On Starving the Beast with No Tax Increases

November 29, 2011

This piece was included as part of distributed materials for an American Enterprise Institute (AEI) event.

“Starve the Beast” Not Effective at Federal Level

Before the first decade of the twentieth century, many smart people believed that “starve the beast” could work at restraining federal spending growth. After cutting taxes, or at least not raising them, as Milton Friedman explained, “[r]esulting deficits will be an effective restraint on the spending propensities of the executive branch and the legislature.” The much harder job of rolling up sleeves and cutting spending by terminating ineffective programs and confronting entrenched interests could thus be avoided.

After a decade of experience, we know now that “starve the beast” does not work at the federal level. Instead of creating pressure to reduce expenditures to a smaller revenue total, spending exploded. After the 2001-03 tax cuts, federal spending under the George W. Bush Administration grew 55 percent (29 percent after adjusting for inflation). Defense spending grew 6.8 percent a year even after adjusting for inflation, other discretionary spending grew 5.4 percent a year (again, after adjusting for inflation), and the federal debt rose to 66 percent of GDP.

Why? The best theory I’ve heard is “fiscal illusion”: that tax cuts without spending cuts just reduces the apparent cost of government to the taxpayer. Instead of paying $1 in taxes to get $1 in services, the taxpayer is apparently paying only 70 cents to get $1 in services. Taxpayers thus demand more services. (Some argue that something similar is happening with nearly half of Americans paying no federal income tax, in that they will demand more in services but paid for by other people.) While tax increases lead to increased government spending, so apparently do tax cuts. The only thing that leads to spending cuts iscutting spending.

How You Tax is Just as Important as How Much You Tax

Some advocates of limited government believe that any reduction in government revenue is effective to this end because it puts money in consumers’ hands. However, if the ultimate policy goal is to reduce government involvement in individual and market decisions, tax credits are a poor choice. These credits are often complex, administratively burdensome, use government policy to distort behavior, create damaging uncertainty, and are the result of political micromanaging. Even as a tax credit modestly drops government revenue, it increases government meddling in the economy and resultant harmful outcomes.

One recent example is the ethanol tax credit, which has heavily distorted domestic gasoline prices and foreign food prices (causing hunger overseas, as found by 17 studies) and warped economic decisions by just about everyone who uses energy, for the benefit of a small group of politically-connected insiders. Stopping this unconscionable policy and its harmful outcomes should supersede in importance the relatively small amount of additional revenue the government would gain from ending the tax subsidy. Serious analysis of this and other tax incentives should look not just at the revenue but also other economic costs.

Tax Foundation analysis is guided by the principles of economically sound tax policy: simplicity, transparency, neutrality, stability, and growth-promotion. These principles originally derive from Adam Smith’s “maxims” about taxes from The Wealth of Nations. While we look at revenue impacts, we also look at other costs to taxpayers, such as administrative and compliance costs (Americans now spend 7 billion hours per year complying with the federal tax code), and reduced economic activity caused by a badly designed tax system. We analyze not just whether a tax change would increase or reduce revenue, but also whether it moves us towards a simpler, more sensible tax system.

Conclusion

I don’t like paying taxes but if there are to be taxes, they should be as simple and sensible as possible. Tax policy should be used to raise revenue, not micromanage a complex economy by trying to pick winners and losers in the market. Everyone should kick in a bit, to avoid fiscal illusion. “Starve the beast” has not worked at the federal level, so we should recognize that there is no way out of the hard work of pursuing genuine tax reform.


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