Is There a Limit to Government?

A central tenet of a free enterprise market economy is limited government. In this limited role, the government protects and ensures property rights, individual freedoms, economic opportunity, and competitive markets largely through an agreed-upon and enforceable set of rules. Government also has a limited role in addressing the provision of goods and services not provided by the private market, and in addressing the by-products of one person’s or entity’s behavior on another’s well-being.

Based on this past year, it is evident that the proper role of government and its limits are the subjects of intense debate. The accompanying figure depicts federal and state and local government spending as a percent of GDP from 1929 to 2020. Federal spending rose substantially during WWII, reaching 32.2% of GDP in 1945, and never returned to its pre-war level. For the decades between the war and prior to the Great Recession, federal spending hovered at around 20% of GDP. During the Great Recession, it reached 25.1% of GDP in 2010, but thereafter declined as a percent of GDP, though it did average almost 22% from 2015-2019. Then, in 2020, federal spending reached 32.5% percent of GDP, exceeding its previous historical high-water mark from World War II.

State and local government spending rose as a percent of GDP following WWII. In 1950, it was 6.5% of GDP and doubled its share of GDP by the early 1990s. Over the last ten years it averaged 14.2%. Together with federal spending, total government spending reached 46.8% of GDP in 2020, topping the previous high of 40.4% in 2010.

As is evident in the figure, even apart from 2020, total government spending has exceeded a third of the economy in recent years. At the federal level, 64% of expenditures are current transfer payments, the bulk of which are Social Security, Medicare, and Medicaid benefits. The aging of the population and the growth in per capita health care spending that exceeds the growth in per capita GDP has strongly contributed to the rise in the government’s share of the economy.

Underlying these mechanical explanations of the growth in the government’s share of the economy is the expansion of the government’s role through legislation. Health care legislation over the last 20 years is a prime example. Medicare was expanded to include prescription drug benefits in 2003 with the Medicare Modernization Act. In 2010, the Affordable Care Act further increased the government’s role through subsidies of health insurance purchased on the health care exchanges and through Medicaid's coverage of low income adults in the 39 states that have thus far expanded coverage.

The figure below depicts the Congressional Budget Office’s estimates of federal spending as a percentage of GDP to 2051. Looking forward, population aging and excess health care cost growth will continue drive higher federal spending, as will paying interest on the rising federal debt.  And this is only the federal portion of government spending!

Due to continuous deficit spending for almost two decades, including the huge increase in spending over the last two years, the debt held by the public is projected to reach 102% of GDP this year. Interest on the debt is expected to be only 1.4% of GDP this year, due to the current historically low interest rates. However, the CBO projects ongoing deficits far into the future, resulting in mounting debt, so that by 2051, the debt held by the public is forecast to be over 200% of GDP.

The annual deficit can be divided between the primary deficit and the deficit due to interest payments. The primary deficit, or the difference between revenues and noninterest expenditures, is expected to decline from 8.9% of GDP this year to average 2.7% of GDP for the rest of the decade. The primary deficit is then expected to rise, averaging 4.5% of GDP from 2041-2051. Importantly, when the primary deficit is small and interest rates are lower than the growth rate of GDP, the ratio of debt to GDP will fall. Unfortunately, while interest rates are currently low, the primary deficit is not small, and the debt-to-GDP ratio is forecast to continue to increase.

The CBO projects that the component of the deficit due to interest payments on the debt will rise through time. During the first decade of the forecast, interest payments average 1.5% of GDP, but rise to 7% of GDP by the final decade of the forecast. The CBO raises its interest rate assumptions from 1.1% in 2021, on 10-year notes, to 3.4% by 2031, and to 4.9% by 2051. In this forecast, interest payments will exceed Social Security benefit payments by 2045, and by 2051, federal spending will rise to 31.8% of GDP, with growing interest payments accounting for much of the rise. Interest payments on the debt will surely be felt as a constraint on future generations of politicians and future generations of taxpayers. This is the legacy being left to our children and grandchildren.

The CBO forecasts do not include state and local government spending, but even assuming that state and local spending does not rise as a share of GDP in the future, total government spending in 2051 will exceed 46% of GDP. A more likely scenario is that state spending will rise with added Medicaid spending and the total government share may well approach 50% of GDP.

To realize the benefits of limited government, corrective legislative action to reduce the annual deficits is necessary. Otherwise, the government’s share of GDP will continue to grow, as will its influence over the economy.

Posted: August 03, 2021 by Dennis W. Jansen, Andrew J. Rettenmaier