National output without government? State capacity and welfare measurement

Abstract

Should government services be counted in GDP? In this paper, we argue that this is the wrong question. The more relevant question is: what do government services allow us to capture about economic well-being? By construction, counting government spending at cost as part of GDP turns it into an upper-bound approximation of welfare—one that tends to overvalue the contribution of the state. We use the concept of the Private Product Remaining (PPR) from Rothbard (1972) as a lower-bound measure of economic output that removes government in a comprehensive manner from GDP. We argue that the gap between GDP and PPR reflects the uncertainty surrounding the true welfare contribution of the state (thus affecting the reliability of any attempts of using national accounts to speak to welfare). This gap becomes analytically useful once we introduce state capacity into the picture: improvements in state capacity shift us along the spectrum between these two bounds. We formalize this idea through a "measurement legitimacy" function of state capacity which lies between PPR and GDP depending on the effectiveness of the state. Using newly extended data for the United States from 1889 to 2024, we find that the size and direction of the gap between the two measures vary systematically in ways that alter our understanding of American economic history and the role of state capacity. From 1889 to 1928, rising state capacity leads to GDP understating growth. Between 1929 and 1985, GDP overstates growth. After 1985, GDP once again understates it.