Tag: government spending

What’s the Future for Supply-Side Economics?

Kevin Williamson has a long-overdue piece in National Review making two essential points about supply-side economics and the Laffer Curve. First, he explains that tax cuts are not the fiscal equivalent of a perpetual motion machine. Simply stated, too many Republicans have fallen into very sloppy habits. They oftentimes fail to understand the difference between “supply-side” tax rate reductions that actually improve incentives to engage in productive behavior and social-engineering tax cuts that simply allow people to keep more money, regardless of whether they create more wealth. This does not necessarily mean the latter form of tax cuts are bad, but they definitely do not boost economic performance and generate revenue feedback. Moreover, even when GOPers are talking about supply-side tax cuts, they frequently exaggerate the positive effects by claiming that lower tax rates “pay for themselves.” I certainly think that can happen, and I give real-world examples in this video on the Laffer Curve (including Reagan’s lower tax rates on those evil rich people), but self-financing tax cuts are not common.

Williamson’s second point is that the true fiscal burden is best measured by looking at how much government is spending. I might quibble with his description of deficits as a form of deferred taxation since technically debt can be rolled over in perpetuity, but his main point is right on the mark. There is no doubt that most forms of government spending – regardless of the means of financing – harm growth by diverting money from the productive sector of the economy (technically, the economic damage occurs because capital and labor are misallocated and incentives are diminished, but let’s not get too wonky). Here are some excerpts from Williamson’s article:

Properly understood, there were no Reagan tax cuts. In 1980 federal spending was $590 billion and in 1989 it was $1.14 trillion; you don’t get Reagan tax cuts without Tip O’Neill spending cuts. Looked at from the proper perspective, we haven’t really had any tax cuts to speak of — we’ve had tax deferrals. …even during periods of strong economic growth, there has been nothing to indicate that our economy is going to grow so fast that it will surmount our deficits and debt without serious spending restraint. This should be a shrieking klaxon of alarm for conservatives still falling for happy talk about pro-growth tax cuts and strategic Laffer Curve optimizing. …The exaggeration of supply-side effects — the belief that tax-rate cuts pay for themselves or more than pay for themselves over some measurable period — is more an article of faith than an economic fact. But it’s a widespread faith: George W. Bush argued that tax cuts would serve to increase tax revenues. So did John McCain. …It is true that tax cuts can promote growth, and that the growth they promote can help generate tax revenue that offsets some of the losses from the cuts. …The problem with magical supply-siderism is that it gives Republicans a rhetorical and intellectual framework in which to ignore spending — just keep cutting taxes, the argument goes, and somebody else will eventually have to cut spending. The results speak for themselves: Tom DeLay and Dennis Hastert and Trent Lott and Bill Frist all know how to count, but, under their leadership, Republicans spent all the money the country had and then some.

Now that we’ve chastised Republicans, it’s time to turn our attention to the Democrats. We know they are bad on spending (I often joke that Republicans expand government out of stupidity, while Democrats do it for reasons of malice), so let’s focus on their approach to Laffer Curve issues. If the GOP is guilty of being too exuberant, the Democrats and their allies at the Joint Committee on Taxation (the bureaucracy on Capitol Hill that estimates the revenue impact of tax policy changes) are guilty of deliberate blindness. The current methodology used by the JCT (with the full support of the Democrats) is to assume that changes in tax policy – regardless of magnitude – have zero impact on economic performance. If you double tax rates, the JCT assumes the economy is unaffected and people earn just as much taxable income. If you replace the IRS with a flat tax, the JCT assumes there is no effect on macroeconomic performance. Sounds unbelievable, but this video has the gory details, including when my former boss, Senator Bob Packwood was told by JCT that revenues would rise year after year even if the government imposed a 100 percent tax rate.

Interestingly, the European Central Bank just released a new study showing that there are substantial Laffer Curve affects and that lower tax rates generate large amounts of revenue feedback. In a few cases (Sweden and Denmark), the researchers even conclude that some lower tax rates would be in that rare category of self-financing tax cuts. But the key point from this ultra-establishment institution is that changes in tax rates do lead to changes in taxable income. This means it is an empirical question to determine the revenue impact. Here’s a key excerpt from the study’s conclusion:

We show that there exist robust steady state Laffer curves for labor taxes as well as capital taxes. …EU-14 countries are much closer to the slippery slopes than the US. More precisely, we find that the US can increase tax revenues by 30% by raising labor taxes but only 6% by raising capital income taxes, while the same numbers for EU-14 are 8% and 1% respectively. …We find that for the US model 32% of a labor tax cut and 51% of a capital tax cut are self-financing in the steady state. In the EU-14 economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing. We therefore conclude that there rarely is a free lunch due to tax cuts. However, a substantial fraction of the lunch will be paid for by the efficiency gains in the economy due to tax cuts.

Contrary to over-enthusiastic Republicans and deliberately-dour Democrats, the Laffer Curve/supply-side economics debate is not a binary choice between self-financing tax cuts and zero-impact tax cuts. Yes, there are examples of each, but the real debate should focus on which types of tax reforms generate the most bang for the buck. In the 1980s, the GOP seems to have the right grasp of this issue, focusing on lowering tax rates and reducing the discriminatory tax bias against saving and investment. This approach generated meaningful results. As Nobel laureate Robert Lucas wrote, “The supply side economists, if that is the right term for those whose research we have been discussing, have delivered the largest genuinely free lunch that I have seen in 25 years of this business, and I believe we would be a better society if we followed their advice.”

But identifying and advocating pro-growth tax reforms, as Williamson notes, is just part of the battle. The real test of fiscal responsibility if controlling the size of government. Republicans miserably failed at this essential task during the Bush year. If they want to do the right thing for the nation, and if they want to avert a Greek-style fiscal collapse, they should devote most of their energies to reducing the burden of government spending.

Greece’s Problem Is High Tax Rates, Not Tax Evasion

The New York Times has an article describing widespread tax evasion in Greece, along with an implication that the country’s fiscal crisis is largely the result of unpaid taxes and could be mostly solved if taxpayers were more obedient to the state. This is grossly inaccurate. A quick look at the budget numbers reveals that tax revenues have remained relatively constant in recent years, consuming nearly 40 percent of GDP. The burden of government spending, by contrast, has jumped significantly and now exceeds 50 percent of Greek economic output.

The article also is flawed in assuming that harsher enforcement is the key to compliance. As this video shows, even the economists at the Paris-based Organization for Economic Cooperation and Development admit that tax evasion is driven by high tax rates (which is remarkable since the OECD is the international bureaucracy pushing for global tax rules to undermine tax competition and reduce fiscal sovereignty).

Ironically, the New York Times article quotes Friedrich Schneider of Johannes Kepler University in Austria, but only to provide an estimate of Greece’s shadow economy. The reporter should have looked at an article that Schneider wrote for the International Monetary Fund, which found that:

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy. …In Austria, the burden of direct taxes (including social security payments) has been the biggest influence on the growth of the shadow economy… Other studies show similar results for the Scandinavian countries, Germany, and the United States. In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points. …A study of Quebec City in Canada shows that people are highly mobile between the official and the shadow economy, and that as net wages in the official economy go up, they work less in the shadow economy. This study also emphasizes that where people perceive the tax rate as too high, an increase in the (marginal) tax rate will lead to a decrease in tax revenue.

It is worth noting the Schneider’s research also shows why Obama’s tax policy is very misguided. The President wants to boost the top tax rate by nearly five percentage points, and that’s on top of the big increase in the tax rate on saving and investment included in Obamacare. Based on Schneider’s research, we can expect America’s underground economy to expand.

Shifting back to Greece, Schneider does not claim that tax rates are the only factor determining compliance. But his research indicates that more onerous enforcement regimes are unlikely to put much of a dent in tax evasion unless accompanied by better tax policy (i.e., lower tax rates). Moreover, compliance also is undermined by the rampant corruption and incompetence of the Greek government, but that problem won’t be solved unless politicians reduce the size and scope of the public sector. Needless to say, that’s not very likely. So when I read some of the details in this excerpt from the New York Times, much of my sympathy is for taxpayers rather than the greedy politicians that turned Greece into a fiscal mess:

In the wealthy, northern suburbs of this city, where summer temperatures often hit the high 90s, just 324 residents checked the box on their tax returns admitting that they owned pools. So tax investigators studied satellite photos of the area — a sprawling collection of expensive villas tucked behind tall gates — and came back with a decidedly different number: 16,974 pools. That kind of wholesale lying about assets, and other eye-popping cases that are surfacing in the news media here, points to the staggering breadth of tax dodging that has long been a way of life here. …Such evasion has played a significant role in Greece’s debt crisis, and as the country struggles to get its financial house in order, it is going after tax cheats as never before. …To get more attentive care in the country’s national health system, Greeks routinely pay doctors cash on the side, a practice known as “fakelaki,” Greek for little envelope. And bribing government officials to grease the wheels of bureaucracy is so standard that people know the rates. They say, for instance, that 300 euros, about $400, will get you an emission inspection sticker. …Various studies have concluded that Greece’s shadow economy represented 20 to 30 percent of its gross domestic product. Friedrich Schneider, the chairman of the economics department at Johannes Kepler University of Linz, studies Europe’s shadow economies; he said that Greece’s was at 25 percent last year and estimated that it would rise to 25.2 percent in 2010.

Greek Chutzpah

There’s an old joke that if you owe a bank $10,000, you have a problem, but if you owe a bank $10,000,000, the bank has a problem. The Greek government certainly seems to have that attitude. Short-sighted and corrupt politicians in Athens have spent their nation into a fiscal ditch and they now want to mooch from both the IMF and other European nations (especially Germany). The German Prime Minister (if only for political reasons) is talking tough, saying that Greece should do more to reduce subsidies and handouts. Why should Germans work until age 67, after all, so Greeks can enjoy overpaid government jobs and retire at age 61? So what is the response from the Greeks? Amazingly, one of the politicians had the gall to say his nation “cannot accept” further wage cuts. Here’s an excerpt from the Daily Telegraph:

It is far from clear whether Athens will agree to further austerity as strikes hit the country day after day. Andreas Loverdos, Greece’s labour minister, said the EU-IMF team wants further wages cuts. “We cannot accept that.” Greece knows it can opt for default at any time, setting off an EMU-wide crisis and bringing down Europe’s banks. It also knows that key figures in the Bundestag favour debt restructuring. ‘Those who chased high yield by purchasing Greek debt must share the costs,’ said Volker Wissing, chair of Bundestag’s finance committee. Leo Dautzenberg from the Christian Democrats said banks should prepare for a `haircut’ of up to 50pc. The ECB, Brussels, and the IMF have been fighting feverishly to head off such a move, fearing a financial chain-reaction.

If the Germans have any brains and pride, they will tell the Greeks to go jump in a lake (other phrases come to mind, but this is a family-oriented blog). And if this means that German banks take a loss on their holdings of Greek government debt, there’s a silver lining to that dark cloud since it is time for financial institutions to realize that they should not be lending so much money to corrupt and wasteful governments.

Greetings from Spain

I arrived in Madrid yesterday for a speech to the annual Convention of Independent Financial Advisors, and it is somehow fitting that Spain was downgraded by Standard and Poor’s as I entered the country. I’m not a fan of the bond-rating agencies, and the fact that it has taken so long for Spain to be downgraded simply reinforces my skepticism about their value. So let’s focus instead on identifying the sources of Spain’s fiscal crisis. If you look at the OECD’s fiscal database, you will see that Spain’s short-run problem is solely the result of a growth in the burden of government spending. Over the past seven years, the budget in Spain has skyrocketed from 38.4 percent of GDP to 47.2 percent of GDP. And since tax revenues have stayed the same as a share of national economic output, it is difficult to see how anyone can conclude that the fiscal crisis is the result of inadequate revenue. In the long run, the problem also is excessive government spending, largely because demographic factors such as an aging population will push up outlays for pensions and health care.

In other words, Spain is in trouble for the same reason that Greece is in trouble. Government is too big and politicians are unwilling to take the modest steps that are needed to rein in dependency. This, of course, is exactly why there should not be a bailout. Subsidizing Greek politicians and Spanish politicians – regardless of whether the bailout comes from German taxpayers and/or the IMF – will send a signal to other European nations that there is an easy way out. But the “easy way out” simply postpones the day of reckoning and makes the eventual adjustment much more challenging. Here’s an excerpt from the Washington Post report:

European and International Monetary Fund officials on Wednesday were considering a dramatically increased $158 billion bailout package for Greece as the country’s debt crisis continued to ripple across Europe, with Standard & Poor’s downgrading the credit rating on Spain, the continent’s fourth-largest economy. …In Europe, the most intense focus remains on Greece, but fears were intensifying elsewhere, especially in Portugal and Spain. Though analysts noted that both countries are in better shape than Greece – with lower ratios of debt – they both shared large fiscal deficits and poor long-term economic prospects. On Wednesday, the government in Portugal announced that it would move up a program of painful spending cuts to shrink its budget deficit and shore up confidence amid signs that fearful depositors were moving capital out of Lisbon banks. After lowering Greek debt to junk bond status on Tuesday, Standard & Poor’s kept Spain at investment grade status, but lowered its rating one notch, to AA.

Don’t Give Up on the American People…at Least not Yet

Gloominess and despair are not uncommon traits among supporters of limited government – and with good reason. Government has grown rapidly in recent years and it is expected to get much bigger in the future. To make matters worse, it seems that the deck is stacked against reforms to restrain government. One problem is that 47 percent of Americans are exempt from paying income taxes, which presumably means they no longer have any incentive to resist big government. Mark Steyn recently wrote a very depressing column for National Review Online about this phenomenon, noting that, “By 2012, America could be holding the first federal election in which a majority of the population will be able to vote themselves more government lollipops paid for by the ever shrinking minority of the population still dumb enough to be net contributors to the federal treasury.” Walter Williams, meanwhile, has a new column speculating on whether this cripples the battle for freedom:

According to the Tax Policy Center, a Washington, D.C., research organization, nearly half of U.S. households will pay no federal income taxes for 2009…because their incomes are too low or they have higher income but credits, deductions and exemptions that relieve them of tax liability. This lack of income tax liability stands in stark contrast to the top 10 percent of earners, those households earning an average of $366,400 in 2006, who paid about 73 percent of federal income taxes. …Let’s not dwell on the fairness of such an arrangement for financing the activities of the federal government. Instead, let’s ask what kind of incentives and results such an arrangement produces and ask ourselves whether these results are good for our country. …Having 121 million Americans completely outside the federal income tax system, it’s like throwing chum to political sharks. These Americans become a natural spending constituency for big-spending politicians. After all, if you have no income tax liability, how much do you care about deficits, how much Congress spends and the level of taxation?

Steyn and Williams are right to worry, but the situation is not as grim as it seems for the simple reason that a good portion of the American people know the difference between right and wrong. Consider some of the recent polling data from Rasmussen, which found that “Sixty-six percent (66%) believe that America is overtaxed. Only 25% disagree. Lower income voters are more likely than others to believe the nation is overtaxed” and “75% of voters nationwide say the average American should pay no more than 20% of their income in taxes.” These numbers contradict the hypothesis that 47 percent of Americans (those that don’t pay income tax) are automatic supporters of class-warfare policy.

So why are the supposed free-riders not signing on to the Obama-Reid-Pelosi agenda? There are probably several reasons, including the fact that many Americans believe in upward mobility, so even if their incomes currently are too low to pay income tax, they aspire to earn more in the future and don’t want higher tax rates on the rich to serve as a barrier. I’m not a polling expert, but I also suspect there’s a moral component to these numbers. There’s no way to prove this assertion, but I am quite sure that the vast majority of hard-working Americans with modest incomes would never even contemplate breaking into a rich neighbor’s house and stealing the family jewelry. So it is perfectly logical that they wouldn’t support using the IRS as a middleman to do the same thing.

A few final tax observations:

The hostility to taxation also represents opposition to big government (at least in theory). Rasumssen also recently found that, “Just 23% of U.S. voters say they prefer a more active government with more services and higher taxes over one with fewer services and lower taxes. …Two-thirds (66%) of voters prefer a government with fewer services and lower taxes.”

There is a giant divide between the political elite and ordinary Americans. Rasmussen’s polling revealed that, “Eighty-one percent (81%) of Mainstream American voters believe the nation is overtaxed, while 74% of those in the Political Class disagree.”

Voters do not want a value-added tax or any other form of national sales tax. They are not against the idea as a theoretical concept, but they wisely recognize the politicians are greedy and untrustworthy. Rasumussen found that “just 26% of all voters think that it is even somewhat likely the government would cut income taxes after implementing a sales tax. Sixty-six percent (66%) believe it’s unlikely to happen.”

Fiscal restraint is a necessary precondition for any pro-growth tax reform. If given a choice between a flat tax, national sales tax, value-added tax, or the current system, many Americans want reform, but it is very difficult to have a good tax system if the burden of government spending is rising. Likewise, it would be very easy to have a good tax system if we had a federal government that was limited to the duties outlined in Article I, Section VIII, of the Constitution.

Republicans should never acquiesce to higher taxes. All these good numbers and optimistic findings are dependent on voters facing a clear choice between higher taxes and bigger government vs lower taxes and limited government. If Republicans inside the beltway get seduced into a “budget summit” where taxes are “on the table,” that creates a very unhealthy dynamic where voters instinctively try to protect themselves by supporting taxes on somebody else – and the so-called rich are the easiest target.

Last but not least, I can’t resist pointing out that I am part of a debate for U.S. News & World Report on the flat tax vs. the current system. For those of you who have an opinion on this matter, don’t hesitate to cast a vote.

Do Earmarks Crowd Out Local Private Investment?

The extent to which government spending either complements or crowds out private investment has long been one of the most heated debates in economics (and politics).  Generally economic theorists posit that an increase in government spending drives up interest rates, which increases the cost of private investment, accordingly reducing such investment.  Most macroeconomic models are build on this relationship. 

In an interesting new working paper, a trio of economists attack the question from a different angle.  They measure the impact of increased earmarks on the local economy receiving those earmarks, and compare the impact to areas not receiving the increased earmarks, which allows them to control for the overall macroeconomic environment.  Their finding: even in a setting where government spending is “free” to the recipients (but not free to the rest of us), such spending reduces private investment. 

More specifically, the authors examine what happens to a state when one of its senators becomes a chair of a powerful committee.  First, the obvious, upon taking a power chairmanship, the value of earmarks increase almost 50%.  This results in roughly a $200 million annual increase to the state.  But the authors find this is not simply a transfer from the rest of the country to the state, it also depresses private capital investment and R&D spending in the state.  On average, once a state has a senator obtain a powerful chairmanship, state level private investment in capital expenditures decreases $39 million annually and state private R&D decreases $34 million annually. 

For states seeking to get your senator into a powerful chairmanship:  be careful of what you wish for.  There’s no free lunch, even when someone else is paying.

Cutting Government Spending in a Recession

One of the topics Chris Edwards will be discussing with Glenn Beck this evening (5:00 EST, Fox) is the “Not-So-Great Depression” of 1920-21.

Cato Senior Fellow Jim Powell notes that President Warren G. Harding inherited from his predecessor Woodrow Wilson “a post–World War I depression that was almost as severe, from peak to trough, as the Great Contraction from 1929 to 1933 that FDR would later inherit.”

However, instead of calling for bigger government to right the economy, as President Obama did upon inheriting George Bush’s mess, Harding pushed for spending and tax cuts.

The result?

With Harding’s tax and spending cuts and relatively non-interventionist economic policy, GNP rebounded to $74.1 billion in 1922. The number of unemployed fell to 2.8 million— a reported 6.7 percent of the labor force— in 1922. So, just a year and a half after Harding became president, the Roaring Twenties were underway. The unemployment rate continued to decline, reaching an extraordinary low of 1.8 percent in 1926. Since then, the unemployment rate has been lower only once in wartime (1944), and never in peacetime.

The following chart shows federal spending from 1920 to 1940: