Sunday, April 5, 2009

Government Spending and Other People's Money

A friend told me recently that Milton Friedman divided spending into four categories:

1) spending your own money on yourself;

2) spending your own money on other people (e.g. a gift);

3) spending other people's money on yourself (e.g. using a corporate expense account);

4) spending other people's money on other people (e.g. spending by government bureaucrats).

The first kind of spending is the most efficient. Since you are presumably aware of what you want, you will purchase goods and services which will make you happy. Since it is your own money you are spending, you will be careful about not over-paying.

The second kind of spending is certainly less efficient. To some extent you are guessing at what the needs of the "other people" are, and you are certainly not going to be privy to their utility function. It's your money you're spending, so you may try to spend wisely and not over-pay, but sometimes -- particularly if it's a gift -- paying above a certain amount of money is part of your goal. There is a lot of evidence that gift items (e.g. a bottle of perfume) will not sell at all if priced too cheaply. We've all had that experience. You see a great gift for $20, but decide not to get it because it's not expensive enough. If the same gift were $50, it would be perfect.

The third kind of spending is also less efficient than the first. You end up spending the money on things you need and desire, but you are less concerned with price. You end up buying things that you wouldn't if you had to use your own money. At least you know that the purchases will be enjoyed and thus not be a total waste. Furthermore, there is at least some incentive to keep costs down, since you will look greedy to other people if you spend too wildly.

The fourth kind of spending is the least efficient of all. You have all of the problems of both the second and third type of spending without any of the mitigating factors. Because you're spending money on other people and not yourself, you really don't have to worry about looking greedy if you spend too much.

Often there is a perverse incentive to overspend because a key metric used to gauge success is the amount of money allocated. How many times have you heard a politician boast about how much money he allocated for this or that project? You certainly never hear of a congressman boasting that he got $100MM for building a highway in his state but was able to cut costs and return $20MM to the federal government.

And the government bureaucracy is even more perversely incentivized. I've worked in a government research laboratory where at the end of the fiscal year we frantically spent any remaining money in our budget because if it wasn't all spent, we would be allocated less money the next year.

Milton Friedman's succinct categorization makes it clear why government spending should be minimized. If the solution to today's economic problems lies in the government getting more money into the private sector, it should be accomplished by tax cuts and/or transfer payments, not government projects.

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