The Laffer curve is a nifty way of expressing the idea that a government’s ability to raise tax revenue is limited. The maximum amount of revenue that can be raised by a normal developed economy (per capita) is roughly 55% of France’s GDP, 45% of Germany’s GDP, or 36% of the US GDP. Because the US is richer than Germany, which is richer than France, these figures are not far apart in absolute terms.
It’s less well known that a similar concept applies on the borrowing and spending side. Italy’s government currently spends roughly 50% of GDP. The center-right populists that won the recent election favor higher government spending. (Notice how often spending rises faster when the right takes office.) Yesterday they reached an agreement on a budget that will boost spending significantly, enough to boost the budget deficit from 0.8% of GDP to 2.4% of GDP. The previous government understood that Italy had a severe debt problem, and was committed to gradually reducing the debt as a share of GDP.
The new Italian government is populist—need I say more?
Because Italy lacks its own currency, there is significant default risk with Italian debt. Even before the recent election, the interest rate on Italian debt was more than 100 basis points higher than the interest rate on German government bonds. Since the election, yields have soared another 150 basis points. Because Italy’s public debt is 132% of GDP, that will eventually push interest costs up by roughly 2% of GDP. (132% of 1.5%) Ironically, that’s actually more than the boost in government spending being proposed by the new government. In other words, in the long run the level of government spending (net of interest costs) will have to fall. The extra spending will accomplish precisely nothing, at a big cost to Italy.
In fairness, it will take a while for the interest costs to show up, as there is a large stock of outstanding bonds that were issued at lower rates. As those bonds mature and are rolled over into new debt, the interest costs will steadily rise. Thus the new coalition government may be able to boost spending on a few programs in the short run, but in the long run Italy will actually have less money to spend, net of interest, and more will be spent servicing the debt. Of course populists do not care about the long run.
Does this have any implications for the US? We don’t have a significant default risk, but the future interest burden of the debt will tend to crowd out other types of government spending, and necessitate higher taxes.
If I were a fan of the “basic guaranteed income” concept, I’d be horrified that Italy was considering implementing this idea. There’s a real danger the entire concept becomes discredited if it pushes Italy toward a debt crisis.
PS. If someone wanted a one-word explanation of why I’m not a progressive, it would be “Italy”. (BTW, Italy and Japan are my two favorite countries.) For instance, there is vast inequality between northern and southern Italy. Progressives would have you believe that inequality within a country is caused by “discrimination”. A much more plausible explanation is cultural differences, and Italy provides an almost perfect case study. Progressives believe that high levels of government spending can “solve problems”. Italy has extremely high levels of government spending, and also has poor infrastructure and lots of poverty. Yes, there are countries with high levels of government spending that do well, say Austria, but next door Switzerland does even better with low levels of government spending. Government spending does not solve poverty or infrastructure problems. Nor does it boost aggregate demand, as we see in Italy. What we need is not large government, rather effective government of modest size—something like Singapore, Switzerland or Australia. Instead of drawing up a seemingly never-ending set of new programs, American progressives should advocate replacing poorly performing current programs with other programs that they view as a higher priority. Keep the government footprint at no more than 1/3 of GDP; that’s more than enough.
READER COMMENTS
Mark Z
Sep 29 2018 at 2:32am
I’m a bit confused why multiplying by the 132% would be informative. I’m guessing most of Italy’s bonds aren’t inflation protected, so they won’t being paying higher interest rates much debt outstanding. If you’re saying that, once the new debt issued with higher rates has fully replaced the older debt (as it matures), the cost of servicing the debt will be higher than the increase in spending, then shouldn’t we expect that the debt, at that point, will be higher than merely 132%, since a sustained increase in the deficit must lead to a higher debt/gdp ratio, excluding some unexpected economic growth spurt?
Philo
Sep 29 2018 at 10:37am
“Of course populists do not care about the long run.” Politicians, populist or not–especially in a democracy–will care about the national debt when and only when the people (voters) care. Various Cassandras have been warning about the national debt for generations, but the people, in their collective wisdom, have noticed that, though the debt keeps rising, the day of reckoning never seems to come. Understandably, they have stopped listening.
“[T]he future interest burden of the debt will tend to crowd out other types of government spending, and necessitate higher taxes.” Or maybe it will just necessitate more borrowing, or less “other” government spending.
Jon Murphy
Sep 29 2018 at 11:27am
Right, but the idea is that, at some point, lenders will not lend (or demand higher returns). No nation has ever been able to borrow forever. Once that happens, more borrowing is not an option, and there will need to be higher taxes and/or less spending, as you note.
Scott Sumner
Sep 29 2018 at 7:49pm
You said:
“Politicians, populist or not–especially in a democracy–will care about the national debt when and only when the people (voters) care.”
That’s clearly not true, as the previous Italian government cared a lot more than the current government.
You said:
“Various Cassandras have been warning about the national debt for generations, but the people, in their collective wisdom, have noticed that, though the debt keeps rising, the day of reckoning never seems to come. Understandably, they have stopped listening.”
So the day of reckoning never arrived for Greece? Is Italy that different?
Mike Sandifer
Sep 29 2018 at 12:46pm
Scott,
I’m curious as to your thoughts about Norway. Is it a simple case of an exception due to its oil reserves?
That’s my impression, but I haven’t studied Norway in detail. They have an interesting mixed economy and they manage their oil wealth unusally well.
Scott Sumner
Sep 29 2018 at 7:46pm
Mike, I’m not sure what you are asking. Exception to what?
Frank
Sep 30 2018 at 9:14am
Is the test of effective government how much good it does per dollar spent? If so, I think that introducing this variable complicates the argument in your postscript.
Country A has higher government spending than country B, but worse results. Does this show that higher spending does not produce better results, or that country B has a more effective government?
The relevant question seems to be: For a given level of effectiveness, does higher spending produce better results? This is the general question facing voters, since it is harder to make government more effective than to change the level of spending. (At least we know how to do the latter.) I’m not sure the facts adduced in you postscript shed much light on that.
Scott Sumner
Sep 30 2018 at 12:02pm
Frank, I have only provided a few suggestive anecdotes, but my intention was to convey the intuition behind my skepticism about big government. Fans of big government also often rely on anecdotes—“look at Sweden”, etc. In my view, the anti-big government anecdotes are more persuasive.
But yes, a systematic study would be best.
S D
Oct 1 2018 at 3:33am
Very basically, the state as a share of GDP in Italy is too large for its ability to raise taxes.
Italy’s public debt becomes unsustainable in the event of only a medium-severity recession, say a one-in-ten-year event.
This will mean a very painful shrinking in the size of the state, either voluntarily in the short run or through an EU financial assistance programme when things go bad.
The best way to do it is via across-the-board, progressive cuts in the wages of all public workers. This was done in Ireland in 2009 and is much simpler than selective cuts to spending programmes.
Ironically enough, now would be the perfect time to do this, given the benign state of the global economy. Sadly, Italians have elected the very opposite of a government which could do this.
In the next ten years, the probability of a very messy public finance crisis in Italy are high.
Kevin L Guo
Oct 1 2018 at 2:10pm
How did you get the laffer peak numbers of 55% for France and 36% for the US? Why couldn’t the US tax more?
Larry Stevens
Oct 2 2018 at 2:42am
1/3 sounds good, but does it apply when US healthcare costs are double those of Europe? When Social Security, Medicare and Mdicaid eat up an ever expanding slice of the pie? Not to mention our uniquely high defense bill. You could afgue that the metric is about non-market spending, without regard to what it’s for, but that seems to leave out a lot.
dede
Oct 2 2018 at 9:58pm
“is roughly 55% of France’s GDP”
Not even close! I think the tax in France is roughly 45% of GDP while spending is roughly 55%. How do they do to avoid printing a 10% budget deficit?
That’s a mystery to me but I found out at least one of their tricks : they issue debt at 5.5% interest when they can borrow at 0%. This increases the price of the issuance to 148.84% (!) and they get away with a nominal debt at 100% on the books and 48% of it in the pocket but away from the books :
http://www.aft.gouv.fr/articles/aft-issuance-a-total-amount-of-euro6-356bn-in-oats_13305.html
Yes, this is depressing but you cannot trust the official figures on government debt and budget deficits.
Thaomas
Oct 4 2018 at 4:21pm
But surely one ought to specify what the rate of return on the additional spending will be. If it is greater than the marginal borrowing rate then the D/GDP ratio will fall rather than rise.
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