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.