Spending, Taxation, and the Fiscal Cliff-Becker

A front page article today in the New York Times points out that around 1990 the Republican Party shifted away from an emphasis on balancing the federal budget to an emphasis on the level of taxes. I believe that this shift was in the right direction, and it is highly relevant in understanding the Republicans’ position on what to do to prevent the so-called “fiscal cliff” in 2013.

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.

 

 

Comments

[jim kirby]

Why do you fail to mention the best candidate for elimination among the "tax expenditures"--- the deduction for employee health insurance? The effect of the deduction is that a high-earning employee pays 40 cents for $1 worth of insurance, which pays for medical treatment that costs the uninsured some $2.

Why should health insurance be favored over food and housing, which are more essential to welfare?

[rjs]

both emphasis on balancing the federal budget and an emphasis on the level of taxes are running a modern fiat currency monetary system as if you were still on the gold standard...

neither balance or taxes are necessary...in fact we need greater deficits, because there is a shortage of safe government bonds adequate for the funtioning of the financial system...

[James Walker]

Becker states: "The level of taxation ultimately determines the size of government since no government can continue to spend substantially more than its revenues." This is politically naive. Both the Reagan Administration and the George W Bush administration cut tax rates and increased spending, Reagan through the arms build-up and for Bush, the Iraq war and the unfunded Medicare prescription drug benefit program. Both resulted in massive deficits. But during the Clinton Administration taxes were raised and spending constrained resulting in surpluses by 2000. In the long-run the federal government must have a balance of constrained spending with recognized priorities along with an effective tax policy that funds those government priorities.

[Terry Bennett]

I react to the same sentence James picked out. "Ultimately" might not arrive in my lifetime. The level of taxation, in the short run, is having no effect whatsoever on the size of government. Cheney's assertion that "deficits don't matter" has to be false in the long run - deficits will matter someday, to somebody, but not to Cheney.

I did logistical consulting for some midsize product-based businesses years ago, and I remember the bank would call every week to demand reports of what stock was in the warehouse, to be sure it was adequate protection for their line of credit. During the housing bubble, banks did no such thing. During the "U.S. government" bubble, currently in progress, nobody seems to care where the money to pay it back is going to come from. In that sense, the lenders who are enabling us will rightly bear some of the blame if and when our reckoning ever comes.

[Jdwalton]

#jim kirby -- kudos -- your point brought up in this morning's (12/26/12) NYTimes.

It's nigh unto impossible for the Federal Government to achieve the personal income tax revenues estimated by the White House for 2015, 2016 and 2017 without broadening the tax base, or increasing the top marginal tax rates to the levels recently imposed in France.

Meanwhile, the White House estimates that debt service costs will exceed defense spending in 2017. That's a wonderful situation to impose upon our children and grand-children. Linked here:http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/hist.pdf

[Christopher Graves]

I completely agree with Professor Becker's view that the key problem that we are facing in regard to the budget is overspending and the high levels of taxation that facilitate the overspending. Judge Posner's analysis is entirely too Keynesian and, therefore, wrong.

But I believe that it would be best if we would all hold hands and go over the Fiscal Cliff together. Doing so would not be without its drawbacks, but it would serve a number of purposes.

First, it would force American foreign policy-makers to reassess the mission of the military. A less interventionist foreign policy would allow us to realize enormous savings at the same time that we scale back the role of the U.S. in the world so that other peoples can sort out their disputes, their own institutions, their own policies in their own way. It would also lessen the "blow-back" of those who feel threatened or aggrieved by our interventions. Deep cuts in the military budget would also lessen the role of the central government here in the United States that particularly has a hold on the right. The American liberal left has used the military budget as a crucial bargaining chip in budget deals that have increased not only military spending but social welfare spending over the years.

Second, given the results of the last election, this might be the only way to cut the increase in spending in any meaningful way.

Third, as taxes go up for us all, political pressure is more likely to arise that leads to real tax reform that lowers tax rates across the board or forces people to recognize the true cost of Federal spending on popular social welfare programs as higher taxes shift at least some of their costs to the current generations.