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2006 May 20 Saturday
Do Tax Cuts Increase Government Spending?

Nick Schulz wonders whether tax cuts are the best way to cut the size of government.

I want the government both to spend less money and cut taxes. But if in cutting taxes the government is prompted to spend more money, should I still be in favor of tax cuts?

I ask this question in response to recent opinions taken by a few influential writers, including Jonathan Chait, Sebastian Mallaby, and Jonathan Rauch. Each has pointed to research that claims cutting taxes leads to increased spending. One implication of the research, they aver, is that if conservatives and libertarians are truly interested in cutting spending, they should reconsider their support for tax cuts.

Parenthetically, this strikes me as an argument against privatizing trash collection and highways. If we pay for more stuff directly governments will probably just grow in other areas as it becomes possible for it to spend more in other areas without raising taxes.

One of the proponents of the theory that tax cuts increase spending is William Niskanennnn, chairman of the very libertarian limited government Cato Institute. Will Wilkinson, also of the Cato Institute, summarizes Niskanen's argument.

Tax hawks like Grover Norquist, of Americans for Tax Reform, maintain that we should "starve the beast": create pressure on Congress to reduce spending by cutting the government's intake of taxes and running up deficits. This is the approach prescribed last year by Milton Friedman and Gary Becker, both Nobel Prize-winning free-market economists, in separate Wall Street Journal op-eds. Friedman predicts that "deficits will be an effective... restraint on the spending propensities of the executive branch and the legislature. The public reaction will make that restraint effective."

However, economist William Niskanen, chairman of the Cato Institute (also my employer), has presented econometric evidence that federal spending tends to increase when tax revenues decline, flatly contradicting the starve-the-beast theory. Furthermore, according to William Gale and Brennan Kelly of the Brookings Institution, members of Congress who signed the President's "No New Taxes" pledge were more, not less, likely to vote for spending increases, which is hard to square with the starve-the-beast theory.

"Starve The Beast" didn't work during the Reagan Administration. I suspect a better approach would be to make all taxes more visible to tax payers. Hidden taxes that only show up in the prices of goods and services without separate line items on the prices of goods (because, say, a tax is levied on businesses and is only seen by business owners) allow governments to collect more revenue without letting most of the public know what is happening.

Why do "Starve The Beast" tax cuts fail to rein in government spending? In a nutshell: When people think future generations will pay for the spending of today they are more eager for spending today.

Niskanen's analysis suggests that when current spending is financed by current taxes, voters see it as their money being spent, and so are more motivated to be frugal. But when current spending is financed by debt, voters see it as future voters' money being spent. If voters prefer to benefit now and have some one else pay later, there is no good reason to think legislators will see deficits as a reason to restrain themselves.

Starve-the-beast advocates might retort that the theory has yet to be tried. Sure, we're running record deficits. Sure, we've had tax cuts. Sure, most Republicans in Congress nevertheless voted for plush increases in education, defense, Medicare and more. And sure, President Bush has never seen a spending bill he wouldn't sign. The reason "starve the beast" has yet to kick in, they say, is that things aren't bad enough yet.

But if the deficit reaches crisis proportions - and it will, quickly, if it continues to grow at the current rate - we should not imagine that the government will rush to contain the crisis by rapidly cutting the fat from government. As George Mason University economist Alex Tabarrok recently argued, "The combination of changing demographics and current tax cuts is seeding our economy for a fiscal 'perfect storm.' When the storm hits, there will be a crisis, and... small government rarely does well in a crisis."

Tha "perfect storm" is going to start hitting as the baby boomers start to retire. The 2010s are going to be a battle royale over tax increases and spending cuts as old age entitlements programs create massive US government deficits. A similar clash will play out in other Western nations.

Miskanen argues his position against tax cuts as a way to cut spending:

First, this position is not consistent with the evidence, at least beginning in 1981. In a professional paper published in 2002, I presented evidence that the relative level of federal spending over the period 1981 through 2000 was coincident with the relative level of the federal tax burden in the opposite direction; in other words, there was a strong negative relation between the relative level of federal spending and tax revenues. Controlling for the unemployment rate, federal spending increased by about one-half percent of GDP for each one percentage point decline in the relative level of federal tax revenues. Although not included in the sample for this test, the first three years of the current Bush administration were wholly consistent with this relation.

What is going on? The most direct interpretation of this relation is that it represents a demand curve—that the demand for federal spending by current voters declines with the amount of this spending that is financed by current taxes. Future voters will bear the burden of any resulting deficit but are not effectively represented by those making the current fiscal choices. One implication of this relation is that a tax increase may be the most effective policy to reduce the relative level of federal spending. On this issue, I would be pleased to be proven wrong.

Second, acceptance of the “starve the beast” position has led too many conservatives and libertarians to be casual about the sustained political discipline necessary to control federal spending directly and to succumb to the fantasy that tax cuts will solve this problem. President George W. Bush, for example, has proposed and won the approval of most congressional Republicans for large increases in federal spending for agriculture, defense, education, homeland security, and Medicare, and he has yet to veto a single spending bill. As a consequence, real federal spending during the Bush administration is now growing at the fastest rate since the Johnson administration. And Congress has yet to act on the expensive energy and transportation bills or Bush’s proposal for a base on the moon and manned exploration of Mars!

This all is an argument for a balanced budget amendment. If the budget can't get too far out of balance without super majorities in Congress then spending and taxes will be more restrained.

Share |      By Randall Parker at 2006 May 20 02:43 PM  Economics Political


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Comments
noone said at May 20, 2006 4:02 PM:

Brilliant,tax the dickens out of everyone and everything now and Hey,Presto! smaller government later.


Our deficit spending will be solved when the rest of the world refuses to subsidize us.
Things will get really interesting when our debt holders demand their money back,with interest.

America enters an era of sustained austerity as we either pay our debts,leaving little for necessities,never mind consumer toys or we repudiate our debts and have no borrowed money for necessities,never mind consumer toys.

Or we print money,or rather print even MORE money and try to inflate our way out of debt.

Ouch.

Stephen said at May 20, 2006 8:23 PM:

China has recently changed its forex system - they were worried that their US dollar portfolio was too exposed, so they're now giving greater weight to other currencies. Apparently China's biggest problem is finding places to invest their surplus billions per month.

Stephen said at May 20, 2006 8:53 PM:

The fundamental error of the research cited is that the researches treat the 'no new taxes' pledge as an economic statement, when really it was nothing more than a media event. Good governance isn't found in such silly Rovean 'no new taxes' pledges. In fact, I'm inclined to think that any politician who signed up to such nonsense is more interested in political expediency than good governance.

Good governance requires good policy which requires leaders with a sense of public responsibility. Unfortunately, "the system" eliminates those politicians with nuanced positions and instead promotes politicians who are willing to spew any old feel-good nonsense in a 10 second sound bite.

Thrasymachus said at May 21, 2006 8:47 AM:

A tax cut funded through a budget deficit is just another sort of tax increase. Young guys like me will have to pay interest on the increased debt until it's paid off (never). Maybe if you're old and going to die soon, then a tax cut sounds like a great deal.


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