Thursday, May 04, 2006

Starve the Beast?

A basic tenet of economics is that if you lower the price of something people demand more of it. According to the head of the libertarian CATO institute, this includes government. He points that, over the past 25 years, government grew as a percent of GDP in the years following tax cuts and shrunk in the years following tax hikes. He argues that this reflects voters responding to price incentives. When government is cheap (taxes are low), I want more; when it is expensive (taxes are high), I want less. I don't know if his empirics are all that sound, but the correlation is interesting.

Since the Reagan years, some conservatives have advocated a starve the beast approach to reducing the size of government. This approach involved getting elected by selling popular tax cuts and then counting on the resulting growth and/or distaste for deficits to balance the budget. Of course, the supply-side arguments (tax cuts pay for themselves with economic growth) were wrong. So that leaves the deficit approach. Students of behavioral economics should quickly recognize that this idea is also unsound (unless your goal is to impose serious costs on future generations) because hyperbolic discounting likely plays an important role in this decision making process. Cutting spending when there are large deficits, like exercise, eating healthy, or saving money, is something that I realize I probably should do, but I always assume that later me (or later elected officials) can take care of it. Today, I want my cookies, my bridge to sparsely inhabited islands in Alaska, or my tax cut. Of course, when tomorrow comes, I still want my cookies, tax cut, and/or pet project, and I know that tomorrow me will take care of it. This doesn't happen either, and pretty soon, I am fat, the government has a huge deficit, and Medicare is going to fall apart (despite all the rhetoric Social Security is not that big of a problem, Medicare, though, scares the crap out of me and many of the smartest economists I know).

Sadly, I don't know how to solve the overall problem with hyperbolic discounting in government. All I can do is refuse to support tax cuts which are not offset by other tax increases or spending cuts. Tax cuts by themselves are not actually tax cuts. They are tax shifts (and I recommend using this language whenever discussing "tax cuts" with people). Taxes are shifted from today's tax payers to later tax payers (either in the form of higher taxes or lower services) -- i.e., they are shifted from your parents to you.

Some argue that economic growth will make future generations richer and thus it will be less of a burden on them to pay it off (I guess this sort of like arguing that it is ok because taxes will be progressive across generations). While quasi-true (economic growth is likely, but not certain -- update -- Tony V debunks the whole idea over at econball pointing out that growth in GDP does not substantially outpace the interest on the debt), I find this position morally dubious given that these future citizens are not represented in our current system. They have no chance to vote on these policies, and it is pretty easy to predict that our future citizens (or future selves) would oppose large deficit spending among current generations almost unanimously. Unless it is abundantly obvious that the public goods being produced by our current deficits are used to make future generations substantially better off, I don't see how we can reasonably justify them.

"Knowingly make future generations worse off so we can consume more today" seems like a strange philosophy to embrace, but maybe that's just me.

A quick note: Unless economic growth is faster than the interest rate paid on gvt debt (I don't know if this is true- my sense is that they have been relatively similar in recent years, but I'd wager on the growth rate being smaller), then future generations are not better able to pay the tax than we are currently.
Excellent point Tony V.
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