Tax Cuts or Spending Cuts: Part 1

There are some very good organizations out there fighting to keep taxes down. Americans for Tax Reform is at the forefront, with others not far behind. They all fight the good fight: it is always preferable to have lower taxes than higher taxes.

Many economists propose tax cuts as a way to reduce the budget deficit. The idea, known as supply-side economics, is based on the premise that lower taxes generate stronger economic growth, which in turn generates more tax revenue.

Supply side economics is a valid theory and the Laffer Curve – almost the hallmark of supply-side theory – has strong empirical support. I recently published an article where I reported data for the European economy, showing a solid Laffer effect on tax revenue. However, I also cautioned:

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

Once the welfare state grows past a certain point, the Laffer effect, while still visible, will be far too weak to close deficit gaps. Plain and simple, the supply-side mechanism ceases to function insofar as the government budget goes. Tax cuts still generate more economic growth and thereby an increase in tax revenue, but without adequately affecting the government budget.

The reason is as simple as it is brutal: too much spending. Having grown increasingly frustrated with the lack of focused attention to the spending side among libertarians and conservatives, in the next few days I will be rolling out a series of articles on the dynamics between tax cuts and spending cuts.

While fiscal conservatives do pay attention to spending, it is almost always in an ad-hoc manner. A common idea for reform is a penny-plan style reform that slows the growth of government spending. This is not a bad idea in and of itself, but as we will see in a coming article it does not solve the underlying structural problems that drive government spending. A penny-plan style spending reform buys us time, slowing the growth of government enough to let Congress piece together a major entitlement reform agenda.

What we need is a master plan for the structural overhaul of our welfare state. We need to reform it away until government is out of the business of economic redistribution.

This is no easy task. It is in fact more daunting than it was back in the 1960s putting the first man on the moon. That, however, is no excuse not to do it. Leaving an unaffordable welfare state for our children to pay for, and asking them to do so while also funding our consumption of the welfare state in the form of a big government debt, is nothing short of collective egoism.

It is also a safe way to ruin the country and the future of generations of Americans.

To see why the master plan is the way to go, and supply-side economics no longer works, we will work our way through a stack of data. We start today with a review of state and local government finances. Specifically, the review will show that the absence of an income tax does not help in terms of containing government spending. Bluntly: states with no income tax have just as big governments as states where income taxes provide a large share of government revenue.

As a first step, Figure 1 reports the combined fiscal balance for general revenue and expenditure for 2018 in all the 50 states. The vertical axis represents the difference between general revenue and general spending as percent of general revenue. This metric varies from year to year, with the majority of states swinging between surplus and deficit. However, the picture is almost always mixed, as reported here:

Figure 1: State and local government fiscal balances

Source of raw data: Census Bureau

Over the long term, states and local governments have had about the same problem with balancing their books as the federal government has. The deficit problem is not as pervasive, but there are years when almost all of them run deficits.

It is important to remember that these numbers include both states and local governments; the local-government share of spending varies significantly across state lines. In other words, to ignore local governments would be to give an unfair, even skewed representation of the role of government in our states’ economies.

Most of our government spending is allocated to the welfare state, i.e., programs that provide government benefits to people for the purposes of economic redistribution.* Two thirds of federal spending is for the welfare state; in 2018 the average for states and local governments was 56 percent. This share has increased over time, slowly increasing the stress on government finances. A spending program for economic redistribution is driven not by what taxpayers can afford, but by the definition of the entitlement embedded in the program. Medicaid, e.g., provides health care to its enrollees, giving them access to a portfolio of medical services the quality of which is defined by medical technology, and the quantity by patient health conditions.

I have discussed the discrepancy between health-care costs and tax revenue in a previous article. The same principle of independent cost hikes applies to education, income-security programs, housing and everything else provided under the welfare state.

This point is almost universally overlooked in the fiscal-conservative movement. Too much focus is no tax reform, specifically to keep taxes as low as possible. While, again, a respectable ambition in itself, it does not help with containing the growth of government. For example, if a state eliminates its income tax, it will most certainly not reduce the size of its government. Again based on 2018 Census Bureau data on state and local government finances,

-In the nine states where the personal income tax contributes 0-1 percent of total revenue, government spending amounted to 21.9 percent of total private-sector economic activity, a.k.a., private-sector GDP;

-In the 12 states where the personal income tax provided more than 15 percent of total revenue, government spending was equal to 21.2 percent of private-sector GDP.

The 29 states in between had roughly similar-sized governments. In other words, it does not help fiscal conservatism to abolish the personal income tax.

But does it harm fiscal conservatism to do so? That question is not primarily a matter of economic analysis, but there is one point that can contribute to the answer. Table 1 reports the revenue share of the personal income tax (Typ) and the revenue share from non-tax sources:

Table 1: Government revenue sources

Source of raw data: Census Bureau

In short: when governments cannot rely on the income tax they seek out other revenue sources instead. To take one of the favorite examples among opponents to the income tax, in 2018 government in Wyoming got 75 percent of its revenue from non-tax sources. This is the highest share in the country. Contrast this to Connecticut, where the personal income tax provided 22.3 percent of total government revenue and non-tax sources added one third of total revenue.

Government spending as share of private-sector GDP was 16.6 percent in Connecticut – and 29.9 percent in Wyoming. In other words, the supposedly low-taxed Cowboy State has the fourth largest government in the country. And this is a reasonably generous measure: if we use private personal income instead – the most proper tax base measure available – Wyoming has consistently ranked in the top two in the country.

However, more important than these factoids is the problem with political effort. It takes a lot of work to advance policy reform – spending of political influence capital – which means that every such effort must be designed to yield the best possible outcome. If we use proper metrics for that outcome (rolling back the welfare state) then it is unquestionably better to focus on spending reform instead of tax reform.

In Part 2 of this series we take a detailed look at why supply-side tax cuts are no longer effective, and why spending reform is the only way forward.


*) This category of spending includes social programs, income maintenance, health care, unemployment benefits, housing and community development and education. The last item is often overlooked, but regardless of whether or not one defines education as an essential government service, it does belong in the redistribution category. Government provides the service based on criteria defined by government, not decisions made by individuals; funding is also independent of the use of the service.

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