There is a simple equation that every first-semester student in macroeconomics learns. It is the equation for measuring gross domestic product or GDP. GDP is used to measure the size of state and national economies. And growth in GDP is used to demonstrate how well the economy is performing, usually for a quarter or a year. This equation is designed to measure total spending in the economy (this measurement, in and of itself, is a problem, but will not be discussed here) for a point in time and includes consumption spending plus investment spending plus government spending. It is typically abbreviated as C+I+G=GDP. The full equation also includes an expression for net exports, i.e., trade deficits, but, for ease of discussion, I am omitting that variable.
According to this equation, any increase in consumption, investment, or government spending will make GDP larger and, by implication, be good for economic growth. But is that true?
Let’s examine the first two components of GDP: consumption spending and investment spending. These are, indeed, a reflection of how well the economy is performing. If consumption or investment increase, it suggests that productivity has increased. In a free market economy, all else being equal, for people to increase their purchases of goods and services or put more resources into investments and savings, they must produce more. In other words, more money has to be earned overall. Indeed, this is how we obtain the ability to increase our spending of any kind – by producing more.
But the third component of GDP, government spending, doesn’t fit this narrative. There is no causal link between higher income and increased government spending. In fact, increased government spending can actually reduce productivity and lower incomes.
Leaving aside the issue of printing of more money (inflation), the government can only increase spending by invoking its taxing power or by borrowing money, that is, invoking its power to tax in the future. What this means is that if government spending increases, one or both of the other two components of GDP must decrease by, at least, an equivalent amount. In other words, for the government to increase spending, it must draw on production that is occurring in the private sector and would otherwise be counted as consumption or investment spending.
If increases in government spending are funded strictly by increased tax revenues, then it is likely that both consumption and investment spending will be adversely affected because people typically divide their after-tax paychecks between these two categories of spending. Of course, this would depend on the kind of taxes that are collected. For example, at the state level, if the money for increased government spending is coming primarily from sales taxes, the increased government spending might fall hardest on consumption spending. On the other hand, if the increased government spending is coming from dividend or capital gains taxes, then investment spending will probably suffer the most.
If increased government spending comes from deficit spending, that is, from additional borrowing, then the spending will come primarily at the expense of investment spending. When the government borrows money, it reaches into what are called loanable funds markets and competes with private sector borrowers for the scarce funds that are available for investment. If the government is borrowing more of this money, others must be borrowing less. Simply put, the potential for private investment is crowded out by government borrowing.
The point here is that, while public sector spending adds to GDP in official government statistics, it can only increase spending at the expense of the private sector because of the way that the government obtains its revenues, that is, by decreasing private consumption and private investment. When government spends money, it is simply substituting the resource allocation decisions of politicians and bureaucrats for the those of private sector consumers and investors. The G in C+I+G, should be viewed as the extent to which the government, in attempting to accomplish public sector goals, is burdening the economy, not enhancing it.