August 19, 2012


With the selection of Paul Ryan as the Republican vice presidential candidate, it is clear that the central issue in the presidential election will be the scale and scope of government involvement in the economy. There is disagreement over what constituted “normal” levels of spending in the past and, indeed, over what constitutes “spending.” But there is a widespread view in both parties that it is feasible and desirable that in the future the federal government should be no larger as a share of the overall economy than it has been historically.


First, demographic change will greatly expand federal outlays unless politicians decide to degrade the level of protection traditionally provided to the elderly. Between Social Security, Medicare, Medicaid and some smaller programs about 32 percent of the federal budget, or about 7.7 percent of gross domestic product, is devoted to supporting those over 65. The ratio of this age group to those of working age will rise from 1 for every 4.6 workers to 1 for every 2.7 over the next generation. If no other adjustments are made, this implies an increase in federal spending of 5.6 percentage points of GDP. As Americans’ health and life expectancy improve, it may be appropriate to revise upward the assumed retirement age. That would, however, be unlikely to counteract the expected 34 percent increase in the share of the population over the next generation who will be within 15 years of estimated life expectancy.

Second, the accumulation of more debt and a return to normal interest rates will raise the share of federal spending devoted to interest payments. In 2007, before the financial crisis, federal debt held by the public was equivalent to 36.3 percent of GDP. On a very optimistic view, where recommendations such as those of the Simpson-Bowles commission are implemented, net debt held by the public will nearly double, to 65 percent of GDP, by 2020. This implies that the federal government’s outlays to service its debt will rise from 1.7 percent of GDP in 2007 to 3.2 percent of GDP in 2020.

Third, increases in the price of what the federal government buys relative to what the private sector buys will inevitably raise the cost of state involvement in the economy. Since the early 1980s the price of hospital care and higher education has risen fivefold relative to the price of cars and clothing, and more than a hundredfold relative to the price of televisions. Similarly, the complexity, and hence the cost, of everything from scientific research to regulating banks rises faster than overall inflation. These shifts reflect long-running trends in globalization and technology. If government is to continue providing the same level of these services, government spending as a share of the economy has to rise, by at least 3 percent of GDP.

Fourth, several methods that have been used to repress the deficit, such as federal pension liabilities and the deferred maintenance of federal infrastructure, will soon be unsustainable.

Meanwhile, there is a steady decline in the fraction of tax returns that are audited and evidence of growing tax noncompliance. Both reflect unsustainable cuts in spending. And on almost any reasonable view of the state’s responsibility, large increases in inequality such as those observed in recent years should call forth increased government activity. All of these factors suggest that pressure on federal budgets is likely to increase in the years ahead.

Now, there are ways in which federal spending can be reduced. Defense spending, which represents 4.7 percent of GDP (its average level over the past 40 years), could be reduced significantly. But the fact that in a dangerous world our military is badly stretched by sustained deployments that are far smaller than even the Persian Gulf War, suggests there is little reason for confidence that the Pentagon budget will be cut dramatically.

Technology could greatly reduce government costs in some areas, but it is important to recognize that by far the largest parts of the federal budget involve cash or in-kind transfers. These parts are far less susceptible to productivity-enhancing technologies than areas that involve the production of goods or services. So there is scope for the elimination of outdated or duplicate programs but efforts to identify waste, fraud and abuse invariably come up with only negligible savings.

For the next three months the nation will debate the merits of growing vs. shrinking government. But for the next three decades the United States will confront the reality that major structural changes in its economy will compel an increase in the public sector’s fraction of the total economy unless the functions that the federal government has long performed are substantially scaled down. How government can best prepare for the pressures that loom, and how greater revenue can be mobilized without damaging the economy, are the great economic questions for the next generation.