Obama Needs to Look at the Other Side of the Ledger

In his speech this afternoon, President Obama is expected to call for, among other things,  an increase in taxes on investors, entrepreneurs, small business owners, and other “rich” people who make over $250,000 a year.  The goal, the President claims, is to reduce deficits.

America has a spending problem, not a revenue problem, as the Congressional Budget Office chart below shows. The federal budget has ballooned nearly $2 trillion in the past 10 years and that increased burden of spending is undermining growth. And if left on autopilot, the spending crisis will get worse in coming decades. Rather than trying to keep up with that growing burden of government – an impossible task –  by raising taxes, our leaders should be looking at ways to treat the underlying problem:  Our government is too big and it spends too much.   We cannot tax our way out of this problem, particularly since politicians will spend any additional revenue.

The federal tax burden will rise above the historical average of 18 percent of GDP with no help from President Obama.  Even without expiration of the Bush tax cuts or the alternative minimum tax, the tax burden is expected to climb because even modest economic growth slowly but surely pushes more and more people into higher tax brackets.

The chart below shows CBO’s estimate of personal income tax revenue based on current policy (as opposed to estimates based on current law, which includes already legislated tax hikes). To be more specific, it shows how much revenue the government will collect from the individual income tax even if the 2001 and 2003 tax cuts are made permanent and the AMT is indexed.

The aggregate individual income tax burden will increase by roughly 5 percentage points of GDP when compared to the long-run average of about 8 percent of GDP (the CBO estimate only goes to 2035, so I extrapolated to show the same time period as the first chart). And remember, this is the forecast of what will happen to income tax revenues even if politicians don’t impose any new laws to coercively extract more revenue.

This might not be too bad if other taxes were falling, but that’s not what CBO is projecting. As such, this big increase in revenue from the individual income tax means that the overall tax burden will climb by approximately the same amount.

In other words, revenue likely will rise close to 25 percent of GDP as we approach the next century. So if we use this more realistic baseline, we can say that more than 100 percent of the long-run deficit problem is because spending is out of control.

The second reason for a firm no-tax increase position is that higher taxes are a very ineffective way of reducing budget deficits. Indeed, tax increases generally backfire and lead to more red ink. To understand why, it’s important to put away the calculator and instead consider the real world of politics and public policy. For instance:

Tax increases rarely raise as much revenue as predicted by government forecasters. This is because of “Laffer Curve” effects, as taxpayers change their behavior to earn less income and/or report less income. Simply stated, people respond to incentives, and this means taxable income falls as tax rates increase.

o  Tax increases erode pressure to control spending. Why would politicians want to make tough decisions and upset special interest groups, after all, when there is going to be more revenue (or at least the expectation of more revenue)? Using more colloquial language, trying to control spending with higher taxes is like trying to cure alcoholics by giving them keys to a liquor store.

o  Milton Friedman was right when he said that, “In the long run government will spend whatever the tax system will raise, plus as much more as it can get away with.” In other words, if politicians think they can get away with deficits averaging, say, 5 percent of GDP in the long run, then the the only impact of higher taxes is an equal amount of additional spending – while still retaining deficits of 5 percent of GDP.

The real-world evidence certainly points in this direction. We’ve seen “bipartisan budget summits” several times in Washington, and the result is more spending rather than lower deficits.

America’s fiscal challenge is too much spending. Government is too big and it is wasting too much money. Taking more money from the American people is not the way to solve that problem.