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Lower Taxes Lead to Bigger Government

November 28, 2010 Leave a comment

Small government advocates need to make a choice. Do they prefer lowering taxes or reducing the size of government? Confronting the common myth, Bruce Bartlett explains cutting taxes does not “starve the beast.”

When Bush took office in January 2001, we were already well into fiscal year 2001, which began on Oct. 1, 2000. He immediately pushed for a huge tax cut, which Congress enacted. In 2002 and 2003, Bush demanded still more tax cuts, even as the economy showed no signs of having been stimulated by his previous tax cuts. The tax cuts and the slow economy caused revenues to evaporate. By 2004, they were down to 16.1 percent of GDP. The postwar average is about 18.5 percent of GDP.

Spending did not fall in response to the STB [starve the beast] decimation of federal revenues; in fact, spending rose from 18.2 percent of GDP in 2001 to 19.6 percent in 2004, and would continue to rise to 20.7 percent of GDP in 2008. Insofar as the Bush administration was a test of STB, the evidence clearly shows not only that the theory doesn’t work at all, but is in fact perverse. (my emphasis)

When tax cutters decouple spending and taxes they artificially decrease the cost of government services and consequently increase the demand for those services. That is why I favor linking specific taxes to corresponding spending programs that need more constraint. For example, I’ve argued that a VAT tied to healthcare spending would be the most effective way of controlling costs. Additionally, policies like PAYGO attempt to ensure the cost of government programs will be accurate. The Republican Party – a party dedicated to cutting taxes, not small government – wants to replace that with CUTGO, which should upset anyone that actually cares about the deficit. How do “small government conservatives” expect citizens to vote for fewer services if they don’t feel like they’re even paying for them? I don’t know many people that turn down “free” benefits.

The more directly people experience the cost for a service the less they’ll demand it (unless they feel it’s truly worth it). This is why Milton Friedman allegedly came to regret helping create the income tax withholding system. Here’s Austrian/libertarian thinker Murray Rothbard,

One of Friedman’s most disastrous deeds was the important role he proudly played, during World War II in the Treasury Department, in foisting upon the suffering American public the system of the withholding tax. Before World War II, when income tax rates were far lower than now, there was no withholding system; everyone paid his annual bill in one lump sum, on March 15. It is obvious that under this system, the Internal Revenue Service could never hope to extract the entire annual sum, at current confiscatory rates, from the mass of the working population. The whole ghastly system would have happily broken down long before this. Only the Friedmanite withholding tax has permitted the government to use every employer as an unpaid tax collector, extracting the tax quietly and silently from each paycheck. In many ways, we have Milton Friedman to thank for the present monster Leviathan State in America. (my emphasis)

So the best way to get smaller government might just be to increase taxes so they reflect the true cost of programs. It’s possible if people are getting beneficial services they might just be willing to pay more for them – but in a democracy people get what they vote for: if we choose to pay for something it’s harder to argue we shouldn’t have it. At least we wouldn’t be running unsustainable deficits or passing off the cost of our benefits to others.

Tax cutting ideologues need to understand that if you cut taxes without cutting a corresponding amount of spending that doesn’t permanently lower taxes, it shifts them to the future. Just as if I purchase a $200 TV but only have $100 in my checking account, I still owe another hundred bucks – I’ll just have to raise that money later and then pay back whoever I borrowed the initial money from. Low taxes now with high spending just results in higher taxes later. If you want low taxes and small government, you need to cut spending first. Only when our “cost of living” is lower can we afford to lower our income.

Small government advocates must confront reality: making government seem cheaper will never convince Americans to choose less of it.

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Categories: Bruce Bartlett, VAT Tags: ,

Taxplomacy

September 21, 2010 15 comments

You’ve all heard the cliche enough times used in international diplomacy: “All options are on the table.”  Of course, that’s code for the military option or even the nuclear option. Here, I want to use that metaphor to discuss our current debate about tax policy. Since the previous administration and legislature wrote into law that the “Bush tax cuts” must expire, we’re now faced with the predicament that lots of taxes will be raised amidst an anemic economy if something isn’t done, but if we extend them the deficit problem will be even worse. The locus of the debate or, if you will, the options on the table seem to be that we do nothing and let all the tax cuts expire, extend all the tax cuts, extend all but those for the wealthiest taxpayers, or compromise by extending the tax cuts for only 2 years.

The argument for extending all the tax cuts is pretty simple. Raising taxes now during a weak economy is going to make the economy worse, not better. Cato’s Jeff Miron wants to see them extended permanently.

Extending the Bush tax cuts — permanently — is a crucial step in restoring economic growth. The Bush cuts provided lower taxes on ordinary income, especially for taxpayers at the high end of the income distribution. These are some of the most energetic and productive people in society; raising tax rates would discourage their effort and entrepreneurship. High-income taxpayers also have multiple ways of avoiding high tax rates, so any revenue gain from raising rates would be modest.

Alan Viard of AEI likes them all too.

The figure shows the increases that will occur in marginal tax rates at the top income levels if the high-income rate reductions (including the dividend tax cut) expire. Beginning in 2011, the top income-tax bracket for wages and self-employment income, and for ordinary investment income, would revert from 35 to 39.6 percent; wages and self-employment income would continue to face an additional 2.9 percent Medicare tax. The top capital-gains tax rate would revert from 15 to 20 percent. Dividends would lose their current 15 percent tax rate and become taxable as ordinary income, subject to the new 39.6 percent rate. All four categories of income would also face a 1.2 percent stealth-tax-rate increase, from the restoration of a provision that phases out itemized deductions at high income levels. Figure 1

Economists left of center like Paul Krugman think that extending the top-rate tax increases is not worth the $700 billion price tag (sounds hypocritical but it’s well reasoned).

Now, consider first what would happen if we extend the [high-end] tax cuts for the next 10 years. This would add $700 billion to the debt (pdf). If the rich spread their windfall evenly across the decade, that’s $70 billion a year in additional consumer spending — or $140 billion during the period when we need it. So, $700 billion in deficits for $140 billion in stimulus; not a good bargain!


Alternatively, suppose we extend the tax cuts for only 2 years. That’s only $140 billion on the deficit. But the rich, knowing that it’s temporary, won’t spend much of it — if they really operate on a 10-year horizon, they’ll spend only $14 billion a year more, so $28 billion of stimulus when we need it, in return for $140 billion of debt; still a lousy bargain! 

Just for the record, it’s not like the rich wouldn’t get a tax cut under the Democrat’s proposal.

That’s because of how marginal tax rates work. For a good discussion on that go here.

Most famously President Obama’s former OMB director, Peter Orszag wants to extend all the tax cuts for 2 years, then let them all expire.

In the face of the dueling deficits, the best approach is a compromise: extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now. Getting a deal in Congress, though, may require keeping the high-income tax cuts, too. And that would still be worth it.

In a great piece, Bruce Bartlett explains why the Bush tax cuts were inefficient, of little benefit, and harmful to the debt, but acknowledges that during this recession recovery economy it’s probably best we just extend them. 

Subsequent research by Federal Reserve economists has found little, if any, impact on growth from the 2003 tax cut. The main effect was to raise dividend payouts. But companies cut back on share repurchases by a similar amount, suggesting that only the form of payouts changed. (See herehere, and here.) Moreover, according to a study by Steven Bank of the UCLA law school, the fact that the dividend tax cut was temporary was a key motivation for higher dividend payouts; had the dividend tax cut been permanent, as the supply-siders favored, the impact probably would have been much less.

Maybe the answer is obvious (politics) but I’m not sure why these are the only options on the table. Can’t we extend the table? The nuclear option doesn’t even seem to be an option right now. But now may be the perfect time to blow up the tax code and put a new one in place. Here’s the diplomatic stick for the Administration to use: “Let’s put in a simpler, better tax code or all the tax cuts are going to expire and opponents will be responsible for raising taxes on Americans at the worst possible time.” There’s a carrot too: “You get to support a simple efficient tax code that everyone has long claimed they support.”

I honestly have trouble understanding why we have to extend poorly designed, little bang-for-the-buck tax cuts rather than doing something that could really be a huge boon for the economy. Talk about a game-changer from the Obama Administration! A Democratic administration gets to be the one supporting fundamental and economically productive tax reform while forcing the Republicans (or Democrats), if they vote against it, to be essentially responsible for raising taxes and blocking what a lot of their supporters favor. If Republicans are really worried, rest assured that the tax reform wouldn’t be able to save the economy soon enough to have a dramatic positive effect by the election so the GOP candidates will still have a great chance to pick up a ton of seats – and most likely take the House. Will businesses, conservative intellectuals, and angry tea-partiers (so-called small government types) really be able to support the Republicans ever again if they don’t jump on an opportunity like this?

I’ve long touted a VAT as a potential replacement for our absurd tax code. Many mainstream conservatives have even had good things to say about it assuming it was replacing the tax code, not being added on top of it. Here’s a favorite option of progressive policy wonks – something that might appeal to Obama, that I’d be excited to support: the progressive consumption tax. Maybe the Democrats could even slip in some decent energy policy (that they’ve given up on) by raising energy taxes as part of tax reform. Even a flat tax that conservatives have often pushed for would be better than the status quo. Lots of different and better options have to exist rather than being stuck with tinkering with the Bush tax cuts.

If the problem is just lack of time, I’m not sympathetic – everyone has known since the Bush tax cuts passed that they were going to expire. It seems difficult to imagine a potentially better time to force lawmakers’ hands to simplify the tax code than now. We’re in desperate need of new revenue, the weak economy could strongly benefit from a more efficient tax code, taxes will automatically rise if nothing is done, and sometimes it takes the people you’d least expect to be able to dramatically shift course. Think of Nixon going to China or Clinton with welfare reform. What Republican wants to be outflanked by a “socialist president” on tax reform? President Obama might be able to drag along enough in his own party to support a tax reform that the business community surely must favor.

It seems perverse that such extreme options can be on the table for international relations but are so limited for domestic issues. When it comes to tax policy, I welcome the mushroom cloud.



File:Nagasakibomb.jpg
(h/t to Greg Mankiw)

Fed Up

September 19, 2010 Leave a comment

The legislature is clearly impotent to do much to improve the economy right now. It looks like the best it can hope for is piecemeal bills to keep things from getting much worse. Given that it seems the Fed really needs to step in, stop worrying about its image, and do what it can to help the economy. Here’s a few ideas that seem worth trying to me.


If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury

Mark Thoma seconds Cowen’s own questions about that policy:

As for Tyler’s (and others’) call for monetary policy instead of fiscal policy, here’s the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it’s unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you’ll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it’s hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here. 

Bruce Bartlett:

Thus many economists believe that the Fed has unwittingly encouraged banks to sit on their cash and not lend it by paying interest on reserves. Eliminating interest on reserves would therefore encourage lending. A rumor that the Fed might do so caused the stock market to rise earlier this week, according to press reports. But the policy remains in place.

Discouraging Excess Reserves 

Some economists go further and suggest that the Fed impose a penalty rate on excess reserves. This is what Sweden’s central bank does. There, banks currently pay 0.25 percent on reserves — called the deposit rate — rather than receiving 0.25 percent as they do here. This may be a key reason why Sweden has bounced back much more rapidly from the worldwide economic crisis than the United States has.

Scott Sumner enlists Milton Friedman to support monetary stimulus:

I forget to mention the interest on reserves policy, which is very similar to the 1936-37 policy of doubling reserve requirements.  Both programs only raised short term rates by about a 1/4 point, but Friedman (and Schwartz) understood that the 1937 policy was highly contractionary despite the tiny interest rate increase, because it sharply reduced the money multiplier.  He would have been a severe critic of the current IOR policy.

[update 09/20]: Here’s a David Leonhardt column from about a month ago that should help squelch some readers fears about inflation.

(Bureau of Labor Statistics, via Haver Analytics) (Six-month change in the Consumer Price Index.)

Over the last two years, inflation has been zero. Over the last year, it has been just 1.3 percent. Over the last six months, it has been below zero — negative 0.7 percent.

[…]

The Fed — especially the regional Fed banks — is filled with economists and bankers who have strong memories of the 1970s and 1980s inflation. They’re always on guard against it.

There is no question that inflation can be terrible. Right now, though, it sure looks like the last war. 

By the way, can we at least fully staff the Federal Reserve!? 

How Modern Conservatives Aren’t Like Hoover

July 14, 2010 2 comments

Recently, I posted a picture of Herbert Hoover attached to my thoughts on the austerity versus fiscal expansion debate. He famously (and should be more famous for) sought to balance the budget during the Great Depression, which exasperated the situation. In his defense, that was what the dominant consensus of economists advocated. Even FDR tried it for a while. Of course, Keynes came a long and eventually changed everything. In order to save capitalism (too many people forget that part) Keynes argued for increasing government deficits by fiscal stimulus to push aggregate demand rightward making up for the lack of private sector spending and to fight deflation. 


For Hoover, balancing the budget was a priority; for modern conservatives, balancing the budget is not only unimportant but something they actively work against. Matthew Yglesias makes the argument that lowering taxes and, thus, tax revenue is the only goal they pursue. He ably shows that they don’t ever work to reduce the deficit. 

1) There have been two presidents who were members of the modern conservative movement, Ronald Reagan and George W Bush, and they both presided over massive increases in both present and projected deficits.

 2) The major deficit reduction packages of the modern era, in 1990 and 1993, were both uniformly opposed by the conservative movement.

 3) When the deficit was temporarily eliminated in the late-1990s, the mainstream conservative view was that this showed that the deficit was too low and needed to be increased via large tax cuts.

 4) Senator Mitch McConnell says it’s a uniform view in his caucus that tax cuts needn’t be offset by other changes in spending.

 5) The deficit reduction commission is having trouble because they think conservative politicians won’t vote for any form of tax increase.

In sum, there are zero historical examples of conservatives mobilizing to make the deficit smaller.  

So the problem today with the modern mainstream conservative movement is that they don’t care about the deficit while simultaneously refusing to allow modern Keynesians from pursuing fiscal expansion or allowing real deficit hawks from reforming entitlements to adequately contain costs.

To preempt anyone that might agree with McConnell that tax cuts don’t lead to “diminished revenue” here is an older National Review piece blowing up that absurdity. And here’s Bruce Bartlett with a roundup of studies showing that “starve the beast” doesn’t work either. Meanwhile, Ezra Klein and Paul Krugman post some graphs that utterly demolish the idea that tax cuts pay for themselves: 


The above also bolsters my claim that unemployment insurance “benefits add almost nothing to the deficit and are just a temporary measure anyway”
Click to Expand

Tax Credits = Government Spending

Bruce Bartlett explains why tax expenditures are just government spending in disguise. They have the same effect on the deficit as spending and should be treated as such. 

To see just how similar a refundable tax credit is to direct spending, imagine that instead of having the Defense Department pay $1 billion to Lockheed Martin for some spare parts for the Air Force, it instead gave it a $1 billion refundable tax credit that was tradable. If Lockheed Martin didn’t have at least a $1 billion federal tax liability, it could simply sell the unused portion to another company that did. Either way the company gets paid $1 billion and $1 billion worth of resources are extracted from the private sector for government’s use.

There’s not a tax expert on the left or the right who doesn’t recognize the illegitimacy, inefficiency and ineffectiveness of many tax expenditures. There is a desperate need to clean up the Tax Code, as Ronald Reagan and a Democratic Congress did in 1986. Unfortunately, Republicans now take the view that eliminating any tax expenditure constitutes a tax increase, and they oppose it because they oppose all tax increases for any reason.

If one wants to defend government promotion of a particular activity (or something like a military purchase), it should be defended on its own merits and in a cost/benefit analysis not some vague notion of wanting to have lower taxes or more tax breaks. The case for low marginal taxes and for promoting desirable behavior through the tax code are two different arguments. Until we can understand that we’ll continue to have a convoluted and inefficient tax code – and probably higher deficits too. 

VAT Watch, ctd: Responses to Critics

April 23, 2010 3 comments

I’m all set to attack George Will’s particularly bad column on the VAT and I get beat to it by more able writers.  Will disparages the idea of a VAT because he thinks adding it on top of the income tax makes our bad tax system worse. I agree with his central premise that having a VAT just replace the income tax would be best but the rest of his argument doesn’t hold up. 


Before I get to my main critique, here’s Bartlett teaching Will a lesson on the 16th Amendment:

The 16th Amendment issue should be seen for what it is: a red herring. If people don’t think we should have both an income tax and a broad-based consumption tax at the national level, fine. That’s a good debate to have and I for one don’t oppose abolishing the income tax and replacing it with a VAT. But the idea that we must repeal the 16th Amendment as a precondition for consideration of a VAT in order to prevent the possibility of having both an income tax and a VAT is not a serious proposal. It’s just a trick to put up an insurmountable barrier to adoption of a VAT without addressing the questions of how we will stabilize the national debt without higher revenues or why a VAT is a better way to raise those revenues than higher income tax rates, which is the default option in the absence of a VAT.

The 16th Amendment just clarified that Congress could tax income with direct and indirect taxes.  It’s a pretty complicated issue because the Founding Fathers never made it entirely clear what separated direct and indirect taxes. What’s important is that Congress can enact an income tax with or without the 16th Amendment.  
Bartlett in Forbes and Clive Crook in National Journal counter the odd argument that we shouldn’t enact a VAT because it works well.
Bartlett:

In my opinion, opposing a VAT means implicitly supporting our current tax system, which imposes a dead-weight cost equal to a third or more of revenue raised–at least 5% of GDP–according to various studies. This is insane. The idea that raising taxes in the most economically painful way possible will hold down the level of taxation and the size of government is obviously false. It just means that the total burden of taxation including the dead-weight cost is vastly higher than it needs to be. If we raised the same revenue more sensibly we could, in effect, give ourselves a tax cut by reducing the dead-weight cost. 

Those who oppose big government would do better to concentrate their efforts on actually cutting spending. The idea that holding down taxes or insisting that we keep a ridiculously inefficient tax system because that will give us small government is juvenile. If people want small government, there are no shortcuts. Spending has to be cut. But if spending isn’t cut, then I believe that we must pay our bills. I think it’s better to do so as painlessly and efficiently as possible. That’s why I support a VAT.

Crook:

But opponents of a VAT are surely under an even stronger obligation to say what spending they would cut, unless they are saying that a deficit of 6 percent of GDP is no problem. Let’s hear from them. Show us how to cut 6 percent of GDP from federal spending — approximately a quarter of the current total — without popular outrage and real economic distress. Show us how to do it without gutting Social Security and Medicare, or seriously compromising national security. And tell us how to make it politically feasible.

[…]

If blocking the growth of the state is your overriding priority, you might oppose a VAT precisely because, as taxes go, it is a good one. By the same logic, of course, you should strive to make the income tax even worse. The rule would be, collect revenue in the most damaging ways possible. That will raise the price of Big Government and tie the liberals’ hands. 

I’ll also continue to stress that despite Will’s claim that “adoption of a VAT would proclaim the impossibility of serious spending reductions” there is little evidence that not raising sufficient revenue by starving the beast stifles the growth of government.  We don’t have a VAT now and it hasn’t seemed to dampen anyone’s enthusiasm for adding new programs.  Maybe, as Crook points out, widening the tax base with a VAT would make more people understand that they actually have to pay for more government. I’d support that, but I’m skeptical of it having that effect. 

I’m also disappointed George Will (who I normally enjoy) has to disparage the motives of the Obama administration.  

Believing that a crisis is a useful thing to create, the Obama administration — which understands that, for liberalism, worse is better — has deliberately aggravated the fiscal shambles that the Great Recession accelerated. During the downturn, federal revenues plunged and spending soared. And, as will happen for two decades, every day 10,000 more baby boomers are joining the ranks of recipients of Medicare and Social Security, two programs with unfunded liabilities of nearly $107 trillion.

Really? There are plenty of respectable arguments for taking strongly different approaches to deal with the recession that wouldn’t have increased spending nearly as much (Mankiw and Ed Glaeser come to mind) but the idea that there aren’t mainstream economic arguments for taking exactly the approach Obama and his economic team took to save the economy (not destroy it) is ridiculous.  Maybe Obama actually wanted to improve the healthcare system to improve people’s lives – I don’t see much reason to believe he only wanted to put the country on a path to bankruptcy in order to raise taxes.  Will, no serious person wants to raise taxes or thinks they are a good thing in and of themselves.  Responsible governors just understand that we have to pay for the government we have not the government we wish we had.   

On a related issue, I want to direct readers attentions to Andreas Kluth’s tax day pitch for the FairTax. Maybe unknowingly he responded to my asking for ideas for a simpler tax: 

If someone has a better idea for a more efficient and simpler tax I’d be happy to support that. 

I remember reading about the FairTax years ago when Neal Boortz’s book came out and liked it then. Kluth makes the case in a way that only Kluth could.  Who else could advocate tax reform with allusions to Croesus and Diogenes!? I don’t want to excerpt any of it because the whole post is really worth reading. A familiar theme on Hannibal Blog is the value of simplicity and here the FairTax, as Kluth stresses, excels. I’d be happy to support a VAT or the FairTax. My main concern is that the VAT has a better political chance of becoming law. It’s been introduced before and at most received only 76 congressional votes. 


Mostly likely, a VAT could be enacted while dialing down the income taxes as necessary. For healthcare reform a new system developed from scratch such as voucher system like Zeke Emmanuel’s or a complete HSA system coupled with a national catastrophic fund would be vast improvements over any reform that keeps our current base model in place.  But that seems to be politically impossible. The lesson from healthcare is that the same is probably true (although I’d love to try) for tax reform. In America, even comprehensive reform has to be incremental. Get a VAT in there and then squeeze out the clutter.  Anyone think that Obama could sell the FairTax to enough on the left and right to pass it while throwing out the rest of the tax code (with all its political giveaways)?  Worth floating, at least.  

Does the VAT Increase Government?

April 11, 2010 Leave a comment

Daniel Mitchell from CATO argues that we shouldn’t accept a VAT. He makes 3 major points. My comments are bulleted. 


1. A VAT on top of our existing income tax wouldn’t reduce the “economic distortions” of our current tax code.

  • Well that’s hard to argue with. I’d hope we could ultimately replace the complexity of the old system with a simpler tax like a VAT. 

2. Starve the Beast. Mitchell writes,

Simply stated, there’s no way to finance all this new spending without an added broad-based tax. But this is exactly why we should vigorously resist a VAT.

Blocking a VAT may not be sufficient to control the size of government, but it’s necessary. Handing Washington a whole new source of revenue would be akin to giving keys to a liquor store to a bunch of alcoholics.

  • The problem with this argument is that “starve the beast” doesn’t work (see: here and here) – we get more spending anyway along with less revenue. It’s a great way to continue our path of huge deficits and will eventually lead to recessions and insolvency. 

3. A VAT will increase the size of government – i.e. feeding the beast will make it grow. He writes,

The real-world evidence shows that VATs are strongly linked with both higher overall tax burdens and more government spending.

  • Most of the evidence he points to reveals correlation not causation. I’m not saying he’s wrong, it is just hard to know. This ties into his overall narrative that “blocking a VAT” is “necessary” to “control the size of government.” I actually may have assumed he was right but a day earlier I read this at Marginal Revolution: “In a purely statistical sense, there is, thus, no strong evidence that the VAT has in itself caused the growth of government.” That’s from a paper Tyler Cowen links to which surveys a lot of evidence about the VAT around the world. 
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