Why did the share of government expenditure in GDP rise so rapidly in the 1970s? How have "successful" fiscal stabilisations been accomplished?

The 1970s saw a marked deterioration in the government budget deficits of almost all the OECD countries. Those that had in the post-war period up until then maintained a small surplus, such as Japan (averaging 1.0% over the period 1960-67), Germany (0.8%), and France (0.5%), saw their budgets tip into deficit by the end of that decade (such that the Japanese government budget deficit over the period 1974-79 was 3.4% of GDP, with the figures in Germany and France for the same period being 3.0% and 1.1% respectively), whilst those countries already running deficits saw these increase drastically (e.g. Italy was running a deficit of 1.1% in the early 1960s, increasing to 9.2% in the late 1970s). This situation persisted throughout the 1980s and in many cases became even more severe, despite the persistent efforts of government to combat the problem and reduce their borrowing requirements. That towards the end of the 1990s especially these policies appear to have borne little reward (the average budget deficit for the OECD as a whole was still 3.0% in the period 1990-97) suggests that the proposition of the second part of the title can be challenged as not having occurred. Before dealing with that however, we must first examine why this situation arose to such a chronic extent in the first place.

Undoubtedly there are correlations between periods of economic slowdown and increases in government borrowing. Thus the recessions of the mid-1970s, the early 1980s, and the early 1990s are all contributory factors to the rise in government spending over this period. As growth slows and unemployment especially rises, the government increases transfers to compensate those who have suffered in this way. What is notable is that expenditure does not decline as rapidly after the recession abates, but instead maintains an almost constant (or slightly falling) level until the next slowdown when it rises significantly again. That this is the case can be traced to the difficulty with which benefits especially (as well as more indirect forms of government help) can be withdrawn once they have been implemented. It is obviously costly politically to do this, and some governments will prefer to maintain funding levels, thereby increasing the deficit substantially. According to Oxley and Martin, there is also an underlying trend of increasing the government's share in GDP over the course of this period, which is indicative of a shift in belief about the role of government in the economy in many of the OECD countries. Thus there are both cyclical and non-cyclical causes to the increasing deficits. This upwards trend was merely exacerbated and heightened by the recessions of the period. They argue that from as early as the 1960s, there was a consensus that the provision of public and merit goods in the individual countries of the OECD was sub-optimal, and consequently there was an expansion of government spending on such programmes as income support, health, education, and housing. Individual countries illustrate the general trend, for example the US had the War on Poverty manifested in the Great Society enactments (as well as the build-up in Vietnam, which also contributed to the US' rising budget deficit). That this took place indicates that the obstacles to deciding on how large the public sector should be (as Beckerman discusses) were either ignored or agreed upon. If this was the case, then there would have been agreement on the difficult normative area of deciding what the government should do as regards economic stabilisation (to smooth the fluctuations of the economic cycle and/or maintain full employment), allocation (by providing public and merit goods that would otherwise not have been produced or produced in Pareto-sub-optimal quantities), and distribution (in terms of social security benefits to support those affected by unemployment, illness, etc.). Oxley and Martin further argue that this consensus broke down as the economic crises of the 1970s gave rise to stagflation, increasing debt interest payments, and opposition to rising taxes. This last point demonstrates the difficulty governments have in financing large deficits due to the political reluctance to raise taxation. This thus leaves only expenditure cuts as the way to achieve a balanced budget, and consequently it was this path that was taken by many governments towards the target of a balanced budget in the 1980s. The OECD themselves stress the importance of changed attitudes to the public sector at the end of the 1970s, reflected in hostility prompted by the belief that to concentrate increasing quantities of resources in a sector that was not subject to the discipline of market forces was detrimental to the efficiency of the economy.

The way in which running persistent deficits leads to difficulties should be examined. Essentially, as the government must pay interest on its outstanding debt, in order to finance its deficit, it must either run a larger and larger primary surplus (i.e. the excess of tax receipts over government outlays) or the rate of growth of the economy must increase dramatically if borrowing is not to increase exponentially. This can lead to vicious circles of debt that bring the economy to a halt as interest rates are increased to maintain adequate capital in the economy from investors to finance the deficit, which in turn suppresses private investment (which could allow for a higher growth rate), and raises the interest payment on the outstanding stick of debt. Given this potential, and the general increases in real interest rates over the course of the 1980s, it is no surprise that attempts were made to reduce the deficits of the late 1970s. As was mentioned, there are two options open to governments to accomplish this - either through revenue increases or expenditure cuts. An alternative is a combination of the two, and this was the most commonly used approach. Widespread reform in tax systems in the 1970s generated a rapid increase in revenue in this time, which slowed in the 1980s and 1990s. The shift from direct to indirect taxation contributed to this, and overall trends broadened the bases of both income and corporation taxes. The tax share of GDP has increased from 25% in 1965 to 38% in 1986 according to the OECD. To balance this, there have been coincident reductions in public investment, subsidies and capital transfers, and spending on education and housing across the OECD. This has been possible due to falling numbers of younger people requiring education, but there has also been a rise in the level of expenditure per student. The downside of this is the ageing of the population which means that healthcare and pensions are likely to comprise an increasing share of government expenditure in the future. Other areas where governments have restrained expenditure have been in the area of public sector employees, who have seen a freezing of numbers over the 1980s, and very small real wage increases, although there is evidence that these are starting to increase again.

These changes in expenditure patterns have implications of the long-term sustainability of the reductions in deficits for the OECD countries. As Alesina et al point out, the success or failure of fiscal restraint rests on the types of programmes that have been affected, and whether the adjustments are substantial or merely superficial. They maintain that long-lasting expansionary budget adjustments rely primarily on cuts in categories of current spending (for example government wage bills, social security, and welfare), whereas most short-lived contractionary adjustments rely on cuts in government investment and revenue increases. Given the pattern of adjustment that we have examined, this does not suggest that the changes that have taken place in the OECD go far enough to guarantee that the problem of unsustainable government deficits has been solved. The public sector wage bill increased in half of the OECD countries during the 1970s, and there were substantial rises in social security transfers. The reforms of the 1980s merely put the brakes on these trends, without actually reversing them. Thus the achievement of restraining the growth of income support to less than 1% over the course of the decade may not be sufficient to aid the deficit problem. Further, the share of public goods in the economy remained almost constant (and rose greatly in the US as a result of increased defense expenditure), public sector numbers and real wage increases may be creeping back up, and there is the shift in population trends that cause great concern for future spending needs. This combination of factors leads this author to believe that OECD governments will still need to devote large amounts of time to stabilising their budgets in the future to avoid greater problems ahead. The difficulty of fiscal consolidation has been demonstrated by the problems that have been encountered by European countries attempting to qualify for entry to EMU under the Maastricht convergence criteria. Moreover, even if balanced budgets are achieved as it is claimed has happened in the US, there is still the question of the debt that countries have run up over the course of the last thirty years that must be repaid. It will only be once long-term fiscal balance is achieved that this issue can be addressed. Finally, evidence from Alesina's survey suggests that political reluctance to stabilise deficits is based on an unsubstantiated belief that this will lead to losses at the next election. If the reverse is actually true, that voters are more likely to punish a government for fiscal profligacy, then it is also necessary for governments to realise this fact, and to use it as an incentive to act to control budgets in the future.