Why do States Spend Money?

I have a file drawer full of research projects at some point abandoned. Since I am unlikely to ever get back to them I thought it would be worth describing some here in the hope that someone else, earlier in his career, would be interested in reviving them.

This is one.

There are two theories of what determines how much a government spends, that it is determined by the need for government services or that it is determined by the ability of the government to get money. Applied to the rise over the past century-plus in the fraction of national income spent by governments, the one theory might explain it as due to the increasing complication of an advanced society requiring more government services, the other as due to the increasing fraction of the population who, because they are employed by firms, are more easily observed and taxed than self-employed farmers.

It would be valuable to have an objective measure of which approach is more nearly true.

Tests

A war sharply increases the need for government spending. Taxes are raised, demonstrating at least one case where spending is driven by need. The end of the war eliminates most of the need but leaves standing the higher taxes. On a pure need theory one would expect government expenditure to fall back to about its pre-war level. On a revenue theory, since keeping a tax is easier than passing one, one would expect expenditure to remain high, probably not as high as during the war when it was financed in part by borrowing and/or inflation but higher than before.

That is an approach to the question that others have written on, most entertainingly C. Northcote Parkinson in The Law and the Profits.¹ I thought of another.

Different U.S. states have different tax structures. Different taxes respond differently to exogenous changes such as inflation. In a state financed by a progressive income tax, inflation pushes taxpayers into higher brackets and so raises real (inflation adjusted) revenue; if prices and incomes double, tax revenue more than doubles. In a state financed by regressive income taxes or property taxes that are rarely reassessed, inflation should reduce real revenue; if prices and incomes double, tax revenue less than doubles. If expenditure is driven by the availability of revenue we would expect the first sort of states to have real expenditure increased, the second sort decreased, by inflation. One could also look at other changes in the economic environment that could be expected to change revenue differently for different states and see how their expenditure was affected by those changes.

To test the alternative hypothesis you need changes that affect need for revenue. The largest expenditure of state and local governments is schooling. The cost of schooling largely depends on the number of school age children, which changes over time. On a need theory, when the fraction of the state’s population that is school age goes up, as it did when the post WWII baby boom reached school age, state expenditure should go up. When it goes down, as it did in the years when the baby boom was coming out of the schools and onto the labor market, it should go down.

For both hypotheses, the best evidence would be differences in what happened in different states, since that controls for causes you are missing that affect all states equally such as changes in technology that might make schooling or tax collection more or less costly. You would also want to look at changes that affected all states similarly, such as demographic changes that affected the fraction of the population of school age, although in that case it would be harder to eliminate other explanations for expenditure changes..

That is the project. Calculate, for each state, how real revenue would be expected to respond to changes, tax structure held constant. Calculate, for each state, how the demand for government services would be expected to respond to changes in its environment. See which does a better job of predicting what happened.

Within the U.S., cities and counties have their own budgets and, often, their own taxes, so one might be able to do similar tests for them.

The Rest of the World

Comparing the data for different U.S. states is the first approach that occurred to me but there are other possibilities. There are other countries with subdivisions that could be compared, such as Canadian provinces. One could compare the experience of countries reasonably similar to each other such as the Scandinavian countries or Spain and Portugal.

The approach would be the same as with interstate comparisons but the details would of course differ. For some countries government revenues from oil or gas represent a significant fraction of their budget, increase or decrease with price changes or new discoveries. If revenue increases do other taxes go down or is the additional revenue added to government expenditure?

A Problem

If I did the project and concluded that governments spend whatever they can get their hands on independent of need a reader familiar with my political views might suspect that I had biased the result, made multiple judgement calls in a way designed to produce my preferred conclusion. If someone with the opposite biases did it and got the opposite result, that would be grounds for a similar suspicion in the other direction.

A solution would be for the project to be done jointly by two researchers with opposite political views but a common desire for objective evidence. Ideally they would work out in advance what they were going to do, including any judgement calls, before they looked at the data.

What Scott Alexander describes as an adversarial collaboration.

A Possibly Relevant Post Script

I first encountered the effect of changing demographics on the need for government spending when I spent a summer in Washington as a congressional intern and ended up working for a group producing a fact book on state and local finance on behalf of the Joint Economics Committee, the Governors’ Conference and George Washington University.²

That would have been about 1967. I discovered a relevant fact — that the ratio of school-age children to adults had been going up for about the past fifteen years as the children of the post-war baby boom went through the K-12 school system and would be going down in the future as they came out of school and into employment. Maintaining a constant level of per-pupil expenditure had required increasing taxes in the recent past, could be done in the near future with decreasing taxes. K-12 schooling was the largest expenditure of state and local governments so the effect was obviously relevant to their need for revenue, the subject of the fact book.

The people running the project did not deny my facts, which were demographic facts about people already born. They did not deny their relevance or importance, which was obvious — K-12 schooling was about a quarter of total state and local spending.  They refused to include them in the fact book they were producing. Pretty clearly the reason was that they pointed in the wrong direction. The people writing the fact book wanted readers to conclude that state and local governments needed more money, my fact was a reason they needed less.

I think of that incident as my loss of innocence,³ the discovery that respectable academics, people I knew and liked, did deliberately dishonest work.

P.S. (from a commenter)

"A government, like an individual, spends money for any or all of three reasons: because it needs to, because it wants to, or simply because it has it to spend. The last is much the shabbiest.” (Nero Wolfe in And Be a Villain by Rex Stout)

1. Parkinson’s 2^nd Law: Expenditure rises to meet or exceed income.

2. I discussed the incident in an earlier post on Ends and Means.

3. I was about 22 at the time.