Structural Spending Reform, Part 3

In Part 2 we discussed reactive spending cuts, which include the Penny Plan and traditional European austerity. We concluded that this type of spending reform defeats its own purpose: it does not solve the underlying problems causing a structural budget deficit. The reform type does not incentivize economic growth, but instead contradicts it by keeping government expensive over time, while eroding its benefits.

Today we will dive into the alternative reform type: proactive spending cuts. This type is almost unheard of in reality, and there is scant literature – if any – explaining either its theory or its practice. The closest real-world example is the Dutch health-insurance reform: in 2005, the year before the reform went into effect, government paid for two thirds of all health care in the Netherlands; in 2007, the year after the reform went into effect, the proportions were reversed.

As of 2017, the latest year with available data, the private share was three quarters. This is higher than in America.

A coming article will examine the Dutch reform in detail; for now, let us lay out the principles for proactive spending reform. Before we do, though, let us notice that this reform type is associated with some significant political and policy challenges. We can overcome those – in fact, we must. Proactive reform is the only way to secure the fiscal sustainability of our government. However, the challenges are not be under-estimated, and will be discussed in articles on specific reform proposals: health insurance, Social Security and income security.

In Part 2 we noted that entitlement spending, which accounts for two thirds of all federal government spending and more than half of state and local government spending, is defined in principle by a simple equation. Spending, GE, is determined by the share of the population, e, that is eligible for the entitlement program, and the amount they get in benefits, B:

Benefits, in turn, are determined by the value of those benefits, b, as share of household income, Y:

The problem with these two equations is that they define a trajectory of perpetual increase in government spending. The key element of proactive spending reform is to break this trajectory and point government spending in a new, fiscally sustainable direction.

There is a technical and a theoretical component to this reform. First, the technical component, which consists of severing the tie between b and Y in the equation above. We replace the bY variable with a fixed B:

Each eligible individual now gets a fixed amount of benefits. That amount is independent of household income; as a ratio of household income, it declines over time.

From a theoretical viewpoint, this reform requires a more substantial change than its technical representation may suggest. The key is to redefine the formula by which we estimate poverty: today our definition of what it means to be poor is relative, with the poverty limit largely tracking median household income. This has absurd consequences, primarily that a thriving economy cannot reduce poverty. On the contrary, the population defined as poor can actually increase, even though employment is high and household income is rising.

The reason is, again, that poverty is defined as a percentage of median household income:

  1. If median income is $50,000 and the poverty limit is 55 percent of that, then you are poor if you make $27,500;
  2. If median income rises to $55,000, then the poverty limit rises to $28,250.

You are now better off being poor than you were before. As a result, the amount of entitlement spending has to rise, as per the definition of B above.

To decouple B from Y, we need to replace the relative definition of poverty with an absolute definition. This is represented by the third equation above, where entitlement benefits are capped and kept constant.

Before the War on Poverty, the federal government used an absolute definition of poverty. It constituted the foundation for the welfare-program reforms under the Social Security Act of 1934. Figure 1a sketches the idea behind a return to this reform. The present trajectory in government spending (1) will continue unchanged (2) if no reform is made. If the definition of poverty is changed from relative to absolute (A) the trajectory of entitlement spending will change radically (3):

Figure 1a

But wait: doesn’t this look a lot like a Penny Plan in practice?

Superficially, yes, it does. However, Figure 1a only tells half the story of a proactive spending reform. There is another side to the equation, namely the funding of the welfare state. However, before we get to the taxes, let us also note that this is just the fiscal schematics of a proactive reform; its execution within each entitlement program will bring far more difference than is laid out here. Those details will come in subsequent articles.

One more point before we get to the tax side: let us not forget the purpose behind proactive spending reform. The reactive type aims to make the welfare state more affordable – it does not seek to eliminate the welfare state. Therefore, government promises remain on the shoulders of the taxpayers, whose duty it is to work harder and harder over time to foot the bill.

A proactive reform seeks to permanently alleviate the burden on taxpayers.

Speaking of which, if the proactive reform is going to work as intended – in other words to roll back the welfare state – it must include reforms that alleviate the burden on taxpayers. In other words, tax cuts, but not just any tax cuts.

Today, the welfare state is paid for with tax revenue that rise and fall with GDP and, more specifically, personal income. Let TE be total tax revenue paying for the welfare state. Let t be the aggregate tax rate – how large a share we all pay in taxes combined – and let Y, again, be household income:

If we leave taxes alone, the burden will rise not only with income, but also relative welfare-state spending after the reform in Figure 1a. In other words, we have to combine the reform that changes the spending trajectory with a reform that caps taxes on par with spending:

Let us now plot the tax-revenue trajectory together with spending from Figure 1a. We assume that we have a structural budget deficit, represented by the vertical difference between the red (spending) and blue (tax revenue) functions.

With points 1, 2, 3 and A being the same as before, we now have tax revenue originally growing parallel to, but numerically below spending (4). If no reform takes place, it continues upward (5). However, suppose we combine spending reform (A) with tax reform (B). Revenue now veers off (6) to eventually catch up with the news spending trajectory:

Figure 1b

What type of tax reform would produce this result? It would take a reform that shifts from a tax that is proportionate to economic activity – be it income or consumption – to a tax that is proportionate to expected spending. Denoting this spending variable with *, we set the tax rate to:

Expected spending, in turn, is determined by spending in the past – say one year – and a forecast for spending in the coming year:

Since economists are notoriously bad at forecasting, it is reasonable to balance the forecast against past experience.

An important consequence of defining the welfare-state funding tax in this way, is that the tax rate will change with spending. Increases in spending will immediately translate into higher taxes, and vice versa. This has one important effect: as incomes grow and entitlement spending remains constant, the tax burden will gradually decrease.

As the tax burden declines, the private sector gradually gets more room to spend, invest, create jobs and build wealth. Over time, this keeps the economy on a path where demand for government entitlements will not only be a lighter burden at a constant rate of eligibility, e, but where the population needing government assistance will gradually decline.

Now: how do we put this proactive type of spending reform to work? The answer begins with Part 4!

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2020: Libertarian Victory?

In a stunning departure from its long-standing tradition of analytical rigor, the Cato Institute has declared Joe Biden “president elect”:

Screen shot from cato.org, 11/8/2020

While votes are still being counted and we have weeks of re-counting and election-fraud litigation ahead of us, this formerly prominent think tank has now decided to climb down the precarious ladder of political punditry. I can only wonder what the constitutional experts on the Cato payroll say – or dare not say – about this.

Fortunately, not all of their output is undergoing this metamorphosis of discernment. Michael Tanner, a Cato senior fellow and an accomplished public-policy scholar, has published an article detailing other outcomes of the election that, he points out, are of interest to libertarians. His long list of ballot initiatives stretches from tax policy in Colorado and Illinois to drug liberalization in New Jersey and Oregon.

Tanner explains clearly why the initiatives on his list are important to libertarians, making a good case for every item on the list. However, there are two points missing, which we will return to in a moment. First, a summary of Tanner’s list.

His top issue is the War on Drugs, which, he says “took a major hit”. Every single initiative toward drug legalization passed, he explains,

including proposals to legalize medical marijuana in Mississippi, recreational marijuana in Arizona, Montana, New Jersey and South Dakota, to decriminalize hallucinogenic plants in Washington, DC, as well as a far-reaching measure to decriminalize drugs – including cocaine, heroin, and LSD – in Oregon.

Next up is tax policy, where Tanner notes that voters in both Colorado and Illinois voted against higher taxes. In fact, in Colorado the ballot measure to destroy TABOR – a constitutional measure to limit taxation – was defeated and the initiative to cut the state income tax was approved. There was also a tax policy item on the ballot in California, Tanner explains:

Possibly the biggest question put to California voters, Prop. 15, would have changed property tax rules for commercial properties, resulting in an overall ax increase of $7.5-$12 billion.

According to Tanner, the outcome on this item is still uncertain.

Most of the rest of the items on Tanner’s list cover civil liberties (largely matters under the Fourth Amendment) and criminal justice reform. Some items pertain to economic regulations, including the now-infamous attempt by the state of California to force “gig workers” over in the employment fold.

For the most part, this account of ballot initiatives does indeed have a libertarian profile. Deregulation is essential for economic freedom, and even social deregulations can have positive economic effects. For example, the right of gay couples to marry can be helpful in their entrepreneurship as they get access to the same tax code as married, heterosexual couples. However, the deregulation of narcotics – what Tanner refers to as a “major hit” to the War on Drugs – does not belong under that banner. As I explained recently, the attention that libertarians give to drug legalization is a major reason why their movement never really translates into electoral victories. It puts on full display their indifference to how legal drugs affect the ability of a libertarian society to defend its own liberty.

There is a technical difference between decriminalization and legalization, but that difference does not play out in practice. Wherever the use of these drugs is associated with criminal impunity, drug use will expand, and wherever drug use expands, society gradually deteriorates. Respect for property rights, even public safety, weakens, as does the ability of members of a community to support themselves and their families.

If anyone needs proof of this, a review is recommended of what alcoholism has done to our society over the decades, even centuries. Is liberty advanced by an expansion of this destructive domain of human society?

A common argument for legalization, one that Tanner does not mention, is that lawmakers want a new tax base. This was a major argument in Colorado when legalization of THC was being debated. It has also been an often-heard argument in the fledgling legalization debate in Wyoming, and I cannot help wondering how long it will take before the state of Oregon fully legalizes all drugs and puts an excise tax on their sales.

Ironically, the same libertarians that celebrate the defeat of tax-hiking ballot initiatives also celebrate the de facto creation of a new tax base in more states across the country.

Perhaps in the future, the Cato Institute and other outfits that propose legalization should add a caveat to their efforts: legal drugs, so long as they cannot be taxed. However, I doubt that this would ever happen: libertarian legalizers like drugs more than they hate taxes.

This preference is visible in the priorities that libertarian think tanks make. Not only do they allocate about ten percent of their staff resources to any research and policy work related to government spending, but they also isolate their fight against tax hikes from that very same spending. It is well known that opposition to higher taxes without proposition of spending reform eventually folds to higher taxes and higher spending.

There is, namely, one question that every opponent to tax hikes will eventually trip up on: “So how do you want to pay for [insert any given government spending program here, preferably one of high emotional value]?”

Tanner’s list is conspicuously void of examples of efforts to reduce government spending. This is not his fault, of course – he is only reporting on ballot initiatives from across the country. However, it is very important to understand the significance of the silence on spending. It is more common with state laws that mandate ballot initiatives for tax hikes than it is with state laws that mandate ballot initiatives for spending hikes. In fact, the latter does not exist anywhere; there is not a single state where voters have to approve an increase in appropriations for state and local governments before the increase goes into effect. Government spending is for the most part autopiloted through the legislative process; the squabbling that always takes place tends to be limited to small, isolated items of no real consequence to the bottom line.

In other words, while there are good reasons for libertarians to celebrate the defeat of tax-hiking initiatives in California, Colorado and Illinois, there are even better reasons to ask what the point is of those victories when government spending keeps growing by its own volition. Over time, resistance to higher taxes becomes increasingly difficult as government spending keeps growing. Colorado is a case in point: its TABOR, which only applies to the General Fund, held the line well on state government spending in the 1990s, the Centennial State’s first decade with TABOR. Since then, however, its effect on government spending has weakened.

Proponents maintain that without TABOR, government spending would have been even higher today. That is an unverified statement – there is no study that shows how many more spending initiatives would have passed the state legislature if TABOR had not been in place – but it is not unlikely that they have a point.

The question, of course, is how much higher spending would have been, but with reference to Tanner’s list there is an even more important question to ask. Why isn’t the libertarian movement pushing for the same hurdles to be placed in front of spending hikes as they have created to thwart attempts to raise taxes?

Again, Michael Tanner’s account of libertarian causes that moved forward in the November 3 election, is worth a read. It is inspiring in some ways, but its foremost contribution is in shedding light on what is not on the list. If there is any lesson to be learned here for libertarians, there it is.

If Cato gets its wish and Biden become president, we will wake up one day with a top tax bracket of 62 percent. More of us will also have the displeasure of waking up to the foul smell of legalized marijuana. Therefore, the one question that every libertarian has to ask himself is: would you rather smoke a legal joint and pay a 62 percent marginal income tax, or stay away from the joint and pay 26 percent?

Laffer and Moore Get It Wrong

Art Laffer and Steve Moore are widely considered to be the foremost economists of the libertarian movement. They are praised and raised to the skies, lauded and quoted widely. In Laffer’s case, it is in many ways merited. He did a fantastic job getting the Reagan administration to agree to a sweeping tax reform.

Since then, though, as I have shown in my four-part series on tax and spending reform, his theory has lost its steam.

Tax cuts don’t work anymore. I wish they did, but they don’t. The evidence is irrefutable.

But it gets worse than that. Not only do tax cuts don’t work, but these two fine gentlemen are selling this ineffective medicine as a means to pay for the welfare state. In short: cut taxes, and we can afford socialism.

Yes, that’s right. Art Laffer and Steve Moore make this case. In their book Trumponomics they explain that higher growth will pay for our socialist welfare state:[1]

One underappreciated dividend from this higher permanent pedestal of economic growth is that, if Trump succeeds, it will help largely solve the long-term funding crisis of Social Security and Medicare. With 3 percent economic growth, up from the 1.8 percent predicted by the Social Security and Medicare actuaries, the compounding effect over 50 years means more than $50 trillion of revenues into Medicare and Social Security trust funds, largely dissolving the funding shortfalls of these programs – and perhaps leaving them in long-term surplus, not deficit.

That’s it. Cut taxes, get more growth, and we can continue to use two thirds of the federal budget to take from Pete and give to Paul.

This paragraph is also the closest that Laffer and Moore get to even discussing government spending. They have a non-committal passage on pages 99-100 about how nice it would be if people didn’t get more in welfare than they get working a minimum-wage job, but they have absolutely no ideas on how to approach that problem with tangible reform ideas.

I have actually proposed a welfare reform that would do what Laffer and Moore are dreaming about. If Steve Moore had shot me an email, I could have shared my plan with him (again). If the original version is not palatable, I have an updated model from 2012, published on SSRN in 2013, that I originally developed for a presidential campaign.

The problem, of course, is that spending reform is hard work. It is quite a bit harder than to propose and lobby for tax cuts. Spending reform quickly runs into a fire storm of criticism from the left: do you really want to take away Medicare from this grandma and Medicaid from that poor family? Are you cruel and cold-hearted?

My reform circumvents that problem. In other words, the big obstacle to spending reform is not the design of workable solutions – it is the lack of courage among the layers of libertarians. Courage to propose workable reforms. Courage to convince Congressional Republicans to think anew.

Courage to go against the mainstream.

Laffer and Moore lack that courage. The closest they get to discussing actual, actionable spending reform is a quick, positive mention of the Penny Plan. As I recently demonstrated, this plan is entirely unworkable. Why? Because it keeps all the welfare-state promises intact. It rests on the premise that government can provide everything it has said it will provide, only do so more efficiently.

As my numbers show, that is wholeheartedly impossible. The only option is to reform away the promises – to return them to the private sector and get government out of economic redistribution altogether.

Laffer and Moore steer clear of that one. Their solution is a dreamy comment about how higher growth would eliminate the budget deficit and perhaps even let the welfare state run a surplus.

This is the neoconservative approach to the welfare state. It is close to what Irving Kristol, William F Buckley Jr. and others talked about when they discussed the American welfare state. Like Laffer and Moore, the neocons of the 20th century firmly believed that the welfare state should be preserved, but that it should be run a bit more efficiently than it would be under socialist management.

In the 21st century model, this neoconservative dream relies on yet more tax cuts to generate yet more economic growth. I hate to be the Grinch that stole Christmas, but the facts on the ground speak a different language. First, consider Figure 1, which reports 715 pairs of observations of government revenue as share of GDP, and GDP growth. The numbers are from 29 European countries from the period 1996-2019 (with limited availability from some countries). These observations are then organized in deciles based on the tax-to-GDP ratio, with average tax ratios and growth rates for each decile:

Figure 1: Growth and government in Europe

Source of raw data: Eurostat

The bigger government gets, the more sluggish the economy grows. The same economic mechanisms that work in Europe, work here as well.

But wait – didn’t I just say that this is tax revenue as share of GDP? Exactly. But what if we cut taxes? Doesn’t that move us up the blue function?

No, it doesn’t. Laffer and Moore want to keep spending as usual (assuming that they realize what will happen in Congress when the Penny Plan starts pinching away big chunks of our entitlement programs) which means that the welfare state will not get smaller. It will continue to grow. Therefore, government spending will continue in the bracket of 37-40 percent of GDP. If we are going to balance the budget, we need to collect the same share of GDP in taxes, fees and charges.

Since the size of the welfare state remains unchanged, all that the Laffer-Moore growth strategy will accomplish is a redistribution of the tax burden.

But wait: if GDP grows, then the denominator grows. That means the welfare state may not shrink in terms of dollars, but it certainly declines are share of GDP, right?

No, it doesn’t. As I explained in my book The Rise of Big Government, our welfare state has a built-in mechanism that automatically grows its size as GDP grows. It is called the “relative definition of poverty” and states that people are entitled to government benefits, cash and in-kind, when their income is at a certain percentage of median household income. Since GDP growth means that median household income grows, so does the eligibility threshold for welfare-state benefits.

In short: the more the economy grows, the bigger the welfare state gets. Therefore, if Laffer and Moore got what they wanted, their sought-after surge in tax revenue would be chasing welfare-state spending like the rabbit that tried to race the turtle and never caught up with him.

To solve this problem, you need to redefine the ideological nature of the welfare state.

Then, of course, there is the problem with economic planning. Government does not operate under the free-market price mechanism. It uses a different value unit, one that is directly derived from Marxist labor-value theory. Therefore, the allocation of resources under government is neutral, even hostile, to economic growth.

I elaborate on this problem in my forthcoming book Socialism or Democracy: The Fateful Question for 2024. Until it is out this winter, we will simply note that the bigger government gets, the larger a share of the economy is put under growth-hostile administration. There is simply less economic activity out there that can produce the growth that Laffer and Moore depend on.

Simple arithmetic, in other words. I am surprised that two guys as smart as Steve Moore and Art Laffer did not figure this out.

Structural spending reform, folks. Nothing else works.

[1] Moore and Laffer: Trumponomics. All Points Books (2018).

Tax Cuts or Spending Cuts: Part 4

As we have seen so far, our efforts to rein in government spending and balance the federal budget (in that order) have failed. The reason is that people have been focused on the wrong solutions:

  1. There is too much focus on tax reform; specifically, there is no point in eliminating the income tax, because as state and local governments have demonstrated so carefully, the one tax is always replaced by other revenue sources;
  2. Supply-side economics has stopped working; the welfare state is simply too big; and
  3. Once you turn to the spending side, the salami approach – also known as the Penny Plan – will force government to default on its promises in Social Security, Medicare, Medicaid and other entitlements.

So if we want to bring fiscal sanity to Washington, what is the alternative? Structural spending reform.

First, though, one final word on the tax side. The more we reform taxes in order to stimulate economic growth – with the implied goal to increase tax revenue and reduce the budget deficit – the more serious our budget problems get. In addition to the reasons I discussed in earlier installments of this article series, there is also the problem of increased revenue volatility. Every tax reform we have done has increased the amplitude of tax revenue. Consider Figure 1a, which reports the current-price growth rates in GDP (blue) and in government revenue for all levels of government combined (grey):

Figure 1a: Growth rates in taxes and GDP

Source of raw data: Bureau of Economic Analysis

Specifically, there are three episodes in Figure 1a that illustrate how our ability to balance government finances has been weakened over time:

Figure 1b: Episodes in revenue and GDP growth

Source of raw data: Bureau of Economic Analysis

Before the Kennedy tax reform, the correlation between tax revenue and GDP growth was fairly close (1). With the Kennedy reform we saw a slight departure of the two, but it was not very pronounced. It indicated, though, what was to come.

In the late 1970s we saw high inflation and very high growth rates in tax revenue (2). The reason, of course, was the combination of inflation indexing in income-tax scales and the high reliance of federal, state and local governments on income taxes. The combination of high taxes and high inflation was bad for the economy, with both of them ending in the early years of the Reagan presidency.

At this time, supply-side economics still worked. Economic growth was solid during the Reagan years, as was growth in tax revenue. The problem was that the federal tax base shifted toward higher incomes, a problem that would become even more pronounced with the Bush tax reform. The swings in tax revenue increased over time (3), making it increasingly difficult for governments at all levels to balance their budgets.

The Trump tax reform appears to have increased the revenue amplitude. This problem is particularly noteworthy since inflation has been low and GDP growth only moderate, removing two factors that otherwise would cause sharp swings in government revenue.

To summarize, the problem with government finances is not the revenue side. It is the spending side. Figure 2 summarizes this point by reporting swings in tax revenue, GDP growth and government spending for the same period of time as in Figures 1a and 1b. The swings are sorted based on GDP growth from high to low. As we move from the origin of Figure 2, outward to the right, and as the GDP growth rate tapers off (blue) so does the growth rate of tax revenue (dashed black), albeit more pronounced.

What is really interesting in Figure 2 is the trend in government spending (dashed red). While remaining relatively unchanged for the better part of the interval of GDP growth rates, it rises noticeably as GDP growth falls below two percent:

Figure 2: Growth rates for GDP, tax revenue and government spending

Source of raw data: Bureau of Economic Analysis

In short: as GDP growth slows down over time, the discrepancy between tax revenue and government spending increases.

Herein lies the key to government reform. It is not about taxes, and it is not about salami-tactic spending reform.

It is about structural, permanent reductions in government spending. The reason why government outlays increase more prominently when GDP growth tapers off is that the programs that government spends most of its money on are designed to become more important in the lives of Americans precisely for that reason. When GDP grows more slowly, fewer people are able to work their way out of poverty (as statutorily defined) and more people become vulnerable to the thresholds in those programs.

The Earned Income Tax Credit is a classic example, where someone making $35,000 per year can face the same marginal-tax effect from a $5,000 income rise as someone making ten times that amount. More people get locked in to dependency on the welfare state, simply by virtue of how the welfare-state entitlements are designed.

Over time, more people remain dependent on Medicaid, on food stamps and other programs. Even Social Security is affected by slow growth, although that only shows up in its finances over an extended period of time. Still, the effect is worth noting: retirees who earned a relatively modest wage get a larger percent of their income replaced than those who earned more. With low incomes paying modest taxes into the system, over time this means a more rapid depletion of the system – and a relatively higher increase in Social Security spending.

In other words, what we need is a comprehensive, structural reform of all the spending programs that the federal government spends our money on. This kind of reform fundamentally rewrites the role of the federal government by terminating the promises that come with its vast portfolio of entitlement programs. A structural reform gets government out of the business of economic redistribution and strictly bans the use of taxpayer money for this very purpose.

Structural reform means that the private sector resumes responsibility for everything the government does today, except its minimal-state functions: defense, law enforcement and infrastructure.

There are two big challenges in executing structural reform:

  1. Making sure the private sector can actually take over the responsibilities that government has today without leaving poor and vulnerable citizens worse off; and
  2. Making the transition from the current system to the new so smooth that it does not disrupt either economic growth or political and social stability.

These are significant challenges, and they can seem daunting. That, however, is no reason to shy away from them.

I have my own plan for this in the making. Until I publish it, here is a first taste of what structural reform can look like.

Tax Cuts or Spending Cuts: Part 2

In Part 1 I explained that fiscal conservatives no longer can rely on tax cuts to save us from big government. I noted specifically that libertarians who want to eliminate the income tax as part of such tax cuts, are missing the point entirely. Using state-level data I pointed out that states without an income tax show no sign of having smaller governments than states with an income tax.

In short: tax cuts no longer work as a means to contain government growth. They also do not help with balancing government finances. Government is simply too big.

Supply-side economics doesn’t work anymore. Only an ideologically principled, theoretically consistent and morally sound welfare-state reform effort can make the difference. There is compelling data to make this point, but first, let us take a look at the theory behind the demise of supply-side economics.

The blue, solid line in Figure 1 represents government spending, growing at a steady pace (hence the modest upward slope). Tax revenue is represented by the solid red line. A supply-side oriented tax cut initially depresses tax revenue, but as the economy starts growing faster under lower tax rates, revenue picks up at a faster pace. Eventually, revenue collection surpasses government spending and government runs a surplus:

Figure 1: The theory behind supply-side tax cuts

There is nothing wrong with the theory behind the red, solid function, quite the contrary. It has good empirical support from previous tax-cut reforms. The problem lies instead on the spending side: consider a slightly higher growth rate in government spending, as per the dashed blue line. When government grows faster, its depressing effect on government spending kicks in earlier than it otherwise would.

Specifically, there is the 40-percent threshold where four out of ten dollars in the economy runs through government. I discussed this point in my book Industrial Poverty, where I presented evidence by me as well as others on how this threshold works. Once government occupies more than 40 percent of GDP, there is a permanent slowdown in economic growth.

Once this happens, it becomes harder for the private sector to put a tax cut to good use. Bluntly, there will be less growth from every dollar’s worth of tax reductions. Hence the dashed red line.

Once the solid lines in Figure 1 become dashed, tax cuts no longer work. It is futile to spend political energy and efforts on those; we should still oppose tax hikes, but the reform efforts must be allocated to the spending side.

As a reinforcement of this point, consider Figure 2. It reports the growth in $100 worth of, respectively, total government spending and current-price GDP for the U.S. economy. For every $100 we spent through government in 1954, we spent more than $7,500 in 2019; over the same period of time, $100 worth of GDP grew into $5,000.

Government outpaced its own tax base by $1.50 to $1:

Figure 2: Growth in government spending relative GDP

Source of raw data: Bureau of Economic Analysis

The growth of government is stunning in itself, as are its causes. Consider Figure 3, where we also pinpoint how the size of government (relative GDP) has become increasingly immune to supply-side tax cuts. To highlight the relationship between federal tax cuts and the size of government, we now disregard states and local governments and focus solely on the spending that Congress has jurisdiction over:

Figure 3: Cycles in federal government spending

Source of raw data: Bureau of Economic Analysis

President Kennedy worked with Congress on the lowering of federal income taxes (1). It is hard to identify any clear downward trend, the reason being in part that defense spending at this time constituted almost 50 percent of the federal budget. That spending tends to be entirely immune to the ups and downs of the economy; at this time it was slowly being ramped up for the purposes of the Vietnam War.

Nevertheless, it is worth noting that the Kennedy tax cuts were indeed followed by a strong growth episode in the U.S. economy, one we would not see the like of until the 1990s. Unfortunately, the relatively modest size of the federal budget under JFK was replaced by a steady climb under President Johnson (2). Launching his War on Poverty, LBJ led the transformation of the American welfare state from socially conservative to redistributive socialist. New entitlement programs, built around a new, relative definition of poverty, permanently expanded the federal government. What had been a budget equal to 17-18 percent of GDP became a fiscal conglomerate equal to 22 percent and more.

It was not just the federal government that expanded. State spending grew even faster, as they became responsible for running a good part of the new programs that Congress put in place under the auspices of fighting poverty. With the rapidly expanding weight of government on the economy, growth slowed down and taxes depressed both entrepreneurship and career development.

In response, President Reagan spearheaded major tax reforms that rejuvenated the U.S. economy. Growth picked up and the private sector gained back some ground lost to government (3). The architect behind the supply-side strategy, Art Laffer, was proven correct on all points except one: the federal budget deficit did not vanish.

This was a sticking point that supply siders never quite addressed. It was not their theory in itself that was wrong; it was its omission of the spending side. Notably, it took a fiscally conservative Democrat in the White House to shed light on the importance of the spending side: working with fiscally conservative Republicans, President Clinton significantly tightened the belt on the federal budget, not to a point where he shrunk it, but by significantly reining in its growth (4).

With an economy growing in excess of four percent, Clinton was able to sign four budgets with a surplus. However, despite a reasonably good welfare-reform bill, known by its PRWORA acronym, he did not do much to turn the long-term tide of the welfare state. On the contrary, when he signed SCHIP into law he added a big spending program that later became a driver in Medicaid costs.

Once again, a Republican took the leadership on the tax side of the budget. With two tax cuts, one in 2001 and one in 2003, President Bush Jr. tried to counter the Millennium recession by repeating the Reagan supply-side success. It worked to some degree: while the economy revved back up again and tax revenue with it, non-military spending increased at about 6.5 percent per year. The welfare state almost outpaced tax revenue.

Not quite, though. If the economy had not gone into the Great Recession in late 2008, the federal budget would have been in balance by 2009. For sure, that was six years after the second Bush tax cut, but it was en route to happen.

Does this mean that supply-side economics worked under Bush? Modestly. It showed that it could still deliver good government finances under the best possible economic conditions. The problem is that last part: best possible conditions. A recession was all it took to throw the federal budget back in the hole again (5). For sure, President Obama and the Democrats recklessly increased government spending in the first couple of years of his presidency, but once the Republicans took back the House a fiscal standoff between Congress and the White House actually led to a de-facto practice of fiscal responsibility.

With Trump in the White House, Republicans tried for a third time to put supply-side theory to good use. Its positive effects, which were visible in the economy all the way up to the artificial economic shutdown in 2020, were too modest to bring about three percent annual economic growth. They also failed to make a dent in the budget deficit.

The reason is painfully obvious: government spending has weakened the transmission mechanisms that generate economic growth. The welfare state has eroded the incentives that drive employment, innovation, investments and entrepreneurship. It has not destroyed them, but it has worn them down to a point where we get much less growth out of every $100 worth of tax cuts than we did under Kennedy, or even Reagan.

Figures 2 and 3 tell us that the size of government is immune to tax cuts. What it does not tell us is how that size has remained comparatively stable since the 1970s thanks only to growing budget deficits.

A coming article will discuss tax hikes – and why they are a thoroughly bad idea. First, though, in Part 3 we look at what would have happened if we had tried to end the deficits by means of a Penny Plan.

Tax Cuts or Spending Cuts: Part 1

There are some very good organizations out there fighting to keep taxes down. Americans for Tax Reform is at the forefront, with others not far behind. They all fight the good fight: it is always preferable to have lower taxes than higher taxes.

Many economists propose tax cuts as a way to reduce the budget deficit. The idea, known as supply-side economics, is based on the premise that lower taxes generate stronger economic growth, which in turn generates more tax revenue.

Supply side economics is a valid theory and the Laffer Curve – almost the hallmark of supply-side theory – has strong empirical support. I recently published an article where I reported data for the European economy, showing a solid Laffer effect on tax revenue. However, I also cautioned:

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

Once the welfare state grows past a certain point, the Laffer effect, while still visible, will be far too weak to close deficit gaps. Plain and simple, the supply-side mechanism ceases to function insofar as the government budget goes. Tax cuts still generate more economic growth and thereby an increase in tax revenue, but without adequately affecting the government budget.

The reason is as simple as it is brutal: too much spending. Having grown increasingly frustrated with the lack of focused attention to the spending side among libertarians and conservatives, in the next few days I will be rolling out a series of articles on the dynamics between tax cuts and spending cuts.

While fiscal conservatives do pay attention to spending, it is almost always in an ad-hoc manner. A common idea for reform is a penny-plan style reform that slows the growth of government spending. This is not a bad idea in and of itself, but as we will see in a coming article it does not solve the underlying structural problems that drive government spending. A penny-plan style spending reform buys us time, slowing the growth of government enough to let Congress piece together a major entitlement reform agenda.

What we need is a master plan for the structural overhaul of our welfare state. We need to reform it away until government is out of the business of economic redistribution.

This is no easy task. It is in fact more daunting than it was back in the 1960s putting the first man on the moon. That, however, is no excuse not to do it. Leaving an unaffordable welfare state for our children to pay for, and asking them to do so while also funding our consumption of the welfare state in the form of a big government debt, is nothing short of collective egoism.

It is also a safe way to ruin the country and the future of generations of Americans.

To see why the master plan is the way to go, and supply-side economics no longer works, we will work our way through a stack of data. We start today with a review of state and local government finances. Specifically, the review will show that the absence of an income tax does not help in terms of containing government spending. Bluntly: states with no income tax have just as big governments as states where income taxes provide a large share of government revenue.

As a first step, Figure 1 reports the combined fiscal balance for general revenue and expenditure for 2018 in all the 50 states. The vertical axis represents the difference between general revenue and general spending as percent of general revenue. This metric varies from year to year, with the majority of states swinging between surplus and deficit. However, the picture is almost always mixed, as reported here:

Figure 1: State and local government fiscal balances

Source of raw data: Census Bureau

Over the long term, states and local governments have had about the same problem with balancing their books as the federal government has. The deficit problem is not as pervasive, but there are years when almost all of them run deficits.

It is important to remember that these numbers include both states and local governments; the local-government share of spending varies significantly across state lines. In other words, to ignore local governments would be to give an unfair, even skewed representation of the role of government in our states’ economies.

Most of our government spending is allocated to the welfare state, i.e., programs that provide government benefits to people for the purposes of economic redistribution.* Two thirds of federal spending is for the welfare state; in 2018 the average for states and local governments was 56 percent. This share has increased over time, slowly increasing the stress on government finances. A spending program for economic redistribution is driven not by what taxpayers can afford, but by the definition of the entitlement embedded in the program. Medicaid, e.g., provides health care to its enrollees, giving them access to a portfolio of medical services the quality of which is defined by medical technology, and the quantity by patient health conditions.

I have discussed the discrepancy between health-care costs and tax revenue in a previous article. The same principle of independent cost hikes applies to education, income-security programs, housing and everything else provided under the welfare state.

This point is almost universally overlooked in the fiscal-conservative movement. Too much focus is no tax reform, specifically to keep taxes as low as possible. While, again, a respectable ambition in itself, it does not help with containing the growth of government. For example, if a state eliminates its income tax, it will most certainly not reduce the size of its government. Again based on 2018 Census Bureau data on state and local government finances,

-In the nine states where the personal income tax contributes 0-1 percent of total revenue, government spending amounted to 21.9 percent of total private-sector economic activity, a.k.a., private-sector GDP;

-In the 12 states where the personal income tax provided more than 15 percent of total revenue, government spending was equal to 21.2 percent of private-sector GDP.

The 29 states in between had roughly similar-sized governments. In other words, it does not help fiscal conservatism to abolish the personal income tax.

But does it harm fiscal conservatism to do so? That question is not primarily a matter of economic analysis, but there is one point that can contribute to the answer. Table 1 reports the revenue share of the personal income tax (Typ) and the revenue share from non-tax sources:

Table 1: Government revenue sources

Source of raw data: Census Bureau

In short: when governments cannot rely on the income tax they seek out other revenue sources instead. To take one of the favorite examples among opponents to the income tax, in 2018 government in Wyoming got 75 percent of its revenue from non-tax sources. This is the highest share in the country. Contrast this to Connecticut, where the personal income tax provided 22.3 percent of total government revenue and non-tax sources added one third of total revenue.

Government spending as share of private-sector GDP was 16.6 percent in Connecticut – and 29.9 percent in Wyoming. In other words, the supposedly low-taxed Cowboy State has the fourth largest government in the country. And this is a reasonably generous measure: if we use private personal income instead – the most proper tax base measure available – Wyoming has consistently ranked in the top two in the country.

However, more important than these factoids is the problem with political effort. It takes a lot of work to advance policy reform – spending of political influence capital – which means that every such effort must be designed to yield the best possible outcome. If we use proper metrics for that outcome (rolling back the welfare state) then it is unquestionably better to focus on spending reform instead of tax reform.

In Part 2 of this series we take a detailed look at why supply-side tax cuts are no longer effective, and why spending reform is the only way forward.

*) This category of spending includes social programs, income maintenance, health care, unemployment benefits, housing and community development and education. The last item is often overlooked, but regardless of whether or not one defines education as an essential government service, it does belong in the redistribution category. Government provides the service based on criteria defined by government, not decisions made by individuals; funding is also independent of the use of the service.