Challenge of over expanded public sectors: in the UK, Europe and North America

Elevated public expenditure crowding out private sector growth, is a problem in advanced OECD economies, the UK offers an egregious example, the EU exhibits it and the US, is not immune from it.

Britain has a public expenditure problem. The state does too many things and does them inefficiently. It is a problem common to most advanced OECD economies, the kind of countries that the historian Simon Sebag-Montefiore evocatively described as the ‘comfortable democracies’. Most European economies exhibit it and the USA is not immune from it. The USA when General Government Expenditure is fully scored to include state and local government as well as federal government expenditure, and the full impact of tax expenditures - tax reliefs that have the same effect as a spending programme in federal and state fiscal policy is exposed to similar challenges.

Britain’s Public Spending Problem

As a rough rule of thumb the optimal ratio of public spending to national income would be for it to average around 35 per cent of GDP over the economic cycle. Once more than about 38 or 39 per cent of an economy’s resources are absorbed in state spending, additional spending will exhibit clear diminishing returns at the margin, and the results will be disappointing. As the ratio rises much above 41 per cent, it becomes more difficult to finance, given that it begins to crowd out private sector activity. Less productive activity in the public sector supplants more productive activity in the private sector. While the efficiency of private labour and product markets are impeded by state regulation and taxation blunting market incentives. In the UK historical experience suggests that when the ratio of public spending settles within GDP at around 45 per cent, it becomes difficult for finance, whether the finance is coming from taxes or borrowing. Economic agents become reluctant to pay the rising tax burden and employers try to pass the cost of higher taxes on to consumers. This concept of tax resistance was first explored in an article by Colin Clark, Public Finance and Changes in the Value of Money, published in the Economic Journal in December 1945.

Public expenditure involves real resource and opportunity costs. That real resource cost is greater than its cash cost, because of the economic distortion of collecting the resources to finance it has on the economy as a whole. Although rising ratios of public spending in local economies financed by other taxpayers, also has crowding out effects, even when local economic agents do not foot the bill for it. Economists at Harvard Business School examining the economic effects of US Senate and Congressional chairs, successfully bringing federal spending to their localities; and ECB economists looking at the effects of EU structural programmes have shown that higher local public spending paid for by someone else, has the effect of supplanting private output.

UK Budget in October 2024, set plans to stabilise public expenditure at a level that exposes the full resource costs of financing public spending

The UK Budget in October 2024 laid out a fiscal agenda for a parliament that raised spending, taxation and borrowing with the plan of stabilising public expenditure at 45 per cent of GDP. This will result in both disappointing results from programme spending and increasing difficulty in financing the spending through taxation and borrowing, given the previous experience of UK governments. Elevated spending exposes the real resource and deadweight costs of public expenditure.

Historically large public sectors can make market economies work better

In modern economies we should expect to see what in historical terms are large public sectors that result in relatively high spending compared to 125 years ago. Modern states finance education, health, merit goods such the arts and science, they supplement economic activity in complete markets, help to smooth incomes over the life cycle through support for families with children and pensions, as well as modifying market incomes to mitigate household poverty. This means public spending goes far beyond the traditional provision of public goods such as defence, the judiciary and the support of lighthouses.

Much of this growth in spending has yielded great benefits in terms of social and economic outcomes. These benefits are carefully catalogued by two IMF economists Vito Tanzi and Ludger Schuknecht in their book Public Spending in the 20th Century a Global Perspective published in 2000. They illustrated the way in which higher spending on education and health yields benefits and the way that comprehensive welfare states make social pathology more tractable. They also show that for much of the 20th century the growth in public spending that generated these social improvements did not impede the working of market economies that performed well in terms of output growth, employment and incomes. The clear message of the experience of the 1950s and 1960s was that a significant public sector and welfare state contributed to not just a well functioning economy but a better performing economy.

Tanzi and Schuknecht also showed that there were diminishing returns to higher public spending. Education and health did not mechanically improve simply as a result of higher public spending at the margin. Moreover, there comes a point where higher spending is not simply disappointing in terms of its impact in reducing difficult social pathology, it begins to impede the performance of the market economies that support the spending.

Britain’s post-war Keynesian welfare consensus and the crisis of Keynesian welfare spending in the 1970s

The country that was in the vanguard of progressively higher social spending, the construction of a comprehensive welfare state that supported its citizens from the cradle to the grave as Winston Churchill vividly expressed it, was the UK. The combination of the construction of the principal building blocks of the welfare state by the Wartime Coalition Government that Churchill included free secondary and university education, national insurance, as well as a commitment to full employment in the 1944 Employment White Paper to be achieved through the application of active Keynesian demand management, as set out by Sir Kingsley Wood in the 1941 Budget statement when combined with the socialist programme applied by the Labour Government led by Clement Attlee between 1945 and 1951 that set up the National Health Service in 1948 and nationalised the ‘commanding height of the economy - coal, railways, gas, electricity, road haulage, canals and steel.The Attlee Government bequeathed a so-called’ mixed economy’ that was partly based on the social nationalised industries controlled by the government and a larger conventional private sector albeit operating in an environment of market capitalism that was highly regulated and guided by wilder collectivist policy. It was an economy where, as the post-war years progressed, the state became increasingly an employer of last resort.

As a result the effects of an over expansion of the public sector in a modern economic context became apparent in the first instance in the UK in the 1970s in an acute form. From the mid 1960s the British economy exhibited increasing difficulty at different stages of the economic cycle - balance of payments crises, rising inflation and rising unemployment. The commitment to maintain full employment became increasingly difficult to achieve by 1970.

The diagnosis of the Eltis-Bacon Thesis in 1975

Two Oxford economists Robert Bacon and Walter Eltis offered a comprehensive analysis and a cogent diagnosis of the problem. It was laid out in three 6,000 word articles in the Sunday Times in November 1975 and then published in full book form in 1976 as Britain’s Economic Problem: Too Few Producers. Walter Eltis was my economics tutor. I owe him a lot. Over many years I explored the implications of what became known as the Bacon-Eltis Thesis for economic policy.

The genesis of Bacon-Eltis Thesis was their NEDC monograph The Age of US and UK Machinery published in September 1974. This made a detailed comparison of machine tools in Britain and the USA. British machine tools were no older than those in the US and both economies had expanded investment into the most up-to-date machines at the same rate. Yet American workers produced between two and three times the output as British workers using the same capital stock. This analysis was confirmed in other research such as the report on the volume car industry by the Cabinet Office's Central Policy Review Staff published in November 1975. There was systematic over manning and under production in British industry.

Robert Bacon and Walter Eltis concluded that for an economy to function, the part of the economy that consumed resources without producing them, had to rely on the productive part of the economy that produced a surplus to finance it. If the productive part of the economy that produced the necessary surplus grew rapidly, the economy would prosper, but if it declined, the economy would collapse.

Lesson of an over expanded state, provided by the French 18th century Ancien Regime

Walter Eltis had a long standing interest in the great classical economists. He taught the Smith, Ricardo, Mill and Marx economics paper. This interest drew him to look at the work of Francois Quesnay, the 18th century physiocrat economist, who studied the economic challenges that the French Ancien Regime encountered. Quesnay suggested that the French monarchy based at Versailles, the aristocracy, armed services and the gallic catholic church was financed from taxation levied on the surplus provided by the agricultural sector. That surplus depended on the farmers being able to both feed themselves and reinvest in expensive capital to maintain their production. When taxes were raised, farming households were left with only enough income to feed themselves, selling farm capital to pay the higher taxes. This produced a smaller surplus that resulted in a dwindling tax base. To expose his analysis Quesnay constructed a sophisticated input-output table, his famous Tableau Economique. This illustrated the complete relationship between agricultural inputs and outputs in 18th century France. Robert Bacon and Walter Eltis considered that the 18th century French economy’s problems were analogous to those of the British economy in the 1970s. A large sector that did not produce marketed output, the public sector absorbed the shrinking surplus of the marketed sector that produced and sold its production, namely the private sector and that part of the public sector that was engaged in producing marketed output, such as the nationalised industries.

After 1975 the UK public expenditure crisis was resolved by governments cutting spending as a share of national income to a ratio that was sustainable

Their essential proposition was that a public sector could be over expanded, preempt resources from the private sector and undermine the private sector's capacity to grow. Bacon and Eltis argued that it was possible for the public sector to crowd out the private sector that finances the taxes to pay for public spending. They argued that there comes a point where the position can be unsustainable and only resolved by making a choice. Either public spending is reduced as a proportion of national income making it possible to lower taxes and restore incentives or the state nationalises the investment function. In the 1976 Public Expenditure White Paper the Labour Chancellor of the Exchequer chose to cut public spending and lower state spending within national income, a direction of travel maintained and amplified by Conservative Prime Ministers Mrs Margaret Thatcher and John Major in the 1980s and 1990s.

Bacon- Eltis Thesis as a distinctive structural analysis of macro-economic challenges

A distinctive feature of the Bacon-Eltis thesis was the structural approach that it took. Until the Bacon-Eltis thesis mainstream economists had not taken a structural approach to economic analysis. The identification of structural pathologies in capitalism had until then been very much the preserve of Marxist economists.

Britain’s Economic Problem: Too Few Producers read fifty years later is very much a book of its time. Its argument is presented in elaborate Keynesian input-output tables with elaborate equations identifying accounting properties between the balance of payments and the domestic budget public sector deficit that draws on the work of Lord Kaldor. It is very much a set of macro-economic propositions that hardly draws on micro-economic analysis at all. They applied their analysis to the UK, and to other economies with large social democratic public sectors, such as 1970s Sweden, the US state of New York and the Canadian province of Ontario.

Yet its central proposition that the public sector can become so great that it crowds out the private sector that finances its taxes that pays for it, still holds. In Britain's Economic Problem Revisited in 1996 Robert Bacon and Walter Eltis examined how well their arresting thesis had weathered. They extended its analysis to the EU of the 1990s. Slow growth affected France after the implementation of the Programme Common after 1981, and Helmet Kohl's Federal German Republic where the legacy of Ludwig Earhard’s Social Market Economy became increasingly social and the rigours of the market were diluted, as part of a wider Fortress Europe framed around the German ‘social partners’ determination to avoid social dumping or more precisely competition and Jacques Delors social action programme of directives to regulate the labour market..

They accepted that it was possible to doubt some of the channels of causation that they identified in 1975. Among them were the extent to which public borrowing itself directly crowds out private investment and whether, for example, there was strict one-for-one crowding out of private sector employment by public sector employment. They also understood that their thesis under estimated the scope that there had been to reform UK trade union law successfully in the 1970s and make the labour market more efficient.They, however, maintained their central propositions had a continuing relevance.

The continuing relevance of the Bacon-Eltis Thesis, fifty years later

They observed that ‘if the UK's public expenditure ratio is allowed to return to the sustained expansion which occurred between 1961 and 1976, the ratio of taxation and GDP and in all pay packets and salary cheques would inevitably rise. There would be powerful adverse effects if the UK private sector was again allowed to return to near zero-sum conditions whether real net-of- tax pay of the average worker scarcely grew. The need to limit the relative growth of the public sector so there is room for private-sector net-of-tax incomes to grow at adequate rates must continue to be understood.’

The UK is now in the position that Robert Bacon and Wallter Eltis warned about when they revisited their analysis thirty years ago. The Economic and Fiscal Outlook published by the Office for Budget Responsibility (OBR) for the Budget on 30 October 2024 illustrates the position.The ratio of public expenditure within GDP is planned to be stabilised at 45 per cent of GDP. The tax burden is planned to be raised further to over 38 per cent of GDP. The Budget contained discretionary decisions to raise both public expenditure and the tax burden from previous plans where both the ratios of public spending and the tax burden were already historically elevated. The OBR’s charts illustrate the position.

Public spending as a share of GDP

National Accounts taxes as a share of GDP

The UK is not alone. The central challenge is a long standing one for many advanced OECD economies. As the Financial Times reported in Merkel warns on cost of welfare, Angela Merkel vividly expressed it in December 2012 ‘If Europe today accounts for just over 7 per cent of the world’s population, produces around 25 per cent of global GDP and has to finance 50 per cent of global social spending, then it’s obvious that it will have to work very hard to maintain its prosperity and way of life’. Large public sectors that blunt market incentives have been reflected in slow economic growth relative to the American economy since in the 21 century and a slower recovery from the Covid public health crisis.

Yet the USA is not immune from the challenges arising from an elevated ratio of General Government Expenditure to GDP. Federal, state and local government spending will account for over 37 per cent of national income in 2025. Federal Government spending on present plans will absorb 23.3 per cent of GDP in 2025. The projections laid out in the Congressional Budget Office’s report The Budget and Economic Outlook: 2025 to 2035 published on 17 January 2025, show the ratio will rise to 24.4 per cent. This is driven by spending on debt service, and demand led social programmes such as Social Security, Medicare and Medicaid. Much of US public spending at every level of government from the federal level to local authorities is poorly focused, badly delivered and disappointing in its outcomes. These matters are explored in a book I published in 2017 America’s Exceptional Economic Problem.

Ratio of government expenditure to gross domestic product (GDP) in the United States from 2019 to 2029

The US Federal Budget and Economic Outlook: 2025 to 2035

President Trump has signed an executive order to set up a new Department of Government Efficiency - DOGE - under the leadership of Elon Musk and Vivek Ramaswamy. The White House says that the new department will look at matters ,such as regulations, expenditures, and the restructuring of federal government agencies. The administration’s announcement said that DOGE would provide “advice and guidance from outside of Government” by partnering with the White House and the Office of Management and Budget (OMB).

A good starting point for Mr Musk and his colleagues would be to look at the concept of deadweight cost in public expenditure developed by Arnold Harberger. In 1964 he estimated that the deadweight costs of federal pending programmes arising from distortions generated by tax was equivalent to 2.5 per cent of revenue receipts. In various CBO reports the deadweight cost of public expenditure has been estimated at between 20 and 60 per cent of tax revenue raised. For many years the Office of Management and Budget therefore insisted that all federal government spending proposals should include an estimate of the ‘excess cost’ or deadweight cost of public spending that arises from the economic distortion that it involves that is greater than simply its cash cost. The number the OMB employed was 25 per cent. Another concept developed by an American economist in the 1960s - lost X-efficiency would be helpful. It was originally developed to explain how firms engaged in internal inefficiency resulting in higher production costs for a given level of output. Harvey Leibenstein, Harvard economist, developed the concept of X-inefficiency in an article Allocative Efficiency vs. X- Efficiency, published in the American Economic Review in 1966. Its analysis could be beneficially applied to the public sector.

The UK has an egregious public spending problem aggravated by the October 2024 Budget

But the country that has the most pressing public expenditure problem is the UK where its ministers and their advisers in the Government Economic Service and the think thanks closely aligned to it, naively consider that public investment and private investment stimulated by artificial public sector incentives is the route to higher national income, while pay little attention to the expected rate of return on the investment. One of the lessons of the work carried out by Robert Bacon and Walter Eltis in the 1970s was their NEDO paper showing that the same capital stock in the UK produced roughly half that in the USA. This revisited Lord Kaldor’s saltatory warning in the 1960s that the reason why investment may be lower in the UK than in other advanced economies may be a lack of profitable opportunities, and that merely by raising investment by artificial policy measures may merely yield more investment with low rates of return making little difference to GDP growth. A significant contributor to weak returns on capital is market incentives and price signals impeded by the effects of high public expenditure and regulation. The fact that wages have held up in the UK and profits appear to have fallen in the UK in contrast to the behaviour of factor shares in other countries over the last thirty years, is further evidence of the problem.

Warwick Lightfoot

29 January 2025

Wawick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer from 1989 to 1992, he is the author of the book America’s Exceptional Economic Problem.