 and by 2002, its average income had zoomed to 129% of the OECD average. A recent Bloomberg news item confirmed how much labour benefited from a policy tied to vigorous private sector growth. Irish workers now pay out only 6.34% of their income in tax and social insurance costs, compared to 23% in Britain and 50% in Portugal.

The lessons for us are obvious. Chopping taxes on capital – particularly corporate taxes – spikes up job-creating private investment. More importantly, both Canada and Manitoba can increase wealth levels by reducing the size of government. Although the corollary is counterintuitive for many, that policy in sequence fattens the public purse.

The theory of the optimum size of government relates public spending to an economy’s potential economic growth rate. Where there is no government at all, you find no economy. Economic and investment growth begins when governments begin spending resources for roads and infrastructure, police to maintain order and courts to enforce contracts and property rights. Beyond a few other public goods however, excess government spending beyond some level begins slowing growth as taxes rise to carry expenditures. At the limit, as governments spend towards 100% of resources, there is no investment and again no growth.

Several studies have determined that the optimum size of government, that point which maximizes living standards and public welfare, lies between 20 and 30% of the economy. The latest research from Gerald Scully, a senior fellow at the Texas-based National Center for Policy Analysis (www.ncpa.org/pub/st/st292), shows the U.S. would maximize growth with government spending at 23% of the economy. However, since government spending in that country has ranged between 30 and 34% since 1950, real GDP growth has only been 3.5% a year instead of 5.8% possible at the optimum size.

Illustrating the power of compound interest over the 54 years of analysis, the faster growth rate would have taken the American GDP to a level three times higher than it is with a higher burden of government and a slower rate of growth. More intriguingly, particularly for the few open-minded socialists among us out there, is that Scully’s study confirms the Irish experience described above. At a lower rate of taxation, higher growth produces far more government revenue than the amount collected at higher rates. Scully estimates that a 23% rate of taxation would have produced $62 trillion more in taxes, enough money to fund all spending programs without any public debt.

More money for healthcare, daycare, universities or fixing ramshackle roads? Start squeezing out unnecessary spending that keeps the pie smaller than possible. Instead of force-feeding government money into blatantly wasteful programs – call us, we’ll send you a list – let’s do the Irish thing and embark on an “expansionary fiscal contraction” by trimming back low-quality, dysfunctional spending while cutting taxes on investment and capital.

All of us, capitalists and socialists alike, will be better off. Let’s hope 2007 will see some leadership that comprehends the benefits of the Irish model. We can enjoy better public services and higher living standards by cutting government down to its optimum size.