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Wednesday, October 26, 2011

Taxation Is the Lifeblood of the State

The cliffhanger debate over whether or not to raise the federal government’s debt ceiling threw U.S. fiscal policy into brighter relief than it has been in recent memory.

Suddenly people were calling for significant cuts in government spending in the face of a rapidly growing national debt.

As often happens, calls for cuts in government spending were met by competing calls for higher taxes, especially on higher-income earners and businesses. They can afford to pay the extra taxes, we were told. And what’s more, higher taxes could actually help the economy.

In making this case, proponents of raising taxes pointed to the tax increases that came out of Washington under President Clinton in 1993. The U.S. economy, as measured by GDP growth, was strong in the years after those tax hikes while unemployment and inflation were relatively low. The argument now is that the 1993 tax increases did not inhibit the economic boom the country enjoyed in the last six or seven years of the twentieth century.

In April New York Times columnist Nicholas Kristof made this very argument. He wrote that while it’s true higher taxes in general “tend to reduce incentives,” this apparently “weak effect” is often overwhelmed by other factors. “Were Americans really lazier in the 1950s, when marginal tax rates peaked at more than 90 percent?” Kristof asked. “Are people in high-tax states like Massachusetts more lackadaisical than folks in a state like Florida that has no personal income tax at all?”

Like other observers, Kristof also contrasted the “golden period of high growth” after the Clinton tax hike with the “anemic economy” that followed George W. Bush’s tax cuts.

But do higher taxes really spur (or at least not inhibit) prosperity? Looking at the data from the 1990s, one might believe so. After all, the 1993 tax hikes were followed by years of strong economic performance. Post hoc ergo propter hoc (after this, therefore because of this), many might believe.

But not everyone agrees the data are quite so clear. The Heritage Foundation’s J. D. Foster, for example, believes the data show that the U.S. economy was already expanding when the Clinton tax increases took effect. If anything, he believes, those tax hikes slowed overall growth for several years until 1997, when the Republican-led Congress passed a series of tax cuts, including a reduction in the capital gains tax rate from 28 to 20 percent.

The “real acceleration in the economy began in 1997, when economic growth should have cooled,” Foster wrote. “This acceleration in growth coincided with a powerful pro-growth tax cut.”

Foster also authored a 2008 Heritage Foundation summary of several scholarly studies showing tax hikes corresponding with slower or negative economic growth. In theory higher taxes could encourage greater levels of private investment through lower borrowing costs—if government used the money to retire debt and reduced its competition for lendable funds. But this potential “silver lining” is overshadowed by the negative effects of higher taxes, he stated. However plausible theoretically, in practice the argument runs into trouble, not least from the fact that governments seldom save any of their revenue, Foster notes.

Still, the idea that the 1993 tax increases spurred economic growth will not die easily. For instance, some people argue that those tax hikes provided much needed confidence in the U.S. economy. As Kristof put it: “Tax increases can also send a message of prudence that stimulates economic growth.”

With this much disagreement it’s hard to know what is really the truth. And this is always the case when looking at the effects of any single economic policy in a vast and complex system. Indeed, so much is happening at any given time in a modern economy—central-bank policy, trade policy, military spending, technological innovation, war or peace, and more—it’s impossible to draw hard and fast conclusions from macroeconomic data alone.

The Austrian economist Ludwig von Mises made this point in his classic treatise, Human Action, in 1949. In discussing the role of historical data in economics, he wrote: “The champions of logically incompatible theories claim the same events as the proof that their point of view has been tested by experience. The truth is that the experience of a complex phenomenon—and there is no other experience in the realm of human action—can always be interpreted on the ground of various antithetic theories. . . . History cannot teach us any general rule, principle, or law.”

Stepping back, therefore, it may be worthwhile to consider fairly uncontroversial economic propositions, such as the law of demand or the law of marginal utility, when trying to determine the likely effects of a tax increase.

Basically, taxes alter relative prices. A tax on gasoline makes gasoline more expensive. A tax on whiskey makes whiskey more expensive. By the same token, a tax on income affects the “price” of leisure; that is, an income tax reduces the reward or “price” one receives for forgoing leisure in order to work. If you are willing to work for $10 an hour, you’re essentially “selling” your leisure time for that price. You might not be willing to sell that leisure time for a lower price. Thus an income tax can be expected, on the margin, to reduce the willingness of some people to work.

While all this is important, it’s probably more important to consider what happens to taxes after the government collects them. How government officials spend tax revenue can damage the economy as much as the tax itself can. That’s because taxes are used for any number of things that distort markets and waste resources, such as providing subsidies to favored industries or strengthening bureaucracies.

As a newspaper reporter I have frequent opportunities to witness government decisions to spend taxpayer dollars. Often an argument in favor of a particular spending program is that it will only add a few dollars to any single individual’s tax burden. Once a government program is in place, however, it’s extremely difficult to reverse it because government spending benefits particular individuals and they are quite motivated to maintain it. When budget cuts are proposed, government officials have effective ways of fighting back. For example, a proposed cut in education spending is nearly always said to be taking teachers out of classrooms, and a proposed cut in police spending is nearly always said to be taking neighborhood cops off the streets. The “fat” in education and law-enforcement spending may be elsewhere. But those are the items placed on the public chopping block by clever bureaucrats and politicians.

So the real problem with taxes and tax increases may be that they simply feed the beast—the political and less-efficient government sector—while shrinking the voluntary, more-efficient private sector. For anyone concerned about liberty this is reason enough to oppose higher taxes.