A Laffer Curve for government spending
By Scott Sumner
The Laffer curve is a nifty way of expressing the idea that a government’s ability to raise tax revenue is limited. The maximum amount of revenue that can be raised by a normal developed economy (per capita) is roughly 55% of France’s GDP, 45% of Germany’s GDP, or 36% of the US GDP. Because the US is richer than Germany, which is richer than France, these figures are not far apart in absolute terms.
It’s less well known that a similar concept applies on the borrowing and spending side. Italy’s government currently spends roughly 50% of GDP. The center-right populists that won the recent election favor higher government spending. (Notice how often spending rises faster when the right takes office.) Yesterday they reached an agreement on a budget that will boost spending significantly, enough to boost the budget deficit from 0.8% of GDP to 2.4% of GDP. The previous government understood that Italy had a severe debt problem, and was committed to gradually reducing the debt as a share of GDP.
The new Italian government is populist—need I say more?
Because Italy lacks its own currency, there is significant default risk with Italian debt. Even before the recent election, the interest rate on Italian debt was more than 100 basis points higher than the interest rate on German government bonds. Since the election, yields have soared another 150 basis points. Because Italy’s public debt is 132% of GDP, that will eventually push interest costs up by roughly 2% of GDP. (132% of 1.5%) Ironically, that’s actually more than the boost in government spending being proposed by the new government. In other words, in the long run the level of government spending (net of interest costs) will have to fall. The extra spending will accomplish precisely nothing, at a big cost to Italy.
In fairness, it will take a while for the interest costs to show up, as there is a large stock of outstanding bonds that were issued at lower rates. As those bonds mature and are rolled over into new debt, the interest costs will steadily rise. Thus the new coalition government may be able to boost spending on a few programs in the short run, but in the long run Italy will actually have less money to spend, net of interest, and more will be spent servicing the debt. Of course populists do not care about the long run.
Does this have any implications for the US? We don’t have a significant default risk, but the future interest burden of the debt will tend to crowd out other types of government spending, and necessitate higher taxes.
If I were a fan of the “basic guaranteed income” concept, I’d be horrified that Italy was considering implementing this idea. There’s a real danger the entire concept becomes discredited if it pushes Italy toward a debt crisis.
PS. If someone wanted a one-word explanation of why I’m not a progressive, it would be “Italy”. (BTW, Italy and Japan are my two favorite countries.) For instance, there is vast inequality between northern and southern Italy. Progressives would have you believe that inequality within a country is caused by “discrimination”. A much more plausible explanation is cultural differences, and Italy provides an almost perfect case study. Progressives believe that high levels of government spending can “solve problems”. Italy has extremely high levels of government spending, and also has poor infrastructure and lots of poverty. Yes, there are countries with high levels of government spending that do well, say Austria, but next door Switzerland does even better with low levels of government spending. Government spending does not solve poverty or infrastructure problems. Nor does it boost aggregate demand, as we see in Italy. What we need is not large government, rather effective government of modest size—something like Singapore, Switzerland or Australia. Instead of drawing up a seemingly never-ending set of new programs, American progressives should advocate replacing poorly performing current programs with other programs that they view as a higher priority. Keep the government footprint at no more than 1/3 of GDP; that’s more than enough.