When conservatives approach economic policy, one of the first items on their list is that government needs to be fiscally responsible. This is a worthwhile goal in general—frivolity with taxpayers’ money is always bad—but what does it mean in practice?
It is easy to dismiss this question: after all, we all know what it means to be fiscally responsible, don’t we?
Not so fast. There are commonly two definitions of what ‘fiscal responsibility’ means. Depending on which one we adopt, we get very different policy results in the other end:
- That government should concentrate its spending only to a set of core functions; or
- That government needs to balance its budget.
In theory, these two definitions are not mutually exclusive, but in practice, they tend to crowd out one another. Conservatives tend to emphasize one version over the other, with European conservatives generally preferring the balanced-budget definition.
American conservatives have moved in the same direction. Starting with President Reagan, the Republican party—assuming they are a good proxy for conservatism in America—moved away from the spending-related definition of what it means to be fiscally responsible. This was the definition of the Goldwater-era of American conservatism.
To the extent that it has been replaced with any sense of fiscal responsibility, it has been the balanced-budget version. A fledgling new crop of current conservative members of the House of Representatives are trying to shift the fiscal-responsibility focus back to the old, spending-oriented version. So far, their influence has been limited but not insignificant.
While American conservatives often debate fiscal responsibility, their European peers are usually more muted on the issue. This could be the result of an overall more socially oriented focus of conservative policy, but it could also have to do with the fact that Europe has long suffered from a political consensus on government spending. This consensus de facto includes both the size and the purpose of government: it is practically unheard of that conservatives anywhere in Europe raise questions about the welfare state and its role in society.
By virtue of their tacit acceptance of the size and role of government in the European economy, conservatives are part of an overall coalition across ideological barriers in European politics. Broadly speaking, everyone from the far left to the far right accepts that government consumes 40-50% of the economy, and that 80% of that spending furthers a socialist agenda of economic redistribution.
This coalition is not new. It has governed the EU and, more importantly, its member states, since the middle of the last century. It is a permanent feature of the European public-policy debate, one that is not only visible in the party platforms in the European Parliament, but curiously also in the profiles of Europe’s many public policy think tanks. None of them devote any meaningful resources to the question of the fundamental purpose of government spending.
The lack of activity on this issue among the think tanks is conspicuous. Think tanks exist for the purpose of leading the public policy conversation, of breaking new ground and addressing controversial issues that are left untouched by mainstream politics. Therefore, one would perhaps expect them to show more interest in economic policy issues in general and the welfare state in particular. After all, the size of government is the reason for Europe’s perennial economic stagnation. Yet the absence of meaningful research on this issue is particularly conspicuous to the right of the political center.
A key reason for this is the implicit acceptance of ‘fiscal responsibility’ as meaning that government should not run excessive deficits.
A case in point is the Wilfried Martens Centre for European Studies. I am pointing to them not because they stand out in any negative way—on the contrary, they are a high-quality think tank that consistently publishes good research on a range of policy topics. They are interesting because of their affiliation with the European People’s Party, EPP, in the European Parliament.
Of the six people on the Martens Centre policy research team, only one devotes any meaningful time to economic issues. This marginal interest in economic policy is reflected in their flow of publications: in the past 18 months, they have published a large volume of policy papers, only three of which have an economic focus.
One of the papers addresses recent proposals for reforms to the debt-and-deficit limits in the Treaty of the European Union. Known as the Stability and Growth Pact, these limits confine the EU members to a government debt no larger than 60% of their GDP and a budget deficit of no more than 3% of GDP.
According to the paper from the Martens Centre, the fiscal challenges associated with drastic policy measures during the recent pandemic
have led to demands to put even more money on the table at the EU level … possibly based on the issuance of common debt by the EU. Moreover, there are proposals to introduce (even) more flexibility to the Stability and Growth Pact (SGP) to tackle the aforementioned problems.
Without saying so out loud, the authors of the paper give away their concern that Europe cannot handle more debt. In effect, this means that they are worried about the impact of further expansion of government in the continent’s economy—and that they want to see more fiscal responsibility across Europe.
They even point to the risk of a sovereign debt crisis (p. 7), lending welcome support to the numerous articles that the European Conservative has published on the matter.
The paper is clearly opposed to reforms making it easier for EU member states to indebt themselves, thus promoting the balanced-budget version of fiscal responsibility. However, there is no mention of the critical tie between the size of government and Europe’s perennial economic stagnation. This omission indicates that the authors explicitly or implicitly assume that fiscal responsibility can indeed only mean one thing: a balanced government budget.
Without going out on a limb, it is fair to note that since the Martens Centre is affiliated with the EPP, they also represent the cutting edge of public policy thought for the center-right spectrum of European politics. By their own words, the Martens Centre want to be “the key platform of cooperation for centre-right partners and experts.”
There is some work needed among the center-right, including conservatives, in European public policy. Specifically, they need to take their ideological commitment more seriously, especially in terms of economic policy. Time is ripe for more pertinent questions about what role government ought to—and ought not to—play in the economy.
If for no other reason, this debate is motivated by the frequently recurring fiscal problems in EU member states. It is impossible to solve the structural deficit problems that put member states at odds with the Stability and Growth Pact without eliminating the suppressing effect on economic growth that originates with a large government.
To be clear, the Martens Centre is a valuable resource here, and could be so even more in the future. The Centre has an explicit ambition to bring valuable technical reform ideas to the table regarding the future of the Stability and Growth Pact. This ambition is worthy of respect and support, but it also remains technical in nature, focusing on ways to make the SGP work as a fiscal-policy tool (see p. 22-23 in the aforementioned paper) to gradually reduce government indebtedness among EU member states.
Again, fiscal responsibility is defined as budget balancing, with no reference to the size and purpose of government spending.
As mentioned earlier, almost 80% of government spending in the EU has an explicit ideological purpose: economic redistribution, a.k.a., taking money from ‘rich’ people and giving it to ‘poor’ people. So long as this ideological purpose remains intact in the government spending programs, new technical reforms for the purpose of a balanced budget will not work any better than the original mechanism in the Stability and Growth Pact.
To see why, let us do a little experiment. Suppose we have a country with a GDP of €1,000 per year. Government spends 10% of the economy and pays for that with taxes of the same amount. (Yes, this is a small government by European comparison…)
Every year, the economy grows at 3%, adjusted for inflation. After 12 years GDP has grown to €13,842. Spending and taxes are at €1,384, which means that we have a balanced budget.
Suppose, now, that there is a slowdown in economic growth. In the third year of our time line it falls from 3% to 2.5%, and then to 2%, where it remains for the rest of the 12-year period. Let us not specify a reason for the decline in growth at this point; I will introduce one in a little bit, one that is of high relevance to this experiment.
Since tax rates are unchanged, government collects less tax revenue—they decline with GDP. In the 12th year government collects €1,262.
Government spending, on the other hand, does not decline. The welfare state has made spending promises to people, including cash benefits, health-care and child-care services, tax rebates and itemized subsidies (e.g., energy costs) for low income families, etc. These promises of entitlement benefits are statutory and morally written in stone. Entitled households have adjusted their lives to those benefits; government chooses to continue to deliver what it has promised. Its spending in the 12th year is therefore €1,384.
In short: we have a budget deficit. It opens up already in the third year and grows steadily from there.
Suppose now that the legislature decides to be fiscally responsible. They raise taxes in the third year, which leads to a boost in tax revenue in the following year. Instead of a small budget deficit, tax revenue now exceed spending by 8.4%. The tax hikers uncork the champagne.
The problem with this scenario is that the tax hikes have a depressing effect on the economy. Growth slows down further, to 1.5% in the fifth year and 1% from thereon. This depresses tax revenue; the budget surplus dwindles rapidly until the budget goes into the red again.
Figure 1 compares the government’s budget balance under the two scenarios. The blue line represents the initial decline in growth, where taxes remain constant. The dashed green line shows how the budget balance evolves under the higher tax rates. The numbers represent the budget balance as percent of government spending: e.g., in the fifth year, under the first scenario the budget balance is -2.4% of total government spending, while under the higher taxes it is a surplus of 6.82% of total government spending.
Figure 1
The reason why the post tax-hike surplus goes away is the decline in GDP growth that the tax hikes cause. This is a perfectly realistic scenario; what we have left out so far is the reason for the initial slowdown in GDP growth, i.e., the one that causes the deficit along the blue line.
In a real-world setting, this decline can easily be caused by a large welfare state. There are thresholds for the size of government where its weight on the economy leads to a permanent decline in economic growth. As I explained recently, those thresholds lead to
- Less than 3% real growth per year when government spending exceeds 40% of GDP and taxes pass 37%; and
- Less than 2% real GDP growth per year when government spending exceeds 45% of GDP and taxes pass 42%.
In other words, when a welfare state expands to where spending and taxes exceed these thresholds, GDP growth declines as a direct result of that policymaking. That decline sets in motion the scenario laid out in Figure 1 above.
In conclusion, we have two ways to define what it means to be fiscally responsible: to balance the government budget or to shrink government spending. The former does not lead to the latter, but the latter facilitates the former. The choice of which definition we prefer is an easy one if we apply conservative values. In the next part of this article I will go into detail on what that means in practice.
