The Visible Hand

What is the role of the government in a modern society? There were two developments in the 1990s that brought this issue to the center of public debate.  The first was the explosion in federal red ink - the budget deficit in 1992 had grown to almost $300 billion, and the national debt to $3 trillion.  The second was the collapse of the "wall" and the decline of communism in Central and Eastern Europe.  As the countries left behind communist rule, the obvious question was: what was the proper role of the government as the countries attempted to move from command to market economic systems.

In this unit we will examine an important dimension of the role of government in a modern economy - an issue addressed continuously throughout the course.   In microeconomics we examined market failures and the government's role in correcting them, while in macroeconomics we compared the conservative and liberal perspectives on the proper scope of monetary and fiscal policies in fine-tuning the economy and promoting growth.  Here we will begin with a brief overview of alternative perspectives on the question. The focus in the remainder of this unit will be on the fiscal aspects of the government, on questions concerning how it collects money and how it spends it.  At the outset of any discussion of government finances we must recognize there are three very distinct levels of government - federal, state, and local - and their finances differ markedly.  For that reason we will look at the three separately, although we will focus on the finances of the federal government.  Included here will be a separate section devoted to a discussion of some of the more important questions concerning taxes - what we should tax, how we should tax it, and what is fair.  

When examining government finances it is also useful to follow the lead of Wallis and recognize that "between 1790 and 1990 the United States passed through three distinct systems of government finance."₁  The periods / systems were characterized by dominance of one level of government and one form of taxation.   In the first system lasting from 1790 to 1842, it was the state governments that were the largest spenders, taking "an active lead in promoting economic development through infrastructure investment and legal innovation to promote corporations and banks."  The spending was financed in large part from asset (land) sales.  In the second period it was the cities that dominated government spending as "local governments grew in size and importance and took over most of the important infrastructure investment in education, highways, water systems, sewer systems, and public utilities."  The primary source of funding here was the property tax.  The third system was ushered in by the Great Depression.  "This system had two components: a federal system of domestic economic programs (including infrastructure investment) funded by national grants and administered by state and local governments; and a national system of defense and old age security."  The major sources of income in this last period were the income and payroll taxes.  

The unit will conclude with a section on government deficits, surpluses, and government debt. These were THE issue in the 1990s.   At the outset of the decade the budget deficit was THE political issue in the presidential election with both candidates proposing alternative plans for reducing the deficit, but by the 2000 election the disposition of the projected budget surplus had become a major issue.  In this section we will look at the magnitude of the imbalance in the government's books and focus our attention on three issues - how to explain the imbalances, what is their impact, and what can we do to eliminate them.

Some of the questions you should be better able to answer when this unit is completed are:  Where does the government get its money and where does it spend it?  What will happen to the government's finances when the baby boomers retire and what will the internet do to the finances of government?  What is the future of the safety net that protects individuals from the ravages of rapid change and economic decline that are an ever-present feature of a market system?  What is fair when it comes to taxes?  What are the advantages of a flat tax, a sales tax, a progressive income tax?  Why should we care if there is a movement from an income tax to an employment tax? What is bad about a budget deficit? How BIG is the budget surplus? How should we "spend" the budget surplus?

Government's role in the economy

What should the government do and how big should it be?  The answers to these questions depend very much upon who you ask.  Frye & Schleifer, in a study of Eastern European countries attempting to make the transition from command to market economies, identify three perspectives on these questions - the invisible hand, helping hand, and grabbing hand.

Invisible hand: In the 19th and early 20th centuries the economics profession generally agreed that the role of the state should be limited to "the essential core functions, which were mostly of an allocative character.  These were defense, law and order, basic public works, protection of property rights, and other similar functions." _{Tanzi 1997} In large part this was viewed as a reaction to the 18th century when governments' mercantilist policies were centered more on increasing gold in the coffers of government and less on putting food on the tables of the people.  The leaders of this movement were Adam Smith, who praised the virtues of the market system, and David Ricardo, who identified the gains associated with free exchange.   In their view, a good government is a small government, and their followers certainly would not want to grant governments discretionary power to manage the macroeconomy.  This was the basis for support of the gold standard, which took discretionary monetary policy out of the hands of government, and the balanced budget, which took away discretionary fiscal policy.  Among advanced countries, the US is the economy that comes closest to the ideal of the invisible hand guiding a market economy, although it is certainly a mixed economy with a good dose of the visible, helping hand.

Helping hand: The market system is imperfect and well designed government intervention can improve society's welfare.  As a result, the potential scope of government's activity has grown as the markets'  limitations have become more accepted.  A  list of some of the more important "imperfections" appears below   - some topics being the subject of microeconomics (1-6) and some the subject of macroeconomics (7-8).  

Market Imperfections

1. Imperfect competition
2. Preservation of common resources
3. Public goods
4. Externalities
5. Inequality
6. Imperfect information
7. Business fluctuations:
8. Economic growth

In macroeconomics we have examined the potential role for government in managing the macroeconomy - in dampening the cycles and speeding up the growth process.  In microeconomics the discussion focused on the government's role in improving the efficiency of the system by designing policies that influence the behavior of individual decision makers or supplying certain goods and services.   Just how much the government should intervene remains a hotly debated issue, one that has surfaced repeatedly during the course.

Grabbing hand: Not all government intervention is beneficial.  The mercantilism of the 18th century is a good example of the grabbing hand of government.  So were some of the modern kleptocracies, governments that managed to create vast fortunes for those who ruled over a nation of poor.  The Marcos and Suharto regimes in the Phillipines and Indonesia are two of the more publicized examples from East Asia.  Another would be Russia which experienced exceptional difficulty in making the transition from a command to a market economy.  In their comparison of economic growth in Poland and Russia after the enactment of market reforms, Frye & Schleifer found Poland to be more successful than Russia in part because in Russia the government was far more interventionist.  A survey of shopkeepers in Krakow and Moscow revealed that in Moscow the shopkeepers could expect to be visited by more government officials from more agencies - and each time with a hand out. 

Who has it right?  In the America, government has historically been viewed as a necessary evil and the "American tradition considered poverty to be the result of individual moral failure." Chudacoff _p43   Slowly over time, however, the role of the government expanded as the inadequacies of market solutions to some problems appeared and the power of the individual to control his/her own destiny was questioned.  By the early 19th century a number of people "who were concerned about the effects of rapid change and who observed the predicaments of the poor most closely came to believe that social and economic conditions, not individual failure, were responsible for poverty.... society had failed to provide all of its members with opportunities to avoid indigence and thus had an obligation to care for those who lacked means of subsistence." _{Chudacoff p43}  The result was that many cities opened almshouses and workhouses between 1820 and 1840. Cities also took it upon themselves to deal more directly with the roots of the problem by providing education.  Boston established free elementary school in 1828 and by the Civil War most large cities and states in the North and West had some form of free education.

There was also the problem of adequate supply of the basic utilities of modern life. In 1798 the government of Philadelphia took over the supply of water to city residents and within fifty years the nation's major cities all had public water supplies.  Police forces were next - the logical response to urban unrest. "Mob violence had characterized American cities since colonial days, but by the 1830s and 1840s ethnic, racial, political, and social conflicts were beginning to stir upper and middle class to support the creation of stronger, more efficient police forces to preserve life and property." _{Chudacoff p43.}   The result was that by 1840, following the lead of Boston, cities were establishing salaried policemen.  

The role of the government continued to expand over the next century as the government took on new responsibilities such as the regulation of certain industries and the discouragement of non competitive business practices by BIG business through the antitrust laws.  The BIG change, though, came during the Great Depression of the 1930s with Roosevelt's New Deal that contributed most to the acceptance of a wider role of government involvement.  By the 1960s the developed world was in the midst of a love affair with the helping hand as the world's problems seemed tractable and their solution simply awaited the efforts of well intentioned government officials implementing policies proposed by academics.  

By the mid 1970s, the problems seemed less tractable, politicians less selfless, and academicians less than omniscient.  Ronald Reagan in the US and Margaret Thatcher in the UK led the move to the political and economic right with a rediscovery of the merits of the invisible hand and weaknesses of the visible, or helping, hand.  These politicians were following the lead of the economics profession that provided the theoretical underpinnings of the move - the work of Friedman, Lucas and Sargent had weakened the faith in discretionary macroeconomic policy while the work of Buchanan raised doubts about the good-intentioned, selfless government bureaucrats.  The collapse of communism in the late 1980s was the ultimate victory of the market system, or at least this was the story pushed by the free marketers, and governments across the developed world set about the task of dismantling the safety nets that had grown out of the Great Depression.  The rapid growth of Asia in the 1980s and early 1990s raised concerns that the Asian model of capitalism, with its heavy government involvement, was superior to its American version with limited government involvement, but this crashed with the Asian economies in 1987. As the 20th century closed it was the American model that had regained its luster as the Asian economies collapsed under what had become referred to as crony capitalism. 

As for a forecast on how the debate proceeds, you can expect, based on past experience, that a shift from the ideological right will not happen without a catalyst provided by an economic crisis.  While it is too early to know what the crisis will be, one obvious possibility would be governments' financial crises, and now we will now turn our attention to the finances of government.

Government's finances: outlays, receipts, deficits, and debt

How does the government collect its money and where does it spend it?   Who pays the taxes and who gets the benefits?  How much does it borrow and how does it borrow money? How much does the government owe?  The answer depends upon what government you are talking about.   We will talk about the local, state, and federal governments - each of which tends to specialize in how it collects money and how it spends it.  One place to begin any study of government finance would be the US Census Department that conducts a Census of Governments - the latest being in 1992.  According to the Census Department, there were more than 87,000 independent governments in 1992 plus the federal and state governments.  The breakdown of governments, and their number, appear below. (Information on governments can be found on-line at the Census web site including descriptions of governments by states.) 

• County Governments (3,043)
• Municipal Governments (19,372)
• Township Governments (16,629)
• Special District Governments (34,683)
• School District Governments (13,726)

According to the census, RI has 125 governments.  There are counties in the state, but they have no governmental structure. There are 39 sub county governments that include 8 cities and 31 towns, and 83 other governments including water, sewer, fire districts, the Port Authority, and the Public Transit Authority. 

We will begin our analysis with a briefly examination of the finances of the local, state, and federal government.  You can find information on state and local government finances on-line as well as more detailed data of state finances.  For data on the federal budget you should check out the government finances web site.  Before we examine the data, let's specify the terminology. 

• Outlays (Spending): what the government spends.  It includes spending on currently produced goods and services (G in macroeconomics) and transfer spending (ex. unemployment, social security).
• Receipts (Income): what the government "earns." It includes taxes (ex. property and income taxes), fees and charges (ex. sewerage) and utility revenue (ex. water, electric).
• Deficit (Surplus): how much the government borrows (saves).  This represents the difference between the outlays and receipts.
• Debt: how much the government owes.  This is comparable to the principal on your student or car loans.

An examination of government outlays cited in Wallis reveals three distinct periods based on the size of the government.  The first period (I) extends to approximately WWI during which government revenue's share of GDP rose from 4% in 1840 to 7.5% in 1913.  The second phase was the interwar period where government's share rose from 12.6% (1922) to 17.9% (1940).  During this period government spending never declined to its pre WWI levels.  Finally, in the third phase government revenues rose from 29.5% of GDP in 1946 to 37.5% of GDP in 1992.  Once again, revenues failed to fall after WWII as the income tax, expanded during WWII, provided a steady stream of revenues to the federal government which allowed it to fund high levels of income security and defense spending.  

State and Local Governments: Revenue Sources

We will begin our analysis of finances with the state finances.  You may want to compare the US average to RI.  On the revenue side we find state governments' took in a little more than $1 trillion in 1997.  Of that total, 78 percent was general revenue (ex. taxes) and 21 percent came from insurance trust revenue (ex. pension contributions).  Of the general revenue, 22 percent comes from the federal government and 43 percent comes from taxes.  The largest share of state general revenue comes from sales and individual income taxes, each of which contributes a third. 

These figures, which are averages of all 50 states, hide some substantial variations in how states raise and spend money.  Some states, for example, do not have income taxes while others have no sales taxes.  Below is a table that provides a breakdown for five states including RI.   Intergovernmental transfers (primarily money from the federal government) range from about 33 percent of revenue in NY to 11 percent in FL. Individual income taxes, meanwhile, bring in nothing in TX and FL where there is no income tax, while they bring in 18 percent  of state funds in NY and 15 percent in RI.  New Hampshire, with its liquor stores located just inside the NH borders, generates 7 percent of its revenue from these stores.

Table 1
1997 State Revenue: Percent of Total Revenue

The sources of funds at the local level are substantially different [state and local budgets].  Local governments are more dependent upon monies from other governments - more than one of every three dollars comes from intergovernmental transfers - and less dependent on taxes and insurance trust funds which produce 34 and 3 percent of local revenues.

Diagram 1

There are also significant differences in the sources of tax revenue at the state and local level. Sales (16%), individual income (5%) and corporate income (0%) taxes are generally rather small sources of local government income, while the property tax is by far the largest source of tax revenue (75%).  At the state level, meanwhile, sales taxes are the largest source of state tax revenue (50%) followed by the individual income tax (32%) and the corporate income tax (7%). 

Diagram 2

State and Local Governments: Outlays (Spending)

On the expenditure side, 30 percent of state expenses go to other governments (local and federal) and 70 percent to direct expenditures.  When broken down by function, the four largest components of expenses at the state level are education (31%), public welfare (23%), insurance trust expenditures (11%) and highways (9%).  

Expenditures at the state level also vary substantially across states.  In TX and NY, 26 and 31 percent of state expenditures are monies going to other governmental units (primarily local areas) while in RI and NH the figures are 13 and 12 percent.  TX spends the most on education and corrections, NY spends the most on public welfare, FL spends the most on highways, NH spends the most on interest, and RI spends the most on insurance trusts.  

Table 2
1997 State Expenditure: Percent of Total Expenditure

On the spending side of the ledger at the local level, 4 of every 10 dollars spent by local governments goes to pay wage and salary expenses, substantially higher than the states' 13 percent share.  Education, at 37 percent of outlays, is the biggest expense for local areas while intergovernmental expenses (28%), welfare (17%) and insurance trust expenses (12%) are the largest expenses at the state level.  Police and fire protection combined account for 7 percent of total outlays in local areas while utilities account for 11 percent. 

Diagram 3

Federal Government:  Outlays and Revenues

It is the federal government's finances, however, that tend to be in the news - at least the national news.  Information on local finances is likely to show up in a local paper such as the Narragansett Times or the Newport Daily News, while state papers such as the Providence Journal and nightly local news would be your source for state finances.  When you want information on the federal budget, you would want to pick up a national paper such as the New York Times or Wall Street Journal or watch CNN or the nightly national news.

So how big is the federal government? As a first step toward answering this question let's look at how the federal government compares to the state and local governments.  In 1995 the federal government, whether measured by revenues or expenses, was about the combined size of the state and local governments.  The federal government's spending accounted for 52 percent of the total, while state and local governments accounted for 25 and 23 percent respectively. 

We can also look at some of the world's biggest corporations, the Fortune 500  which are the 500 largest companies when measured by the size of annual sales.  The list of the top five companies for 1999 from the Fortune website appears below.  General Motors was at the top of the list with sales of $161 billion and there were 45 corporations with sales exceeding $25 billion.

Table 3

W e can also look at the size of some countries, using GNP as a measure of size.   The US is by far the largest with a GNP of $7.247 trillion - about 50 percent larger than Japan, three times as large as Germany, and nearly 300 times the size of Albania.

Table 4
GNP 1997

Based on these numbers, the federal government is BIG.  To find out exactly how big you can check out the federal budget web site where historical data on federal finances is readily available.  In 1997 the federal government spent  $1.6 trillion - about ten times GM's sales in 1998, 60 percent more than the value of China's output for 1997, and 2,700 times as much as the government spent in 1901.  The growth in government revenues and outlays during the 20th century are evident in Diagram 4.  It is evident in the diagram that something happened around 1918 and 1943 that increased outlays, and in the early 1980s that reduced tax revenues.   What happened were the two world wars (1918 and 1943) and the Reagan tax cuts (1981).

Diagram 4

Over the century, however, the US economy has also grown which accounts for some of the increase in the size of the US government.  Diagram 5 provides a picture of how the government's relative size has changed over 100 years.  The two world wars are very clear in the diagram.  In both wars US government outlays surged, accounting for nearly 25% of national output in WW I and 50% of national output in WW II.  It is also apparent from the diagram there were two "breaks" in the pattern.   After WW I federal government outlays tended to return to prewar levels, but in the 1930s as the nation struggled through the Great Depression spending moved to a new, higher level, and then again following WW II, outlays failed to return to pre war levels.  Before WW I federal outlays averaged about 3-4% of GNP, in the 1930s they averaged 8-9%,  in the years directly following WW II they averaged 12%, and following the Korean War they averaged 18%.   As the US ended the 20th century, federal government outlays accounted for approximately 20 percent of the economy, nearly ten times the share that it opened the century with.

Diagram 5

Federal Outlays

The government is not only bigger, but how it spends its money and earns it has also changed substantially.  Defense spending's share of total federal outlays, which during WW II accounted for nearly 100 percent of federal outlays, declined steadily and at the turn of the century stood at approximately 20 percent.  The only exceptions were a large reversal in the early 1950s for the Korean War, a small "blip" in the late 1960s for the Vietnam War, and a modest increase in the first half of the 1980s during the Reagan build-up.  Spending on physical resources (energy, transportation, and natural resources and the environment) and net interest (interest on the national debt) both remained under 20 percent of the total, with physical resources declining in importance after 1980 and net interest increasing.   In 1998 outlays for net interest were four times as large as those on physical resources, while in the early 1980s they were roughly equal. 

The biggest changes, however, were in the area of human resources.  In the early 1950s, human resources accounted for about 20 percent of federal outlays but by the late 1990s the share was near 60 percent.  The biggest gainer was social security which grew approximately ten times as fast as the overall budget so its share of total outlays increased from 2 percent to 23 percent during this period.  The other big "winner" was Medicare which came into existence only in the mid 1960s and by the late 1990s accounted for 12 percent of outlays.  

The changing composition of federal outlays has also meant that the government has less "control" over its spending.   The distinction is increasingly being made between discretionary spending, what the government can control, and nondiscretionary, what existing laws mandate and cannot be controlled without rewriting the laws. An example of the former would be spending on a new fighter plane, while an example of the latter would be social security.  The changing scope of the two can be seen in the diagram below.  Nondiscretionary spending, which accounted for roughly one-third of all spending in the early 1960s, accounted for two-thirds in the late 1990s. At the turn of the century the US government's spending is largely on autopilot.

Federal Revenues

Changes on the composition of outlays has been accompanied by significant changes in the sources of government revenues.  In 1939, just prior to WW II, personal and corporate income and social insurance taxes each raised approximately $1 billion, while excise taxes raised $1.5 billion.  To finance the war, however, it was the income taxes that provided the bulk of the additional revenue as their share of total revenue increased from 34% to 80%.  Following the war, personal income taxes remained at the higher level and continued to account for between 40 and 50 percent of total revenue.  Corporate income taxes, meanwhile, continued to decline in terms of general importance with the exception of the reversal in the early 1950s to help finance the Korean War.  Offsetting the decline in corporate income taxes has been an increase in social insurance taxes - what you can think of as the FICA contribution on your pay stub.  These taxes, which accounted for less than one of every ten dollars raised by the federal government in the late 1940s after W.W.II, accounted for nearly one of every three dollars raised in the late 1990s.  Finally, excise taxes that accounted for about one-third of federal revenue before WW II, accounted for about one-twentieth at the end of the 1990s. 

Conclusion and Two Extensions: Taxation and Imbalances

It should be clear from the data presented the government has become an increasingly important force in the lives of US individuals in the twentieth century.  But the US is not unique on this count.  Below is a table of general government (combined federal, state, and local) based on public sector finances data compiled by the OECD.  It is clear the government is a large and growing component of all of the economies and the scope of government in the US is on the low side among the industrialized countries.

General Government Outlays: Percent of GDP

Furthermore, the changing composition of the federal government's revenues and outlays indicate the government's influence has changed substantially and therefore it should be no surprise that federal taxes and spending have been an important issue in a number of presidential elections including the 1999 presidential campaign for the 2000 election.  As a guide to that discussion, both what lies behind us and what lies ahead, we will briefly outline in separate sections some of the important issues surrounding taxation and budget deficits and surpluses - the imbalances in government finances you hear so much about.   In the taxation section we will examine three of the major taxation issues - what should we tax, how should we tax it, and what does the future look like.  In the section on the deficit and surplus we will examine four issues - how big are the deficits and debt, what is the source of the fiscal imbalances, what is the cost of a budget deficit, and what should we do with a budget surplus.   

1 John Joseph Wallis, "American Government Finance in the Long Run: 1790 to 1990," Journal of Economic Perspectives, 14:1 2000