Sunday, May 7, 2006

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Do tax cuts starve or stoke the government beast?

Kevin Drum links to a Jonathan Rauch column in the Atlantic Monthly (non-subscribers can click here to read the whole thing), which summarizes William Niskanen's finding that starving the government of tax revenue doesn't starve the beast of government spending -- if anything, the trend is the exact opposite. From Rauch's story:

Even during the Reagan years, Niskanen was suspicious of Starve the Beast. He thought it more likely that tax cuts, when unmatched with spending cuts, would reduce the apparent cost of government, thus stimulating rather than stunting Washington’s growth. “You make government look cheaper than it would otherwise be,” he said recently.

Suppose the federal budget is balanced at $1 trillion. Now suppose Congress reduces taxes by $200 billion without reducing spending. One result is a $200 billion deficit. Another result is that voters pay for only 80 percent of what government actually costs. Think of this as a 20 percent discount on government. As everyone knows, when you put something on sale, people buy more of it. Logically, then, tax cuts might increase the demand for government instead of reducing the supply of it. Or they might do some of each.

Which is it? To the naked eye, Starve the Beast looks suspiciously counterproductive. After all, spending (as a share of the gross domestic product, the standard way to measure it) went up, not down, after Reagan cut taxes in the early 1980s; it went down, not up, after the first President Bush and President Clinton raised taxes in the early 1990s; and it went up, not down, following the Bush tax cuts early in this decade.

Niskanen recently analyzed data from 1981 to 2005 and found his hunch strongly confirmed. When he performed a statistical regression that controlled for unemployment (which independently influences spending and taxes), he found, he says, “no sign that deficits have ever acted as a constraint on spending.” To the contrary: judging by the last twenty-five years (plenty of time for a fair test), a tax cut of 1 percent of the GDP increases the rate of spending growth by about 0.15 percent of the GDP a year. A comparable tax hike reduces spending growth by the same amount.

Again looking at 1981 to 2005, Niskanen then asked at what level taxes neither increase nor decrease spending. The answer: about 19 percent of the GDP. In other words, taxation above that level shrinks government, and taxation below it makes government grow....

[C]onservatives who are serious about halting or reversing the dizzying Bush-era expansion of government—if there are any such conservatives, something of an open question these days—should stop defending Bush’s tax cuts. Instead, they should be talking about raising taxes to at least 19 percent of the GDP. Voters will not shrink Big Government until they feel the pinch of its true cost.

Without necessarily endorsing the "starve the beast" theory of political economy, my first reaction is to ask about lagged effects. As I've understood it, the starve the beast idea does not say that government spending will immediatekly go down as deficits rise; it argues that eventually the increase in deficits creates market and political pressure to cut government spending. My guess is that if you lagged taxes by five years you might get a different result.

I see that this paper made the blog rounds a few years ago -- but it does not appear to have been published. Furthermore, the link to the original conference paper is not not working.

Still, the argument is provocative enough for readers to chew on.

UPDATE: Sebastian Mallaby sure seems convinced.

posted by Dan on 05.07.06 at 09:37 PM


My guess is that if you lagged taxes by five years you might get a different result.

The same thought occured to me, however, the first Bush and Clinton's 8 years had more than encompassed 5 years. Similarly, GWs tax cuts have now lasted for more than 5 years and I don't know when Reagan started starving the beast but it is likely that those tax cuts (plus Sr. Bush first coupla years) lasted for longer than 5 years too.

However, 1981 - 2005 seems like a small sample. Why not go further in time and do a more extensive analysis? (Ok I will read the paper now)

posted by: Jav on 05.07.06 at 09:37 PM [permalink]

There are plenty of conservatives in Congress who could stop the spending if they wanted to, though perhaps it's the separation of the executive from the legislature that is to blame. Do other conservative governments (in other countries) who cut taxes have the same problem? Somehow I don't think it's the tax cuts which are the problem.

posted by: FM on 05.07.06 at 09:37 PM [permalink]

Reagan's original tax cut proposal in 1981 was based on a belief that the very high top marginal rates in the tax code were so high that they deterred investment, depressed economic activity and ultimately cost the government revenue it would collect if top marginal rates were lower.

"Starving the beast" came later -- after Reagan's administration had launched an ambitious though mostly unsuccessful effort to cut non-defense spending in the most direct way possible, by cutting and ending government programs. Even agencies like the Small Business Administration and the Appalachian Regional Commission were put on the chopping block, evoking desperate resistance from a Congress determined to protect the status quo. Reagan's administration basically acknowledged the failure of its effort to shrink government by 1983, though it supported Congressional efforts to put freezes and caps on spending in the late 1980s to deal with the deficits caused not only by the 1981 tax cut package but also by the collapse of inflation.

"Starving the beast" was never part of Reagan's justification for tax cuts. It was instead the product of post-Reagan conservative organizations like Grover Norquist's Americans for Tax Reform. The important thing about "starving the beast" was that it was never an argument advanced in good faith. It was always, always intended only as an argument to justify any tax cuts, related to marginal rates or not, for business and upper-income people of the type that funded groups like Americans for Tax Reform.

Grover Norquist is interested in Grover Norquist. That's it. That's what "starving the beast" was all about. Real spending cuts involve taking current dollars away from people who expect to receive them. It is hard, it is painful, and it is something Norquist and his associates never wanted to be involved with -- because there was no money in that for them, and there was money in advocating for tax cuts.

So, no, you could say I'm not surprised that Niskanen found what he did. There is where I would typically make a snide observation about academic economists finding out what was going on about ten years after it had become evident to everyone else, but everyone else in this case thought it expedient to accept the contention that "starving the beast" was an actual theory of fiscal governance and not just a convenient slogan.

posted by: Zathras on 05.07.06 at 09:37 PM [permalink]

First this is a bit unfair:
here is where I would typically make a snide observation about academic economists finding out what was going on about ten years after it had become evident to everyone else,

Amusing but unfair as Zathras surely knows, given you need data to test hypotheses, etc. which means lags in getting something proper to publish.

But regardless, the observation fits instinctually what I would guess would be the real incentives in terms of governmental spending - reduced apparent cost, etc. Above all in the US case where current cost of high deficits (interest rate pressure) is disguised or transfered in part based on the dollar's unique status.

Indeed, as I think about international examples, high spending to revenue ratios (more or less the same as tax cuts to spending) strike me as only correcting in crises, rarely due to recalibration.

No, I very much doubt if you take either American or international data that lagging will provide you with any starvation support, doesn't really make sense in any real incentive terms, wishful thinking really.

posted by: The Lounsbury on 05.07.06 at 09:37 PM [permalink]

It seems to me that everyone is making this harder than it needs to be. From time to time, there are enough grownups in the halls of power that appreciate that we're shooting ourselves in the foot; when that happens they take the obvious step of raising marginal tax rates and restraining growth of spending. Too few grownups, and the opposite happens. The two effects -- tax rates and spending -- don't cause each other, they're both caused by the third factor.

posted by: Anonymous Coward on 05.07.06 at 09:37 PM [permalink]

At what point does adjusting for lagged effects go from an exercise in discovering real patterns to an exercise in fitting the data to a preconceived theory? As soon as you add lag you also allow other confounding factors to affect the data. Even if an ironclad justification can be found for adding a certain lag, the data pollution that comes with it would appear to negate any benefit from doing so. How do you factor out changes in spending that had nothing to do with previously enacted changes in taxation, such as the collapse of the Soviet Union or 9/11? Play with different lags enough and you could support just about any conclusion. Lag seems more like a way to introduce error than to remove it.

posted by: Platypus on 05.07.06 at 09:37 PM [permalink]

Along the lines of Platypus' point, it seems to me that measuring the deficit as a percentage of GDP, even if it is "the standard method" of doing so, obscures the results in this particular instance, because it introduces too much noise into the data. GDP can be affected by all sorts of macroeconomic factors independent of federal spending.

Moreover, Congresspeople don't budget on the basis of % of GDP, they budget on the basis of real dollars. Indeed, at the time of budgeting, one can't know what the GDP will be for the upcoming budget year. If Rauch wants to examine the effect of deficits on the budgeting actions of legislators, he should examine the issue from the perspective of the legislators as they budgeted, and compare real dollars year over year.

posted by: Tom T. on 05.07.06 at 09:37 PM [permalink]

Did this study look at whether tax rates were cut or whether tax revenue was cut? Tax cuts don't neccessarily reduce revenue (depends where you are on the laffer curve, which is really hard to determine i realize). But reducing tax rates might not neccessarily starve the beast

posted by: Pat on 05.07.06 at 09:37 PM [permalink]

My suspicion is that we're using too few data points to draw any real conclusions. The increased spending during the Reagan years was predictated on a trade whereby Reagan got his defense spending by greasing the wheels with enough domestic spending to get his budgets through. The reduced spending in the Clinton years was partially due to his advisors concern about the relationship between the deficit and interest rates (which, right now, doesn't seem to hold up), but also to the fact that for six years he had a Republican Congress who wasn't looking to fund anything Clinton was looking to do (surprise).

My point here is that the examples we're looking at more likely turn on the politics of the time than any "golden rule" applicable across the board, but it's an interesting topic and I'll be interested to hear what others have to say.

posted by: adr on 05.07.06 at 09:37 PM [permalink]

Let's just admit it: conservative support for tax cuts has lost yet another piece of empirical evidence. They're wrong, in other words, like they are on so many other things. It's time conservatism received the intellectual pounding that liberalism received in the 1980s.

posted by: Chris on 05.07.06 at 09:37 PM [permalink]

We should note that this arguement is perhaps really a strong case for a balanced budget amendment (that's probably where Niskanen is coming from), which would ensure that we paid for the services government provides in current taxes (i.e. taxes) rather than future taxes (borrowing). If we really want to stop spending, let's take away the credit cards and force ourselves to decide how much government we really want based on how much we're willing to pay - not how much we're willing to saddle future generations.

posted by: adr on 05.07.06 at 09:37 PM [permalink]

In tangentially related news, Ahnold is pushing for a hundreds of billions of bond issues for infrastructure and education spending in California. California needs it to 'keep up' with its immigration driven population growth. Of course, even if successful, this building program will only succeed in alleviating some of immigration's externalities, and will produce others. But its neat to see how immigration ties in with deficit spending and both tie in with growth of government. Yet another blow to the libertarian case for open borders.

posted by: Mitchell Young on 05.07.06 at 09:37 PM [permalink]

Should one consider tax cuts merely lagged policy for higher tax spending on interest on accumlated debt? It seems lagging should work both ways.

posted by: Lord on 05.07.06 at 09:37 PM [permalink]

Personally I am profoundly uninterested in American party politic warfare, but the argument over fiscal rectitude generally is interesting.

First, I would suggest Constitutional solutions to problems of political will are probably mad, stupid and childish approaches to the issue. My sense based on international experience is writing into law willpower that does not exist results in undermining of rule of law, ceteris paribus (as well as putting on legal straightjackets that may be deeply unwise).

The question of the political willpower to have reasonably stable fiscal policies (meaning, at the very least, sustainable debt loads relative to the tax paying base) strikes me as one of "transparency of cost" - and probably something achieved via one or another political party passing compact on the issue, making it a profiled political point and perhaps some legal restraints that would be embarassing to undo. I beleive there was something of this during the Clinton presidencies (please do correct me if the impression is wrong).

As to this conservative support for tax cuts has lost yet another piece of empirical evidence.

Well, no.

Support for tax cuts without any relation to spending certainly, although I think if one stopped treating the US fiscal position as something existing in its own universe and drew conclusions from global lessons, the lessons are already clear re blowing out spending without proper income (taxes, fees, whatever).

That does not mean reducing the tax burden is a bad idea, although if one is not ideological but practical one has to admit that there is a great muddle in the middle where the trade offs between government expenditure and taxation versus reducation are not entirely clear.

Regardless, again if one treats the US as an ordinary country, it has always seemed clear to me that the "starve the beast" argument is primarily a ideological one and a fine way to go down the route to systematic financial crisis at some point.

posted by: The Lounsbury on 05.07.06 at 09:37 PM [permalink]

Note that Mallaby and Rauch take Niskanen's research in a different direction than Niskanen does. In the underlying article, Niskanen makes that point that tax cuts don't lead to lower levels of spending, and therefore are not a subsitute for the real thing - i.e., actual spending cuts.

Niskanen proposes that we ask whether the spending is (a) constitutional and (b) (in essence) worth the taxes needed to pay for it, and only spend if both these criteria are met.

This clearly isn't a call for greater spending. To the contrary, Niskanen states that government spending and regulation should be the true test of how large government is, and that whether we use taxes or deficits to fund is a matter of whether we shift the burdens to future generations or bear them ourselves.

In effect, Rauch uses Niskanen for what he likes, and discards what he doesn't.

posted by: adr on 05.07.06 at 09:37 PM [permalink]

Correction to above: I should say that this his clearly isn't a call for greater TAXES as Rauch proposes as a means to control spending.

posted by: adr on 05.07.06 at 09:37 PM [permalink]

Denial of the obvious.

Remember who wants more government services. Those for whom their return on government services is greater. By transfering my expenses to government something happens. My net goes up, but so do my taxes.

How much do my taxes go up? If I am a Walmart executive paying 50 cents on every dollar of government services, then each time I can transfer an expense to government I gain a dollar and lose 50 cents.

If I am a Wal Mart clerk, then for each dollar of goverment services transfered from the WalMart expense sheet may gain me 10 cents, but I am likely to pay 15 cents for it.

So WalMart executives and stockholders whould like the government to train workers on computers and cash machines. Hence, No Child left Behind becomes law.

This is why government spending goes up when progressive rates fall. The return on government services accelerate the higher one is on the food chain.

What do businessmen tell government? Educate the kids, we need a more competetive work force! So why doesn't business educate the work force? Government does it for them and transfers half the cost down the food chain.

Who gets a differential gain when government protects the oil lanes? The higher up you are in the chain, the greater return you get when government provides oil security.

This has been well known since the beginning of the Republic, its an old Alexander Hamilton trick. You have to match progressive tax rates so each increment of additional services keeps the original rates of returns intact.

posted by: Matt on 05.07.06 at 09:37 PM [permalink]

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