The Shrinking Government Sector

The run-up in government expenditures during the recent financial crisis has led some to believe that growth in the government sector is far outpacing the economy. Over the past five years, the government-to-GDP ratio has averaged 20.2 percent, just a bit above its average of 19.9 percent since 1970. While it is true that the ratio of government expenditures—including federal, state, and local government—to GDP increased precipitously during the crisis (reaching 21.1 percent in 2009), it has been trending down sharply since. At 19.7 percent as of the fourth quarter of 2011, it has given back 70 percent of its post-crisis increase.

This downward trend is the result of decreasing shares at all levels of government; however, the most significant factor has been cuts at the state and local level. Unlike the federal government share, which currently sits at 15.7 percent, state and local government spending is now nearly 3 percent below its first-quarter 2007 level. Because state and local government accounts for about 60 percent of total government spending, the trend in this component has more weight than the federal component on the overall government share.

Some of the decline in the ratio is also due to the recovery of GDP, as the year-over-year change in levels for GDP show steady growth since the beginning of 2010. Growth in state and local government has remained modest relative to its recent history. Most striking is that federal government expenditures (year-over-year) are negative for the first time since the late 1990s, a period of government surpluses.

This time is different, however. Despite the downturn in government consumption and investment relative to GDP, deficits continue to accrue. This is because government as a component of GDP does not include transfers; however, transfers greatly exceed tax revenue and nearly exhaust total revenues. This leaves little funding to pay for government consumption and investment, and so the difference must be borrowed.