Professor Friedrich Heinemann, head of the ZEW Research Department “Corporate Taxation and Public Finance”, welcomed Ludger Schuknecht to the virtual #ZEWBookTalk on 6 July 2021. He discussed with him his current book “Public Spending and the Role of the State – History, Performance, Risk and Remedies”. Schuknecht, who is currently a visiting professor at the Lee Kuan Yew School of Public Policy, previously held the positions of Deputy Secretary-General at the OECD and Chief Economist at the German Federal Ministry of Finance. For the #ZEWBookTalk, he was connected from Singapore.

Heinemann and Schuknecht
Friedrich Heinemann (see left) discusses government spending with Ludger Schuknecht (see right).

Schuknecht opened his brief presentation by stating that citizens essentially expect a government to provide framework conditions that guarantee a good functioning of state and society. According to Schuknecht, whether the government is doing a good job can be seen in the trust that the population places in its actions and especially in its responsible handling and use of taxpayers’ money. This is all the more true in view of the fact that the public spending ratio has increased dramatically over the last 150 years.

Development of the public spending ratio over the last 150 years

In a short review, Schuknecht illustrated the development of the public spending ratio over the past 150 years in the 22 countries he looked at. Overall, the ratio rose from eleven per cent in 1870 to 43 per cent in 2017 and, fuelled by the COVID-19 pandemic, reached 51 per cent in 2020. The main drivers of this development towards a modern state were the growing administration and the welfare state. While spending on the latter amounted to one per cent of GDP in 1870, it was already nine per cent in 1960 and 24 per cent in 2017.

The central question now, according to Schuknecht, is to what extent higher government spending and especially the strong growth in social spending actually have positive effects for citizens. He said that there was no clear correlation to be found, e.g. when looking at the Gini coefficient as a measure of income distribution. The Gini coefficient is almost the same for Switzerland, Germany, Ireland and Korea, although in Korea, for example, the share of social expenditure is only ten per cent, i.e. far lower than in countries such as Switzerland and Germany.

From his findings, Schuknecht concludes that countries with a high public spending ratio could potentially save a lot of money without significantly worsening the living conditions of their citizens. This is also confirmed by looking at countries like Ireland, Greece, Spain or Portugal, which have had to implement reforms over the past 40 years. They have often succeeded not only in reducing government spending and lowering their debt levels, but also in enhancing economic dynamism.

Adhering to fiscal rules and maintaining fiscal discipline regarding public debt

In his book, Schuknecht also deals with future fiscal risks. It is important to provide sufficient state funds for the productive sectors and not to let the share of social spending grow too high, especially in view of demographic change. The experiences from the financial crisis show that the financial sector is also a risk factor that needs to be kept in mind. In addition, it must be possible to finance measures against climate change and geopolitical challenges. According to Schuknecht, in order to be able to cope with these tasks, it is necessary to comply with fiscal and budgetary regulatory mechanisms as well as to maintain discipline in public debt and to reduce debt levels.

Against this backdrop, the coronavirus pandemic has not made things any easier for the industrialised countries. Public spending has once again increased significantly from 2019 to 2020. The big challenge is to bring government spending back to pre-pandemic levels in the coming years, as the crisis was largely financed by a further build-up of debt. For the G7 countries, the debt level is now 140 per cent of GDP. Countries worldwide are swimming in a sea of debt, says Schuknecht. As long as interest rates are as low as they are at the moment, this is not a problem. But that can change. Therefore, the top priority in the coming years must be to reduce public debt to a sustainable level. Special attention should also be paid to central banks, whose importance has increased considerably with the growth of public debt and especially as a result of the economic and financial crisis and the COVID-19 crisis. There is a danger that policymakers in some countries may forgo necessary reforms and measures to reduce debt and instead rely too much on central banks to intervene in case of an emergency.

Using government spending in a targeted and efficient manner

In order to reduce the risks outlined above, Schuknecht recommends using government spending in a more targeted and efficient way instead of just increasing it further and further. It is also important to return to a policy that adheres to clear rules in order to achieve healthy growth and financial stability, to open up opportunities for people and to promote trust in the government and its problem-solving competence.

Schuknecht’s subsequent discussion with Friedrich Heinemann focused on the further significant rise in government spending over the past twenty years and how social spending and the financial and economic crisis in particular have contributed to this. They agreed that low interest rates alone have so far prevented some states from becoming incapable of acting due to their debt burden. In Heinemann’s view, however, a growth-oriented spending policy is indispensable for the future. Schuknecht added that after the crises the time had come to talk about which government expenditures were actually necessary and where savings could be made. Other questions raised at the end of the #ZEWBookTalk were how to strike a better balance between costs and benefits in government spending in order to increase trust in government, and the role of crises in initiating reforms. In response to Heinemann’s question on how he views the European Recovery Fund, Schuknecht said that it does have a positive incentive function for some countries to start making changes and investments. However, he is very critical of the joint liability that has been introduced. Introducing it permanently is not really necessary and represents a risk and a clear change of strategy for the future.

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