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Case study 5.2: State spendingA particularly controversial example of the law of diminishing returns is in the area of state, or public, spending. Some recent studies indicate that diminishing returns have been very much in evidence in developed countries in recent decades, with returns even being negative in some cases. An example is the IMF paper by Tanzi and Schuknecht,5 which examined the growth in public spending in industrial economies over the past 125 years and assessed its social and economic benefits.At the beginning of this period, 1870, governments confined themselves to a limited number of activities, such as defence and law and order. Public spending was only an average of 8% of GDP in these countries at this time. The higher taxes that were introduced to pay for the First World War allowed governments to maintain higher spending afterwards. Public spending rose to an average of 15% of GDP by 1920. This spending increased again in the years after 1932 in the surge of welfare spending to combat the Great Depression. By 1937 the average for industrial countries had reached nearly 21% of GDP.The three decades after the Second World War witnessed the largest increase in public spending, mainly reflecting the expansion of the welfare state. By 1980 the proportion of GDP accounted for by state spending was 43% in industrial countries, and by 1994 this had risen to 47%. By this time there were large variations between countries: the EU average was 52%, in the UK it was 43%, in the USA 33%. In the newly industrializing countries (NICs) the average was only 18%. These variations over time and area allow some interesting comparisons regarding the benefits of additional spending.Tanzi and Schuknecht found that before 1960 increased public spending was associated with considerable improvements in social welfare, such as in infant-mortality rates, life expectancy, equality and schooling. However, since then, further increases in public spending have delivered much smaller social gains, and those countries where spending has risen most have not performed any better in social or economic terms than those whose spending has increased least. In the higher-spending countries there is much evidence of revenue churning: this means that money taken from people in taxes is often returned to the same people in terms of benefits. Thus middle-income families may find their taxes returned to them in child benefits. Furthermore, in many of those countries with the lowest increase in public spending since 1960, efficiency and innovation appear to be greater; they have lower unemployment and a higher level of registered patents.Another study found a similar pattern in Canada specifically.6 In the 1960s public spending, at modest levels, helped the development of Atlantic Canada. Most of the money went into genuinely needed roads, education and other infrastructure. Later large increases in spending not only had a smaller effect, but in general had a negative effect. For example, generous unemployment insurance reduced the supply of labour and impeded private investment. Subsidized industries, like coal, steel and fishing, involved using labour that could have been employed in more productive areas, as well as in the last case decimating the cod stocks. Even the roads eventually deteriorated, as local politicians had little incentive to spend public funds wisely, and voters felt unable to discipline them. Questions1 In what areas of public spending do there appear to be increasing returns?2 In what areas of public spending do there appear to be diminishing or negative returns?3 Explain the difference between diminishing and negative returns in the context of public spending, giving examples.4 Explain what is meant by revenue churning, giving examples.5 Why do local politicians have little incentive to spend public money wisely?6 Is it possible to talk about an optimal level of public spending? How might this level be determined?
1 In what areas of public spending do there appear to be increasing returns? There are increasing returns to public spending in areas like schooling and education, healthcare and hospitality. This is because,spending done in such areas given higher returns in terms of better educational achievements of the citizens and better quality of life that ultimately gives better returns to the economy. 2 In what areas of public spending do there appear to be diminishing or negative returns? There has been evidences of diminishing returns in public spending in the developed countries which have had mostly negative returns.This has been mostly noted of the newly industrialising countries where there were improvements in the level of social welfare and similar features which gradually started dimishing in value.The areas include defence, law and order, improvement of life expectancy, establishment of equality and equanimity among citizens. 3 Explain the difference between diminishing and negative returns in the context of public spending, giving examples. Dimishing returns in the context of public spending means that with every additional unit of money spent, the returns being derived is getting smaller and smaller. But a negative returns would mean that with every additional unit of money spent, the returns are actually falling and it is worsening the present condition unlike the previous case where the benefits are risisng but by a lesser amount in each instance. 4 Explain what is…

t by revenue churning, giving examples. Revenue churning is the phenomenon in higher spending countries where the money collecetd from the people in the form of taxes is returned to them in form of benefits or transfer payments. Example: the government collects higher taxes from people but in turn also provides with child benefits or unemployment benefits to people or grants. 5 Why do local politicians have little incentive to spend public money wisely? Local politicians have little incentive to spend money wisely because they have a short sighted vision of garnering as much personal benefit from the money available which they can extract during their tenure in power. They do not think it worthy to invest in public issues to uplift the condition of the people becuase they find a higher utility by extracting the money for issues that benefit themselves. 6 Is it possible to talk about an optimal level of public spending? How might this level be determined? An optimal level of public spending can be derived from the conditions of finding the marginal cost of providing an extra unit of service and the marginal social benefit it creates. The condition of equality between the two would ensure an optimal level of spending with accurate spending levels such that the most efficient use of the resources can be made.

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