Sunday, May 24, 2009

Spending Cuts Before Tax Cuts

By Bob McLeod

In a commentary entitled Christie: “I’ll Cut Spending Before Reducing Taxes,” posted on MMM, May 13, 2009, you noted that “Pro-growth Laffer/Kemp /Reagan economic theory is based on the premise that lowering marginal tax rates increases economic activity and leads to a higher level of government revenue.” Commenting on Christie’s proposal you state: “I don’t know of a school of economics that has studied the effect of reducing government spending while keeping taxes stable. I don’t know if it has ever been done.”

The lack of such a study arises from the fact that politicians are reluctant to cut services; thus, there is a dearth of empirical data. However, neither the Keynesian (also discussed in your May 13 commentary) nor the Laffer/Kemp/Reagan (also known as “supply side”) theories dependably produce the desired result of increasing tax revenues sufficient to offset the public debt created by either the increased spending or the tax cuts. I will leave a discussion of the merits of Keynesian theory to our Democratic colleagues. President Obama is providing them an excess of data to throw into their models.

“Supply side” economics promises prosperity, sound fiscal policies, and low taxes. It is a nice idea, but it is far from a certainty. It is more of a hope based on faith and optimism. Even a conservative icon such as economist Thomas Sowell does not support the claim that tax cuts will always generate more tax revenues by stimulating the economy than are lost by the cuts.(1)Ultimately that is an empirical question whose answer will be discovered after the fact.”(2)

Former Federal Reserve Chairman Alan Greenspan warned President George W. Bush that, “‘Economic growth cannot be safely counted upon to eliminate deficits and the difficult choices that will be required to restore fiscal discipline.’ … I was trying to get people to see the need for fiscal restraint, encompassing not just taxes but more important, spending”(3)

In simple terms a tax cut without an equivalent spending cut is a gamble with the public trust. At the Federal level that gamble resulted in a huge federal budget deficit—which President Obama is increasing by a multiplier—and a reduction in the American sense of economic security. If not corrected it will “produce hyperinflation and economic devastation. So deficits must matter.”(4)

When President Kennedy proposed a tax cut in 1963 the top income tax rate had risen to 91 percent. The estate tax, the “death tax,” had risen to 77 percent. Personal income derived from capital gains and dividends was taxed away by the government to pay off the debts incurred during World War II and the Korean War and to finance the cost of the Cold War with the Soviet Union and Communist China.(5)These tax cuts redirected capital into the private economy resulting in the economic growth of the 1960’s. The economy only began to deteriorate again when the administration of President Johnson attempted simultaneously to finance both the Vietnam War and the social programs of the Great Society.(6)

When President Reagan cut taxes during the 1980’s the government was still taking 49% to 70% of the paychecks of successful people. That is double today’s rates. The tax cuts were intended to reduce the burden on people and to stimulate the economy. The tax cuts did both, but the additional revenue generated by the tax cuts never reduced the deficit.(7)These tax cuts were also followed by a large increase in defense spending as the Cold War limped to its conclusion. The result was an increase in the federal debt and a reduction in aid to the States.

The Bush tax cuts were a blip on the screen of the economy. They reduced the top marginal rates by less than five percent. Such small reductions released only limited additional capital into the private sector. Their positive effect soon vanished. Two wars and increased domestic spending by Republicans ended that moment in the fiscal sun. Their long term effect was to further increase the federal debt.(8)

Unlike the Federal government the State cannot print money or incur long term operating deficits. When there is a revenue shortfall the only alternatives are to cut spending or raise taxes. Obviously we have had enough of the latter.

Both Sowell and Greenspan agree that stimulating economic growth through tax cuts is an uncertain avenue to increasing tax revenues. The answers to the questions posed at the end of your commentary of May 13 do not lie with the experts, whether they be “smarter than [you],” or me, or not. I think Sowell and Greenspan would agree that the answers lie only at the conclusion, i.e., “an empirical question whose answer will be discovered after the fact.”

Christie’s proposal to cut spending before reducing taxes is simply a statement of financial common sense. It also indicates a willingness to make the “difficult choices… required to restore fiscal discipline,” as Greenspan advised Bush. If one is expecting a reduction in income—like when planning for retirement—it is only prudent to reduce spending first. Once upon a time this pragmatic approach produced the good management and sound fiscal policies associated with the Republican Party.

Economics is often called the “dismal science,” but it is not a science. It is a social study which obscures its uncertainties in a barrage of numbers and graphs. Republicans must remove the blinders imposed by unquestioning adherence to supply side economics. Experience, prudence and caution must be our guide, not speculative economic hypotheses. That is true economic conservatism.

Bob McLeod is a former municipal court judge and was the GOP Congressional candidate in New Jersey's 6th district in 2008. He is the first MMM contributor to submit a column with footnotes.

1) Basic Economics, A Common Sense Guide to the Economy, Thomas Sowell, Third Edition, Basic Books (New York, 2007), p. 398;
2)Basic Economics, A Common Sense Guide to the Economy, supra, p. 407.
3)The Age of Turbulence, Alan Greenspan, Penguin Group (New York, 2007), p. 24.
4)The Age of Turbulence, supra,, p. 237.
5)The Conscience of a Liberal, Paul Krugman, W.W. Norton & Company (New York, 2007), pp. 47-48.
6)The Age of Turbulence, supra,, pp. 54-55
7) "WHAT’S NEXT,” Janice Revell, Money, March, 2008, p. 88.
8)The Age of Turbulence, supra, pp. 237-241; “Tax Cuts Don’t Boost Revenue,” Justin Fox, TIME, December 17, 2007, p. 62.


Chris said...

Regarding the effect of tax cuts on the GDP (and therefore on tax revenues), I'd recommend this paper published in 2007 by Christina and David Romer of Berkeley:

It proposes that tax cuts have a GDP multiplier of 3 (meaning that if taxes are cut by 1%, nominal GDP will increase by 3%) - p.39
This supports supply-side and it's interesting that Mrs. Romer is not on Obama's economic team, advocating Keynesian policies.

There's also a study by Valerie Ramey of UCSD:

According to this, government spending has a multiplier of just 1.4 (meaning that $1 spent by the government will result in a $1.4 increase in GDP).

Combining the 2 studies, we can conclude that by maintaining the current deficit (matching lower taxes with reduced spending), each $1 reduction will increase GDP by $3 (tax cut multiplier), and decrease it by $1.4 (gov. spending multiplier), which is a net increase of $1.6. This will of course result in a corresponding increase in tax revenues.

Anonymous said...

but, they're never going to cut the spending,period: that's the crux of the problem: not being economists, we have the luxury of simply knowing,that, when you spend much more, on too many programs we can't sustain, because more are collecting than contributing, it's an ongoing horror and recipe for disaster,period..don't see it changing, but rather will get much worse, whether they "cut taxes," or not..

Chris said...

The best solution to cut spending is to go to zero-based budgeting. Between the candidates with tax plans and with no tax plans, I only heard one of them mentioning this.