Bob Cropf

Why taxes aren’t so bad

In economics, public finance, statistics on February 25, 2009 at 5:59 AM

Ever since the Reagan administration, the American people have been bombarded with the unrelenting message that tax increases are unacceptable. The idea is that taxes hinder economic growth and sap the incentives of individuals and families to earn more because the government will just take it all away.

In the meantime, government spending continued to grow. Entitlements like Social Security and Medicare kept expanding as a result of demographics and increased benefits. The US embarked on an expensive military venture in Iraq and Afghanistan. So while taxes have been holding steady over the last three decades, spending has continued to grow. In the simple calculation of public finance, if spending grows and revenues from taxes remain flat then deficits have to grow. As we have seen, these deficits have been financed from borrowing–increasingly from countries with more robust rates of growth than ours. See the chart from the Times article cited below:

In today’s NY Times, Dave Leonhardt writes a thoughtful piece on the “upside of tax increases.” For many Americans bamboozled by years of being told we can pay for everything we need without raising taxes, his title might seem strange. However, as he points out, there is a fundamental law of economics, known as Wagner’s Law, which says that as society matures then taxes show a tendency to grow. This law was discovered in the 19th century and recent economic research confirms that it still operates.

Taxes, as Oliver Wendell Holmes, Jr., said are the price we pay for civilization. Without them, there would be no schools, highways, defense and many other things that make life worth living today. As a society, we have accepted half of the equation: The part that recognizes that we need those things to have a properly functioning society. But we seem to have forgotten or ignored the other half, the part that says that we have to sacrifice something to get what we want.

The bottom line is we cannot keep pushing off into the indefinite future paying for things we need today. By continuing to do this, we burden future generations and reduce their opportunities for economic advancement or we risk our creditors strangling our economy with higher interest rates as demand begins to outstrip supply of capital.

  1. Something I am not entirely clear on here – why is the projected tax revenue essentially constant? What about the effect of gov’t debt on credit markets, which in NORMAL times inhibits growth (see Krugman’s “Return of Depression Economics” for why that isn’t the case now). If that is the case, tax revenues would necessarily decline as expenditures increased UNLESS the tax structure were altered and given that dynamic, the relationship would be exponential not linear (right???).

  2. The expectation is that the debt will continue to increase as spending outpaces revenues. If nothing changes, then the gap between the two will increase faster. The chart as it is copied in the blog is not as easy to read as the one on the NY Times website. It is not a one-to-one relationship that as expenditures rise then tax revenues drop off. One can conceive of several scenarios in which that is not the case. For example, expenditures could grow and tax revenues could also grow as a result of the spending stimulating the economy. This is what the Obama administration hopes will happen.

  3. Yes, but in NORMAL times, government debt drives up interest rates (increases the demand for money), making it more expensive to borrow to finance private-sector growth. So, if the gap between revenue and expenditures continues (assuming we will eventually get out of Depression Economics mode), then interest rates will increase along with the gov’t debt, which will slow growth, which will further restrain tax revenue, further increasing deficit spending, and so the cycle continues (thus exponential and not linear).

    The projection goes out to 2050, well beyond Bernanke’s (laughably optimistic?) prediction of out of recession by the end of the year, recover in 2-3. So that is about 35 years of non-Depression Economics in which capital is more or less fully utilized and gov’t debt crowds out private debt (also, that means service payment on that debt would be much larger, making the tax/revenue situation even worse).

    That is Krugman’s argument, USUALLY increasing deficit spending does have a crowding out effect, but when you have entered an era of massive under-utilization of capital, then there is no crowding out effect, there is a lot of slack to be taken up – gov’t spending (deficit) employs those under utilized resources (including money) and actually increases efficiency. So, once (if) we recover, we’ll have to go back to playing by regular rules and not be able to finance gov’t deficit spending at ~0% (remember when those were the credit card offers we were getting… where did that get us?).

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