It Can Happen Here

Government really can be cut: case studies from Canada, New Zealand, and the United States

In an era of frightful budgets and frightened politicians, cutting government may seem like a flatly impossible task. But a look around the world—and at our own recent economic history—turns up a few inspirational examples of knife work that not only trimmed back budget deficits but created the conditions for unprecedented prosperity.

New Zealand, Canada, and the postwar United States all managed to slash the state on a grand scale. Governments shed responsibility for forests, railways, radio spectrum, and more while relaxing labor markets, slimming the welfare state, and ending price controls. Far from damaging economies or increasing unemployment, these reductions in the size and scope of government boosted GDP, improved services, and created jobs.

Government cutters faced opposition along the way, from skeptical Keynesians to Kiwi bureaucrats. But they also found unlikely allies, with left-wing parties playing major roles in the Canadian and New Zealand examples. The stories below should encourage would-be cutters and reassure skeptics: It can be done.

Turning Guns to Butter

How postwar America brought the boys home without bringing the economy down
Arnold Kling

When World War II ended in 1945, President Harry Truman faced a problem. Public opinion called for a rapid demobilization that would bring the boys home as soon as possible. But the Keynesians who were gaining prominence in the economics profession warned that a rapid decline in government spending and the size of the public work force would produce, in the late economist Paul Samuelson's words, "the greatest period of unemployment and dislocation which any economy has ever faced."

Thankfully, Truman ignored the Keynesians. Government spending plummeted by nearly two-thirds between 1945 and 1947, from $93 billion to $36.3 billion in nominal terms. If we used the "multiplier" of 1.5 for government spending that is favored by Obama administration economists, that $63.7 billion plunge should have caused GDP to fall by $95 billion, a 40 percent economic decline. In reality, GDP increased almost 10 percent during that period, from $223 billion in 1945 to $244.1 billion in 1947. This is a rare precedent of a large drop in government spending, so its economic consequences are important to understand.

The end of World War II thrust more than 10 million demobilized servicemen back into the labor market, but without the catastrophic consequences Keynesians feared. Close to 1 million took advantage of the GI bill to attend college. In addition, some of the increase in the male work force was offset by a decline in female labor force participation from World War II levels. But if Rosie the Riveter became a housewife, many of her friends continued to work outside the home. Over all, from 1945 to 1947 the civilian labor force increased by 7 million, or 12 percent. The vast majority found work, as civilian employment rose by 5 million, an increase of 9 percent.

In addition to the demobilized servicemen, the federal government let go of more than a third of its civilian employees—over 1 million workers. Many of these civilians had been engaged in government attempts to manage the economy. As the economist Gary M. Anderson has pointed out in The Freeman, more than 150,000 people were employed by various wartime economic regulatory agencies, such as the War Production Board, the War Labor Board, the Office of Civilian Supply, and the Office of Price Administration.

With responsibilities that extended well beyond wartime production to include restrictions and controls on the civilian nonmilitary economy, those agencies and boards disbanded with great reluctance. The 1946 election, which gave Republicans a majority in the House of Representatives for the first time since 1930, prompted a change of heart, with Price Administrator Chester Bowles removing virtually all remaining price controls five days after the vote. 

The conversion to a peacetime economy was a remarkable undertaking by the private sector. It did not merely involve converting wartime manufacturing to peacetime uses. For example, of the 2.8 million workers let go by the "other transportation equipment" sector between 1943 and 1948, when military vehicles were no longer needed, just half a million were absorbed by the civilian automobile industry. The big employment gains turned out not to be in manufacturing at all. The sectors that saw the most hiring were retail trade, services, contract construction, and wholesale trade, which together added nearly 4 million workers. 

There are important differences between circumstances today and the circumstances in 1945, of course. Back then, federal spending was much larger as a share of GDP (40 percent, vs. less than 10 percent today), and government employment was a much larger share of the labor force than now (20 percent vs. 2 percent), so a more significant adjustment was required.

But there are other factors that make change more difficult today. During World War II, the personal savings rate climbed to more than 20 percent, so after the war households were able to offset the decline in government spending by consuming a larger share of their incomes. Today, with a savings rate of about 5 percent, households have much less room to expand. In addition, the skill requirements of today's industries make it more difficult to match workers with jobs than was the case in the much simpler economy of the 1940s.

Any way you look at it, though, America's experience from 1945 to 1947 demonstrates that the private sector is capable of overcoming a tremendous drop in government spending. As a percentage of GDP, the decrease in government purchases then was larger than would result from the total elimination of government today. While no one can be sure what would happen if the government were to shrink that quickly, the '40s boom offers a hopeful example. 

Arnold Kling ([e-mail]) is a member of the Financial Markets Working Group at the Mercatus Center at George Mason University. He blogs at econlog.econlib.org.

The New Zealand Miracle
When left and right worked together on far-reaching market reforms
Maurice McTigue

In the early 1980s, New Zealand was on the fast track to bankruptcy. By 1984, when the conservative National Party called a snap election, the deficit was approaching a massive 9 percent of GDP with no budget in place. The government's share of GDP was 45 percent, unemployment was 9 percent (it would later peak at 11 percent), the top tax rate was 66 percent, and the rate of economic growth was a sluggish 2 percent.

A decade later, New Zealand had one of the most competitive economies in the developed world. The government's share of GDP had fallen to 27 percent, unemployment was a healthy 3 percent, and the top tax rate was 30 percent. The government went from 23 years of deficits to 17 years of surpluses and repaid most of the nation's debt.

This remarkable change was not only possible; it was fast and comparatively easy. The incoming Labour Party government paved the way in 1984 with its market-oriented approach to the economy; the National Party administration that took over in 1990 enthusiastically expanded the successful reforms. To solve deep economic problems, successive governments of New Zealand set out to eliminate the deficit, lower unemployment, and increase investment by shrinking the public sector, reforming or eliminating expensive programs, privatizing government enterprises, and reforming a burdensome regulatory process that was weakening our economy. Here's how it happened.

Privatization: From 1986 through the mid-1990s, New Zealand sold off airlines, airports, maritime ports, shipping lines, irrigation projects, radio spectrum, printing offices, insurance companies, banks, securities, mortgages, railways, bus services, hotels, farms, forests, and more. The capital released by privatization paid down the debt and was reinvested in higher priorities. In each of the services sold, productivity increased and costs went down; the country's competitiveness improved, and taxes poured into government coffers.

Rightsizing government agencies: After we eliminated those government functions, the bureaucracies that used to perform them were too large to perform their remaining tasks. So the civil service was reduced by 66 percent. Some agencies remained almost the same size, while others were reduced by 90 percent to 100 percent. After we privatized our forests, for example, only 17 of the Ministry of Forestry's former 17,000 employees were deemed necessary.

Cutting taxes: At the same time, we reformed the revenue system by eliminating capital gains taxes, inheritance taxes, luxury taxes, and excise duties and by allowing income to be taxed only once. We halved tax rates, eliminated all deductions that were not a cost of earning income, and created a system where one-third of revenue came from consumption taxes and two-thirds came from income taxes. Under the simplified system, about 65 percent of the population no longer had to file tax returns—a major selling point for reform.

Reforming the appropriations process: Before 1987, a government appropriation was simply a grant to spend on a specific activity. If money was appropriated to employment programs, for example, there was no expectation that a certain number of unemployed people would become employed as a result. With the State Sector Act of 1987 and subsequent laws, funding was linked directly to results. Agency heads were now CEOs, chosen for capability. They received fixed-term contracts: five years with a possible three-year extension. The only grounds for removal was nonperformance, so a newly elected government couldn't replace department heads with its own people. In the new appropriations process, these CEOs signed a purchase contract identifying exactly what was to be produced for the money allocated. 

Consider this case from one of my own portfolios, the Ministry for Employment. Under the old system, a total of $60 million was appropriated in 1989 to 34 different programs, which found jobs for 40,000 clients. After 1990, under the new purchase agreements, the same amount was allocated to just four programs; the other 30 were terminated. The contract required the ministry to place 120,000 people in jobs, with 56 percent of that figure drawn from the long-term unemployed, 25 percent from the Maori, 14 percent from people with disabilities, and 7 percent from people with social and drug or alcohol dependence problems. The ministry successfully placed 135,000 people in jobs that year.

Welfare policy: We now aimed not just to shrink the state but to reduce the number of people dependent upon it. Welfare had evolved into an entitlement to state support for social circumstances such as solo parenting, unemployment, health problems, and other forms of dependency. Under the new approach, resources were devoted to resolving health problems, education problems, social problems, and poor work skills. This approach moved 300 percent more people from dependency to independent living. It was a carrot-and-stick approach, though: If work was available and a citizen was capable of doing the job, he or she had to take it or forgo benefits.

As the New Zealand example demonstrates, it is possible to meet a crisis with serious, substantial reforms. All it requires is a good plan and strong political leadership. 

Maurice McTigue ([e-mail]) helped guide New Zealand's reforms as a member of parliament, cabinet minister, and ambassador. He is currently the director of the Government Accountability Project at the Mercatus Center at George Mason University.

If Canada Can Do It…
Slashing the state in the Great White North
David R. Henderson

In 1994 government debt was 68 percent of Canada's GDP. By 2008 that number was down to 29 percent. Finance Minister Paul Martin Jr. and Prime Minister Jean Chrétien, both of the Liberal Party, are the two unlikely stars in this heroic tale of fiscal discipline. 

Paul Martin's father was also known as "the father of Medicare," Canada's federally mandated single-payer health care plan, so revered by American liberals. Chrétien was the political heir of Pierre Trudeau, prime minister of Canada for all but nine months between 1968 and 1984, who bore a great deal of the responsibility for accumulating all that debt to begin with.

In the 1993 election, the Liberal Party promised to reduce the deficit. Almost unbelievably, its candidates actually kept this pledge after winning office. Chrétien and Martin accomplished the task with large budget cuts—not cuts in the growth of spending, but cuts in nominal dollars spent—and only small increases in taxes.

In assembling these cuts, Paul Martin didn't follow the usual pattern of consulting interest groups one by one. Instead, he held four televised regional consultations in which various lobbyists, experts, and ordinary citizens contended with one another. Martin also spoke directly to the public about what was needed to turn Canada's budget around. In October 1994, his Department of Finance published a report, A New Framework for Economic Policy, showing that in order to keep the ratio of debt to GDP from rising, government had to run a substantial surplus on its program budget—that is, have revenues significantly exceeding state expenditures.

Martin and Chrétien enforced discipline on other cabinet members with a zero-sum ground rule: If a cabinet member wanted a smaller cut in one program, he had to propose a bigger cut in another.

Martin's 1995 budget remains a shining example of how to deliver on promises of aggressive fiscal discipline. Government spending didn't just grow more slowly; it actually shrank. Spending on programs (as opposed to debt service) was lower in dollar terms, and therefore even lower when adjusted for inflation, than spending in 1993–94. Indeed, program spending was lower as a percentage of GDP than it had been at any time since 1951. The 1995 budget also privatized a number of government corporations, including a railway, a uranium company, and the air traffic control system; and it tightened Canada's unemployment insurance program.

In this and later budgets, Martin used conservative assumptions to make sure he achieved his goals come "hell or high water," an expression he used so often it became the title of his autobiography. Because his assumptions often turned out to be too pessimistic—a refreshing change from the usual budgetary wishful thinking—the ratio of debt to GDP fell even faster than projected. Martin also had a "no-deficit rule": Once he had managed to get rid of the deficit, he pledged to avoid future deficits by keeping spending in check.

From 1992–93 to 2000–01, Canadian spending on federal programs fell from 17.5 percent of GDP to 11.3 percent. The Canadian economist Thomas Courchene notes that the latter figure was the lowest "in more than half a century."

Not everything Martin did would meet with universal libertarian approval. Although there were six to seven dollars in budget cuts for every dollar of tax hikes, he did raise taxes. Virtually all of these increases were announced in the 1994 and 1995 budgets, and most were nickel-and-dime stuff: a reduction in the deductibility of meal and entertainment expenses, elimination of the $100,000 capital-gains tax exemption that a taxpayer could claim cumulatively over a lifetime, a 5.7-cent-per-gallon increase in the gasoline tax, a reduction of the upper limit on deductible contributions to Registered Retirement Savings Plans (Canada's version of a deductible IRA), an increase in the corporate income tax rate from 39.14 percent to 39.52 percent, and a few others. 

Martin did not raise individual income tax rates. He did, however, increase the degree of means testing for various federal benefits. Within some income ranges, benefits ended up falling for every additional dollar of income, so the implicit marginal tax was several percentage points higher than the explicit rate.

As a result of this fiscal discipline, in every year between 1997 and 2008 Canada's federal government ran a budget surplus. In one fiscal year, 2000–01, its surplus was a whopping 1.8 percent of GDP. If the U.S. government had such a surplus today, it would amount to a cool $263 billion rather than the current deficit of more than $1.5 trillion.

Chrétien and Martin's efforts were so successful that in 2000 they reduced the corporate tax rate by seven percentage points, cut income taxes, decreased the amount of capital gains subject to taxation, and increased the contribution limit for retirement accounts. Through most of this time period, Canada's economy boomed, thus belying the Keynesian view that large budget cuts reduce economic growth. If the Canadians can do it, maybe, just maybe, we can too. 

Contributing Editor David R. Henderson ([e-mail]), a former Canadian, is an associate professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, California, and a research fellow with the Hoover Institution at Stanford University.