Governments, historically, have messed with GDP. They count government spending as part of GDP. So I’m going to separate those two and make it transparent… If the government buys a tank, that’s GDP. But paying 1,000 people to think about buying a tank is not GDP — that is wasted inefficiency, wasted money, and cutting that, while it shows in GDP, we’re going to get rid of that, we’re going to show you how that is

A few days ago, it was US Commerce Secretary Howard Lutnick. To put it simply, Lutnick thinks it’s a terrible idea to include government spending in GDP statistics. And removing it from the equation is his answer.

He makes a straightforward argument. Real economic growth is not necessarily correlated with government spending. Therefore, wasteful spending shouldn’t be included in GDP calculations.

It makes sense, doesn’t it? However, is this concept viable?

We must first comprehend the rationale behind including government spending in GDP to determine that. Furthermore, the solution isn’t as difficult as it seems. The total worth of products and services produced by a nation over a specific period is known as its gross domestic product or GDP. Additionally, if you were to deconstruct it into a formula, it would be like this:

GDP = Consumer Spending + Business Investment + Government Spending + Net Exports

(Net exports = Total Exports – Total Imports)

In other words, every component of the equation represents actual economic activity. GDP ceases to provide the complete picture if any one of them is eliminated.

But let’s concentrate on the portion of the equation that deals with government spending. What happens if the government employs a group of individuals to do nothing? Let them fidget with their thumbs all day. Yes, in theory, GDP would increase. But will the economy benefit from that? Except for the pro-thumb-twiddlers, not really.

This is not merely a speculative case that we thought of. Both Elon Musk and Lutnick have alluded to this possibility. The case for reducing wasteful government spending from GDP begins to make sense at this point.

This is supported by a National Bureau of Economic Research (NBER) research. It was discovered that a 1% decrease in primary spending by governments in the OECD nations included in the sample resulted in an almost instantaneous 0.16% increase in the investments to GDP ratio. This effect compounded to 0.8% during five years. Furthermore, the impact was much greater—2.77% over five years, to be exact—if the budget cuts were directed towards reducing government salaries.

What causes this to occur? Easy. Governments frequently increase employment when they increase spending. Pay increases as a result. Businesses incur higher costs as a result of higher wages in the private sector. Profits decline as a result, and businesses make fewer investments in expansion. Additionally, this slows down the economy over time.

This has happened to us previously. Consider the financial crisis of 2008. The US government increased expenditure by 11% to $3 trillion to stabilise the economy. This kept things afloat in the short run. However, it ultimately resulted in weaker economic development, increased debt, and higher interest rates.

Then, keep in mind that governments do not produce all of their money on their own. Through taxes, they receive a portion from us, the businesses and consumers. They borrow money if that is insufficient to finance their plans. Therefore, when the government spends, it is only moving a portion of that money around rather than creating new revenue in its entirety.  Additionally, spending doesn’t contribute much to economic growth if it isn’t productive.

The United States may be thinking, “Hey, inefficient government spending is a huge problem,” for that reason. So let’s just label it a fix and remove it from GDP.

But, you wonder, does that resolve anything?

Not exactly. Because taking government expenditure out of GDP could not enhance economic data, but rather distort it.

To put things in perspective, 20% of the US GDP is spent by the government. Without it, it is almost hard to compare the US economy to those of other nations. Since government investment stimulates economic activity, particularly in sectors like infrastructure, healthcare, and education, every country incorporates it in its GDP calculation. These support long-term growth rather than being merely expenses. 

Yes, certain government spending is inefficient. However, doesn’t that also apply to consumer spending? 

Simply consider it. $100 million is spent by a film studio on a bad movie. The film fails.  However, because tickets were purchased, that money is still included in GDP statistics. An excessive number of poor films could eventually harm the business. However, that does not imply that we deduct this expenditure from GDP, does it?

So why is government spending subject to a separate rule?

What if we concentrated on evaluating the quality of government expenditure rather than subtracting it from GDP?

Well, the Quality of Public Expenditure Index is an existing mechanism in India that measures expenditure efficiency.  To assess whether public spending is effective or simply wasteful, the RBI keeps track of it going back to 1991.

This is how it operates.

It starts by examining the expenditures, such as infrastructure development, training and education funding, R&D, and healthcare investments. A government’s spending quality improves as it makes more investments in these.

It then calculates the amount of interest that has accrued on the obligation. Interest payments are a good measure of financial discipline even though they aren’t included in GDP. Maintaining this low indicates prudent government spending.

Lastly, it monitors two important figures: the revenue deficit (the difference between regular income and costs) and the fiscal deficit (the amount borrowed by the government to pay for excessive spending). According to the RBI, maintaining a revenue deficit of zero and a fiscal deficit of three percent guarantees high-quality public spending.

This index has shown to be a helpful tool for determining whether spending is headed in the right direction. Additionally, for the past few years, the trend has been upward.

Perhaps the United States could also learn from this example.

Better yet, consider its own history. In the past, the US government had a structure in place to use actual data and evidence to gauge how effective its initiatives were. Political divisions may prevent the current administration from agreeing with that strategy, but that doesn’t mean they can’t create something better. They may collaborate with economists, improve on outdated frameworks, and develop a model that accurately depicts how successfully or poorly federal funds are being used.

Because let’s face it. Not only is it misleading, but it is downright strange to exclude government spending from GDP calculations. And generating concepts that don’t make sense economically?  That could hurt the US economy.

And the majority of economists would advise against that.

What are your thoughts?