Supporters of a balanced budget approach to fiscal policy want federal spending and revenue to be about equal to each other in the long run. This means that any long-term growth in the deficit and in the public debt should be less than the growth in GDP. By contrast, the level of taxation approach emphasizes that the levels of federal spending and taxation are the primary determinants of the effects of the federal government on the economy, including incentives to work hard, invest, and start businesses.
The level of taxation ultimately determines the size of government since no government can continue to spend substantially more than its revenues. Greater government spending may help stimulate an economy coming out of a major recession, although the absence of any clear stimulus to the economy from the Obama stimulus package raises serious questions about the ease of stimulating an economy with fiscal policy. However, the level of federal government spending also has major direct effects on an economy, such as through spending on medical care, defense, and subsidizing the production of ethanol. Greater government spending also tends to crowd out spending by the private sector on consumption and investments.
Concern about the size of federal spending is particularly relevant at this juncture since federal spending has grown substantially during the past 10 years, especially rapidly during the past four years. In 2007, federal spending was under 20% of GDP, while it rose to over 24% of GDP in 2012. Less than half of this increased spending has been due to the growth in government spending on medical care, social security, and defense, while the rest is the result of increased spending on many other programs. Since greater government spending is also the cause of most of the growth in budget deficits, even those who target budget deficits, let alone those who target total taxation and spending, might well expect most of the reduction in deficits would come from spending cuts (spread out over time) rather than from higher tax rates.
Concentration on the level and nature of taxation implies support for widening the tax base through cutbacks in various unjustified exemptions and deductions from taxable incomes. Many special treatments of particular incomes should just be eliminated. The two most important deductions from taxable income are interest on mortgages and charitable contributions. Deductions of interest on mortgages are hard to justify from an efficiency standpoint, while the case for deductions for charitable contributions is stronger. Still,probably a cap on total deductions would be the best way politically to limit deductions. Such a cap would mainly hit higher income persons, and would raise the effective marginal tax rate for some taxpayers, but it would generally improve efficiency in the economy’s use of resources.
Many commentators have questioned how Republican members of the House could fail to support Representative John Boehner’s “Plan B” that would raise tax rates only on incomes over $1 million. I agree that the suggested tax increase on such a small fraction of taxpayers is unlikely to have much of a negative effect on the economy. But by the same token, President Obama’s compromise suggestion to raise tax rates only on incomes above $400,000 will also raise little additional tax revenue. This explains why the president also wants to raise taxes on dividends, capital gains, and estates, and reduce deductions.
The president is clearly in the political driver’s seat after winning reelection in a major victory. In the end he will probably get something much closer to what he wants than what Republicans in Congress want to offer. However, this does not mean that a position that wants major cutbacks in government spending and opposes increases in taxation that are not due to tax reforms, is a sign of intransigence rather than a thought-through opposition to larger government and bigger taxes.