The appropriate size and role of the government is one of the most fundamental and enduring debates in American politics. Government activity affects the economy in four ways:
The government produces goods and services, including roads and national defense. Less than half of federal spending is devoted to the production of goods and services. The government collects taxes, and that alters economic behavior. It is useful to remember that federal spending is overwhelmingly devoted to a handful of activities. Defense spending, Social Security, Medicare, and Medicaid accounted for nearly two-thirds of all federal outlays in 2009. Thus, any proposal to reduce the government's size would be unlikely to make much of a dent in overall spending unless it reduced one or more of these programs. The merits of government transfers cannot typically be evaluated on the basis of economic efficiency alone, because they often pursue social goals. What should be realized is that even if offsetting collections and receipts are not included in the budget as revenues because they represent choices made in the marketplace (i.e., they are not compulsory like taxes), removing them from revenues also causes the activities that they finance to be removed from the outlay side of the budget. When state and local government spending is included, the decline in the size of the government since 1983 is smaller because of the corresponding increase in the size of state and local government. Economic conditions can temporarily alter the size of government . Spending and tax revenue are not the only ways to think about the size of the government. And yet to ignore it in discussions of the size of government could be misleading. When markets function perfectly, which is defined as a market with many buyers and sellers, no barriers to entry, perfect information, and the costs and benefits of the transaction are completely borne by the buyer and seller, an economically efficient outcome will occur and government intervention can only reduce efficiency. To understand when government intervention in the economy can increase economic efficiency, it is necessary to define a market failure. For example, could an acceptable level of national defense be attained at lower cost? During peacetime, these questions cannot be definitively answered. For that reason, they may be overconsumed and can be depleted or even exhausted over time in the absence of government intervention. Economists can, however, evaluate how to achieve a social goal in the least economically costly way. But unlike a firm, most government goods and services, like defense, are not bought and sold in the private market, and so there is no way to value them. This makes it difficult to measure the effect of government production on the economy empirically, even if there are good empirical reasons for believing it to have an effect. As a result of government intervention, saving (and economic growth) would fall, but economic efficiency would increase. To the extent that "loopholes" in the tax code do divert resources from the pursuit of efficient market activity, this too lowers economic growth, although it is difficult to estimate the size of this effect, and whether there is a one-time reduction in growth when the loophole is introduced or an ongoing reduction in growth. Government intervention increases economic efficiency when it rectifies market failures and reduces efficiency when it distorts perfectly competitive markets. Political choices may lead to second-best outcomes, however, and some therefore argue that accepting market failures can be preferable to government intervention in some cases. Not all government spending is created equally. It is not so much the size of government as what government does with its spending, transfer, tax, and regulatory policies that affects economic efficiency and growth. The financial crisis of 2008 led to a sharp but temporary increase in government outlays as a share of GDP.
The size and role of the government is one of the most fundamental and enduring debates in American politics. Economics can be used to analyze the relative merits of government intervention in the economy in specific areas, but it cannot answer the question of whether there is "too much" or "too little" government activity overall. That is not to say that one cannot find many examples of government programs that economists would consider to be a highly inefficient, if not counterproductive, way to achieve policy goals. Reducing inefficient government spending would benefit the economy; however, reducing efficient government spending would harm it, and reducing the size of government could involve either one. Government intervention can increase economic efficiency when market failures or externalities exist. Political choices may lead to second-best economic outcomes, however, and some argue that, for that reason, market failures can be preferable to government intervention. In the absence of market failures and externalities, there is little economic justification for government intervention, which lowers efficiency and probably economic growth. But government intervention is often based on the desire to achieve social goals, such as income redistribution. Economics cannot quantitatively value social goals, although it can often offer suggestions for how to achieve those goals in the least costly way.
The government intervenes in the economy in four ways. First, it produces goods and services, such as infrastructure, education, and national defense. Measuring the effects of these goods and services is difficult because they are not bought and sold in markets. Second, it transfers income, both vertically across income levels and horizontally among groups with similar incomes and different characteristics. Third, it taxes to pay for its outlays, which can lower economic efficiency by distorting behavior. Not all taxes are equally distortionary, however, so there are ways of reducing the costs of taxation without changing the size of government. Furthermore, deficit spending does not allow the government to escape the burden of taxation since deficits impose their own burden. Finally, government regulation alters economic activity. The economic effects of regulation are the most difficult to measure, in terms of both costs and benefits, yet they cannot be neglected because they can be interchangeable with taxes or government spending.
There are many different ways to measure the size of the government, making its economic effects difficult to evaluate. Budgeting conventions are partly responsible: tax expenditures, offsetting receipts and collections, and government corporations are all excluded from the budget. But some governmental functions, like regulation, simply cannot be quantified robustly. Discussions about the overall size of government mask significant changes in the composition of government spending over time. Spending has shifted from the federal to the state and local level. Federal production of goods and services has fallen, while federal transfers have grown significantly. In 2009, nearly two-thirds of federal spending is devoted to Social Security, Medicare, Medicaid, and national defense. Thus, there is limited scope to alter the size of government without fundamentally altering these programs. The share of federal spending devoted to the elderly has burgeoned over time, and this trend is forecast to continue.
The size of government has increased significantly since the financial crisis of 2008 as a result of the government's unplanned intervention in financial markets and subsequent stimulus legislation. Much of the increase in government spending is temporary and could be reversed when financial conditions return to normal, although many question how easy it will be for the government to extricate itself from new commitments it has made.