Does Government Spending Benefit the Economy?

‘Spend as much as you can’, urged the IMF at the start of 2021 in order to accelerate the global economy’s revival. Others argue that the economy should be left to its own devices – government intervention only creates havoc. Governments spend in a plethora of ways, but we must examine the effects of government spending, originally intended to directly benefit the economy.

On the one hand, government spending on infrastructure can be both constructive and necessary. A survey conducted in Latin America in 2007 illustrated that when infrastructure was left to the private sector, it was largely neglected, with ‘potentially major adverse effects on growth and inequality’. David Hall at the University of Greenwich states that in Africa, a similar trend can be identified: if Africa increased their spending on infrastructure, ‘[economic] growth rates would increase by 1-2%’. Additionally, in Europe public-private partnerships only accounted for 4% of public sector investment in 2007. This is because private corporations tend to feel that the public infrastructure sector does not provide enough profit. Even in the US, where the federal government rarely plays a key role, the great majority of investments in transport, environment and education are public. This illustrates that the government should spend more on infrastructure projects because this benefits the economy. Only the government is willing to uphold this role.

An argument that sometimes follows from this is that infrastructure investment and government-funded projects create more employment, contributing positively to the economy. A contemporary example would be the HS2 railway, which will create 22,000 jobs within the next few years. This seems to be a reasonable argument, because employment opportunities will be created, which benefits the economy since the new workers will be able to use their wages to purchase goods and services, injecting more money into the economy.

Moreover, in times of economic downturn, governments around the world provide a stimulus which revives the economy. We have already illustrated that in the long term, government spending purely to create employment is not sustainable. In the short term, namely under one year, such spending could benefit the economy. This is because previously we assumed that if the infrastructure project was not created, there would still be employment elsewhere, but in a recession, there is often no such alternative; for example, the unemployment rate in the UK was around 5% in the autumn of 2020. Jobs created are not all in construction, since the idea is to invoke the multiplier effect: the construction workers and others directly employed to build the infrastructure are paid wages, so can spend more on goods and services, therefore benefiting other industries too.

Another way governments can stimulate economies during a crisis is to directly give people money or reduce taxes, in the hopes that they can rely on this when unemployed and also to spend it, thereby injecting money into the economy. However, the effect is less straightforward. This is because individuals choose not to spend a significant portion of the money received during recessions: only 30% of the tax rebates given by the American government in 2008 was spent. Thus, the effect of stimulus packages may not be as efficient as expected, but it should also be noted that it means inflation will be of less concern since less money is being forced into circulation, and as long as individuals are willing to save yet still manage, the stimulus should be considered a success.

On the other hand, the argument that government spending creates employment does not necessarily benefit the economy. For example, when we evaluate infrastructure solely by its ability to create employment, we are disregarding its long-term benefit to the economy and people and start to think about where a railway could be built instead of where it must be built. In essence, other than the short-term boost in employment, the railway itself may not benefit anyone, thus could be a significant waste of funds, should we only consider its ability to employ workers.

Additionally, government spending usually leads to increased taxes for both individuals and corporations. The impact of increased taxes is overall negative for a nation, because it disincentivises not only hard work, but also investment since the risks are higher than the rewards. The same applies to corporations, which therefore do not invest so much in new technology or explore new products, so the cost is transferred to the consumers, who cannot purchase better and cheaper goods or services. Higher taxes also means that taxpayers lose money that they would have otherwise spent on goods and services, and depriving taxpayers of purchasing power damages the economy through the de-multiplier effect; but referring back to the argument that government spending creates employment, economist Henry Hazlitt states that construction workers will be seen building, and infrastructure itself is naturally tangible, thus the argument that infrastructure projects creates jobs is commonly believed in. However, the alternative, namely running up a large deficit, may be detrimental to the economy in the longer term, but less so in the short term. A short-term stimulus, for instance, may not be financed by increased taxes, but by an increased deficit which, according to John Maynard Keynes, is acceptable. The alternative to raising taxes is to increase government borrowing and hence debt. However, the effects of this area currently unknown, despite many of conservatives warning about exceedingly high levels of debt.

Overall, it is clear that government spending certainly can benefit the economy, especially in times of recession or even crisis. However, we should be careful to view government spending as something inherently beneficial, and that more government spending does not always positively correlates to a stronger economy, for it is not the spending itself that benefits an economy, but rather how the funds are spent.

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