We have seen before that government spending can only cause reallocation of wealth, and not wealth creation. The money has to come from somewhere, and every dollar the government spends is a dollar that you, the taxpayer, are not spending towards your own ends.
But some might object and say that there is a multiplier effect for government spending by which it can generate wealth creation. The theory goes that when consumers get an increase in their income, they will save some portion of it and spend the rest, which is called the marginal propensity to consume (MPC).1 Then, everytime the consumer spends a dollar, that dollar goes to a different consumer, and so on until that one dollar circulates around the economy enough to have generated more than one dollar of wealth. This is denoted by the fiscal multiplier equation 1/(1-MPC), and implies potentially big gains from government spending depending on the MPC: for example, an MPC of 0.5 will result in a fiscal multiplier of 2, so every $1 of spending will provide a $2 boost to GDP.2
The theory of the fiscal multiplier has been used to justify big government spending packages during times of crises, especially after the 2008 recession. However, empirical tests of the multiplier effect find that it is rarely able to deliver the goods. An analysis of defense spending done by University of California-San Diego professor Valerie Ramey found that the implied government spending multiplier is between 0.6 and 1.2, meaning that in most cases every dollar of government spending generates a dollar or less than a dollar of wealth creation.3 A similar analysis was done for defense spending in the UK by economics professors Nicholas Crafts and Terence Mills, and their findings were even more pessimistic, finding a multiplier of between 0.3 and 0.8 for defense spending in interwar Britain.4 Looking at the overall literature, Mercatus Center scholars Veronique de Rugy and Jack Salmon find, pulling from nearly two dozen academic studies, that the average multiplier found is between 0.3 and 0.77.5
The challenge when it comes to government spending, and why the multiplier in practice tends to be very low, is that government spending also has a “crowding-out effect” in which the government uses resources that the private sector otherwise would have used, creating a decrease in private-sector activity.6 7Indeed, economists Christina and David Romer analyzed postwar tax increases in the US and found that every tax increase of one percent of GDP led to a fall in GDP by 2.5 to 3 percent. So, when analyzing your locality’s spending pressure, remember: every dollar of spending is a dollar (or more) out of your pocket.
