All Commentary
Thursday, April 1, 1993

The Costs of Tax and Spend

How free are Americans when the tax burden is so high?

In 1992, Americans worked from January 1 to May 5 just to pay their taxes. According to the Tax Foundation, this portion of the calendar year represents the portion of their total income Americans, on average, pay in taxes. But the whole truth about taxes and spending, however, is much worse than this.


The Arithmetic

Tax Freedom Day is calculated by adding up all the taxes paid (income taxes, sales taxes, property taxes, corporate taxes, Social Security taxes, user fees, and so on) and dividing by the total income of individuals. This result, approximately 34 percent, is then applied to the calendar year and becomes that portion of the year in which individuals work for government. The remainder of the year after Tax Freedom Day is the time individuals work for themselves. As simple and straightforward as this calculation is, and as intuitively appealing as it is, it significantly understates the amount of government in our lives and consequently overstates the amount of freedom we have.

To begin with, the calculation does not include regulatory requirements, compliance costs, the liabilities of government-sponsored enterprises, and inflation. Regulations are, of course, one of the government’s ways of making citizens incur costs without being taxed directly, but the effect is the same as taxation—earnings are used to enforce government policies. Compliance costs are those that individuals incur in filling out tax forms, consulting tax accountants, maintaining records, keeping up with the tax code (is it possible?), or anything else required in following governmental mandates. The tax-accounting industry absorbs many billions of dollars—this is only part of the compliance costs that fall on the shoulders of citizens.

Inflation, too, is a tax. It is the national government’s way of paying for projects without explicitly taxing its citizens, but it is no less a burden. Inflation is the result of the government creating money. The chief impetus for the national government to inflate is its desire to spend more than it takes in. (A second impetus is the fact that inflation helps borrowers at the expense of lenders. The public sector, of course, is a net borrower while the private sector is a net lender.) When the government pays for projects by creating more money, the result is a decrease in the purchasing power of individuals. The cost of this government-created inflation in terms of decreased purchasing power can be staggering. An inflation rate of just 3 percent (considered tame by recent standards) means an annual decrease of $180 billion in the purchasing power of private Americans. This could represent as many as ten additional days of work for all Americans to cover the government’s hunger for spending.

The Tax Freedom Day calculation also does not include borrowing by governments at the federal, state, and local levels. Not only does the government spend all income earned up until May 5, but it continues to spend more by increasing the liabilities of its citizens. Some might argue that the incurred liabilities are offset by the assets purchased with the borrowing, but this is no less so with the taxes we pay. Government borrowing is every bit an infringement on our economic freedom as taxation. If it weren’t, why wouldn’t we finance all of government by perpetual debt and remain forever free? An important lesson of finance applies here: How we finance expenditures, whether corporate projects or government programs, is much less important than the choice of those expenditures. When government borrows our money or takes it directly through taxes or indirectly in ways mentioned above, the net effect is the same: The government, not individuals, decides how earnings are spent. This diminishes freedom.

So how do we add all this up? How much of the people’s earnings is government taking? Milton Friedman has suggested one way to get an estimate: Begin by adding up all the expenditures of government at the federal, state and local levels. In the current fiscal year, this is about 47 percent of gross domestic product, which means that 47 percent of what the average American earns is going directly to the government. Now add in regulatory costs and compliance costs as well as off-budget items such as expenditures for federal agencies. I have no accurate way of estimating these, but totaled with direct taxes it becomes apparent that the average American is working more than half of the year for government and less than half of the year for himself. Cato the Elder was right—“A king is an animal that lives on human flesh.”[1]


The Consequences

The costs of such an onerous tax burden are less obvious, yet no less severe and exacting, than one might think. The national debt and the budget deficit get attention as causes of impending economic doom. The real problem is not debt-financing of government enterprise, but government enterprise itself. Even if the government had no debt, there could be great costs to its operation. We would, for instance, have a federal government with expenditures of 30 percent of gross domestic product, and if tax collections equaled 30 percent of gross domestic product there would be no debt. Nevertheless, the opportunity cost of such large expenditures by government is enormous. As Adam Smith observed: “The industry of the country, therefore, is thus turned away from a more, to a less advantageous employment, and the exchangeable value of its annual produce, instead of being increased, according to the intention of the lawgiver, must necessarily be diminished by every such regulation.”[2]

It is often commented that deficit spending crowds out investment by the private sector. This is true enough: Funds lent to the government mean fewer lendable funds for the private sector. However, it is no less true that money spent by the government (whether by borrowing or through tax revenues or printing more money) means less spending and investment by the private sector. Hence, all government spending, however financed, crowds out private enterprise. It also sacrifices market decisions, and all the knowledge that the market brings to bear, in favor of decisions made by politicians, whose motivations may be questionable, and whose wisdom is necessarily inferior to that of the market. Again, Adam Smith says it best: “Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct.”[3]

The issue then is not how we finance government, but the size of government. The larger the activity of government, the greater the cost to society, regardless of the amount of government debt. A society which aspires to be free surely must admit that control of over half of its product by government is a serious problem. How much liberty exists in such a situation? How much of our lives is spent complying with the dictates of the IRS and other governmental bureaucracies? How much of our lives is taken directly from us when we are allowed to keep only half of what we produce? How much is lost for the present and the future by the usurpation of our personal sovereignty by government?

It has been claimed that there is a cultural war going on in America. In truth, that battle is part of a larger conflict, the war of public sector versus private sector. Currently, the public sector appears to be winning. It is growing much faster than the private sector and its growth insidiously retards private enterprise. The situation is worse than Tax Freedom Day implies and we need to be aware of this. We need also to be aware of the power of freedom. As Adam Smith said:

The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is alone, without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security.[4]

An economic environment where freedom is being supplanted by political control is one with the highest opportunity cost. That is what makes the fight for freedom so important.

  1. Quoted by Plutarch in Makers of Rome (New York: Penguin Books, 1965), p. 128.
  2. Adam Smith, The Wealth of Nations (The University of Chicago Press, 1976), edited by Edwin Cannan, Vol. 1, p. 479.
  3. Smith, Vol. 1, p. 363.
  4. Smith, Vol. 2, pp. 49-50.