GDP undervalues government services

I.

Gross domestic product can be calculated in many ways, but one of the most common is:

(Government expenditure)+(Consumption)+(Investment)+((Exports)-(Imports))

To see why government expenditure is under-counted consider two countries, one of which provides all of its health care through the public sector, the other through the private sector.

In the latter case, health care is counted in GDP as the amount that consumers pay the private provider.

In the former case, health care is counted in GDP as the amount it costs the public provider to provide the service.

Assume it costs the same amount to provide the service in both countries. This is actually a generous assumption, governments can usually provide healthcare for cheaper than the private sector.

Assuming further that the profit margin of the private provider is not zero, it follows that:

(Price of the private health care services)>(Cost of the public healthcare services)

In the simplest terms, government expenditure is devalorised as a contributor to GDP because it only includes the cost of provision, not the profit margin.

II.

The political implications are obvious. Insofar as GDP is a metric that voters (and investors) care about, politicians are incentivised to focus on private, rather than public growth.

III.

There is a long list of common complaints against GDP. It doesn’t include damage to environmental assets, or resource depletion. It doesn’t include unpaid labour- and therefore especially discounts the contribution of women. It pays no attention to distributional concerns, and treats an extra-dollar going to a billionaire as just as important as an extra dollar going to a pauper who truly needs it.  Given these problems, many of which seem much more serious than a little under-counting of government activity, why make a big deal out of this?

The answer is that GDP is, in a sense, honest about these problems. Everyone knows these faults with GDP, many people can figure them out themselves after a minutes thought about the definition of GDP. The problems a measure wears on its sleeve are less grave for that measure than the problems a measure hides. The problem we have discussed here is less obvious than the others, because at first glance it appears that GDP does allow for government expenditure, yet the worm hides deeper in the apple.

IV.

There are three natural ways to deal with this problem that I am aware of. All have their pros and cons:

1. Value government services at the sales price of equivalent private services.
2. Value government services using willingness to pay analysis
3. Inflate the government expenditure term by a multiplier equal to the average profit margin.

Of these my favourite option is probably (3), although it sounds a little eccentric at first. Option (1) might unfairly overvalue government services if the private provision of certain goods (like roads) is very underdeveloped in relation to the government, and government provision benefits from economies of scale. Option (2) effectively gives the government a sort of monopoly power, since it’s based on the absolute maximum people would be willing to pay, with the only other alternative being losing it altogether.

It might be tempting to say “let’s just not adjust for it at all, it’s too hard to find a fully non arbitrary answer.” But not adjusting it and accepting the biased status quo is equivalent to a deeply arbitrary and pretty steep downward adjustment.