The „Displacement Effect”: A Critical Note

Author(s): Richard M. Bird

Source: FinanzArchiv / Public Finance Analysis , 1972, New Series, Bd. 30, H. 3 (1972),
pp. 454-463
Published by: Mohr Siebeck GmbH & Co. KG

Stable URL: https://www.jstor.org/stable/40910905

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 The „Displacement Effect" : A Critical Note

by

Richard M. Bird*

Definition

The ' 'displacement effect" in public spending was first formulated by

Peacock and Wiseman in connection with a study of British government
expenditure for the period 1890-1955. They interpreted their data to indicate
that government spending grew over this period, not at a constant rate, but
roughly in step wise fashion. Furthermore, the movement from one "step" or
"plateau" to another coincided with the two world wars. Conversion of the
money expenditure series to real expenditures per capita, in order to rule out
the influences of population growth and price change, left the time profile of
government spending essentially unchanged (see Figure 1). Peacock and
Wiseman therefore proceeded to consider "how far the growth in expenditure
can be explained simply as the direct and inevitable consequence of war for
the continuing level of government spending in the postwar periods"1. This
led to their famous "displacement hypothesis", which deserves to be quoted
in full:

,,When societies are not being subjected to unusual pressures, people's ideas
about tolerable burdens of taxation, translated into ideas of reasonable tax rates,
tend also to be fairly stable. Fixed, if low, rates of taxation are obviously compatible
with growing public expenditure if real output is growing, so that there may be some
connection between the rate of growth of real output and the rate of growth of
public expenditure. Much more rapid rates of expenditure growth are unlikely; in
settled times, notions about taxation are likely to be more influential than ideas
about desirable increases in expenditure in deciding the size and rate of growth of
the public sector. There may thus be a persistent divergence between ideas about
desirable public spending and ideas about the limits of taxation. This divergence may
be narrowed by large-scale social disturbances, such as major wars. Such disturbances
may create a displacement effect, shifting public revenues and expenditures to new

* University of Toronto. This note draws extensively on material in my recent

book The Growth of Government Spending in Canada (Toronto: Canadian Tax
Foundation, 1970).
1 Alan T. Peacock and Jack Wiseman, The Growth of Public Expenditure in
the United Kingdom (Rev. ed.; London: George Allen and Unwin, 1967), p. xxxvi.

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 The „Displacement Effect" : A Critical Note 455

levels. After the disturbances is over new ideas of tolerable tax levels emerge, and
a new plateau of expenditure may be reached, with public expenditures again taking a
broadly constant share of gross national product, though a différent share from the
former one.
This displacement effect has two aspects. People will accept, in times of crisis,
methods of raising revenue formerly thought intolerable, and the acceptance of new
tax levels remains when the disturbance has disappeared. It is harder to get the
saddle on the horse than to keep it there. Expenditures which the government may
have thought desirable before the disturbance, but which it did not then dare to
implement, consequently become possible. At the same time, social unheavals impose
new and continuing obligations on government both as the aftermath of functions
assumed in wartime (e.g., payments of war pensions, debt interest, reparation pay-
ments) and as the result of changes in social ideas. Wars often force the attention of
governments and peoples to problems of which they were formerly less conscious -
there is an "inspection effect", which should not be underestimated."2

The "displacement effect" therefore posits an unfilled "demand"

(whether by the government, the public or some combination is uncertain,
since both are invoked in this quotation) for public expenditures. The degree
to which this demand is satisfied depends on a revenue constraint of some
sort. As the revenue constraint is eased, government expenditure expands
relative to national income. The principal way in which substantial increases in
spending are brought about is therefore when a "social disturbance" sets in
process some mechanism that raises the revenue restraint. (New on-going
expenditure programs created by the "inspection effect" of the disturbance
may, of course, be financed by discarding other programs, so this aspect of the
Peacock-Wiseman argument is not really related to the "displacement"
hypothesis, which necessarily relates to total government spending3.) This
general line of reasoning has been accepted by many scholars4. Nevertheless,
there are many questions that can be raised about the meaning and validity
of the "displacement effect".

Interpretation

Given the existence of a "social disturbance" - wars and world- wide

economic depressions are the usual examples - that has acted in some way
to raise the tolerable burden of taxation, why should government expendi-
tures rise until the new higher revenue restraint is encountered? Why should
ideas about "desirable public spending" continually outstrip the desire to
sustain expenditures? Even if the burden of taxation that the community is
prepared to bear has increased, might it not be favourably disposed toward a
government that eases the actual burden by maintaining constant expendi-

2 Ibid., p. xxxiv; emphasis added.

3 The "inspection effect" is discussed further in Bird, op. cit., chaps. 6 and 7.
4 See, for example, L.Johansen, Public Economics, (Amsterdam: North-
Holland, 1965), pp. 155-56; James Buchanan, The Public Finances (Rev. ed.;
Homewood, 111.: Richard D. Irwin, Inc., 1965), pp. 53-54; B. Herber, Modern Public
Finance (Irwin, 1967) pp. 150-51.

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456 Richard M. Bird

tures5? An assumption of inexhaustib

price?) appears to underlie this argum
offer no explanation except for the a
spending vs. taxation in the minds of
ingly likely that ideas about spending ar
force as well as vice versa. As govern
daily lives, it is becoming increasingl
elusive questions of fiscal psychology6
If the "tolerable burden of taxation1
ture, as is done by Peacock and Wisem
tion? Greater progressi vity? Less?
change in the degree of progressi v
taxation has increased, leaving out
because more revenues are raised? I
lower average rates provided the base
the "tolerable burden of taxation" is
effect it is necessary to clarify more
hypothesis is to be testable.
In addition to this wide range of qu
the "displacement effect", it seems q
all. In the first edition of their book Peacock and Wiseman maintained that
British experience with government spending in the period 1890-1955 was
consistent with their hypothesis. But this result depends entirely on their
assumption that defence expenditure is determined in competition with civil
expenditure by the internal dynamics of British society and not at all by the
world situation. Although they notice the argument that defence and war-
related expenditures might be thought to be determined exogenously to the
social system in question, and indeed appear to accept this argument for
wartime periods, they nevertheless argue:

"... peacetime defense expenditure clearly does not lie as completely outside
the influences that affect expenditures of other types as do wartime military
expenditure and other war-related expenditures... From this point of view defense
expenditure is no different from any other expenditure; it is the total that is of prime
importance to a government. Hence, acceptance of the need to spend more on
defense in peacetime may result not (or not only) in changes in the total of govern-
ment spending, but rather in reductions in expenditures of other types." 7

Although this position appears rather forced, it is certainly a legitimate

one. What is really mystifying, however, is that Peacock and Wiseman
maintain that they get their wartime "displacement effect" even when war-

8 In the postwar period, for example, Japan cut tax rates in most years from
1950 to 1961. As one commentator put it, "In postwar Japan, the development of a
social security system has been sacrificed in favor of low government expenditures and
economic growth" (Ryutaro Komiya, "Japan", in: Foreign Tax Policies and Econo-
mic Growth (New York: National Bureau of Economic Research, 1966), p. 9).
6 For some preliminary reflections along these lmes, see my The Tax Kalei-
doscope: Perspectives on Tax Reform in Canada" (Canadian Tax Journal, Sept.-
Oct. 1970), pp. 443-73.
7 Peacock and Wiseman, op. cit., pp. 60-61 ; emphasis added.

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 The „Displacement Effect" : A Critical Note 457

Figure 1
United Kingdom
Total Government Expenditure and its War-Related and Defence Components,
in Relation to GNP, per Head of Population, in 1900 Prices, 1890-1955
Pounds
100 r-

80- VtorUI World I

70 - War War
2- 70 - War
50 - ^s^ss^-^ss"''^'
40 -^y

30- -

20 - /// •>-"•• -

io - / /sK /.zrs ,y
io ¡I - /ViK / /sK /.zrs

co «o a> oí a> o* o> a* a* o* o>o>o> o*

Total government expenditures less na

other war-related expenditures
-

military, and defense expenditures

Source: Alan T. Peacock and Jack Wiseman, T
in the United Kingdom (rev. ed.; London: Geo

related, military and defence expenditures

government spending8. Their charts and th
fact, these residual data, as shown in the bo
ing their Chart 9), show a fairly constant g

8 Ibid., p. 61.

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458 Bichara M. Bird

ing, with temporary periods of acce

as one would expect in view of the ine
tures in wartime. A similar picture
drawn for Canada.
Whatever "displacement effect" there is, if there is one, it is in any event
far from the dramatic departure from underlying trends and the lasting effect
on the trend line that most presentations of this hypothesis would lead one
to expect. Figure 2, taken from Musgrave, illustrates the point succintly9.

Figure 2
The "Displacement Effect": Variants

Public Share in ^2

* ' n
i

f j
i .•
J x

¿r r- - !
b- 1 ¿r r- I ! !
:

f "'S

-■■"'' r - i
c- 1 ! !
Peace War Postwar

Source: R. A. Musgrav
1969), p. 88.
9 See B. A. Musgrave, Fiscal Systems (Yale, 1970), pp. 87-90. It will be noted
Figure 2 is in terms of share of GNP, while Figure 1 is in terms of per capita real
government expenditure. As emphasized in the earlier quote from Peacock and

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 The „Displacement Effect" : A Critical Note 459

The topmost sketch in the chart 2 a represents the case where there is no
"displacement effect": after the war, expenditures return to their prewar
trend line. The usual presentation of the "displacement effect" appears to
postulate a pattern like that shown in Figure 2 b, where the wartime trend
of public expenditure increase is more or less maintained as a result of a post-
war shift upward in civilian spending. It is the pattern shown in Figure 2 c,
however, with the postwar filling of wartime backlogs leading to a temporary
increase in civilian public spending that I have suggested is most in agree-
ment with the data Peacock and Wiseman themselves present. Musgrave's conc-
lusion, while not entirely clear, appears to agree with this statement for both
the U. S. and the U. K. 10. The Canadian pattern depicted elsewhere similarly
suggests more strongly that there was no permanent or long-term effect on
public spending as a result of World War II than it does the contrary.
Peacock and Wiseman themselves do point out that pre-World War I
growth in British government expenditure extrapolated to the most recent
year they considered (1955) would produce a spending total about equal
to the one that did occur. This interesting point is, however, curtly dismissed:
"But this is the world of cmight have been' ; we do not know what would have
happened to British public expenditures had the wars not happened, nor do
we know how one can usefully speculate about such a matter."11 But, of
course, their own arguments on the "displacement" of expenditure trends are
themselves necessarily based on speculation and comparison with the world
of "might have been". Subsequent evidence for the United Kingdom for the
extended period 1890-1966 also appears to suggest that wars cause not
displacements but temporary peaks on a rising trend12, although the "cold war"
greatly confuses the meaning of the war hypothesis anyway. In the U.K.,
as in Canada, "permanent" rather than "transient" influences on expenditure
appear to govern the long-term rising share of government activity.
Perhaps partly in recognition of these problems (none of which, however,
are acknowledged), in the new introduction to the second edition of their
book Peacock and Wiseman appear to have shifted the emphasis of the origi-
nal displacement hypothesis:
"Thus, the displacement effect may be regarded as a change in the opportunity-
cost situation of government, whether in the way alternative public expenditures are
valued relative one to another, or in the way that the electorate view the sacrifice
involved in a public sector of any particular size, or in both these respects. It seems
clear to us that, even where displacement appears (statistically) to be no more than
an interruption of a long-term trend, it is unlikely to be explicable simply as an
anticipation of developments that would otherwise (i.e. in the absence of social
disturbances) have fitted the trend. The character of public expenditures must be
expected to have been changed by the disturbance."13
Wiseman, the displacement hypothesis was originally formulated in terms of share
of GNP, so that Figure 2 is really the correct presentation. Oddly enough, no strictly
comparable graph appears in Peacock and Wiseman, op. cit.
10 Musqrave, ov- cit., pp. 107-09.
11 Peaock and Wiseman, op. cit., p. 28.
12 See, for example, Musgrave, op. cit., and especially A.E.Holmans, "The
Growth of Public Expenditure in the United Kingdom since 1950", The Manchester
School of Economic and Social Studies XXXVI (December 1968), 313-24.
18 Peacock and Wiseman, op. cit., p. 14-15.

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 460 Richard M. Bird

The "displacement effect" thus appe

relating to total public expenditur
"character of public expenditures", a

Empirical Testing
What all this appears to amount to
cannot sustain the original displacem
tion, the new edition of their boo
"the displacement effect" (it is not e
version or the new one) to "rigorous
of countries. Gupta confirms the exi
countries..."14
But does Gupta do this? The original Peacock-Wiseman displacement
hypothesis as it applied to Britain took real per capita government expendi-
ture (or, more properly, the percentage government expenditure is of
national income) as a function of time. Gupta instead takes per capita
government expenditure as a function of per capita income. He then estimates
statistically the equation linking per capita government expenditure and
per capita income for the periods before and after a supposed social disturb-
ance. The value of G (non- war related expenditures, that is, including defence)
is then calculated using both equations for a common year - the first year
following the disturbance - and if the value calculated with the equation
based on the later period exceeds the value calculated with the earlier
equation, an upward "displacement" is said to have occurred. On the basis
of this analysis Gupta concluded that the United Kingdom, the United States,
Canada, and Germany do show wartime displacements. Sweden, a country
not involved in the world wars, showed no wartime displacement. The
depression also appears to have occasioned upward shifts in the case of Canada
and the United States15. The latter displacement, he holds, is accounted for
not by the increase in the "tolerable burden of taxation" but rather by
"a shift in people's ideas about the desirable level of public expenditures . . .
the implementation of such ideas was possible because of the feasibility of
incurring higher expenditures without increasing the total burden of financing
such expenditures"16.
At least one alternative explanation of the observed depression "shift",
stressing the demand rather than the supply side, seems equally plausible,
however. This alternative explanation might run in terms of the Duesenberry
"ratchet effect" familiar from consumption-function literature17. Indeed,
given the relative frequency in most countries of the crises stressed in Gupta's
revised version of the displacement hypothesis, this alternative explanation
of the apparent long-run upward shift of the government expenditure func-
tion over time seems perhaps more plausible in general than the completely
supply-oriented "tolerable taxes" approach.
The statistical problem of identifying exactly what in fact happened

14 Ibid., p. xiv.

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 The „Displacement Effects11 : A Critical Note 461

Figure 3
The "Hatched Effect" and Government Spending
A. B.

G G
Y Y

jjr^L
real income per capita real income per capita

in any country is, unfortunately, insuperable, but Figure 3 will serv

illustrate the general argument. The actual G/Y relation might fall along
line like OB in this figure. OB, then, in effect illustrates Wagner's "law"
time being an implicit third dimension on the diagram18. The "pure" dis
placement hypothesis is that the tolerable tax burden shifts upward ove
time as a result of crises (for example from TT to TT" in Part A of Figure
and that, since in the long-run revenues must equal expenditures, it is rea
this shift which permits the move along OB from E to S. That is, had th
not been a crisis which permitted higher taxes, this move could not have t
place. The "ratchet" hypothesis is illustrated in Part B of Figure 3, wher
OB is again the long-run "government expenditure function"19. The cou
of government expenditure over time may now be described as follows:
normal conditions the government expenditure ratio (G/Y) rises as per cap
income rises along OB from, say, R to S20. If there is a crisis, however, a
say, per capita income declines, as in a depression, then G declines a
but less rapidly, so that G/Y rises, but along the curve GG rat
than along OB. These short-run curves are drawn to reflect
fact that the failure of expenditure to fall as rapidly as income me
that the G/Y ratio rises, as it did in Canada and the U. S. in the 30's. If inc
rises in the crisis instead of falls, then the expenditure ratio will also ri
but at first slowly since it takes time to adjust spending patterns (for exam
along G'G'), then more rapidly when "tastes" and political realities move
economy back to OB, the curve depicting the "desired" (and, in this analy

15 S.P.Gupta "Public Expenditures and Economic Growth", Public Financ

Finances Publiques ,XXII (No. 4, 1967), pp. 433-43.
18 Ibid., pp. 445-446.
17 See James Duesenberry, Income, bavmg, and the lheory oi Consumer
Behavior (Cambridge, Mass.: Harvard University Press, 1949).
18) On Wagner a "law" see K.M. Bird, Wagner's "JLaW ot Uxpancling «tate
Activity", Public Finance/Finances Publiques, XXVI (No. 1, 1971), 1-26.
19 The usefulness of this kind of formulation may be questioned on logical
grounds: see Bird, op, cit., chap. 5. It is used here for illustrative purposes only.
20 As usual, it requires a strong assumption to say that a rise in expenditure
per capita is accompanied by a rise in the G/Y ratio.

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 462 Richard M. Bird

where there is no long-term revenu

at each income level. The speed of th
income-elasticity of government exp
expect to vary considerably dependi
although it is probably statistically im
the confusion engendered by the slop
factors (revenue elasticity and budge
elsewhere21.
Whatever the merits of this partic
that any observed "step" function in
be "explained" theoretically as sati
"ratchet" theory - which is based fa
public goods theory on the way in w
individual preference functions and
in the relative permanence of the bas
of temporary crises - as by the strai
and Wiseman.

Conclusion

To sum up, Peacock and Wiseman stressed the crucial role of war and
the expansion of government activities associated with war as the chief way
in which the assumed socio-cultural limit on revenues could be altered, thus
permitting an expansion of non- war expenditures after the war is over. Their
original argument was defective both in the vagueness of its formulation and
because its empirical support, in the form in which they presented it, is
negligible. Subsequently, however, Gupta, in a more rigorous statistical test
of the Peacock-Wiseman hypothesis (which, however, related the displace-
ment effect to shifts in per capita income rather than time), also stressed the
importance of wars as well as of the Great Depression of the 1930's in the
United States and Canada. Although Gupta's treatment still suffers from
the same ambiguity as Peacock-Wiseman about peacetime defence expendi-
tures and the exact mechanism of "displacement", and from some of the
other vaguenesses of the original formulation, it marks a considerable step
toward the more rigorous formulation needed for satisfactory statistical
testing. Further improvement waits on clearer specification of the hypothesis
and more attention to the process of public decision-making.
War, revolution, and economic crisis have thus been viewed as the three
horsemen of the apocalypse. Only with their unpleasant assistance, it has
been argued, can the limits on government expansion set by the need to
raise taxes be dramatically shifted. It is important to note clearly that the
"displacement effect" hypothesis, whatever its exact formulation and merits,
really has nothing to do with Wagner's "law" and similar "explanations" of

21 Gupta, op. cit., pp. 446-59, actually explains the observed changes in income
elasticity after crisis in terms of a narrowing of the gap between the "desired" level
of expenditures and that permitted by the "tolerable" level of taxes. He also men-
tions (p. 445 n.) the possibility of a "ratchet effect" though he does not explore the
possible mechanism in detail.

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 The „Displacement Effect": A Critical Note 463

the long-run expansion of government activities22. The "displacement

effect" is concerned solely with the time pattern of government expenditure
and not with the reasons why there is (if there is) constant pressure for the
ratio of government expenditure to increase over time. Similarly, the dis-
placement effect cannot explain the slow gradual expansion of size and scope
characterizing most government activities. Although Gupta purports to
examine the displacement effect in terms of both a shift in the expenditure
function and a change in the slope of the function, it seems clear that only the
shift (if any) is an illustration of the displacement effect - of the loosening of
the revenue constraint on expenditures due to crisis. The slope change (if
any) reflects two quite different things: the income-elasticity of the revenue
measures adopted in the crisis and the budgetary strength of the interest
groups - especially the spending bureaucracy - affected by the spending
programs adopted. I do not see that either of these forces is in any way
necessarily connected to the crisis which admittedly may have given them
room to be exerted.
The appropriate test of the socio-cultural hypothesis of Peacock and
Wiseman, that at a particular time in a particular country there is some level
of taxation which is widely viewed (or at least viewed by those who matter
in the political process) as "tolerable"23 and that revenues (and thus expendi*
tures) can be expanded beyond this limit only in times of crisis, is therefore a
shift in the government expenditure function. Gupta's analysis indicates that
there was such a shift in the function in Canada, for example, as a result of
the Great Depression as well as a result of World War II. This is, however, a
most peculiar result in terms of the displacement hypothesis, since the
depression shift came about almost entirely because government expendi-
tures did not fall as sharply as did national income, so that the G/Y ratio
rose.

In short, the final verdict on the "displacement effect",

Canada or elsewhere, cannot yet be handed down because an
hypothesis has not yet been rigorously formulated and tested.
however, in terms both of logic and data, it appears the verdi
"not proven", with the weight of the evidence tending to indi
likely to look better when tested further24. What appears to b
original hypothesis is mainly a rather obvious argument on the
of defence for civilian expenditures in war time and a reverse
afterwards - and even the last part of this proposition seems qu
these days of "cold war" and superpowers, at least for the non
like Canada.

22 See Bird, "Wagner's 'Law'", op. cit.

23 Incidentally, this is really an old idea: it was stated, tor example, by Carl
C.Plehn in: Introduction to Public Finance (Fifth ed.; New York: The MacMillan
Company, 1929), pp. 13-14; see also Josiah Stamp, Wealth and Taxable Capacity
(London, 1922).
24 F. Pryor, Public Expenditures (Yale, 1969), pp. 443-46, also found little
evidence of a displacement effect in the U. K. and little logical basis for the Peacock-
Wiseman formulation of the hypothesis.

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