In today’s Finshots, we tell you why the US wants to separate government spending from GDP calculations and whether that makes any sense.

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The Story

Governments, historically, have messed with GDP. They count government spending as part of GDP. So I’m going to separate those two and make it transparent… If the government buys a tank, that’s GDP. But paying 1,000 people to think about buying a tank is not GDP — that is wasted inefficiency, wasted money, and cutting that, while it shows in GDP, we’re going to get rid of that, we’re going to show you how that is.

That was US Secretary of Commerce Howard Lutnick a few days ago. Simply put, Lutnick believes that including government spending in GDP calculations is a bad idea. And his solution is to rip it out of the equation.

His argument is simple. Government spending doesn’t always mean real economic growth. So inefficient spending shouldn’t really count towards GDP.

Sounds logical, right? But does this idea really hold up?

To figure that out, we need to understand why government spending is included in GDP in the first place. And the answer isn’t as complicated as it sounds. GDP or Gross Domestic Product, is simply the total value of goods and services a country produces over a given period. And if you were to break it down into a formula, it looks like this:

GDP = Consumer Spending + Business Investment + Government Spending + Net Exports

(Net exports = Total Exports - Total Imports)

So yeah, each part of the equation reflects real economic activity. Remove any one of them, and GDP stops telling the full story.

But let’s focus on the government spending bit in the equation. What if the government hires a bunch of people to do… well, nothing? Say, twiddle their thumbs all day. Sure, GDP would technically rise. But would that actually help the economy? Not really, except for the professional thumb-twiddlers.

This isn’t just a hypothetical example we came up with. It’s a scenario that Lutnick and even Elon Musk have hinted at. And this is exactly where the argument for cutting inefficient government spending from GDP starts to make sense.

A study by the National Bureau of Economic Research (NBER) backs this up. It found that when governments in sample OECD countries reduced primary spending by just 1%, it led to an increase in the investments to GDP ratio by 0.16% almost immediately. Over five years, this effect compounded to 0.8%. And if the spending cuts focused on trimming government wages, the impact was even bigger, or 2.77% over 5 years to be precise.

Why does this happen? Simple. When governments spend more, they often do so by hiring more workers. That drives up wages. Higher wages spill over into the private sector too, pushing up costs for businesses. As a result, profits shrink and companies invest less in future growth. And over time, this slows down the economy.

We’ve seen this play out before. Take the 2008 financial crisis. To stabilise the economy, the US government ramped up spending by 11%, pushing it to $3 trillion. In the short term, this kept things afloat. But in the long run, it led to rising debt, higher interest rates and slower economic growth.

Then, you have to remember that governments don’t magically create all the money they have. They get a part of it from us — consumers and businesses, through taxes. And if that’s not enough to fund their plans, they borrow. So when the government spends, it’s not entirely generating new income; it’s just shifting a part of that money around. And if that spending isn’t productive, it doesn’t do much for economic growth either.

Maybe that’s why the US is thinking, “Hey, inefficient government spending is a huge problem. So let’s just strip it out of GDP and call it a fix.”

But does that actually solve anything, you ask?

Not quite. Because removing government spending from GDP could distort economic data rather than improve it.

To put things in perspective, government spending accounts for 20% of the US’ GDP. Remove it, and suddenly, comparing the US economy with other countries becomes nearly impossible. After all, every nation includes government spending in their GDP calculation because it fuels economic output, especially in areas like infrastructure, education and healthcare. These aren’t just expenses, they fuel long-term growth. 

Sure, some government spending is inefficient. But isn’t that true for consumer spending too? 

Just think about it. A movie studio spends $100 million on a terrible film. The movie flops. But for GDP calculations, that money still counts because people bought tickets. Over time, too many bad movies could hurt the industry. But that doesn’t mean we remove this spending from GDP, no?

So why apply a different rule to government spending?

Instead of removing government spending from GDP, what if we focused on measuring its quality?

Well, India already has a system to measure spending efficiency — the Quality of Public Expenditure Index. The RBI actually tracks public spending all the way back to 1991 to determine whether it’s productive or just wasteful.

Here’s how it works…

First, it looks at where the money goes — things like building infrastructure, funding education and training, investing in R&D and healthcare. The more a government invests in these, the better its spending quality.

Then, it checks how much debt interest is piling up. Sure, interest payments aren’t part of GDP, but they’re a solid indicator of financial discipline. Keeping this low means the government is spending wisely.

And finally, it tracks two key numbers ― the fiscal deficit (how much the government borrows to cover excess spending) and the revenue deficit (the shortfall between everyday income and expenses). The RBI believes keeping the fiscal deficit at 3% and the revenue deficit at zero ensures high-quality public spending.

This index has been a useful tool to gauge whether spending is on the right track. And the trend has been up for the past few years.

So maybe the US could take a leaf out of this playbook too?

Or better yet, look to its own past. There was a time when the US government actually had a framework to measure the effectiveness of its programs, using real data and evidence. Sure, today’s administration might not see eye to eye with that approach due to political differences, but that doesn’t mean they can’t build something better. They could team up with economists, refine old systems and create a model that truly reflects how well or poorly federal money is being spent.

Because let’s be honest. Removing government spending from GDP calculations isn’t just misleading, it’s outright bizarre. And coming up with ideas that defy economic logic? Well, that might just backfire on the US economy.

And that’s something most economists wouldn’t recommend.

What do you think?

Until then…

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