My French is rusty, but I’m pretty sure the Fresh Prince just flipped out at the idea of a 75-percent marginal tax rate like that advocated by France’s new socialist president.
My French is rusty, but I’m pretty sure the Fresh Prince just flipped out at the idea of a 75-percent marginal tax rate like that advocated by France’s new socialist president.
With both France and Greece deciding to jump out of the left-wing frying pan into the even-more-left-wing fire, European fiscal policy has become quite a controversial topic.
But I find this debate and discussion rather tedious and unrewarding, largely because it pits advocates of Keynesian spending (the so-called “growth” camp) against supporters of higher taxes (the “austerity” camp).
Since I’m a big fan of nations lowering taxes and reducing the burden of government spending, I would like to see the pro-tax hike and the pro-spending sides both lose (wasn’t that Kissinger’s attitude about the Iran-Iraq war?). Indeed, this is why I put together this matrix, to show that there is an alternative approach.
One of my many frustrations with this debate (Veronique de Rugy is similarly irritated) is that many observers make the absurd claim that Europe has implemented “spending cuts” and that this approach hasn’t worked.
Here is what Prof. Krugman just wrote about France.
The French are revolting. …Mr. Hollande’s victory means the end of “Merkozy,” the Franco-German axis that has enforced the austerity regime of the past two years. This would be a “dangerous” development if that strategy were working, or even had a reasonable chance of working. But it isn’t and doesn’t; it’s time to move on. …What’s wrong with the prescription of spending cuts as the remedy for Europe’s ills? One answer is that the confidence fairy doesn’t exist — that is, claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the past two years. So spending cuts in a depressed economy just make the depression deeper.
And he’s made similar assertions about the United Kingdom, complaining that, “the government of Prime Minister David Cameron chose instead to move to immediate, unforced austerity, in the belief that private spending would more than make up for the government’s pullback.”
So let’s take a look at the actual data and see how much “slashing” has been implemented in France and the United Kingdom. Here’s a chart with the latest data from the European Union.
I’m not sure how Krugman defines austerity, but it certainly doesn’t look like there’s been a lot of “slashing” in these two nations.
To be fair, government spending in the United Kingdom has grown a bit slower than inflation in the past couple of years, so one could say that there’s been a very modest bit of trimming.
There’s been no fiscal restraint in France, however, even if one uses that more relaxed definition of a cut. The only accurate claim that can be made about France is that the burden of government spending hasn’t been growing quite as fast since the crisis began as it was growing in the preceding years.
This doesn’t mean there haven’t been any spending cuts in Europe. The Greek and Spanish governments actually cut spending in 2010 and 2011, and Portugal reduced outlays in 2011.
But you can see from this chart, which looks at all the PIIGS (Portugal, Italy, Ireland, Greece, and Spain), that the spending cuts have been very modest, and only came after years of profligacy. Indeed, Greece is the only nation to actually cut spending over the 3-year period since the crisis began.
Krugman would argue, of course, that the PIIGS are suffering because of the spending cuts. And since there actually have been spending cuts in the last year or two in these nations, does that justify his claims?
Yes and no. I don’t agree with the Keynesian theory, but that doesn’t mean it is easy or painless to shrink the burden of government. As I wrote earlier this year, “…the economy does hit a short-run speed bump when the public sector is pruned. Simply stated, there will be transitional costs when the burden of public spending is reduced. Only in economics textbooks is it possible to seamlessly and immediately reallocate resources.”
What I would argue, though, is that these nations have no choice but to bite the bullet and reduce the burden of government. The only other alternative is to somehow convince taxpayers in other nations to make the debt bubble even bigger with more bailouts and transfers. But that just makes the eventual day of reckoning that much more painful.
Additionally, I think much of the economic pain in these nations is the result of the large tax increases that have been imposed, including higher income tax rates, higher value-added taxes, and various other levies that reduce the incentive to engage in productive behavior.
So what’s the best path going forward? The best approach is to implement deep and meaningful spending cuts, and I think the Baltic nations of Estonia, Lithuania, and Latvia are positive role models in this regard. Let’s look at what they’ve done in recent years.
As you can see from the chart, the burden of government spending was rising at a reckless rate before the crisis. But once the crisis hit, the Baltic nations hit the brakes and imposed genuine spending cuts.
The Baltic nations went through a rough patch when this happened, particularly since they also had their versions of a real estate bubble. But, as I’ve already argued, I think the “cold turkey” or “take the band-aid off quickly” approach has paid dividends.
The key question is whether nations can maintain spending restraint, particularly when (if?) the economy begins to grow again.
Even a basket case like Greece can put itself on a good path if it follows Mitchell’s Golden Rule and simply makes sure that government spending, in the long run, grows slower than the private economy.
The way to make that happen is to implement something similar to the Swiss Debt Brake, which effectively acts as an annual cap on the growth of government.
In the long run, of course, the goal should be to shrink the overall burden of government to its growth-maximizing level.
President Obama imposed a big-spending faux stimulus program on the economy back in 2009, claiming that the government needed to squander about $800 billion to keep the unemployment rate from rising above 8 percent.
How did that work out? One possible description is that the so-called stimulus became a festering pile of manure. About three years have passed, and the joblessness rate hasn’t dropped below 8 percent. But the White House has been sprinkling perfume on that pile of you-know-what and claiming that the Keynesian spending binge was good policy.
But not every politician is blindly ideological like Obama. Vitor Gaspar, Portugal’s Finance Minister, is willing to admit error. Here are some relevant excerpts from a New York Times report.
Mr. Gaspar, speaking to The New York Times last week, has a message for observers who say Europe needs to substantially relax its austerity approach: We tried stimulus and it backfired. Like some other European countries, Portugal tried what Mr. Gaspar called “a Keynesian style expansion” in 2008, referring to a theory by economist John Maynard Keynes. But it didn’t turn things around, and may have made things worse.
Why does the Portuguese Finance Minister have this view? Well, for the simple reason that the economy got worse and more spending put his country in a deeper fiscal ditch.
The yield on Portuguese government bonds – more than 11 percent on longer-term bonds — is substantially higher than the yields on debt issued by Ireland, Spain or Italy. …The main fear among investors is that Portugal is going to have to ask for a second bailout from the International Monetary Fund and the European Union, which committed $103 billion of financial aid in 2011.
Maybe the big spenders in Portugal should import some of the statist bureaucrats at Congressional Budget Office. The CBO folks could then regurgitate the moving-goalposts argument that they’ve used in the United States and claim that the economy would be even weaker if the government hadn’t wasted more money.
But perhaps the Portuguese left doesn’t think that will pass the laugh test.
In any event, some of us can say we were right from the beginning about this issue.
Not that being right required any keen insight. Keynesian policies failed for Hoover and Roosevelt in the 1930s. So-called stimulus policies also failed for Japan in 1990s. And Keynesian proposals failed for Bush in 2001 and 2008.
Just in case any politicians are reading this post, I’ll make a point that normally goes without saying: Borrowing money from one group of people and giving it to another group of people does not increase prosperity.
(This blog post first appeared at Cato@Liberty following the release of the 2006 Medicare and Social Security trustees’ reports. I repost it, with updated links and “exhaustion dates” because sadly nothing else has changed.)
Year after year, federal officials speak of the Social Security and Medicare trust funds as if they were real.
Yesterday Today, the government announced that the Social Security trust fund will be exhausted in 2040 2033 and that the Medicare hospital insurance trust fund will be exhausted in 2018 2024— projections that the media dutifully reported.
But those dates are meaningless, because there are no assets for these “trust funds” to exhaust. The Bush administration wrote in its FY2007 budget proposal:
These balances are available to finance future benefit payments and other trust fund expenditures—but only in a bookkeeping sense. These funds…are not assets…that can be drawn down in the future to fund benefits…When trust fund holdings are redeemed to pay benefits, Treasury will have to finance the expenditure in the same way as any other Federal expenditure: out of current receipts, by borrowing from the public, or by reducing benefits or other expenditures. The existence of large trust fund balances, therefore, does not, by itself, increase the Government’s ability to pay benefits.
This is similar to language in the Clinton administration’s FY2000 budget, which noted that the size of the trust fund “does not…have any impact on the Government’s ability to pay benefits” (emphasis added).
I offer the following proposition:
If the government knows that there are no assets in the Social Security and Medicare “trust funds,” and yet projects the interest earned on those non-assets and the date on which those non-assets will be exhausted, then the government is lying.
If that’s the case, then these annual trustees reports constitute an institutionalized, ritualistic lie. Also ritualistic is the media’s uncritical repetition of the lie.
The Laffer Curve is a graphical representation of the relationship between tax rates, tax revenue, and taxable income. It is frequently cited by people who want to explain the common-sense notion that punitive tax rates may not generate much additional revenue if people respond in ways that result in less taxable income.
Unfortunately, some people misinterpret the insights of the Laffer Curve. Politicians, for instance, tend to either pretend it doesn’t exist, or they embrace it with excessive zeal and assume all tax cuts “pay for themselves.”
Another problem is that people assume that tax rates should be set at the revenue-maximizing level. I explained back in 2010 that this was wrong. Policy makers should strive to set tax rates at the growth-maximizing level. But since a growth-generating tax is about as common as a unicorn, what this really means is that tax rates should be set to produce enough revenue to finance the growth-maximizing level of government - as illustrated by the Rahn Curve.
That’s the theory of the Laffer Curve. What about the evidence? Where are the revenue-maximizing and growth-maximizing points on the Laffer Curve?
Well, ask five economists and you’ll get nine answers. In part, this is because the answers vary depending on the type of tax, the country, and the time frame. In other words, there is more than one Laffer Curve.
With those caveats in mind, we have some very interesting research produced by two economists, one from the Federal Reserve and the other from the University of Chicago. They have authored a new study that attempts to measure the revenue-maximizing point on the Laffer Curve for the United States and several European nations. Here’s an excerpt from their research.
Figure 6 shows the comparison for the US and EU-14. …Interestingly, the capital tax Laffer curve is affected only very little across countries when human capital is introduced. By contrast, the introduction of human capital has important effects for the labor income tax Laffer curve. Several countries are pushed on the slippery slope sides of their labor tax Laffer curves. …human capital turns labor into a stock variable rather than a flow variable as in the baseline model. Higher labor taxes induce households to work less and to acquire less human capital which in turn leads to lower labor income. Consequently, the labor tax base shrinks much more quickly when labor taxes are raised.
There’s a bit of jargon in this passage, so here are the charts from Figure 6. They look complex, but here are the basic facts to make them easy to understand.
The top chart shows the Laffer Curve for labor taxation, and the bottom chart shows the Laffer Curve for capital taxation. And both charts show different curves for the United States and an average of 14 European nations. Last but not least, the charts show how the Laffer Curves change is you add some real-world assumptions about the role of human capital.
Some people will look at these charts and conclude that there should be higher tax rates. After all, neither the U.S. or E.U. nations are at the revenue-maximizing point (though the paper explains that some European nations actually are on the downward-sloping portion of the curve for capital taxes).
But let’s think about what higher tax rates imply, and we’ll focus on the United States. According to the first chart, labor taxes could be approximately doubled before getting to the downward-sloping portion of the curve. But notice that this means that tax revenues only increase by about 10 percent.
This implies that taxable income would be significantly smaller, presumably because of lower output, but also perhaps due to some combination of tax avoidance and tax evasion.
The key factoid (assuming my late-at-night, back-of-the-envelope calculations are right) is that this study implies that the government would reduce private-sector taxable income by about $20 for every $1 of new tax revenue.
Does that seem like good public policy? Ask yourself what sort of politicians are willing to destroy so much private sector output to get their greedy paws on a bit more revenue.
What about capital taxation? According to the second chart, the government could increase the tax rate from about 40 percent to 70 percent before getting to the revenue-maximizing point.
But that 75 percent increase in the tax rate wouldn’t generate much tax revenue, not even a 10 percent increase. So the question then becomes whether it’s good public policy to destroy a large amount of private output in exchange for a small increase in tax revenue.
Once again, the loss of taxable income to the private sector would dwarf the new revenue for the political class. And the question from above bears repeating. What should we think about politicians willing to make that trade?
And that’s the real lesson of the Laffer Curve. Yes, the politicians usually can collect more revenue, but the concomitant damage to the private sector is very large and people have lower living standards. So that leaves us with one final question. Do we think government spending has a sufficiently high rate-of-return to justify that kind of burden? This Rahn Curve video provides the answer.
Actually, Bill Clinton must be something even worse than a social Darwinist. That’s because the title of this post is wrong. Obama said that Paul Ryan’s plan (which allows spending to grow by an average of 3.1 percent per year over the next decade) is a form of “social Darwinism.”
But the proposal from the House Budget Committee Chairman only reduces the burden of federal spending to 20.25 percent of GDP by the year 2023.
Yet when Bill Clinton left office in 2001, following several years of spending restraint, the federal government was consuming 18.2 percent of economic output.
And by the President’s reasoning, this must make Clinton something worse than a Darwinist. Perhaps Marquis de Sade or Hannibal Lecter.
Here’s a blurb from the New York Times on Obama’s speech.
Mr. Obama’s attack, in a speech during a lunch with editors and reporters from The Associated Press, was part of a broader indictment of the Republican economic blueprint for the nation. The Republican budget, and the philosophy it represents, he said in remarks prepared for delivery, is “antithetical to our entire history as a land of opportunity and upward mobility for everyone who’s willing to work for it.” …“Disguised as a deficit reduction plan, it’s really an attempt to impose a radical vision on our country. It’s nothing but thinly veiled social Darwinism,” Mr. Obama said. “By gutting the very things we need to grow an economy that’s built to last — education and training, research and development — it’s a prescription for decline.”
I’m particularly amused by the President’s demagoguery that Ryan’s plan is “antithetical to our entire history” and “a radical vision.”
Is he really unaware that a small and constrained central government is part of America’s history and vision? Doesn’t he know that the federal government, for two-thirds of our nation’s history, consumed less than 5 percent of GDP?
Of course, that was back in the dark ages when people in Washington actually believed that the Constitution’s list of enumerated powers in Article 1, Section 8, actually enumerated the powers of the federal government. How quaint.
No wonder this Ramirez cartoon is so effectively amusing. It certainly seems to capture the President’s view of America’s founding principles.
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