December 11, 2012

Tax Cuts Don't Work Without Spending Cuts

Matthew D. Mitchell

Senior Research Fellow
Summary

It seemed like such a good idea. There weren’t 60 votes in the Senate for George W. Bush’s tax cuts, so the President used a procedural maneuver to get them passed with a simple majority. There was just one hitch: the procedure required that at the end of 2010, rates would go back up. Ten years have quickly come and gone; so has the two-year extension worked out by President Obama and Congressional Republicans in 2010. And now, staring down the barrel of a “fiscal cliff,” temporary tax cuts don’t seem like such a good idea anymore.

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It seemed like such a good idea. There weren’t 60 votes in the Senate for George W. Bush’s tax cuts, so the President used a procedural maneuver to get them passed with a simple majority. There was just one hitch: the procedure required that at the end of 2010, rates would go back up. Ten years have quickly come and gone; so has the two-year extension worked out by President Obama and Congressional Republicans in 2010. And now, staring down the barrel of a “fiscal cliff,” temporary tax cuts don’t seem like such a good idea anymore.

Economists of all stripes worry that a precipitous tax hike—especially in the middle of a weak recovery—could have devastating economic consequences. Among Keynesians, the concern is that the tax increase will sap consumers’ purchasing power, weakening aggregate demand. Among real-business cycle economists, the worry is that higher marginal rates will diminish the incentive to work, save, and invest. And since investment decisions are made with an eye toward the long run, it is even possible that the scheduled tax increase has been undermining the potency of these tax cuts for years.

The truth is that even if the tax cuts weren’t automatically scheduled to end someday, they were never believable as sustainable fiscal policy. That’s because no one in government even attempted to bring spending in line with the lower revenue. In fact, Washington went on a spending binge shortly after taxes were cut: from 2001 to 2009 federal spending leapt from 18.2 to 25.2 percent of GDP. This was the largest such increase in any 8 year period since WWII.

This episode should have advocates of limited government asking themselves an important question: are tax cuts without spending cuts good for the cause of limited government? Decades ago, Milton Friedman answered this question with a resounding yes. Cut taxes, he counseled, and starve the beast. With less revenue, spending will fall too. Tax cutters from Ronald Reagan to George W. Bush have been convinced of “starve the beast” ever since.

But there is another Nobel laureate with free market bona fides who begs to differ. James Buchanan, a founding father of public choice economics—which uses the tools of economics to shed light on the incentives of policy makers—has long questioned “starve the beast.” When politicians are legally and politically permitted to run deficits, he warned, they will simply fund government by borrowing. In this case, tax cuts give voters the illusion that government spending is cheap. And with government seeming less-costly, voters will be happy to have more of it.

A few years ago, economist Andrew Young of West Virginia University tested the two hypotheses using 50 years of federal data. His findings suggest that on this one, Buchanan may have had it right: Tax increases, rather than tax cuts, actually seem to be associated with less government spending. In his words, the findings suggest that “the electorate has to be clearly presented with the bill to recognize the cost of government.” Berkeley economists David H. Romer and Christina Romer recently corroborated Young’s finding using a different dataset and different techniques.

Come the beginning of January, voters will see more of the bill than they are used to. Those of us who want to keep that bill low need to be willing to buy less government. And that means cutting spending and taxes.