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Do More Revenues Lead to More or Less Spending?

by Matt Mitchell on August 5, 2011

in Tax and Budget

This, I think, is (literally) the trillion dollar question.

As you can see from the animated chart below, ours really is a spending problem in the sense that revenue is set to remain fairly constant while non-interest spending is set to skyrocket.  That, in turn, causes interest payments to skyrocket, adding to the amount we spend and causing the whole thing to go to…you get the drift.

One hopes that at least some of the members of the Super-Committee recognize this. If so, they will draw a hard line in the sand demanding meaningful spending reforms in the entitlement programs that are at the heart of the long-term problem.

But a question remains: should they also draw a hard line in the sand against any and all revenue increases?  I believe this question turns on the one above: do more revenues lead to more spending?

If the answer is yes, then a hard line in the sand against revenue increases may be warranted.  But if the answer is no, then negotiators would be wise to focus all of their energies on reforming entitlement spending and should perhaps be willing to give some ground on revenue if it buys more support for spending cuts.  Interestingly, there are good “free market” economists on both sides of this debate.

Milton Friedman exemplifies the view that more revenue will only encourage more spending (see “The Limitations of Tax Limitation,” 1978; I wasn’t able to find a link).  Those who subscribe to his view may point to Reagan’s 1982 “TEFRA” deal with Democrats.  The president agreed to raise some tax revenue, mostly by closing loopholes, in exchange for spending cuts.  But, say critics, the tax increases materialized while the spending cuts never did.

On the other hand, James Buchanan, another Nobel-laureate with free market bona fides, takes the opposite view.  He argues that the ability to deficit spend biases policy makers to favor more spending.  He believes that if you make policy makers charge current taxpayers for what they spend, the current taxpayers will demand less spending.  Ironically, this leads to the conclusion that revenue increases will lead to less spending.  Advocates of this view might point to the 1990s.  Then, revenues as a share of GDP rose while spending as a share of GDP actually fell for the first time in post-WWII history.

As an empirical matter, I don’t think this is settled.  James Payne (2003) has studied the issue at the state level and has concluded that, at least in a plurality of states, spending does seem to respond to revenue, corroborating the Friedman view.  Thus, he concludes that, “any policy to reduce budget deficits via revenues may not result in deficit reduction.”

On the other hand, Andrew Young has studied the matter at the federal level and concludes:

Perhaps counter-intuitively, the findings suggest that tax increases—even temporary—may serve to decrease expenditures by forcing the public to reckon with the cost of government spending.  The findings suggest that the electorate has to be clearly presented with the bill to recognize the cost of government, rather than being allowed to run up a tab.

It makes some sense that the Friedman view would be corroborated at the state level while the Buchanan view would hold at the federal level.  Most states have an obligation to balance their books (more or less), while the Feds have no obligation whatsoever.  Thus, current state taxpayers tend to be the ones to pay for current state spending while current federal taxpayers can more-easily foist their costs onto the next generation.

If you do subscribe to the Buchanan view, what sort of revenue increases should be on the table?  The answer is almost certainly not rate increases on those who are current taxpayers.  They, presumably, are already resistant to more spending (we also know that these are the most inefficient sorts of tax increases).  Instead, revenue increases ought to be focused on closing loopholes and broadening the tax base (about half of all Americans have no income tax liability).  In a new Mercatus working paper, economists Jody Lipford and Bruce Yandle examine what happens to spending when large numbers of Americans have little or no income tax liability, leaving the rest (and future generations) to pick up the tab.

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Update: Josh Barro rightly noted that large numbers of Americans don’t have an income tax liability; they still pay other taxes including payroll taxes.

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