Tax Cuts or Spending Cuts: Part 2

In Part 1 I explained that fiscal conservatives no longer can rely on tax cuts to save us from big government. I noted specifically that libertarians who want to eliminate the income tax as part of such tax cuts, are missing the point entirely. Using state-level data I pointed out that states without an income tax show no sign of having smaller governments than states with an income tax.

In short: tax cuts no longer work as a means to contain government growth. They also do not help with balancing government finances. Government is simply too big.

Supply-side economics doesn’t work anymore. Only an ideologically principled, theoretically consistent and morally sound welfare-state reform effort can make the difference. There is compelling data to make this point, but first, let us take a look at the theory behind the demise of supply-side economics.

The blue, solid line in Figure 1 represents government spending, growing at a steady pace (hence the modest upward slope). Tax revenue is represented by the solid red line. A supply-side oriented tax cut initially depresses tax revenue, but as the economy starts growing faster under lower tax rates, revenue picks up at a faster pace. Eventually, revenue collection surpasses government spending and government runs a surplus:

Figure 1: The theory behind supply-side tax cuts

There is nothing wrong with the theory behind the red, solid function, quite the contrary. It has good empirical support from previous tax-cut reforms. The problem lies instead on the spending side: consider a slightly higher growth rate in government spending, as per the dashed blue line. When government grows faster, its depressing effect on government spending kicks in earlier than it otherwise would.

Specifically, there is the 40-percent threshold where four out of ten dollars in the economy runs through government. I discussed this point in my book Industrial Poverty, where I presented evidence by me as well as others on how this threshold works. Once government occupies more than 40 percent of GDP, there is a permanent slowdown in economic growth.

Once this happens, it becomes harder for the private sector to put a tax cut to good use. Bluntly, there will be less growth from every dollar’s worth of tax reductions. Hence the dashed red line.

Once the solid lines in Figure 1 become dashed, tax cuts no longer work. It is futile to spend political energy and efforts on those; we should still oppose tax hikes, but the reform efforts must be allocated to the spending side.

As a reinforcement of this point, consider Figure 2. It reports the growth in $100 worth of, respectively, total government spending and current-price GDP for the U.S. economy. For every $100 we spent through government in 1954, we spent more than $7,500 in 2019; over the same period of time, $100 worth of GDP grew into $5,000.

Government outpaced its own tax base by $1.50 to $1:

Figure 2: Growth in government spending relative GDP

Source of raw data: Bureau of Economic Analysis

The growth of government is stunning in itself, as are its causes. Consider Figure 3, where we also pinpoint how the size of government (relative GDP) has become increasingly immune to supply-side tax cuts. To highlight the relationship between federal tax cuts and the size of government, we now disregard states and local governments and focus solely on the spending that Congress has jurisdiction over:

Figure 3: Cycles in federal government spending

Source of raw data: Bureau of Economic Analysis

President Kennedy worked with Congress on the lowering of federal income taxes (1). It is hard to identify any clear downward trend, the reason being in part that defense spending at this time constituted almost 50 percent of the federal budget. That spending tends to be entirely immune to the ups and downs of the economy; at this time it was slowly being ramped up for the purposes of the Vietnam War.

Nevertheless, it is worth noting that the Kennedy tax cuts were indeed followed by a strong growth episode in the U.S. economy, one we would not see the like of until the 1990s. Unfortunately, the relatively modest size of the federal budget under JFK was replaced by a steady climb under President Johnson (2). Launching his War on Poverty, LBJ led the transformation of the American welfare state from socially conservative to redistributive socialist. New entitlement programs, built around a new, relative definition of poverty, permanently expanded the federal government. What had been a budget equal to 17-18 percent of GDP became a fiscal conglomerate equal to 22 percent and more.

It was not just the federal government that expanded. State spending grew even faster, as they became responsible for running a good part of the new programs that Congress put in place under the auspices of fighting poverty. With the rapidly expanding weight of government on the economy, growth slowed down and taxes depressed both entrepreneurship and career development.

In response, President Reagan spearheaded major tax reforms that rejuvenated the U.S. economy. Growth picked up and the private sector gained back some ground lost to government (3). The architect behind the supply-side strategy, Art Laffer, was proven correct on all points except one: the federal budget deficit did not vanish.

This was a sticking point that supply siders never quite addressed. It was not their theory in itself that was wrong; it was its omission of the spending side. Notably, it took a fiscally conservative Democrat in the White House to shed light on the importance of the spending side: working with fiscally conservative Republicans, President Clinton significantly tightened the belt on the federal budget, not to a point where he shrunk it, but by significantly reining in its growth (4).

With an economy growing in excess of four percent, Clinton was able to sign four budgets with a surplus. However, despite a reasonably good welfare-reform bill, known by its PRWORA acronym, he did not do much to turn the long-term tide of the welfare state. On the contrary, when he signed SCHIP into law he added a big spending program that later became a driver in Medicaid costs.

Once again, a Republican took the leadership on the tax side of the budget. With two tax cuts, one in 2001 and one in 2003, President Bush Jr. tried to counter the Millennium recession by repeating the Reagan supply-side success. It worked to some degree: while the economy revved back up again and tax revenue with it, non-military spending increased at about 6.5 percent per year. The welfare state almost outpaced tax revenue.

Not quite, though. If the economy had not gone into the Great Recession in late 2008, the federal budget would have been in balance by 2009. For sure, that was six years after the second Bush tax cut, but it was en route to happen.

Does this mean that supply-side economics worked under Bush? Modestly. It showed that it could still deliver good government finances under the best possible economic conditions. The problem is that last part: best possible conditions. A recession was all it took to throw the federal budget back in the hole again (5). For sure, President Obama and the Democrats recklessly increased government spending in the first couple of years of his presidency, but once the Republicans took back the House a fiscal standoff between Congress and the White House actually led to a de-facto practice of fiscal responsibility.

With Trump in the White House, Republicans tried for a third time to put supply-side theory to good use. Its positive effects, which were visible in the economy all the way up to the artificial economic shutdown in 2020, were too modest to bring about three percent annual economic growth. They also failed to make a dent in the budget deficit.

The reason is painfully obvious: government spending has weakened the transmission mechanisms that generate economic growth. The welfare state has eroded the incentives that drive employment, innovation, investments and entrepreneurship. It has not destroyed them, but it has worn them down to a point where we get much less growth out of every $100 worth of tax cuts than we did under Kennedy, or even Reagan.

Figures 2 and 3 tell us that the size of government is immune to tax cuts. What it does not tell us is how that size has remained comparatively stable since the 1970s thanks only to growing budget deficits.

A coming article will discuss tax hikes – and why they are a thoroughly bad idea. First, though, in Part 3 we look at what would have happened if we had tried to end the deficits by means of a Penny Plan.

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