State in the 21st Century

THE STATE IN THE TWENTY-FIRST CENTURY

I. The Growth of Public Spending

In 1888, a famous French economist, Paul Leroy-Beaulieu, discussing the optimal level of taxation, concluded that tax revenue of 5-6 percent of GDP could be considered "moderate," revenue of 8-10 percent of GDP would be "normal," while revenue beyond 12 percent of GDP would be "exorbitant" and would damage the growth prospect of countries.(1)

From the perspective of today's tax burdens of industrial countries (including Italy's of around 43 percent of GDP) Leroy-Beaulieu's position seems extreme. However, it was not extreme at the time he wrote his book. At that time most of today's industrial countries had levels of taxation and of public spending of around 12 percent of GDP. For example, in 1870, France and Italy had public spending and tax levels of about 13 percent of GDP. In line with the level of taxation, the economic role of the state at that time was very limited and was focused mainly on "core" functions such as defense, protection of individuals and property, administration, justice, and public works.

Fifty years later public attitudes vis-à-vis the economic role of the state started changing dramatically. In a small 1926 book, John Maynard Keynes, the famous British economist, was calling for the End of Laissez-Faire.(2) A few years later, in 1932, in an article in L'Encyclopedie Italienne, Mussolini was predicting that the twentieth century would become the "century of the state." This was a prediction that, from an economic perspective, proved to be right. At the time when Keynes and Mussolini were expressing these views, pressures for enlarging the role of the state were coming from both the political right and the political left.

These pressures, together with developments such as wars, the advent of totalitarian regimes in several important countries, and the Great Depression created a social environment, and some of the economic conditions, that led to the phenomenal expansion of the economic role of the state that was to take place in the rest of the century. This growth in public spending accelerated especially in the period between 1960 and 1980 when many countries, and especially the European countries, created mature welfare states. In several of these countries public spending approached or even exceeded 50 percent of GDP. This public spending, and the level of taxation needed to finance it, would have been considered inconceivable in the earlier part of the twentieth century.

Economists contributed to the growth of public spending by developing or popularizing economic concepts that provided theoretical justifications for greater governmental interventions in the economy. Budget experts developed public management tools that, it was claimed, would facilitate the analysis and the evaluation of government programs to avoid policy mistakes and to limit inefficiencies. Concepts such as public goods, externalities, merit goods, natural monopolies, built-in stabilizers, multipliers and so on were developed and used to justify various public-sector interventions. Tools such as cost-benefit analysis, PPBS, zero-base budgeting, capital budgeting, and so forth provided a kind of scientific cover for evaluations of governmental programs that, in many cases continued to be guided largely by political pressures and by political considerations.

II. Spending Levels and Economic Welfare

It is an open and highly debated question whether the very large growth in public spending that took place in the past 50 years has contributed to a genuine increase in the welfare of the majority of citizens. A recent book by the author of this paper has raised some doubts on whether it has.(3) If it is assumed that economic welfare depends on the values reached by various socio-economic indicators--such as life expectancy, infant mortality, educational achievements, literacy rates, per capita incomes, and so on, the information available from many industrial countries shows that there is little relationships, if any, for recent years between the share of public spending into GDP and desirable values of these socio-economic indicators. Countries that allowed their public spending to grow significantly do not show better values for these socio-economic indicators than countries that kept their governments smaller and leaner.

For example, if we take the United Nations Human Development Index as a general reference index for social welfare, among the countries with the best scores, we find some with high shares of public spending to GDP--such as Canada, Norway, Sweden and the Netherlands--and countries with low shares of public spending--such as the United States, Australia, Japan and the United Kingdom. Furthermore, some countries with very small, but highly efficient governments--including Singapore and Hong Kong--show levels for the UNHD index and for various socio-economic indicators that are almost as good as those for countries where public spending is twice or more as large.(4)

Because the high taxes needed to finance high public spending reduce the after-tax, or disposable, income of taxpayers and restrict their economic freedom and, most likely, over the long run, have a negative impact on economic efficiency and on economic growth, the question must be raised of whether it would not be preferable to reduce the level of public spending and, consequently, of taxation if this could be done without reducing public welfare. This reduction would allow individuals to have discretion over a larger share of their pre-tax incomes. In other words the citizens would decide how to spend this money and not the government.

All the theoretical reasons advanced by economists to justify the role of the state in the economy, including the need to assist the truly poor, could be satisfied with a much smaller share of spending in GDP than is now found in most industrial countries. There is a lot of evidence that much of the public spending benefits the middle classes. Or, putting it differently, the government taxes the middle classes with one hand and subsidizes them with the other.(5) It is unlikely that governments need to spend more than, say, 30 percent of their GDPs to satisfy pressing social objectives when there is real-world evidence of well-functioning countries that do not spend more than 20 percent of GDP for public programs.

III. Market Development and the Role of the State

The real problem that would be faced in reducing the role of the state in the economy is not that a less dominant state would necessarily imply a reduction in economic welfare but, rather, that a reduction in public spending would face strong political opposition on the part of those whose standard of living has come to depend on the existing programs. Public programs create many constituencies: pensioners, those close to the retirement age, and many others who have acquired other entitlements vis-à-vis the public sector would oppose reductions in public spending.(6) For these people a reduction in public spending would appear as a negative-sum game. Therefore, the evidence that, some countries with relatively low levels of public spending operate well should not be interpreted as an indication that high-spending countries could easily reduce their public spending.

The current level of public spending depends largely on entitlements and claims on the government created in past periods rather than on well thought-out analyses and considerations of what the state should do in a modern and sophisticated market economy. In other words, given the political forces at work, the level of spending that prevails in a country represents the outcome of the political process. However, if past pressures or actions have determined the current level of public spending, that level cannot be assumed to be optimal even though it may, in some sense, represent a kind of political equilibrium. It is, thus, important to separate, at least analytically, the optimal role of the state in the long run from the current role.

A question to ask, then, is whether the governments of today should simply accept the status quo and, thus, continue with the existing public programs while trying to accommodate, the best way they can, future pressures on spending, as, for example, those coming from demographic changes; or whether they should put in motion radical reforms that in the long run--say over a generation--would bring the role of the state and public spending more closely in line with an ideal or optimal role and spending level. Another way of putting the question is: what role should the state play, especially in relation to public spending in the twenty-first century, in advanced industrial countries? This is a difficult question to answer because inevitably the answer will reflect political biases as well as the importance that one attaches to the transitional costs of getting from where we are today to where we ought to be, say 20 or 30 years from now. The greater the importance that one attaches to the transitional costs, the greater the inclination to support current programs. Let me focus on some essential elements to consider when dealing with the above question.

The first of these elements is the recognition that there should be a relationship between what the market is capable of doing and what the government should do. After all, in a market economy, the state is supposed to correct the mistakes made by the market or to compensate for its shortcomings. In a society where the market is underdeveloped, so that it is not capable of performing well some important tasks--be these to produce necessary goods and services; to create jobs for most of those who wish to work; to create efficient insurance markets that allow individuals to protect themselves against various economic risks; to provide efficient and relatively safe channels for investing individual savings, and so on--there will be a presumption for the state to step in, thus replacing or modifying the market in some of these functions.(7) This to some extent was the main reason that led to the expansion in the role of the state.

In this connection I should mention that an important branch of economics, The School of Public Choice, questions governmental intervention even under these circumstances. Those who adhere to this school believe that governmental intervention to correct shortcomings of the market often makes things worse rather than better. In other words, market shortcomings are likely to be replaced by governmental shortcomings. Or putting it more blandly, the medicine may be worse than the disease. I ignore this aspect here.

As markets develop and become more efficient in performing various tasks, and in allowing a growing number of individuals to satisfy various needs, the theoretical justification for governmental intervention must decrease. Presumably, this should lead to a fall in public spending. To put it more formally, if R represents the role of the state (or the level of public spending) and D represents the degree of development and sophistication of the market, then we can postulate that R should be a negative function of D. The more sophisticated the market, the less the need for large public spending. We assume that the degree of sophistication of the market is a function of time. As time passes, for a variety of reasons including technological advances, markets tend to become more sophisticated. As a result of this change, governments should progressively be able to reduce their spending role in the economy.

A second important element linked to the first is that, when the government enters a market, and introduces laws and regulations that facilitate and justify its own intervention, it often makes it more difficult, or at times even impossible, for the private sector to develop in that market and to create possible private alternatives to the government's activity or service. Thus, governmental involvement creates a situation where the only realistic option seems to be the government's. For example, public monopolies in electricity, communication, transportation, the provision of pensions, health services, and education prevent the private sector from developing efficient alternatives in these areas. This creates the presumption that the public sector must remain engaged in these areas or public welfare will be significantly reduced. Often much of the public comes to believe this. For example, government monopolies in the provision of public pensions prevent the development of private pension funds or other private alternatives to public pension such as individual retirement accounts. The public comes to believe that only public pensions can protect individuals against the economic risks of old age or disability. Government monopolies in the provision of health services prevent or discourage the development of private alternatives in this area. The same argument applies to infrastructure developments and other areas.

The current role of the state was developed mostly in the period after World War II, when, for a variety of reasons, the markets of many European countries were not well developed. At the time it must have seemed natural for governments to take over many responsibilities including, at times, even that of producing some private goods. At one time in Italy the government was even in the business of producing panettoni!

Over the years, however, markets have become much more sophisticated and they would have become even more so if no governmental obstacles had been present. Various technological and other developments now make it possible for the private sector to replace many public sector activities. Technological developments have, for example, destroyed the presumption that there are "natural monopolies" in the generation and distribution of electricity, in various forms of transportation (railroads, airlines), in communications (telephones, telegraphs), and in other areas. This presumption had assigned to the public sector responsibility in these areas. In several countries, the government has withdrawn from these activities and relatively well functioning markets have quickly developed them. In most cases the economic welfare of the citizens has not been damaged by these developments. On the contrary, services have often improved in quality while their prices have fallen.

Major developments in financial markets have also removed the presumption that governments should be involved in the allocation of private savings and of credits. In a modern economy there should be no place for what economists call "policy loans" or "financial repression". In financial markets as well as in the areas mentioned above, there is, of course, a very important surveillance and regulatory function that governments must perform. This function cannot or should not be left to the private sector and it should be taken seriously by the government. It is part of the core activities of the state. This function is necessary to prevent abuses and the creation of private monopolies and to protect individuals against unscrupulous practices. But this surveillance and regulatory function must be focused and limited. Its objective must be to increase the transparency, accountability, and efficiency of the private sector, not to replace that sector.

A third element is that globalization, in its various aspects, is bringing major changes to the way markets operate or can operate. Foreign competition is making private markets more efficient. And globalization is affecting governments in different ways. For example, by eliminating frontiers or making them less constraining, globalization is creating more options for both citizens and governments. Education, health, and other services can now be obtained in other countries. This has created options beside the ones traditionally available within the country and mostly from the public sector. Thus, a government does not need to intervene when an accessible and perhaps cheapen foreign option is available. Insurance against many risks can now be bought, or in time it will be possible to buy it, from providers in other countries when this insurance is cheaper or more reliable. Savings can be invested abroad and even individual retirement accounts can be created in other countries. These developments are reducing the monopolies that governments had in many areas.

Globalization is also creating what I have called "fiscal termites." These are developments that over many years are likely to reduce tax revenue and, thus, the government's ability to finance high levels of public spending. If this forecast proves to be correct, the governments of tomorrow could have far less public revenue available than those of today; thus their ability to maintain a high level of public spending will be reduced. This may occur at the same time when demographic changes will be pushing for more spending under existing programs. If current policies cannot be changed, and the danger coming from the work of fiscal termites meets the time bomb created by demographic changes, 10- 20 years from now industrial countries could face unsustainable fiscal development. For this reason, it is important that policymakers, and those who represent large categories of citizens, consider in a profound and deliberate way, how they can reduce, over future years, the high levels of public spending. They should do this while preserving, to the extent possible, the basic goals that an efficient and compassionate government would want to promote. Over the years I have become convinced that this is possible.

A final element which merits to be mentioned is the potential impact that the technological developments that we associate with the New Economy (Internet, instantaneous and cheap communication, quick data manipulation, facility to store large amount of data in computer systems) could have on how governments operate. As of now this impact seems to be sporadic and limited. In many countries policymakers and public employees may not even be aware that a new era is dawning. Yet, hardware and software for an electronically-based government (what could be called an e-government) are available and have become much cheaper and more accessible than in the past. The main issue now is to learn what to do with them.

It is difficult, at this point, to assess the extent to which, and how soon, these developments associated with the New Economy will penetrate governmental operations and change them. But the potential is enormous provided that the governments facilitate the changes with regulatory reforms and in other ways. Countries that are slow to introduce these changes will pay a price vis-à-vis those that act more quickly and aggressively. Some countries are rushing to exploit the new opportunities. A leader in this area, as in other areas, is Singapore, which recently launched an initiative, backed by a large budgetary appropriation, to make all public employees computer literate within three years. The aim is to eliminate the use of paper in dealings between the private and the public sectors and within the public sector. To achieve this objective many governmental functions will need to be reengineered or redesigned and employees that are not able to adjust to the changes will lose their government jobs.

A reengineered e-government would create a formidable tool for pursuing legitimate governmental objectives in different and more efficient ways. There is little doubt that by the middle of the twenty-first century the role of the state will look very different from the one at the end of the twentieth century. Given the conditions mentioned above, what role would we wish to assign to the public sector if the legacy of past commitments did not exist?

IV. The Limits of Governmental Action in the Twenty-first Century

First, most economists now agree that the state should not be engaged in the production of goods and services that can be produced by the private sector or can be imported. Thus, by the twenty-first century, the state should be completely out of these activities unless enterprises prove to be fully competitive without any kinds of explicit or implicit subsidies.

Second, given the technological development of recent years, it is unlikely that there are still "natural monopolies" that justify public ownership and operation for activities such as airlines, railroads, generation and distribution of electricity, communication in its various aspects and other areas. For these activities the main role of the state would be a regulatory one and one that promotes as much competition as possible. The state should not allow the creation of private monopolies.

Third, markets have developed a great deal and are likely to develop even more if given the opportunity. Furthermore, foreign markets have become accessible and increasingly transparent. They may provide the citizens and the government of a country options when these are not available within the domestic private sector. For these reasons there is no longer a strong reason, for example, for the state to monopolize the areas of pensions. While the guarantee of a minimum pension to anybody reaching the retirement age could be considered a legitimate public goal, and this expenditure could be financed through general revenue rather than through payroll taxes, all pensions above that level could be left to the private sector to provide. If the state wished to play a larger role, as for example to make sure that individuals are not too myopic in their provisions for their old age, it could simply require that a given proportion of a person's salary must be invested in government-supervised but not controlled private funds. These private funds could be foreign funds if these provide higher returns for a given degree of risk.

The same argument advanced for pensions could be advanced for at least some aspects of health care, although this is undoubtedly a more complex area. In several countries with public health systems, parallel private systems have developed implying that health care is no longer equal for everyone as public health systems assume. Surely there must be private sector arrangements that could replace public ones for some aspects of public health. The government could limit its role to financing, for individuals with low income, the purchase of a basic package of health provision from private providers. These could be foreign ones. In addition it would exercise a general supervisory role over the private providers.

In the educational sector a larger role could also be given to the private sector especially for secondary schools and for universities. Private schools are a booming industry in various parts of the world and in some of them their quality is very high.(8) The free, public provision of education can be very costly in terms of economic resources if it encourages many individuals to obtain diplomas or degrees that do not prove useful for obtaining productive jobs. When individuals spend several years to obtain degrees that are never useful in the jobs they get, a society's resources have been misused.

Obviously, the views expressed above are somewhat provocative but they help in making a basic point, namely that if it were not for the legacy of past commitments, the private sector that exists now in many industrial countries, and that will continue to exist and to develop in future years, would make it possible for governments to drastically scale down their public spending and for the tax burdens to fall substantially from their present level. Obviously the change from the current situation to the future situation cannot be, and should not be, achieved overnight. There are too many individuals who have come to depend on the government for their livelihood. For this reason it would be useful to establish a clear commitment to a progressive reduction of the government role in the economy and to assume that over a generation the role of the state could change significantly and public spending could fall. While important, the speed of change is probably less important than the direction of the change.

NOTES:

(1) See Paul Leroy-Beaulieu, Traite de la Science des Finances (Paris: Guillanumin, 1888), pp. 127-128.

(2) This is the title of Keynes' book.

(3) See Vito Tanzi and Ludger Schuknecht, Public Spending in the 20th Century: A Global Perspective (Cambridge University Press, 2000)

(4) See United Nations Development Program (UNDP), Human Development Report 2000 (New York; Oxford University Press, 2000)

(5) In the process the government creates disincentives on the side of taxation and on the side of spending.

(6) For this reason, polls normally show that many citizens support current spending by governments.

(7) This is the situation in which many developing countries find themselves. However, in these countries the governments are limited in how much they can spend by their inability to collect large tax revenue.

(8) It should be recalled that some of the world's top universities (Harvard, Yale, Princeton, MIT) are private.