| November 7, 2011

Taxing Cannot Be Separated from Spending

It is a grave error to attempt to discuss tax reform without discussing spending reform.

Current and future spending determines the future path of taxes. Government spending and taxes are like a train. The taxes are the cars. Rearranging the cars and shifting the loads within the cars can have a large impact on the overall functioning of the train. But spending is the engine. No matter how the cars and the loads are arranged, the cars follow wherever the engine pulls. No matter what Oklahoma may choose to do about taxes—as substantial and as meaningful as it may be—the future path of taxes will be determined by the path of present and future spending.

This is even more true at the state level than at the federal level because (a) states cannot print their own money and finance their spending through inflation, and (b) most states have (more or less binding) laws and rules forcing budgets into closer balance than exists at the federal level.

More spending now and in the future will require more tax revenue in the future. This is almost inescapable if you cannot create inflation. The only crack to squeeze through is this: what if government spending increases economic growth in the state? The argument is that with economic growth comes a growing tax base; therefore a state’s economy will generate the required extra tax revenue out of economic growth, and the government will not have to levy new taxes or raise taxes on households or businesses. Most of the American political spectrum understands and, to some degree, accepts this argument. Therefore, states frequently seek to use fiscal policy tools—the level, structure, and growth of expenditures and taxes—to aid economic growth. This realization is the impetus behind the current political euphemisms that label government expenditure as “investment” and taxes as “contributions.” The differences along the political spectrum lie in which policy settings enhance—or fail to harm—economic growth.

A popular stance among many elected officials, policymakers, pundits, and regular citizens is that many large, ongoing government “investments” (read expenditures) are necessary for economic prosperity. However, in the economics research, the empirical record of government spending in fostering economic development is weak. Today, a great deal of government spending funds current consumption of goods and services, rather than investments in capital or technology. Even much of the spending on education seems to fit this model. The evidence that education beyond fifth grade (but possibly up to tenth grade) has an excess, societal return is pretty weak. Moreover, the evidence that more spending on education improves education quality is basically nonexistent. The crack to squeeze through is, I believe, much smaller than many public officials think it is.

The record of taxes killing economic growth, however, is pretty strong. Taxes can kill growth in a variety of ways. Every real-world tax—as opposed to an ideal, drawing-board tax—reduces the return on a wide variety of economically valuable activities, such as working, capital formation, innovation, or new-venture launching. The general story goes like this: the extra tax owed on my next possible hour of labor reduces the return I get from that hour’s labor. Solely as a result of the tax, the return on that hour of labor is below the value of my next opportunity. I choose another hour of leisure instead of another hour of productive labor.

Other than labor supply, the story of taxation distorting economic returns is, at the margin, quite general. For example, in an economy with lower tax rates or differently structured taxation, my time is slightly more valuable, and my output is slightly higher, as an entrepreneur. However, the actual tax structure and rate encourage me to remain as someone’s employee. Alternatively, I may spend my time figuring out how (legally or illegally) to game the tax code and tax collection system, rather than spend my time doing economically productive things.

Every tax imposes an excess burden on its economy. That is, the tax imposes costs on the economy in excess of the revenue collected and turned over to the government. Larger and more complicated tax codes—which frequently correspond to larger, more complicated government spending—raise the return to lobbying, “astroturfing,” and so on, in order to get the tax code to benefit me and harm my competitors. Because I’m spending time and resources on efforts to sway government policy to my benefit, I cannot use the time and resources to increase my output and create wealth. These sorts of political activities dramatically increase the excess burden of taxation.

Big, complicated paths of government spending and taxation also create uncertainty in a state’s economy. What will the tax code and the patterns of taxes and subsidies look like x years from now? The larger and more expansive a government becomes, the more difficult it is to make these predictions. Economic uncertainty like this makes it that much more risky for me to hire an employee, launch a new venture, finance an expensive piece of capital, or upgrade technology.

Here’s the takeaway: Please do not attempt to discuss tax reform and spending reform as isolated issues. They are inseparable issues.

Textbook analysis shows us that every tax will impose costs upon the economy in excess of the revenues it collects for government use. We call the amount of wealth transferred from the private sector to the government the “direct burden” of a tax. The extra cost the tax creates—wealth lost by the private sector, but not recovered by the government—is the “excess burden” of a tax.

There are three components of excess burden. The first is administrative cost, which is what everyone thinks about. It is the cost of operating a bureaucracy and a staff to collect the tax. Research shows that this is a rather minor portion of excess burden.

The second is compliance cost, the cost of time and resources citizens spend complying with the tax code. As a citizen or business executive, I must devote time and resources to ensuring that I am obeying the law. For example, instead of spending my time seeking new clients and expanding my business, I spend my time checking my tax returns. Instead of hiring a new engineer to develop new software, I hire a new accountant to verify tax compliance.

The last part of excess burden is the so-called “welfare cost.” The essence of taxation is that it increases the price paid by the purchaser and decreases the price received by producer or supplier. The difference, of course, is the tax revenue recovered by the government. However, as I said, purchasers face higher prices. As a result, they choose to consume less of the product. Because purchasers want to buy less of the product, producers produce less of the product. If the product is neither produced nor purchased, the government cannot tax it.

Imagine the market for some product or resource. At current prices and tax rates, purchasers buy and use a certain amount of a product; producers produce and sell that amount; and government collects tax on that amount of the product. Now imagine that the tax rate increases. The consumers’ price rises, and they choose to buy less of the product, so businesses reduce output. Research indicates that this welfare cost is the lion’s share of excess burden.

Estimating the actual amount of excess burden in the national economy or in a state’s economy is an extremely difficult exercise. It is so difficult that very few economists ever attempt to estimate excess burden. However, what evidence we have seems to show that excess burden—especially marginal excess burden, the extra cost imposed on the economy to generate an extra dollar of usable government revenue—is very great. For example, writing in the mid-to-late nineties, the respected, mainstream, Ivy League economist Martin Feldstein estimated that, in order for the federal government to collect an extra dollar of tax revenue to spend, it would create an excess burden of $1.65. That is, for the federal government to generate one more dollar of spendable tax income, it was necessary to reduce the private economy by $2.65!

In sum, taxes impose higher costs than they collect in revenue.

Noel D. Campbell (Ph.D., George Mason University) is an associate professor of economics at the University of Central Arkansas. His article “Better Policy Builds Better Societies” appeared in the March 2010 issue of Perspective.

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