Government Spending May Hurt the Private Sector

This morning, Tyler Cowen links to an interview with Joshua Coval of Harvard Business School on the effect of earmarks on the private business environment of a state.  It turns out that the American political system provides us with a little natural experiment:  when a member of Congress becomes chair of a powerful committee, earmarks to that member's state or district increase dramatically.  But the result of this spending is more than a little surprising:

Sean Silverthorne: First, a little bit about your empirical approach to the research. Why did you decide to study changes in congressional committee chairmanships?

Joshua Coval: Our original goal was to investigate how politically connected firms benefit from increases in the power of their representatives. A benefit in focusing on changes in committee chairmanships is that their timing is largely exogenous from the perspective of the ascending chairman and his constituents. That is, a change in chairmanship can only occur if the incumbent retires or is voted out--both of which are entirely independent of what is currently happening in the ascending chairman's state.

Q: One of your findings was that the chairs of powerful congressional committees truly bring home the bacon to their states in the forms of earmark spending. Can you give a sense of how large this effect is?

A: Sure. The average state experiences a 40 to 50 percent increase in earmark spending if its senator becomes chair of one of the top-three committees. In the House, the average is around 20 percent. For broader measures of spending, such as discretionary state-level federal transfers, the increase from being represented by a powerful senator is around 10 percent.

Q: Perhaps the most intriguing finding, at least for me, was the degree and consistency to which federal spending at the state level seemed to be connected with a decrease in corporate spending and employment. Did you suspect this was the case when you started the study?

A: We began by examining how the average firm in a chairman's state was impacted by his ascension. The idea was that this would provide a lower bound on the benefits from being politically connected. It was an enormous surprise, at least to us, to learn that the average firm in the chairman's state did not benefit at all from the increase in spending. Indeed, the firms significantly cut physical and R&D spending, reduce employment, and experience lower sales.

The results show up throughout the past 40 years, in large and small states, in large and small firms, and are most pronounced in geographically concentrated firms and within the industries that are the target of the spending.

Obviously, libertarians will find this result congenial. But frankly, it has me stonkered.  Earmarks are an exogenous gift of cash from outside the state--which in turn means a transfer of real resources into the state.  Why would private activity go down?

I can tell a story about crowding out, where the federal money either does something that the private sector might have done anyway, or hires away resources (particularly skilled labor) from private firms.  If the government is monopolizing the local supply of cranes and crane operators in order to build a new sewage treatment plant, your construction project may not get built.  And because government funds are for discrete projects, and future funds are uncertain--your chairman may get unelected, or their party may lose power--it's probably hard to get firms or workers to relocate to your area in order to pick up the slack.

I can even tell a slightly more exotic story where there's what economists call a "resource curse" to federal funds.  Countries that have large deposits of natural resources are not, as you would expect, richer and happier as a result; rather the reverse.  It turns out that when you have a fat supply of practically free money, the elites spend all their time thinking about how to divert that money into their pockets, and none of their time thinking about how to build good political and economic institutions.  And because the government can support itself without tax revenues, it is not made accountable to the citizenry it is betraying.  Norway is the great exception to this rule--but Norway had very strong institutions before it had fossil fuels.

The new thinking is that foreign aid may involve a resource curse as well.  And you can argue that perhaps this argument extends to federal largesse--the more money the state or district receives directly from the federal government, the less incentive it has to maximize the efficiency of its own institutions.

These are interesting stories, but do they explain a 15% drop in capital spending?  That's a pretty big drop to be caused by something as seemingly innocuous as a new road project.  I remain puzzled, and would like to see a lot more work done in this area.