Taxes and Spending

A short history lesson - during the 1970s when we had very short business cycles between boom and bust, it was noticed that government would raise taxes during the bad times to make up for lost revenue. Once the economy picked up again and the tax base recovered, government would use the additional revenue to grow further. The cycle would repeat with each economic cycle leading to ever-expanding government. This lead conservatives to adopt "starve the beast" policies. Instead of having ever-expanding taxes and government, taxes would be cut forcing government cuts.

This began in California with a taxpayers revolt best remembered for passing Proposition 13 which rolled back property taxes.

When Reagan became president he implemented a version of Starve the Beast - tax cuts accompanied by spending cuts. At the time Democrats insisted that the cuts were excessive but they mainly cut increases in spending. Democrats were still deriding Republican budget cuts in the 2000 election which led to Bush (43)'s "compassionate conservatism" which amounted to tax cuts without accompanying spending cuts.

The deficit under Reagan grew during the middle of his presidency and was shrinking again by the end. Under Bush, the deficit always grew.

Government today is much larger than when Reagan took office leading some people to declare Starve the Beast a failure. Fromma Harrop recently wrote an interesting column in which she proposed shrinking government by raising taxes. Basically, she is proposing a pay-as-you-go government in which taxes would be high enough to cover all spending. This would cause voters to reevaluate government services since they would be paying for them directly instead of borrowing to pay for them.

There is a certain logic to this. Currently the federal government borrows $0.41 out of every dollar spent. If we gave people the choice between major cuts or raising taxes 67% there would be a lot of cuts.

Unfortunately, Harrop undercuts her argument in several places. The first is how she characterized the Reagan administration:

"Well, if you've got a kid that's extravagant, you can lecture him all you want to about his extravagance," Reagan said in his 1980 campaign. "Or you can cut his allowance and achieve the same end much quicker."

No one turned the starving-beast theory into baloney faster than Reagan, who followed his tax cuts with a spending binge fueled by massive borrowing. What he did, in effect, was cut the extravagant kid's allowance and then hand him 10 credit cards.

This totally misstates Reagan's record. Government spending in real terms spiked around 1983 when the Reagan cuts went into effect. They then declined through the rest of Reagan's presidency. See this chart based on numbers form the CBO.

Harrop also ignores the Democrats' role in spending. They controlled one or both houses of Congress continuously until 1995 (they won both houses in the 1994 election). During all of those years, spending was always higher than revenue although the two came close during the Ford administration. Harrop also ignores the fact that the biggest and fastest-growing outlays in the budget are for Medicare and Medicaid - two entitlements passed by Democrats.

Harrop totally undercuts her argument in a couple of other places.

Are Democrats equally to blame? No. Deficit spending is warranted during an economic crisis. (By the way, their new health-care initiative was fully paid for.) What worries fiscal conservatives most about Democrats is that they might lack the guts to do what must be done, which is raise taxes.

This only makes sense if the Democrats suddenly sprang to life in 2008 with no history behind them. She also blithely ignores the budget trickery that went into the "fully paid for" health care initiative.

That's one place where the "raise taxes to shrink government" argument breaks down. Congress used shameless trickery to produce numbers that made health care seem to be paid for. Even if their figures were honest and accurate, they still delayed implementation of the most expensive parts of health care for years in order to offset the cost. Other parts were pushed to the states and not accounted for in the federal budget.

Does anyone really think that Obama and the Democrats would be willing raise taxes but forgo further spending? Simply requiring that extended unemployment benefits should be paid for from repaid TARP funds instead of through debt was unacceptable to them.

Then there is the question of where these increased taxes should come from. Any tax that caused pressure to reduce government would need to cover most of the population. Right now, slightly less than half of the population pays income tax. You could double the income tax and half the population would be unaffected. More likely, the Democrats would choose some arbitrary point and say that everyone above that made too much and should shoulder the entire increased tax burden.

This leads to another iron law of economics - the higher the taxes, the more effort people spend in avoiding taxes. Prior to Reagan, tax shelters (investments that were either untaxed or taxed at a lower rate) were a big business but this collapsed after Reagan lowered the tax rate.

While it is interesting, the idea of raising taxes to shrink government could only happen with major institutional changes - possibly a balanced budget amendment. Without that, increasing taxes would only led to increased spending.