Economic Brief: Government Spending and Private Activity


by Scott Moody

In December, I released a study that showed raising taxes to cover the budget shortfall at the Department of Health and Human Services would cost private sector jobs–or an estimated 6,463 jobs. Predictably, the liberal “Maine Center for Economic Policy” disputed the obvious crowding-out of the private sector by public sector spending.

The study I recently received in my inbox from the National Bureau of Economic Research is likely to leave the MECEP folks extremely disappointed. The study, authored by Valerie Ramey, Professor of Economics at the University of California, San Diego, is titled “Government Spending and Private Activity.”  The following is from the abstract:

This paper asks whether increases in government spending stimulate private activity. The first part of the paper studies private spending.

Using a variety of identification methods and samples, I find that in most cases private spending falls significantly in response to an increase in government spending. These results imply that the average GDP multiplier lies below unity. In order to determine whether concurrent increases in tax rates dampen the spending multiplier, I use two different methods to adjust for tax effects. Neither method suggests significant effects of current tax rate changes on the spending multiplier.

In the second part of the paper, I explore the effects of government spending on labor markets. I find that increases in government spending lower unemployment.

Most specifications and samples imply, however, that virtually all of the effect is through an increase in government employment, not private employment. I thus conclude that on balance government spending does not appear to stimulate private activity.

In a nutshell, government spending crowds-out private sector spending and all you end up with is a composition shift away from the private sector and toward the public sector.

This is what I’ve been showing for years with the chart below showing Maine’s private sector share of personal income on a perpetual downward trend.

Scott Moody is Chief Economist at The Maine Heritage Policy Center