Return Of The State – Will Big Government Come Back As Recession Hits?

2022 was a dramatic year in markets, economies and across geopolitics. 2023 may bring more of the same and even greater change. David Skilling and I have written that the next year(s) could be characterised by Clausewitz’ dictum that politics can be ‘war by other means’ in the sense that strategic competition between the large regions will be the dominant theme acting on international political economy.

In this note, we focus on a key element of this – the greater role of the state in economies, from taxes to spending.

The size and role of government has trended down over the past few decades across advanced economies, supported by a prevailing policy consensus. But this consensus has been shifting. Austerity was bad politics after the global financial crisis, bond vigilantes generally disappeared in the QE era (providing governments with greater fiscal space), and there has been growing demand for government support in response to the pandemic and the current energy crisis. Support packages of at least several percentage points of GDP have been implemented, even by conservative governments.

Expansive role

Looking forward, we should expect a more expansive role for government due to growing public demand as well as the wartime footing. Governments are expected to socialise risk to a much greater extent and to use their balance sheets to deliver strategic objectives. As stresses grow, it will be difficult to remove fiscal support, particularly in the context of a slowing economy in 2023.

Government spending will increase on higher transfer payments as well as the costs of an aging population. And there are other structural drivers of an increased role for government. Many governments have committed to raise military spending to 2% of GDP (or more) over the next few years; and significant investments are being made in the demanding net zero transition, from supporting renewable energy production to financing hydrogen infrastructure and energy efficiency measures. Combined, these are multiple percentage points of GDP.

Beyond this, many governments are spending more on industrial policy initiatives and research and innovation to develop strategic production capabilities. Large economies in particular (the US, China, and the EU to a lesser extent) are focused on strategic autonomy to deliver greater independence on energy, key technologies (semiconductors, quantum), pharmaceuticals and vaccines, and so on. And they want to develop positions of competitive advantage in the commanding heights of the 21st century economy.

This will consume increased government spending and capital. This trend is already in place and will pick up pace through 2023 and beyond. Beyond financial support governments will also take a more expansive role in trade and regulatory policy to support key strategic sectors, and building national champions.

Wealth taxes

There will be pressure to increase tax revenues to fund this spending. Although there is greater comfort with public debt, this will not be enough. Wealth and asset taxes will become more prominent, together with windfall taxes and higher corporate taxes. An increasingly progressive tax system is likely. Efforts to reduce international tax competition, such as the OECD’s minimum corporate tax rate agreement, are consistent with this.

Macro policy frameworks will also be adjusted for this new context, with a rebalancing away from binding policy rules to more policy discretion to support higher levels of government spending and debt (discussed further in section 4, below).

There is no robust relationship between the size of government and economic outcomes. But given the magnitude of the likely increases in government spending and investment, the quality of those decisions will make a substantial difference. State capability will become a core driver of national competitive advantage.

Implications for corporates and investors

Firms and investors should prepare for higher taxation especially taxes on wealth and assets, as well as windfall taxes.

Identify sectors/ecosystems that are strategic government priorities as destinations for investment.

Invest behind countries with high state capability, who have a competitive advantage in an era of bigger government.