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Archive for the ‘Fiscal Policy’ Category

America’s fiscal future is very grim, largely because of an ever-expanding burden of entitlement spending.

To see the magnitude of the problem, let’s peruse the Budget and Economic Outlook, which was released yesterday by the Congressional Budget Office has some.

Most people are focusing on how deficits are going to climb from $1 trillion to $2 trillion-plus over the next 10 years.

That’s not good news, but we should be far more worried about the fact that the burden of government spending is growing faster than the private economy. As a result, government will be consuming an ever-larger share of national output.

The budget wonks who (mistakenly) focus on red ink say the problem is so serious that we need higher taxes.

They look at this chart, which is based on CBO’s baseline forecast (what will happen if taxes and spending are left on autopilot), and assert we have no choice but to raise taxes.

They point out that the annual deficit in 2032 will be almost $2.3 trillion and that it’s impossible cut spending by that much.

Needless to say, it would be a near-impossible political undertaking to cut $2.3 trillion in one year (though it would fulfill libertarian fantasies).

But what if, instead of kicking the can down the road, policymakers imposed some sort of overall spending cap to avoid a giant deficit in 10 year.

This second chart displays that scenario. I took CBO’s baseline (autopilot) numbers and assumed that spending could only increase by 1.4 percent annually starting in 2024.

As you can see, that modest bit of fiscal discipline completely eliminates the project $2.3 trillion annual deficit in 2032.

In other words, there is no need for any tax increase.

Especially since politicians almost certainly would respond to the expectation of additional revenue by increasing spending above the baseline (as would happen with Joe Biden’s so-called Build Back Better scheme).

I’ll close by noting that there’s no need to fixate on whether the budget is balanced by 2032. What matters is trend lines.

It’s not good for government to grow faster than the private economy in the long run. And it’s not good for deficits and debt to climb as a share of economic output in the long run.

Both of those outcomes can be avoided if we have some sort of spending cap so that outlays grow slower than the private sector.

The stricter the cap, the quicker the progress.

  • I prefer actual cuts (a requirement to reduce nominal spending each year).
  • I would be happy with a hard freeze (like we had for a few years after the Tea Party revolt).
  • As noted above, a 1.4 percent spending cap balances the budget by 2032.
  • But we would make progress, albeit slow progress, even if the spending cap allowed the budget to grow by 2.0 percent of 2.5 percent per year.

P.S. I start the spending cap in 2024 because spending is not projected to grow by very much between 2022 and 2023. That’s not because today’s politicians are being responsible, however. It’s simply a result of one-time pandemic emergency spending coming to an end. But since that one-time spending has a big impact on short-run numbers, I delayed the spending cap for one year.

P.P.S. The blue revenue line has a kink in 2025 because the baseline forecast assumes that many of the Trump tax cuts expire that year. If those tax cuts are extended or made permanent, revenues would be about $400 billion lower in 2032. As such, balancing the budget by that year would require a spending cap that allows annual outlays to increase by less than 0.9 percent per year.

P.P.P.S. President Biden is bragging that the deficit is falling this year, but that’s only because the one-time pandemic spending is coming to an end.

P.P.P.P.S. A spending cap is a simple solution, but it would not be an easy solution. In the long-run, it would require genuine entitlement reform.

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Earlier this year, I pointed out that President Biden should not be blamed for rising prices.

There has been inflation, of course, but the Federal Reserve deserves the blame. More specifically, America’s central bank responded to the coronavirus pandemic by dumping a lot of money into the economy beginning in early 2020.

Nearly a year before Biden took office.

The Federal Reserve is not the only central bank to make this mistake.

Here’s the balance sheet for the Eurosystem (the European Central Bank and the various national central banks that are in charge of the euro currency). As you can see, there’s also been a dramatic increase in liquidity on the other side of the Atlantic Ocean.

Why should American readers care about what’s happening with the euro?

In part, this is simply a lesson about the downsides of bad monetary policy. For years, I’ve been explaining that politicians like easy-money policies because they create “sugar highs” for an economy.

That’s the good news.

The bad news is that false booms almost always are followed by real busts.

But this is more than a lesson about monetary policy. What’s happened with the euro may have created the conditions for another European fiscal crisis (for background on Europe’s previous fiscal crisis, click here, here, and here).

In an article for Project Syndicate, Willem Buiter warns that the European Central Bank sacrificed sensible monetary policy by buying up the debt of profligate governments.

…major central banks have engaged in aggressive low-interest-rate and asset-purchase policies to support their governments’ expansionary fiscal policies, even though they knew such policies were likely to run counter to their price-stability mandates and were not necessary to preserve financial stability. The “fiscal capture” interpretation is particularly convincing for the ECB, which must deal with several sovereigns that are facing debt-sustainability issues. Greece, Italy, Portugal, and Spain are all fiscally fragile. And France, Belgium, and Cyprus could also face sovereign-funding problems when the next cyclical downturn hits.

Mr. Buiter shares some sobering data.

All told, the Eurosystem’s holdings of public-sector securities under the PEPP at the end of March 2022 amounted to more than €1.6 trillion ($1.7 trillion), or 13.4% of 2021 eurozone GDP, and cumulative net purchases of Greek sovereign debt under the PEPP were €38.5 billion (21.1% of Greece’s 2021 GDP). For Portugal, Italy, and Spain, the corresponding GDP shares of net PEPP purchases were 16.4%, 16%, and 15.7%, respectively. The Eurosystem’s Public Sector Purchase Program (PSPP) also made net purchases of investment-grade sovereign debt. From November 2019 until the end of March 2022, these totaled €503.6 billion, or 4.1% of eurozone GDP. In total, the Eurosystem bought more than 120% of net eurozone sovereign debt issuances in 2020 and 2021.

Other experts also fear Europe’s central bank has created more risk.

Two weeks ago, Desmond Lachman of the American Enterprise Institute expressed concern that Italy had become dependent on the ECB.

…the European Central Bank (ECB) is signaling that soon it will be turning off its monetary policy spigot to fight the inflation beast. Over the past two years, that spigot has flooded the European economy with around $4 trillion in liquidity through an unprecedented pace of government bond buying. The end to ECB money printing could come as a particular shock to the Italian economy, which has grown accustomed to having the ECB scoop up all of its government’s debt issuance as part of its Pandemic Emergency Purchase Program. …the country’s economy has stalled, its budget deficit has ballooned, and its public debt has skyrocketed to 150 percent of GDP. …Italy has had the dubious distinction of being a country whose per capita income has actually declined over the past 20 years. …All of this is of considerable importance to the world economic outlook. In 2010, the Greek sovereign debt crisis shook world financial markets. Now that the global economy is already slowing, the last thing that it needs is a sovereign debt crisis in Italy, a country whose economy is some 10 times the size of Greece’s.

Mr. Lachman also warned about this in April.

Over the past two years, the ECB’s bond-buying programs have kept countries in the eurozone’s periphery, including most notably Italy, afloat. In particular, under its €1.85 trillion ($2 trillion) pandemic emergency purchase program, the ECB has bought most of these countries’ government-debt issuance. That has saved them from having to face the test of the markets.

And he said the same thing in March.

The ECB engaged in a large-scale bond-buying program over the past two years…, as did the U.S. Federal Reserve. The size of the ECB’s balance sheet increased by a staggering four trillion euros (equivalent to $4.4 billion), including €1.85 trillion under its Pandemic Emergency Purchasing Program. …The ECB’s massive bond buying activity has been successful in keeping countries in the eurozone’s periphery afloat despite the marked deterioration in their public finances in the wake of the pandemic.

Let’s conclude with several observations.

So if politicians won’t adopt good policies and their bad policies won’t work, what’s going to happen?

At some point, national governments will probably default.

That’s an unpleasant outcome, but at least it will stop the bleeding.

Unlike bailouts and easy money, which exacerbate the underlying problems.

P.S. For what it is worth, I do not think a common currency is necessarily a bad idea. That being said, I wonder if the euro can survive Europe’s awful politicians.

P.P.S. While I think Mr. Buiter’s article in Project Syndicate was very reasonable, I’ve had good reason to criticize some of his past analysis.

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More than 10 years ago, I narrated this video showing how the United States benefited from spending restraint under both Ronald Reagan and Bill Clinton. Since today’s topic is Clinton’s policies, pay attention starting about 4:00.

If you don’t have time to watch the video, I hope you will at least pay attention to this chart, which appeared near the end (about 6:00).

It shows what happened to domestic spending (entitlements plus discretionary) as a share of economic output during the Reagan years, the Clinton years, and the 2001-2010 period under Bush and Obama.

Reagan was the runaway champion, but it’s worth noting that the burden of domestic spending also declined during the Clinton years.

But it wasn’t just that Bill Clinton was good on spending. Good things happened in the 1990s in other areas as well, especially trade.

In a column for the Wall Street Journal, Bill Galston defends Clinton’s “neoliberal” record.

… critics often mark the Clinton administration as the moment when establishment Democrats capitulated to the ideology of the unfettered market. Poor and working-class Americans paid the price, they charge… The historical record tells a different story. …During eight years of the Clinton administration, annual real growth in gross domestic product averaged a robust 3.8% while inflation was restrained, averaging 2.6%. Payrolls increased by 22.9 million… Unemployment fell from 7.3% in January 1993 to…4.2% at the end of President Clinton’s second term. Adjusted for inflation, real median household income rose by 13.9%. …During the administration, federal spending as a share of GDP fell from 21.2% to 17.5%… What about the poor? The poverty rate declined during the Clinton administration by nearly one quarter, from 15.1% to 11.3%, near its historic low. And it declined even faster among minorities—by 8.1 percentage points for Hispanics and 10.9 points for blacks. …In sum, during the heyday of neoliberalism, Americans weren’t forced to choose between high growth and low inflation or between aggregate growth and fairness for the poor, working class and minorities.

Why did we get these good results?

Because overall economic freedom increased during the Clinton years. And when the burden of government is reduced, that creates more opportunity for upward advancement for everyone in society.

By the way, I’m not arguing in today’s column that Bill Clinton deserves all the credit. There’s little doubt that the Republican landslide in 1994 played a big role in many of the subsequent pro-market reforms (such as welfare reform, the 1997 tax cut, etc).

But I will say that Bill Clinton at least was amenable to pro-market compromises, which is not what we saw during the Obama years (and I doubt we will see a shift to the center from Biden if Republicans win Congress this November).

P.S. Republicans were able to impose some fiscal discipline on Obama after the Tea Party landslide of 2010

P.P.S. For those who want more details, click here for a detailed examination of the fiscal policy performance of various modern presidents.

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As part of my (reality-based) opposition to a value-added tax, I testified to the Ways & Means Committee back in 2011.

My primary argument against the VAT is that it would enable a bigger burden of government spending.

I frequently share this chart, for instance, that shows that the nations in Western Europe were quite similar to the United States back in the 1960s, with government budgets that consumed about 30 percent of economic output.

That was before they enacted VATs.

But once European politicians got that new source of revenue, the spending burden diverged, with the welfare state becoming a much larger burden in Western Europe than in the United States.

In other words, the VAT was a money machine for big government.

That argument is just as accurate today as it was back in 2011.

For today’s column, however, I want to focus on what I said in the last minute of my testimony (beginning about 4:00).

I pointed out that VAT supporters are wrong when they claim that adoption of this new tax would enable reductions in the income tax.

And if you peruse my written testimony, you’ll see that I included several charts showing how tax burdens changed between 1965 and 2008. In every case, I showed that European politicians actually increased the burden of income taxes after they enacted their VATs.

Is that still true?

Of course.

Here’s an updated version of the chart showing that the overall tax burden dramatically increased after VATs were imposed.

In the United States, by contrast, the overall tax burden only increased during this time period from 23.6 percent of GDP to 25 percent of GDP.

Still bad news, but nowhere near as bad as Western Europe, where the overall tax burden jumped by more than 13 percentage points.

Now let’s peruse the updated version of the chart showing what happened to taxes on income and profits.

As you can see, European governments definitely did not use VAT revenues to lower other taxes.

In the United States, by contrast, the tax burden on income and profits only increased during this time period from 11.3 percent of GDP to 11.6 percent of GDP.

Still bad news, but nowhere near as bad as Western Europe, where the tax burden on income and profits jumped by nearly 5 percentage points.

Now let’s peruse the updated version of the chart showing what happened to taxes on corporations (this chart is especially important because there are very naive people in the business community who think that they can avoid higher taxes on their companies if they surrender to a VAT).

As you can see, governments in Europe have been grabbing more money from corporations since VATs were imposed.

In the United States, by contrast, the tax burden on corporations actually decreased during this time period from 3.9 percent of GDP to 1.3 percent of GDP.

By every possible measure, the value-added tax is a big mistake (as even the IMF inadvertently shows).

Unless, of course, politicians first get rid of the income tax – including repealing the 16th Amendment and replacing it with an ironclad prohibition against any future income tax.

But that’s about as likely as me playing the outfield for the New York Yankees in this year’s World Series.

P.S. I mentioned at the very end of my testimony that we did not have clear evidence from other nations that subsequently adopted VATs. In the case of Japan, we now do have data showing how the VAT is financing bigger government.

P.P.S. Some VAT advocates actually claim the levy is good for growth. That’s a nonsensical claim. VATs drive a wedge between pre-tax income and post-tax consumption. What they really mean to say is that VATs don’t do as much damage, on a per-dollar-raised basis, as conventional income taxes (with punitive rates and double taxation).

P.P.P.S. You can enjoy some good anti-VAT cartoons herehere, and here.

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Since I’m a big fan of spending caps, I’m very happy to be in Zurich as part of the Free Market Road Show.

Switzerland’s spending cap (called “the debt brake“) is probably the best system in the world. It does have an escape clause for emergencies, so the government did increase spending during the pandemic.

But as this chart illustrates, Swiss lawmakers were much more responsible than their American counterparts. Over the past few years, IMF data shows that the national debt (as a share of GDP) increased by about 3.4 percent in Switzerland compared to 12.8 percent in the United States.

Even more amazing, Switzerland is now quickly restoring spending restraint.

Indeed, as reported by Le News, Switzerland already is going to be back to fiscal balance by the end of this year.

The Covid-19 pandemic plunged Switzerland’s budget into the red in 2020 and 2021. The federal government expects to return to normality with a balanced budget in 2022. …In 2022, the federal government expects to spend CHF 0.6 billion less than it collects. …the government is aiming for an ordinary operating surplus of CHF 1 billion. Past budget surpluses may also be applied to the accumulated deficit to bring the accounting into line with the debt brake rules.

If you want to know why there such quick progress, one of the big banks, Credit Suisse, recently analyzed the nation’s fiscal status and explained how the debt brake requires future spending restraint to compensate for the emergency spending during the pandemic.

As part of the pandemic response, the Federal Council approved fiscal measures of over 70 billion Swiss francs… As a result of the debt brake, this deficit should be offset in the immediate following years. …the Federal Council announced that it would classify the majority of the fiscal measures as extraordinary spending. Under the law, this can be paid back more slowly – specifically, within six years. Additionally, with the escape clause, the Federal Assembly has the option of extending the repayment deadline even further in special cases.

Another international bank, ING, also issued a report about the country’s spending cap and actually expressed concern that the level of government debt is too low.

The main cause of Switzerland’s low indebtedness is a mechanism introduced by the Confederation to stabilise the federal debt: “the debt brake”. Enabled in the Constitution since 2003, with a population approval rate of 85% in 2001, the rule has strong legitimacy and many cantons have introduced similar models. The principle: public spending should not exceed revenues over a full economic cycle. The formula allows for a deficit during a recession, offset by surpluses during an expansion period. …the implementation of this system has resulted in a significant debt reduction, rather than just stabilisation. This is because the rule is applied asymmetrically and expenditure tends to be overestimated each year, while revenue is systematically underestimated. …every budget surplus is greeted with a self-congratulatory round of applause on the sound management of public finances.

Here’s a chart from the article showing on government debt began to decline once the spending cap was implemented. By contrast, debt in other industrialized nations has continued to climb.

Keep in mind, by the way, that this chart was before the pandemic.

Given Switzerland’s more prudent approach, the gap between the two lines is even higher today.

P.S. If you want a more in-depth discussion of how Switzerland’s de facto spending cap operates, there’s a very good article in the Swiss Journal of Economics and Statistics. Authored by Tobias Beljean and Alain Geier, the 2013 study has a lot of useful information.

…the success is not just visible in figures – it is also evident in the way that the budget process has changed. The debt brake has turned the budget process upside down. Previously, spending intentions were submitted by individual government offices, and it was very difficult to make changes to a large number of budget items during the short interval between the first consolidated budget plan (largely influenced by government offices) between April and the final budget proposal in June. More problematic still, the finance minister faced the potential opposition of six “spending” ministers, who were each looking for support to get their policy proposals into the budget. The budget process is now essentially a top-down process, in which targets are set at the beginning of the process and then broken down to individual ministries and offices. …One key aspect is the fact that the debt brake sets a clear target for the deficit and expenditure. …the (risk-averse) administration tends to plan its spending cautiously so as to not exceed the limit of the credit item. Hence, actual outcomes are mostly below spending limits and are not compensated for by occasional overspending and supplementary credits. The consequence for overall spending is a systematic undershooting of expenditure with respect to the budget. … This “revenue brake” and the “debt brake” taken together now result in a framework similar to an expenditure rule, as it is rather difficult to meet the requirements of the debt brake through revenue-side measures – at least in the short term.

P.P.S. You can also read a couple of good summaries (here and here) from the Swiss government’s Federal Finance Administration.

P.P.P.S. Hong Kong also has a spending cap, and Colorado’s Taxpayer Bill of Rights is a spending cap as well. You can click here to watch informative video presentations about the various spending caps.

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During the debate about the Trump tax plan, proponents made three main arguments in favor of reducing the federal corporate tax rate from 35 percent to 21 percent.

  1. A lower rate would be good for workers, consumers, and shareholders.
  2. A lower rate would boost American competitiveness.
  3. A lower rate would produce some revenue feedback for the IRS.

The last item involves the “Laffer Curve,” which is a graphical representation of the non-linear relationship between tax rates and tax revenue.

Put in simple terms, entrepreneurs, investors, and business owners have more incentive to earn money when tax rates are modest.

High tax rates, by contrast, discourage productive behavior while also giving people a bigger incentive to find loopholes and other ways of avoiding tax.

This does not mean that lower tax rates produce more revenue, though that sometimes happens.

The main takeaway is the most modest observation that lower tax rates will lead to more taxable income, which means some revenue feedback.

In other words, tax cuts don’t lose as much revenue as predicted by simplistic models (and tax increases don’t generate as much revenue as predicted).

I’ve shared many, many realworld examples of this phenomenon.

And here’s another. Look at how corporate tax revenues in the United States are increasing at a faster rate than projected.

The chart comes from Chris Edwards, and he helpfully explains what has happened.

The revenue surge came as a surprise to government economists. The chart…compares the new Office of Management and Budget March 2022 baseline projections to prior baseline projections from the OMB in May 2021 and the Congressional Budget Office in July 2021. …congressional estimators figured that the government would lose an average $76 billion a year the first four years… Corporate tax revenues were down from 2018 to 2020, but then soared in 2021. Revenues in 2021 of $372 billion (with a 21 percent tax rate) are 25 percent higher than revenues in 2017 of $297 billion (with a 35 percent tax rate). …we’re learning that a lower corporate tax rate is consistent with strong corporate tax revenues. …lower rates…broaden bases automatically through reduced tax avoidance and higher economic activity. Other nations have learned the same lesson. Keeping the corporate tax rate low is a winner for businesses and workers, but it can also be a winner for government budgets.

The Wall Street Journal has a new editorial on this topic. Here are some relevant excerpts.

…the 2017 tax reform that cut corporate tax rates…has been a winner for the economy and federal tax coffers. …Corporate revenue was supposed to fall to historic lows as a share of the economy. Big business supposedly got a windfall and government was robbed. It hasn’t turned out that way. …the big news now is that more corporate tax revenue is flowing into the Treasury at record levels even with the lower rate. …In June 2017, before tax reform passed, CBO predicted corporate tax revenue of $383 billion in fiscal 2021. But in April 2018, after reform passed, CBO lowered its estimate to $327 billion.

So what happened in the real world?

Actual corporate income tax revenue in 2021 was $372 billion—nearly as much at a 21% rate as CBO expected at the 35% rate that was among the highest in the world. Fiscal 2022 is turning out to be even better for the Treasury. Corporate tax revenue for the first six months was up 22% from a year earlier to $127 billion. …What accounts for this windfall for Uncle Sam…? …the Occam’s razor policy answer is that corporate tax reform worked as its sponsors predicted: Lowering the rates while broadening the base by eliminating loopholes created incentives for more efficient investment decisions that paid off for shareholders, workers and the government.

Notice, by the way, that corporate tax revenues have increased faster than projected in both the 2017 forecast and the 2021 forecast.

All of which shows that I may have been insufficiently optimistic when I wrote about this issue last year.

P.S. The goal of tax policy (either in general or when looking at business taxation) is not to maximize revenue for politicians, but rather to maximize prosperity for people. Indeed, if better tax policy leads to a lot of revenue feedback, that’s an argument for further reductions in tax rates.

P.P.S. Both the IMF and OECD have research showing that lower corporate tax rates do not necessarily lead to lower corporate tax revenues.

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Whether they are based on 10 questions or 144 questions, I can’t resist taking quizzes that supposedly identify one’s political or economic philosophy.

The good news, according to various quizzes, is that I’m 92 percent minarchist and only 6 percent communist.

Today, we are going to take a quiz prepared by the Committee for a Responsible Federal Budget. It is designed to determine fiscal priorities. You can click here to answer the 21 questions.

As is often the case with online tests and quizzes, I’m frustrated by the sloppy wording of certain questions.

Question #8 asks if we should spend more or less on interest. I answered “less,” of course, but the only way to make that happen (other than default) is to change policies so that the government borrows less money.

I imagine 99 percent of people who take the quiz will also answer “less,” but those results mean nothing without follow-up questions about whether they want less spending or higher taxes.*

Question #17 asks if we should spend more or less on seniors or children. Like any sensible libertarian I want to spend less on both categories, so how do I answer?

Question #19 asks if we should spend more or less on seniors or welfare. Once again, the correct answer is to spend less on both categories, so there’s no logical way to respond.

For what it’s worth, I opted to spend less on both children and welfare for the simple reason that – in my libertarian fantasy world – it would take longer to implement reforms to replace Medicare and Social Security.

Given the inadequate wording of the quiz, I’m not surprised I got these strange results.

Notwithstanding what the top panels says, I don’t want to spend more on so-called public investment, regardless of whether that means infrastructure or research and development.

With regards to the bottom panel, I do want to spend less on children. Or, to be more accurate, I want the government to spend less on children so that families will have greater ability to spend more on children.

I’ll close by stating that I much prefer the CRFB quiz I took last year. The questions were better designed and it gave me very accurate results (i.e., I’m a “minimalist” who is “in favor of smaller government”).

*On paper, tax increases reduce debt and therefore reduce interest costs. In the real world, higher taxes lead to weaker economic performance and a larger burden of spending, thus producing more debt and higher interest costs.

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I wrote a few days ago about Biden’s plan to impose punitive double taxation on dividends.

But that’s not an outlier in his budget. As you can see from this table from the Tax Foundation, he wants to violate the principles of sensible fiscal policy by having high tax rates on all types of income.

What’s especially disappointing is that he wants tax rates in the United States to be much higher than in other developed nations.

At the risk of understatement, that’s not a recipe for jobs and investment.

The Wall Street Journal editorialized about Biden’s taxaholic preferences.

Mr. Biden…is proposing $2.5 trillion in new taxes that would give the U.S. the highest or near-highest tax rates in the developed world. …The biggest jump is in taxes on capital gains, as the top combined rate would rise to 48.9% from 29.2% today. That’s a 67% increase in the government’s take on long-term capital investments. The new top rate would be more than 2.5 times the OECD average of 18.9%. Nothing like reducing the U.S. return on capital to get people to invest elsewhere. Mr. Biden would also lift the top combined tax rate on corporate income to 32.3% from 25.8%. That would leap over Australia and Germany, which have top rates of 30% and 29.9% respectively, and it would crush the 22.8% OECD average. …Mr. Biden would also put the U.S. at the top of the noncompetitive list for personal income taxes, with multiple increases that would put the combined American rate at 57.3%. Compare that with 42.9% today and an average of 42.6% across the OECD.

The WSJ‘s editorial contained this chart.

The United States would be on top for corporate tax rates if Biden’s plan is adopted (which actually means on the bottom for competitiveness).

The bottom line is that Biden wants the U.S. to have the highest corporate rate, highest double taxation of dividends, and highest double taxation of capital gains.

To reiterate, not a smart way of trying to get more jobs and investment.

P.S. The “good news” is that the United States would not be at the absolute bottom for international tax competitiveness.

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I’ve already written that massive spending increases for various bureaucracies is the most offensive part of Biden’s new budget.

But I explicitly noted that these huge budgetary increases (well above the rate of inflation, unlike what’s happening to incomes for American families) were not the most economically harmful feature of Biden’s plan.

That dubious honor belongs to either his massive expansion of the welfare state or his big tax increases.

In today’s column, we’re going to focus on his tax plan.

The Wall Street Journal editorialized a couple of days ago about what the president is proposing.

A President’s budget is a declaration of priorities, so it’s worth underscoring that President Biden’s new budget for fiscal 2023 proposes $2.5 trillion in tax increases over 10 years. His priority is taking money from the private economy and giving it to politicians to spend. …Raising the top income-tax rate to 39.6% from 37% would raise $187 billion. Raising capital-gains taxes, including taxing gains like ordinary income for taxpayers earning more than $1 million would snatch $174 billion. Raising the top corporate tax rate to 28% from 21%—a tax on workers and shareholders—would raise $1.3 trillion. Fossil fuels are hit up for $45 billion. We could go on… Let’s hope none of these tax-increases pass, but the Democratic appetite for your money really is insatiable.

That’s a damning indictment.

But the WSJ actually understates the problems with Biden’s tax agenda.

That’s because the White House also is being dishonest, as explained by Alex Brill of the American Enterprise Institute.

The budget proposes $2.5 trillion in net tax hikes, almost entirely from businesses and high-income households, and touts policies that would “reduce deficits by more than $1 trillion” over the next decade. But a short note in the preamble to the Treasury Department’s report on the budget reveals a sleight of hand: “The revenue proposals are estimated relative to a baseline that incorporates all revenue provisions of Title XIII of H.R. 5376 (as passed by the House of Representatives on November 19, 2021), except Sec. 137601.”In other words, the budget pretends that the failed effort to enact President Biden’s Build Back Better Act was a success and considers new budget proposals in addition to those policies. But you won’t find the price of the Build Back Better (BBB) Act (including its roughly $1 trillion in net tax hikes) in the budget tables.

I’m going to use this trick during my next softball tournament. I’m going to assume at the start that I’ve already had 20 at-bats and that I got an extra-base hit each time.

So even if I have a crummy performance during my real at-bats, my overall average and slugging percentage will still seem impressive.

Needless to say, my teammates would laugh at me, just as serious budget people understand that Biden’s budget is a joke.

But there is some good news. Barring something completely unexpected, Congress is not going to approve the president’s farcical plan.

P.S. Don’t fully celebrate. As I noted in my “Hopes and Fears for 2022” column, there is a risk that some sort of tax-and-spend plan might get approved. The only silver lining to that dark cloud is that it wouldn’t be nearly as bad as Biden’s full budget.

P.P.S. If that prospect gets you depressed, here are a couple of humorous images depicting Biden’s fiscal agenda.

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Since the economy suffers when tax rates go up and the burden of government spending increases, there obviously are plenty of awful features in President Biden’s newly released budget.

If I had to select a worst feature, though, I’d be tempted to pick the proposed spending hikes that Biden is seeking for some of Washington’s most-wasteful bureaucracies.

Here’s a chart from a story in today’s Washington Post (based on Table S-8 in the budget), which summarizes how much additional “discretionary spending” Biden is seeking.

Why am I upset about these proposed spending increases?

From a big-picture economic perspective, it’s bad fiscal policy to allow the burden of government spending to grow faster than the private sector.

And since Biden is projecting that real GDP will grown by 2.8 percent next year and inflation will be 2.1 percent during the same period (see Table S-9 of the budget), he obviously wants all these bureaucracies to enjoy big increases (unlike families, who are losing ground compared to inflation).

But I’m also irked from a targeted fiscal perspective. That’s because Biden wants giant spending increases for bureaucracies that should not even exist.

Here’s what I’ve written about some of them.

By the way, “worst feature” is not the same as most economically damaging feature.

There are two other parts of Biden’s budget that definitely will cause more harm.

These tax increases and entitlement expansions will do considerably more damage than the discretionary spending increases excerpted above.

But it’s still an outrage that Biden is shoveling more money at some of Washington’s most wasteful and counterproductive bureaucracies.

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I’ve identified seven reasons to oppose tax increases, but explain in this interview that the biggest reason is that it would be a mistake to give politicians more money to finance an ever-larger burden of government spending.

I had two goals when responding this question (part of a longer interview).

First, I wanted to help viewers understand that America’s fiscal problem is too much government spending and that red ink is simply a symptom of that problem.

Over the years, I’ve concocted all sorts of visuals to make this point. Like this one.

And this one.

And this one.

Second, I wanted viewers to understand that higher taxes will simply make a bad situation even worse.

From my perspective, the biggest problem with tax increases is that they will enable a bigger burden of government spending.

But even the folks who fixate on red ink should adopt a no-tax increase position.

Why? Because politicians who want big tax increases want even bigger spending increases.

Joe Biden is pushing for a massive tax increase, for instance, but his proposed spending increase is far larger.

We also have decades of evidence from Europe. There’s been a huge increase in the tax burden in Western Europe since the 1960s (largely enabled by the enactment of value-added taxes).

Did that massive increase in revenue lead to less red ink?

Nope, just the opposite, as I showed in both 2012 and 2016.

If you don’t agree with me on this issue, maybe you should heed the words of these four former presidents.

P.S. Some people warn that endlessly increasing debt is a recipe for an eventual crisis. They’re probably right. Which is why it is important to oppose tax-increase deals that wind up saddling us with more red ink. Besides, the long-run damage of tax-financed spending is very similar to the long-run damage of debt-financed spending.

P.P.S. As I mention in the interview, the only real solution is spending restraint. And a spending cap is the best way of enforcing that approach.

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I wrote two months ago about Iowa lawmakers voting for a simple and fair flat tax.

I explained how this reform would make the state more competitive, but I want to build upon that argument with some of the Tax Foundation’s data.

Starting with this map from the State Business Tax Climate Index, which shows Iowa in 38th place for individual income taxes.

That low ranking is where the state’s tax code was as of July 1, 2021, so it obviously doesn’t reflect the reforms enacted earlier this year.

So where will the state rank with the new flat tax?

The Tax Foundation crunched the data and shows the state will jump to #15 in the rankings.

The above table shows that the jump is even more impressive when you factor in some modest pro-growth changes that took place a few years ago.

What a huge improvement over just a few years. The only state that may beat Iowa for fastest and biggest increase in tax competitiveness is North Carolina, which jumped 30 spots in just one year.

P.S. Politicians in New York must be upset that there’s no way for them to drop lower than #50. But at least they can take comfort in the fact that they are worse than California.

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Two days ago, I explained that spending caps are better than anti-deficit rules. In this clip from the same panel discussion, I talk about how a spending cap should be designed.

The key design issue is how fast spending should increase.

For libertarians and Reaganite conservatives, the goal is to shrink the burden of government. This means a cap that fulfills my Golden Rule of having government grow slower than the private sector.

So if long-run nominal GDP is projected to grow by, say, 5 percent per year, the cap might allow government to grow 2 percent or 3 percent annually.

That’s somewhat like the TABOR rule in Colorado, which limits government to grow no faster than inflation plus population.

For more moderate types, the goal might be to maintain the status quo.

In other words, don’t attempt to shrink government, but also don’t allow government to expand.

Perhaps that would mean a spending cap tied to nominal personal income growth, which might mean allowing spending to grow 4 percent or 5 percent each year.

That sound anemic, but it is definitely better than nothing since it would force lawmakers to somehow prevent the huge future spending increases that will be caused by America’s poorly designed entitlement programs.

But then there’s the issue of how a spending cap gets enforced.

I was cited in a 2020 article about this challenge in Hawaii.

Hawaii’s existing cap is too easily ignored by lawmakers. …So what would a “spending cap with teeth” look like? Mitchell said there are many types of spending caps that could be adopted. Hawaii added a spending cap to its Constitution in 1978, but it was essentially arbitrary due to an escape clause that allows the Legislature to override the cap with a two-thirds vote. “That escape clause, especially in a state where one party dominates the government, basically means that your spending cap isn’t very effective at all,” said Mitchell. So what would be better? Mitchell is especially fond of the spending cap that Colorado voters adopted in 1992, which Colorado’s Department of the Treasury estimated in 2019 had returned more than $2 billion to state taxpayers since it was implemented. Called the Taxpayer’s Bill of Rights Amendment, it pegs state spending to population growth plus inflation. Colorado’s legislature can still propose a budget that exceeds the spending cap, but “the politicians have to go to the voters and ask for permission, and the voters in almost all cases say no.”

The bottom line is that spending caps are like speed limits in a school zone.

With small children present, the best speed limit might be 20 miles per hour.

By contrast, a speed limit of 45 miles per hour seems unwise. Then again, it would be better than nothing.

And we can’t forget that any speed limit won’t be worth much if there’s no enforcement.

I’ll close by sharing this table, which shows various nations that got very good results with multi-year periods of spending restraint (government growing, on average, by less than 2 percent annually).

P.S. The advantage of a numerical spending cap (such as limiting spending increases to no more than 2 percent annually) is that politicians would have a big incentive to keep inflation under control (meaning Biden’s economic team would not have allowed him to make vapid remarks about inflation during his state of the union address).

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I’ve been writing a series of columns about the failure of Bidenomics (see here, here, and here), but let’s switch gears today and focus on some remarkably bad behavior by the bureaucrats at the Organization for Economic Cooperation and Development (OECD).

Regular readers know that I’m not a big fan of this Paris-based international bureaucracy. Yes, there are some economists at the OECD who do solid research, but the organization routinely advocates for higher taxes and bigger government, often by using dishonest data.

But even I was surprised to receive this email from the OECD, which explicitly urged a giant tax increase on the relatively impoverished people of Mexico.

And “giant” is not a throwaway adjective.

Joe Biden wants a massive tax increase for the United States, but his proposal to increases tax revenue by 1.3 percent of GDP makes him seem like a rabid libertarian compared to the OECD’s plan to increase taxes by nearly three times as much in Mexico.

What’s especially amazing is that the OECD is urging this huge tax increase in a report that supposedly shares “recommendations for improving medium-term growth prospects.”

While I’m shocked by the size of the OECD’s proposed tax increase, I’m not surprised that the bureaucrats are claiming that higher taxes and bigger government are good for growth.

They’ve done it before and I’m sure they’ll do it again.

In China. In Africa. Everywhere.

So at least they are consistent, albeit in a very bad way.

I’ll close by noting that Mexico actually is in desperate need of “recommendations for improving medium-term growth prospects.”

But if you peruse the data for Mexico in the most-recent edition of the Fraser Institute’s Economic Freedom of the World, you’ll see that the country’s economy is being hampered by bad scores for rule of law, monetary policy, trade, and regulation.

So it’s baffling that the OECD’s bureaucrats somehow decided to focus on pushing for bad fiscal policy.

P.S. For those who want more information, you can click here to access the OECD’s report, along with other accompanying materials.

P.P.S. Incidentally, OECD bureaucrats are exempt from paying tax on the very lavish salaries they receive.

P.P.P.S. Adding insult to injury, American taxpayers finance the largest share of the OECD’s budget.

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When I compare the United States and Europe, it’s usually because I want to make the point that people on the other side of the Atlantic have lower living standards in large part because there is a more onerous fiscal burden of government.

Simply stated, America’s medium-sized welfare state doesn’t do as much damage as the large-sized welfare states in Europe.

But I also use US-vs.-Europe comparisons to make another point, namely that big welfare states mean big tax burdens for lower-income and middle-class households.

To be more specific, most of Europe’s redistribution spending is financed by high tax burdens on regular people.

Yes, European politicians impose onerous burdens on upper-income taxpayers, but there simply are not nearly enough rich people to finance big government.

So those politicians have responded by pillaging everyone else as well (onerous payroll taxes, harsh value-added taxes, high income tax rates on modest incomes, etc).

The United States takes a different approach. We also impose onerous burdens on upper-income taxpayers (as confirmed by IRS data), but we impose comparatively modest taxes on everyone else.

Indeed, the net result, as shown in the table, is that the United States actually has the most “progressive” tax system among OECD nations.

Today, let’s look at some research that makes similar points.

Three academics at the Paris School of Economics authored a study for the World Inequality Lab that uses a new database to measure redistribution and inequality.

Their main conclusion is that there are differences between the United States and Europe, but redistribution policies don’t have a big impact on inequality.

This article addresses…substantive and methodological issues by constructing distributional national accounts for twenty-six European countries from 1980 to 2017. To our knowledge, this is the first attempt at doing so. …our series are fully comparable with recently produced US distributional national accounts, allowing us to compare the dynamics of inequality and redistribution in the two regions in great detail. Two key findings emerge from the analysis of our new database. First, we show that, over the past four decades, inequality has increased in nearly all European countries as well as in Europe as a whole, both before and after taxes, but much less than in the United States. …Second, the main reason for Europe’s relative resistance to the rise of inequality has little to do with the direct impact of taxes and transfers. While Western and Northern European countries redistribute a larger fraction of output than the US (about 47% of national income is taxed and redistributed in Europe versus 35% in the US), the distribution of taxes and transfers does not explain the large gap between Europe and US posttax inequality levels. Quite the contrary: after accounting for all taxes and transfers, the US appears to redistribute a greater fraction of its national income to the poorest 50% than any European country.

What drives these results?

Simply stated, the most salient feature of European fiscal policy is that nations tax the middle class and have programs that benefit the middle class.

The United States, by contrast, focuses more on taxing the rich and giving benefits to the poor.

Look at what the study says about tax progressivity.

Figure Vb ranks European countries and the United States according to a simple measure of tax progressivity: the ratio of the total tax rate faced by the top 10% to that of the bottom 50%. The composition of bars correspond to the composition of taxes paid by the top 10%. The US stands out as the country with the highest level of tax progressivity: the top decile faces a tax rate that is more than 70% higher than that of the poorest half of the population. By this measure, the European country with the most progressive tax system is the United Kingdom, followed by Norway, the Czech Republic, and France. Many European countries have values close to 1 on this indicator, corresponding to relatively flat tax systems, in which top income groups face a tax rate approximately equal to that of the bottom 50%. …the US also stands out as one of the countries where the top 10% pay the largest share of their pretax income in the form of income and wealth taxes.

And here’s Figure V, which shows how the U.S. has (far and away) the most “progressive” tax system.

Again, I want to emphasize that this is not because the U.S. imposes higher taxes on the rich. The so-called progressivity of the American system is driven by the fact that there are low taxes on everyone else.

What about on the spending side of the fiscal ledger?

The study finds that the the United States has the most redistribution to lower-income people.

…the US tax-and-transfer system appears to be unequivocally more progressive. The bottom 50% in the US received a positive net transfer of 6% of national income in 2017, compared to about 4% in Western and Northern Europe and less than 3% in Eastern Europe. Meanwhile, the top 10% saw their average income decrease by 8% of national income in the US after taxes and transfers, compared to about 4% in Western and Northern Europe and 3% in Eastern Europe. …Figure VIIb represents the net transfer received by the bottom 50% in all European countries and the United States in 2017. Again, the US stands out as the country that redistributes the greatest fraction of national income to the bottom 50%.

Here’s the aforementioned Figure VII.

I’ll close by observing that there are multiple interpretations of this data. I suspect that authors want readers to conclude that there should be higher taxes and more redistribution. Both in Europe and the United States.

My big takeaway is that this research confirms why people with modest incomes in the United States have a better life than their counterparts in Europe.

Not only do they enjoy higher levels of income, but they also pay much lower tax burdens.

P.S. One other point to emphasize is that it’s wrong to fixate on inequality. In part, that’s because there’s nothing wrong with rich people getting richer (assuming they earn their money rather than getting special favors from politicians). But also because ethical people should be concerned about improving the lives of the less fortunate rather than tearing down the successful.

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The United States needs a constitutional spending cap, sort of like the “debt brake” that has been producing positive results in Switzerland for the past two decades.

Imposing a limit on annual spending increases would be a much-needed way of stopping politicians from saddling the nation with “Goldfish Government.”

The best-case scenario is that a spending cap is very stringent (say, limiting annual spending increases to 2 percent annually). This level of fiscal restraint reduces the burden of government spending compared to the private sector (i.e., it fulfills fiscal policy’s Golden Rule).

The avoid-harm scenario is that a spending cap prevents government from becoming a bigger burden. Given dismal long-run fiscal forecasts (a consequence of demographic change and poorly designed entitlement programs), this actually would be an impressive achievement.

There are also some auxiliary benefits of a spending cap.

A new working paper from Italy’s central bank, authored by Anna Laura Mancini and Pietro Tommasino, considers whether spending caps can mitigate the problem of dishonest budgeting by politicians.

…policy-makers have an incentive to “plan to cheat”. That is, they promise an amount of expenditures higher than what they will actually deliver, because this allows them to cater to the demands of the various groups of voters, and at the same time they present overoptimistic revenue forecasts, in order to preserve the appearance of fiscal discipline. Once the extra revenues hoped for by the government fail to materialize, budgeted investment expenditures are downsized or abandoned altogether. In this context, caps on realized spending can contribute to more realistic ex ante spending plans. Indeed, politicians have less room to inflate planned expenditures, once there is a legal ceiling in place.

The authors crunch the numbers and conclude that spending caps result in a greater level of fiscal honesty.

In this paper, we provide evidence in favour of this theoretical intuition, exploiting a unique dataset including the ex-ante budget plans as well as ex-post budget outcomes of…a rule that constrains capital expenditures in municipalities with more than 5,000 residents. …Our analysis show that the municipalities subject to the new capital-spending rule significantly reduced their over-optimism in expenditure projections… Furthermore, in the new regime revenue projections are also more accurate (less over-optimistic). …The reform reduced the forecast error concerning capital expenditures… The effects is significant both statistically and in economic terms. …the introduction of the cap on investment reduced the forecast error on investment expenditures by almost €1 mln, or 35% of the pre-reform average error.

For wonky readers, Figure 1 shows some of relevant data.

For what it’s worth, we seem to have a different problem in the United States.

Rather than exaggerate potential spending on so-called public investment, as seems to have been the case in Italy, American politicians generally low-ball cost estimates for infrastructure projects.

And then, once the projects get started, we get absurd cost overruns (with the high-speed rail project in California being an especially absurd example).

The good news is that a spending cap solves both the Italian version of the problem and the American version of the problem.

As the authors found in their research, it removes the incentive for dishonest budgeting in Italy. And, if adopted in the United States, politicians would learn that it doesn’t help to produce laughably low cost estimates if a spending cap means there is no way of financing cost overruns in the future.

P.S. There is a spending limit in Hong Kong’s constitution, and it has generated very positive results. Given China’s increasing control, it’s unclear how effective it will be in the future.

P.P.S. There’s also a spending limit in Colorado’s constitution, known as the Taxpayers Bill of Rights. It has been very successful.

P.P.P.S. Last month, I wrote about research from both the IMF and the ECB about the benefits of spending caps.

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Is “austerity” a good thing?

Depends on how it is defined. Johan Norberg points out that spending restraint is the right approach.

Since I’m a fan of spending restraint, I obviously like the video.

But let’s expand on two points.

First, the definition of austerity is critical. Some fiscal policy folks (at the IMF and CBO, for instance) focus on deficits and debt. And this means they view spending restraint and tax increases as being equally desirable.

But that’s nonsense. As I’ve repeatedly explained, red ink is best viewed as a symptom. The real problem is excessive government spending.

Moreover, higher taxes usually exacerbate the spending problem since politicians can’t resist the temptation to spend at least a portion of any expected new revenue.

And since tax increases generally don’t collect as much money as politicians think they will, you can wind up with higher taxes, a bigger burden of government, and even higher levels of red ink!

Second, it doesn’t help to identify good policy if politicians think that’s a path to losing elections.

Which is why I want to highlight some new research published by the IMF.

The study, authored by Alberto Alesina, Gabriele Ciminelli, Davide Furceri, and Giorgio Saponaro, has some very encouraging results about tax increases being political poison.

Spending restraint, by contrast, is actually a political plus – at least when implemented by a right-leaning government.

Conventional wisdom holds that voters punish governments that implement fiscal austerity. Yet, most empirical studies, which rely on ex-post yearly austerity measures, do not find supportive evidence. This paper revisits the issue using action-based, real-time, ex-ante measures of fiscal austerity as well as a new database of changes in vote shares of incumbent parties. The analysis emphasizes the importance of the ‘how’—whether austerity is done via tax hikes or expenditure cuts—and the ‘who’—whether it is carried out by left- vs. right-leaning governments. Our main finding is that tax-based austerity carries large electoral costs, while the effect of expenditure-based consolidations depends on the political-leaning of the government. An austerity package worth 1% of GDP, carried out mostly through tax hikes, reduces the vote share of the leader’s party by about 7%. In contrast, expenditure-based austerity is detrimental for left- but beneficial for right-leaning governments.

For what it’s worth, this new research is an affirmation of my Fourth Theorem of Government.

This implies that Republicans should strive to control spending when they have power.

That’s certainly what happened under Reagan, and he then was reelected with a 49-state landslide.

But other Republicans didn’t learn any lessons from Reagan’s success. Both Bushes were big spenders, as was Trump.

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The Laffer Curve is a method for illustrating the relationship between tax rates, taxable income, and tax revenue.

But it’s important to realize that there are actually lots of varieties.

The Laffer Curve for capital gains taxes, for instance, will look different than the Laffer Curve for payroll taxes. Or corporate taxes. Or marijuana taxes.

In every case, the shape of the curve will depend on what’s being taxed and the ability of affected taxpayers to alter their behavior.

And the shape of the Laffer Curve also will depend on whether one is measuring the short-run revenue impact of tax changes or the long-run impact of tax changes.

Given all these varieties, no wonder so many people, both right and left, sometimes misstate its meaning.

Let’s try to expand our understanding of the Lafffer Curve by looking at some new research.

Professor Aaron Hedlund of the University of Missouri authored a study on the Laffer Curve for the Show Me Institute.

Here’s what he wants to understand.

Empirically, recent research provides a variety of estimates for the revenue-maximizing and welfare-maximizing tax rates, but one lesson that emerges is that analyses that only take into account the response of hours worked to tax increases are bound to greatly overestimate the amount of new revenue that can be raised while underestimating the economic damage from lost GDP growth and wages. This paper examines the relationship between tax rates and revenue by taking a broader view that encompasses the responses of skill acquisition, entrepreneurship, innovation, and the labor market behavior of dual-earner families. The bottom line that emerges is that these additional margins of adjustment imply significantly lower revenue-maximizing and welfare-enhancing tax rates.

He then explains that some economists fail to look at all possible behavioral responses.

Traditionally, much of the economic analysis aimed at finding this peak rate has focused on how the income tax rate affects an individual’s willingness to work, both with regard to hours worked and the decision to enter the labor force at all. Moreover, until the recent arrival of better data, much of the academic research considered only the response of heads of households. …This assumption of tax rate insensitivity led economists Peter Diamond and Emmanuel Saez to conclude that the optimal—revenue maximizing—top income tax rate is 73%. Moreover, in an analysis that also considers the social insurance benefits of progressive taxation—specifically, the ability of redistribution to soften the blow of unexpected economic hardship—economists Fabian Kindermann and Dirk Krueger provide justification for a top rate that approaches 90%. However, both studies omit the many other margins of behavioral adjustment that accompany any significant change to tax rates.

When all behavioral responses are measured, it turns out that the revenue-maximizing rate is much lower.

In one study that accounts for the sensitivity of entrepreneurs to tax rates, increasing the progressivity of the income tax code leads to a revenue-maximizing top rate of only 33%. Furthermore, in this case revenues only increase by 5%—amounting to less than one percentage point of GDP. Another study finds even starker results when looking at the subset of superstar entrepreneurs. In an analysis that incorporates the positive spillovers of ideas and innovation on economic growth, economist Charles Jones finds that the revenue-maximizing tax rate may even be as low as 29%. Furthermore, he shows that raising the top income tax rate to 75% could reduce GDP by over 8%, which would greatly blunt the impact on revenues by shrinking the tax base.

Figure 5 from the study shows how the revenue-maximizing rate varies depending on which factors are included in the study.

My two cents on this issue is to remind readers that we don’t want to maximize revenue for politicians.

As such, I don’t care if the revenue-maximizing rate in 29 percent or 73 percent.

I want to be at the growth-maximizing rate, which is where the government only collects the amount of money that is necessary to finance genuine public goods.

Needless to say, that means tax rates (and spending burdens) far lower than today.

P.S. Tax accountants have a very good understanding of the Laffer Curve.

P.P.S. Heck, even the thugs from ISIS understand the Laffer Curve.

P.P.P.S. Sadly, it doesn’t matter if some leftists understand the Laffer Curve.

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I’ve repeatedly heaped praise on Ronald Reagan.

I’ve also lauded Calvin Coolidge on several occasions.

And I even once extolled the virtues of Grover Cleveland.

Today, we’re going to celebrate the fiscal achievements of Warren Harding.

Most notably, as illustrated by this chart based on OMB data, he presided over a period of remarkable spending discipline.

Harding also launched very big – and very effective – reductions in tax rates.

And his agenda of less government and lower tax rates helped bring about a quick end to a massive economic downturn (unlike the big-government policies of Hoover and Roosevelt, which deepened and lengthened the Great Depression).

In an article for National Review last year, Kyle Smith praised President Harding’s economic stewardship.

In a moment of national crisis, Warren G. Harding restored the economic health of the United States. …America in 1921 was in a state of crisis, reeling from the worst recession in half a century, the most severe deflationary spiral on record… Unemployment, it is now estimated, stood somewhere between 8.7 and 11.7 percent as returning soldiers inflated the size of the working-age population. Between 1919 and August of 1921 the Dow Jones average plummeted 47 percent. Harding’s response to this emergency was largely to let the cycle play out. …The recession ended in mid-year, and boom times followed. Harding and Congress cut federal spending nearly in half, from 6.5 percent of GDP to 3.5 percent. The top tax rate came down from 73 percent to 25, and the tax base broadened. Unemployment came down to an estimated 2 to 4 percent. …Harding was a smashing success in a historically important role as the anti-Wilson: He restored a classically liberal, rights-focused, limited government, and deserves immense credit for the economic boom that kicked off in his first year and continued throughout the rest of the 1920s.

Smith’s article also praises Harding for reversing some of Woodrow Wilson’s most odious policies, such as racial discrimination and imprisoning political opponents (Wilson also had a terrible record on economic issues).

Now let’s look at some excerpts from a new article authored by Vance Ginn of the Texas Public Policy Foundation and John Hendrickson of the Iowans for Tax Relief Foundation.

President Harding assumed office in 1921 when nation was suffering an overlooked severe economic depression. Hampering growth were high income tax rates and a large national debt after WWI. …President Harding’s chief economic policy was to rein in spending, reduce tax rates, and pay down debt. Harding…understood that any meaningful cuts in taxes and debt couldn’t happen without reducing spending. …Not only was Harding successful in this first endeavor to reduce government expenditures, his efforts resulted in “over $1.5 billion less than actual expenditures for the year 1921.”  …The decade had started in depression and by 1923 the national economy was booming with low unemployment. 

By the way, the $1.5 billion-plus reduction from 1921 to 1922 may not sound like much, but it was a 30 percent reduction in the size of government (and this was back in the days when government was a relatively small burden).

That would be akin to cutting more than $1.5 trillion from this year’s federal budget.

What a great idea – perhaps even better than my other libertarian fantasy.

P.S. Thomas Sowell has praised Harding’s economic policies.

P.P.S. And I’ve applauded Bill Clinton’s economic policies. Or, to be more precise, I’ve praised the policies that were enacted during his presidency.

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The title of this column is an exaggeration. What we’re really going to do today is explain the main things you need to know about government debt.

We’ll start with this video from Kite and Key Media, which correctly observes that entitlement programs are the main cause of red ink.

I like that the video pointed out how tax-the-rich schemes wouldn’t work, though it would have been nice if they added some information on how genuine entitlement reform could solve the problem  (as you can see here and here, I’ve also nit-picked other debt-themed videos).

Which is why I humbly think this is the best video ever produced on the topic.

As you can see, I’m not an anti-debt fanatic. It was perfectly okay, for instance, to incur debt to win World War II.

But I’m very skeptical of running up the nation’s credit card for routine pork and fake stimulus.

But my main message, which I’ve shared over and over again, is that deficits and debt are merely a symptom. The underlying disease is excessive government spending.

And that spending hurts our economy whether it is financed by taxing or borrowing (or, heaven forbid, by printing money).

Now let’s look at some recent articles on the topic.

We’ll start with Eric Boehm’s column for Reason, which explains how red ink has exploded in recent years.

America’s national debt exceeded $10 trillion for the first time ever in October 2008. By mid-September 2017 the national debt had doubled to $20 trillion. …data released by the U.S. Treasury confirmed that the national debt reached a new milestone: $30 trillion. …Entitlements like Social Security and Medicare are in dire fiscal straits and will become even more costly as the average American gets older. Even without another unexpected crisis, deficits will exceed $1 trillion annually, which means the debt will continue growing, both in real terms and as a percentage of the economy. The Congressional Budget Office estimates that the federal government will add another $12.2 trillion to the debt by 2031.

As already stated, I think the real problem is the spending and the debt is the symptom.

But it is possible, of course, that debt rises so high that investors (the people who buy government bonds) begin to lose faith that they will get repaid.

At that point, governments have to pay higher interest rates to compensate for perceived risk of default, which exacerbates the fiscal burden.

And if there’s not a credible plan to fix the problem, a country can go into a downward spiral. In other words, a debt crisis.

This is what happened to Greece. And I think it’s just a matter of time before it happens to Italy.

Heck, many European nations are vulnerable to a debt crisis. As are many developing countries. And don’t forget Japan.

Could the United States also be hit by a debt crisis? Will we reach a “tipping point” that leads to the aforementioned loss of faith?

That’s one of the possibilities mentioned in the New York Times column by Peter Coy.

It’s hard to know how much to worry about the federal debt of the United States. …Either the United States can continue to run big deficits and skate along with no harm done or it’s at risk of losing investors’ confidence and having to pay higher interest rates on its debt, which would suppress economic growth. …the huge increase in federal debt incurred during and after the past two recessions — those of 2007-09 and 2020 — has used up a lot of the “fiscal space” the United States once had. In other words, the federal government is closer to the tipping point where big increases in debt finally start to become a real problem. …any given amount of debt becomes easier to sustain as long as the growth rate of the economy (and thus the growth rate of tax revenue) is higher than the interest rate on the debt. In that scenario, interest payments gradually shrink relative to tax revenue. …but it doesn’t explain how much more the debt can grow. …Past a certain point, there’s a double whammy of more dollars of debt plus higher interest costs on each dollar. …sovereign debt crises tend to be self-fulfilling prophecies: Investors get nervous about a government’s ability to pay, so they demand higher interest rates, which raise borrowing costs and produce the bad outcome they feared. It’s a dynamic that Argentines are familiar with — and that Americans had better hope they never experience.

For what it’s worth, I think other major nations will suffer fiscal crisis before the problem becomes acute in the United States.

I realize this will make me sound uncharacteristically optimistic, but I’m keeping my fingers crossed that this will finally lead politicians to adopt a spending cap so we don’t become Argentina.

P.S. The Wall Street Journal recently editorialized on the issue of government debt and made a very important point about the difference between the $30 trillion “gross debt” and the “debt held by the public,” which is about $6 trillion lower.

…the debt really isn’t $30 trillion. About $6 trillion of that is debt the government owes to itself in Social Security and other IOUs. …The debt held by the public is some $24 trillion, which is bad enough.

As I’ve noted when writing about Social Security, the IOUs in government trust funds are not real.

They’re just bookkeeping entries, as even Bill Clinton’s budget freely admitted.

Indeed, if you want to know whether some is both honest and knowledgeable about budget matters, ask them which measure of the national debt really matters.

As you can see from this exchange of tweets, competent and careful budget people (regardless of whether they favor big government or small government) focus on “debt held by the public,” which is the term for the money government actually borrows from credit markets.

If you want to know the difference between the various types of government debt – including “unfunded liabilities” – watch this video.

P.P.S. This column explains how and when debt matters. If you’re interested in how to reduce the debt, there’s very good evidence that spending restraint is the only effective approach. Even in cases where debt is enormous.

P.P.P.S. By contrast, the evidence is very clear that higher taxes actually make debt problems worse.

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Back in 2017, the Center for Freedom and Prosperity released this video to help explain why spending caps are the most sensible and sustainable fiscal rule.

Switzerland actually has a spending cap in its constitution, and similar fiscal rules also exist in Hong Kong and the state of Colorado.

These policies have produced very good results.

There are many reasons to support a spending cap, including the obvious observation that an expenditure limit (as it is sometimes called) directly addresses the actual problem of excessive government.

And addressing the underlying disease works better than rules that focus on symptoms, such as balanced budget requirements or anti-deficit mandates.

You’ll notice toward the end of the video that the narrator cites pro-spending cap research from international bureaucracies, which is remarkable since those institutions normally have a bias for bigger government.

I’ve also written about that research, citing studies by the International Monetary Fund (here and here), the Organization for Economic Cooperation and Development (here and here) and the European Central Bank (here).

Today, let’s look at more evidence from these bureaucracies.

We’ll start with a new study from the European Central Bank. Here’s some of what the authors (Nicholai Benalal, Maximilian Freier, Wim Melyn, Stefan Van Parys, and Lukas Reiss) found when comparing spending limits and anti-deficit rules.

this paper provides an in-depth assessment of two alternative measures of fiscal consolidation and expansion: the change in the structural balance (dSB) and the expenditure benchmark (EB). Both the dSB and the EB are currently used to assess compliance with the fiscal rules under the Stability and Growth Pact (SGP).The EB was introduced as an indicator in 2011, and has gained in importance relative to the dSB since the European Commission began to put more emphasis on it in 2016.A comparison of the fiscal performance of euro area countries reveals significant differences depending on whether the assessment is based on the dSB or the EB. this paper finds that the EB has advantages over the dSB as a fiscal performance indicator. …expenditure rules…provide more predictability in fiscal requirements. …Even more importantly, the EB can be shown to be less procyclical as a fiscal rule than the dSB. 

Let’s also review some 2019 research from the International Monetary Fund.

This study (authored by Kodjovi Eklou and Marcelin Joanis) looks at whether fiscal rules can constrain vote-buying politicians.

In order to increase their chances of reelection, politicians are known to undertake fiscal manipulations, especially in election years. These fiscal manipulations typically take the form of increased public expenditure… Many countries, both developed and developing, have adopted fiscal rules in recent decades as an attempt to enforce fiscal discipline. …In this paper, we employ a cross-country panel dataset in order to test whether fiscal rules adopted in developing countries have been effective in constraining political budget cycles. The dataset covers 67 developing countries over the period 1985-2007. …Our dependent variable is the general government’s final consumption expenditure as a share of GDP.

Here’s what the authors concluded about the effectiveness of spending caps.

Our empirical evidence in a sample of 67 developing countries over the period 1985-2007, shows that fiscal rules cause fiscal discipline over the electoral cycle. More specifically, in election years with fiscal rules in place, public consumption is reduced by 1.65% point of GDP as compared to election years without these rules. Furthermore, the effectiveness of these rules depends on their type… In particular, expenditure rules, rules covering the general government and rules characterized by a monitoring body outside the government dampen political budget cycles in government consumption.

Indeed, footnote 12 of the paper specifically notes the superiority of expenditure limits.

…the results show that public consumption is reduced by 2.44% points during election years with expenditure rules in place. The findings on expenditure rules are consistent with Cordes et al. (2015) who show that the compliance rate for these rules are high.

Last but not least, the fiscal experts at the Office of Management and Budget included in Trump’s final budget some very encouraging language at the end of Chapter 10 of the Analytical Perspectives.

…additional efforts to control spending are needed. Several budget process reforms should be considered, including setting spending caps… Outlay caps that are consistent with the historical average as a share of gross domestic product (GDP), post-World War II levels could be enforced with sequestration across programs similar to other budget enforcement regimes. An outlay cap on mandatory spending would complement discretionary caps, which have been in place since 2013. The Budget proposes to continue discretionary caps through 2025 at declining levels and declining levels through 2030.

Trump was a big spender, of course, but at least there were people in his administration who realized there was a problem.

And they recognized the right solution.

P.S. It’s also interesting that the authors of the IMF study found that fiscal rules work better in democracies.

…estimates focusing on the subsample of democratic elections. The effect of fiscal rules on the political budget cycle is larger… More specifically, public consumption is reduced by 2.46% point of GDP (while it is 1.65% point in the baseline).

This may not bode well for the durability of Hong Kong’s spending cap.

The authors also found that foreign aid makes it less likely that a government will follow sensible policy.

Foreign aid, which relaxes the budget constraint of the government, is negatively correlated with the probability of having fiscal rules.

Needless to say, nobody should be surprised to learn that foreign aid undermines good policy.

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I wrote last year about an encouraging trend of lower tax rates at the state level.

As you can see from this map, one of the states moving in the right direction is Iowa.

But Governor Kim Reynolds isn’t satisfied with just lowering tax rates, which is a worthy goal, of course.

She is now proposing to get rid of the state’s so-called progressive tax and replace it with a flat tax.

This would be very good news for Iowa’s economy and Iowa’s taxpayers.

An article in the Quad-City Times explains Governor Reynolds’ proposal.

In four years, every Iowan’s income would be taxed at 4% by the state under a new proposal from Gov. Kim Reynolds. Reynolds introduced her flat income tax proposal during last week’s annual Condition of the State address to the Iowa Legislature, encouraging the lawmakers to pass her idea.“Flat and fair,” Reynolds proclaimed during the speech. …Ten states currently have a flat state income tax, including Iowa’s eastern neighbor, Illinois. The list includes more blue states like Michigan and Massachusetts, but also red states like Kentucky and Utah. …Under Reynolds’ new plan, top state income tax rate would be eliminated each year over the next four years, until in 2026 every Iowa worker, regardless of income level, pays 4 percent. …The plan would reduce state revenue by $226 million in the first year, and by $1.6 billion at full implementation… Reynolds said during her speech. “Yes, we’ll have less to spend once a year at the Capitol, but we’ll see it spent every single day on Main Streets, in grocery stores, and at restaurants across Iowa. We’ll see it spent in businesses instead of on bureaucracies.” …Republican legislative leaders praised Reynolds’ proposal and said they are eager to begin working on legislation.

The article also explains the previous tax reform, which focused on lowering marginal tax rates.

In 2021, Iowa had nine state income tax rates, tied for the second-most in the country. Most Iowa workers’ income was taxed at between 4.14%, with rates increasing as income increased, up to a top rate of 8.53% for those earning over $78,435 of taxable income. As a result of tax reform passed by the Iowa Legislature and signed into law by Reynolds in 2018, the number of tax brackets will be reduced to four, ranging between 4.4 and 6.5%.

I showed last year how that legislation moved Iowa up one level in a ranking of state income taxes.

Well, here’s an updated look at the state’s total improvement if the governor’s plan for a flat tax is enacted.

Iowa jumps from the worst column to the next-to-best column.

And if I ranked states by the rate of their flat tax, Iowa’s 4 percent rate would be lower than the rates in North Carolina, Kentucky, Illinois, Michigan, Utah, and Massachusetts.

Not as good as the states with no income taxes, but still impressive.

P.S. I’ll be curious to see how much Iowa will improve in the Tax Foundation’s rankings if the proposed flat tax gets approved.

 

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When I wrote about the 2018 edition of Freedom in the 50 States, Florida ranked as the nation’s most libertarian state.

In the 2021 version, New Hampshire takes the top spot (reclaiming the lead it had back in 2016).

Here’s a map showing the 10 best and 10 worst states. One obvious takeaway is that New Hampshire deserves extra praise because it is in a region where there seems to be a general disdain for economic and personal liberty.

And here’s a table showing how all the states rank.

As you can see, Florida is still a very good state.

Indeed, Florida is getting better over time. All that happened in the new edition of Freedom in the 50 States is that New Hampshire got better even faster.

This seems to be a pattern.

You can see from Figure 9 that the best states have been getting better over the past 10 years while the worst states are stagnating.

If you want some background on the publication, here’s how the authors (Will Ruger and Jason Sorens) describe their index.

…the 2021 edition examines state and local government intervention across a wide range of policy categories—from taxation to debt, from eminent domain laws to occupational licensing, and from drug policy to educational choice.We…strive to make it the most comprehensive and definitive source for economic freedom data on the American states.Although the United States has made great strides toward respecting each individual’s rights regardless of race, sex, age, or sexual preference, some individuals face growing threats to their interests in some jurisdictions. Those facing more limits today include smokers, builders and buyers of affordable housing, aspiring professionals wanting to ply a trade without paying onerous examination and education costs, and less-skilled workers priced out of the market by minimum-wage laws. Moreover, although the rights of some have increased significantly in certain areas, for the average American, freedom has declined generally because of federal policy that includes encroachment on policies that states controlled 20 years ago.

For more information, here’s how the states rank for economic freedom.

And here are the rankings for personal freedom.

Let’s look at the some other tables.

Since I’m most interested in fiscal policy, I’m reflexively drawn to Table 7. Kudos to Florida, Tennessee, New Hampshire, and South Dakota (the absence of a state income tax really helps). And I’m surprised to see Massachusetts in the top 10 (it helps to a have a flat tax).

For what it’s worth, Hawaii really stinks. And I’m not surprised to see New York next to last.

Here’s a look at how states have changed since 2000.

No big surprises, though it’s interesting to note that North Dakota (which was ranked #1 back in 2013) has suffered a relative decline (now ranked #15) simply because its improvement has been rather modest compared to the big improvements in other states.

P.S. For those interested in methodological issues, here’s a look at the formula used to determine which states have the most freedom and least freedom.

P.P.S. If you look at the weighting for personal freedom, you’ll find that educational freedom is 2 percent of a state’s score. Given the importance of school choice (for both individual education outcomes and national economic competitiveness), I wonder if that variable is insufficiently appreciated.

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As a libertarian, I view defense spending with the same jaundiced eye that I apply to domestic spending.

  • I’ve pointed out that the U.S. represents a big share of global military outlays.
  • I’ve pointed out that sequestration wasn’t a threat to military preparedness.
  • I’ve pointed out that legacy defense commitments may be senseless nowadays.

And here’s a more-updated view of how much the United States spends on the military compared to other nations.

Call me crazy, but this chart indicates that the United States is probably spending too much on the Pentagon.

For what it’s worth, it’s possible that America’s lead is exaggerated because China and Russia get more bang for their buck on their military spending, but it’s also worth noting that the rest of the nations on the list are largely allied with the United States.

Farhad Manjoo of the New York Times writes there is too much spending on defense. But he undermines the credibility of his position with a deceptive comparison of domestic and defense outlays.

…the nearly three-quarters of a trillion dollars that we are spending this year on a military that has become the epitome of governmental dysfunction, self-dealing and overspending. …does it make any sense to keep spending so many hundreds of billions on the Pentagon? …The Pentagon has never passed an audit… Congress is projected to spend about $8.5 trillion for the military over the next decade — about half a trillion more than is budgeted for all nonmilitary discretionary programs combined… You don’t have to be a pacifist to wonder if this imbalance between military and nonmilitary spending makes sense.

The problem with what he wrote is that he compares defense spending only to the portion of domestic spending that is considered “discretionary.”

And this leaves out all the entitlement programs – which are the biggest and fastest growing part of the federal budget.

So I went to section 8 of the Historical Tables of the Budget and put together this chart, based on inflation-adjusted dollars, showing total domestic spending (huge and growing), total defense spending (relatively flat), and interest payments on the national debt (relatively flat).

Next, let’s look at the data showing what share of the budget goes to different types of spending.

For this chart, I’ve separated domestic entitlements and domestic discretionary.

Once again, the obvious and unambiguous takeaway is that domestic spending is the problem in general, with entitlements being the problem in particular.

Now that we know that entitlement programs are America’s main fiscal challenge, let’s close with a couple of reminders that we also should take a knife to the Pentagon’s budget.

This headline for a story in USA Today.

This heading from a story in Stars & Stripes.

This headline from a story in the New York Times.

And if you want other examples of military waste, click here, here, and here.

But don’t forget that the big savings from defense budget can be achieved by reevaluating whether it makes sense to maintain alliances against enemies that no longer exist, along with reconsidering the wisdom of nation building.

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As part of a recent discussion with Gene Tunny in Australia, I explained why I support “Starve the Beast,” which means keeping taxes as low as possible to help achieve the goal of spending restraint.

The premise of Starve the Beast is very simple.

Politicians like to spend money and they don’t particularly care whether that spending is financed by taxes or financed by borrowing (both bad options).

As Milton Friedman sagely observed, that means they will spend every penny they collect in taxes plus as much additional spending financed by borrowing that the political system will allow.

The IMF published a study on this issue about 10 years ago. The authors (Michael Kumhof, Douglas Laxton, and Daniel Leigh) assert that there’s no way of knowing whether Starve the Beast will lead to good or bad results.

…there is no consensus regarding the macroeconomic and welfare consequences of implementing a starve-the-beast approach, henceforth referred to as STB. …it could be beneficial in the ideal case in which it results in cuts in entirely wasteful government spending. In particular, lower spending frees up resources for private consumption, and the associated lower tax rates reduce distortions in the economy. On the other hand, …lower government spending may itself entail welfare losses…if it augments the productivity of private factors of production. …the paper examines whether the principal macroeconomic variables such as GDP and consumption, both in the United States and in the rest of the world, respond positively to this policy. …In addition, the paper assesses how the welfare effects depend on the degree to which government spending directly contributes to household welfare or to productivity.

The authors don’t really push any particular conclusion. Instead, they show various economic outcomes depending on with assumptions one adopts.

Since plenty of research shows that government spending is not a net plus for the economy (even IMF economists agree on that point), and because I think a less-punitive tax system is possible (and desirable) if there’s a smaller burden of government spending, I think the findings shown in Figure 4 make the most sense.

Now let’s shift from academic analysis to policy analysis.

In a piece for National Review back in July 2020, Jim Geraghty notes that Starve the Beast has an impact on government finances at the state level.

…we’re probably not going to see a massive expansion of government at the state level in the coming year or two. …Thanks to the pandemic lockdown bringing vast swaths of the economy to a halt, state tax revenues are plummeting. …So states will have much less tax revenue, constitutional balanced-budget requirements that are not easily repealed, and a limited amount of budgetary tricks to work around it. State governments could attempt to raise taxes, but that’s going to be unpopular and hurt state economies when they’re already struggling. Add it all up and it’s a tough set of circumstances for a dramatic expansion of government, no matter how ardently progressive the governor and state legislatures are.

For what it’s worth, Geraghty warned in the article that fiscal restraint by state governments wouldn’t happen if the federal government turned on the spending spigot.

And that, of course, is exactly what happened.

Now let’s look at the most unintentional endorsement of Stave the Beast.

A couple of years ago, Paul Krugman sort of admitted that cutting taxes was a potentially effective strategy for spending restraint.

…the same Republicans now wringing their hands over budget deficits…blew up that same deficit by enacting a huge tax cut for corporations and the wealthy. …this has been the G.O.P.’s budget strategy for decades. First, cut taxes. Then, bemoan the deficit created by those tax cuts and demand cuts in social spending. Lather, rinse, repeat. This strategy, known as “starve the beast,” has been around since the 1970s, when Republican economists like Alan Greenspan and Milton Friedman began declaring that the role of tax cuts in worsening budget deficits was a feature, not a bug. As Greenspan openly put it in 1978, the goal was to rein in spending with tax cuts that reduce revenue, then “trust that there is a political limit to deficit spending.” …voters should realize that the threat to programs… Social Security and Medicare as we know them will be very much in danger.

In other words, Krugman doesn’t like Starve the Beast because he fears it is effective (just like he also acknowledges the Laffer Curve, even though he’s opposed to tax cuts).

Let’s close by looking at some very powerful real-world evidence. Over the past 50 years, there’s been a massive increase in the tax burden in Western Europe.

Did all that additional tax revenue lead to lower deficits and less debt?

Nope, the opposite happened. European politicians spent every penny of the new tax revenue (much of it from value-added taxes). And then they added even more spending financed by additional borrowing.

To be fair, one could argue that this was an argument for the view of “Don’t Feed the Beast” rather than “Starve the Beast,” but it nonetheless shows that more money in the hands of politicians simply means more spending. And more red ink.

P.S. I had a discussion last year with Gene Tunny about the issue of “state capacity libertarianism.”

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The fight over President Biden’s budget, the so-called Build Back Better plan, has revolved around very important issues.

For today’s column, let’s zoom out and look at two charts that highlight the big issue that should be getting more attention.

First, here’s a comparison of projected inflation with baseline spending (the current spending outlook) and Biden’s budget – all based on economic and fiscal estimates from the Congressional Budget Office.

As you can see, spending was growing far too fast even without Biden’s budget. And if Biden’s budget is enacted, the spending burden will rise more than twice the rate of inflation.

Now let’s look at a chart that illustrates why Biden’s spending spree is just a small part of the problem.

To be sure, it’s not good that the President is exacerbating America’s fiscal problems, but you can see that he’s simply adding a few more straws to the camel’s back.

You’ll also notice that I included both the amount of spending that technically is in Biden’s budget plan (the orange part), as well as CBO’s estimate of the additional spending (the gray part) that will happen if the budget gimmicks are removed.

The bottom line is that America’s fiscal problem is too much government spending.

And that spending burden is getting worse over time because spending is growing faster than the private sector, violating the Golden Rule, which is bad news for jobs and growth.

Making the problem worse, as Biden proposes, will further hurt American prosperity.

P.S. Biden’s plan will increase the deficit, which also is not good, but keep in mind that tax-financed spending is no better than debt-financed spending. In either case, you wind up with the same bad result.

P.P.S. This column has two serious visuals to help understand Biden’s fiscal policy. If you prefer satire, here are two other images.

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Regarding fiscal policy, almost everyone’s attention is focused on Biden’s growth-sapping plan to increase the burden of taxes and spending.

People are right to be concerned. If the President’s plan is approved, the already-grim fiscal outlook for United States will get even worse.

This battle will be decided in next 12 months, hopefully with a defeat for Biden’s dependency agenda.

Regardless of how that fight is resolved, though, we’re eventually going to get to a point where sensible people are back in charge. And when that happens, we’ll have to figure out how to restore the nation’s finances.

That requires figuring out the appropriate goal. Here are two options:

  • Keeping taxes low.
  • Controlling debt.

These are both worthy objectives.

But, as a logic teacher might say, they are necessary but not sufficient conditions.

Here’s a chart showing how a policy of low taxes (the orange line) presumably enables faster growth, but also creates the risk of an eventual economic crisis if nothing is done to control spending and debt climbs too high (think Greece).

By contrast, the chart also shows that it’s theoretically possible to avoid an economic crisis with higher taxes (the blue line), but it means less growth on a year-to-year basis.

The moral of the story is that the economy winds up in the same place with either tax-financed spending or debt-financed spending.

Which is why we should consider a third goal.

  • Limiting spending.

The economic benefits of this approach are illustrated in this second chart. We enjoy faster year-to-year growth. And, because spending restraint is the best way of controlling debt, the risk of a Greek-style economic crisis is averted.

Now for some caveats.

I made a handful of assumptions in the above charts.

  • The economy grows 2.0 percent annually for the next 31 years with tax-financed spending
  • The economy grows 2.5 percent annually with debt-financed spending, but suffers a 10 percent decline in Year 31.
  • The economy grows 3.0 percent annually for the next 31 years with smaller government (thus enabling low taxes and less debt).

Anyone can create their own spreadsheet and make different assumptions.

That being said, there’s a lot of evidence that higher tax burdens hinder growth, that ever-rising debt burdens can lead to crisis, and that less government spending produces stronger growth.

So feel free to make your own assumptions about the strength of these effects, but let’s never lose sight of the fact that spending restraint should be the main goal for post-Biden fiscal policy.

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Nearly 10 years ago, I shared some data to show how a Swiss-style spending cap would have prevented some of the excess spending of the Bush and Obama years.

Trillion-dollar deficits would have been avoided. But, more important, the burden of government spending would have been significantly lower.

That would have enabled stronger growth, as confirmed even by researchers from left-leaning bureaucracies such as the OECD and CBO.

I then did the same thing in 2020, showing once again how a spending cap would have produced great results.

And, earlier this year, I crunched the numbers to show how Italy and Greece could have avoided their fiscal nightmares if they had imposed spending caps a couple of decades ago.

Today, let’s look at similar data for Canada.

Except I don’t need to do any work because Livio di Matteo has a new study on tax and expenditure limitations from the Fraser Institute. Here’s some he wrote about the conceptual issues.

Tax and expenditure limits restrict the growth of either revenues or expenditures or both by either setting them at a fixed dollar amount or by limiting the growth rate by linking them to the growth of specific economic variables. …A key perceived benefit of TELs is that they serve as a restraint on politicians and bureaucrats who often have little incentive to restrain spending in response to pressures from interest groups. A second benefit of TELs is that smaller government can be associated with higher rates of economic growth. …One noteworthy type of TEL is a strict restriction on tax or expenditure levels, or, more commonly their rates of growth. This is generally a formula driven approach and the most common mechanism involves restricting expenditure growth to the pace of personal income, GDP, or combined population and inflation growth.

Now let’s look at his numbers for Canada, starting with a look at the the status quo outlook for 2015-2025, which shows that the spending burden will climb by 58 percent over the 10-year period.

Perhaps the best way to illustrate the implementation of a simple TEL and assess its impact and effectiveness is via an example that makes use of recent federal public finance data. …The base scenario…shows revenues rising from…$292.6 billion to $437.7 billion—an increase of 50 percent. …Meanwhile, expenditures rise from $295.4 billion to $466 billion for an increase of 58 percent.

But what if spending was limited so it could only grow at the same rate as population plus inflation?

The spending burden would increase by just 33 percent.

The simulations in this paper…involves a fixed growth rule for expenditures so that they cannot exceed growth in population plus inflation… Under this approach, federal expenditures grow from $295.5 billion in 2015–16 to reach $393.2 billion by 2025–26, which is a much smaller increase in spending relative to the projections contained in Budget 2021. …Expenditures grow from $295.5 billion in 2015–16 to reach $393.2 billion by 2025–26, an
increase of 33 percent.

The report also looks at what would happen if there was an opt-out clause to allow emergency spending, specifically the outlays for Canada’s response to the COVID pandemic.

The net result is that spending climbs by 43 percent over the 10-year period.

…In figure 3, a…final scenario is presented that…assumes that the TEL was designed to accommodate the need for an emergency fiscal response… Expenditures are assumed to grow at 2.9 percent annually from 2015–16 to 2019–20 and then from 2023–24 onwards. …The results show that revenues rise from $292.6 billion in 2015–16 to $427.7 billion by 2025–26 for a total increase of 46 percent. Meanwhile, expenditures rise from $295.5 billion in 2015–16 to reach $423.7 billion by 2025–26 for an overall increase of 43 percent.

Here is the aforementioned Figure 3, for those interested.

The main takeaway is that a spending cap can be very successful, even if there’s a provision that allows emergency spending.

Total spending grows by less than total revenue, thus satisfying my Golden Rule. And, as a result, there’s far less government debt.

In other words, even with a TEL as structured under this scenario, it would have been possible for the federal government to deliver the exact same amount of COVID-19 fiscal support as laid out in the 2021 federal spring budget, balance the budget by 2025–26, and only accumulate half the deficits

P.S. Let’s look at a final excerpt from the study. We have reviewed a bunch of data showing how spending caps would be successful.

By contrast, balanced budget requirements do not have a good track record.

Balanced budget legislation is often perceived as a form of TEL but in practice it is considered different in that it simply attempts to achieve budget balance so that debt stops being accumulated. Such legislation is not necessarily designed to constrain the rate of growth of government spending—nor to limit the size of the public sector… Indeed, according to Clemens et al. (2003) the adoption of balanced budget laws in Canada, which by the early 2000s existed in eight out of ten provinces, coincided with increases in government spending and taxation as measured by real per-capita consolidated provincial and municipal spending.

This is not surprising. The cyclical nature of revenues means it is very difficult to maintain a balanced budget rule.

By contrast, the International Monetary Fund (twice!), the European Central Bank, and the Organization for Economic Cooperation and Development (twice!) have acknowledged that spending caps are the most, if not only, effective fiscal rule.

P.P.S. If you want some real-world evidence, Switzerland’s spending cap continues to produce strong outcomes.

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In my column yesterday about state tax systems, I specifically noted that North Carolina has been making big improvements.

Not only did the state shift to a flat tax a few years ago, it recently voted to lower the rate from 5.25 percent to 3.99 percent.

Why did this happen?

The easy answer is that Republicans gained control of the state legislature. But that’s – at best – only a partial answer. After all, there are plenty of places where Republicans gain power and don’t enact good fiscal policy.

So maybe a better answer is that Reagan-style Republicans took control.

I suspect that’s a far more accurate answer, but I want to dig deeper and look at a policy reform that made the tax cuts possible.

Simply stated, North Carolina politicians embraced the Golden Rule of spending restraint.

And by controlling the growth of spending, they created fiscal maneuvering room for lower tax rates.

In a column for a North Carolina newspaper, John Hood, a board member of the John Locke Foundation (the state’s pro-market think tank) explains what happened.

…in North Carolina, conservative governance has actually reduced the size of state government and significantly improved its fiscal condition. …As a share of the economy, state spending has averaged about 5.8% over the past 45 years. It was well over 6% as recently as 2009. Since fiscally conservative Republicans won control of the General Assembly in 2010, however, budgets have gone up every year in dollar terms but have gone down almost every year when expressed as a share of GDP. That’s because legislative leaders have stuck to their commitment to keep annual spending growth at or below the combined rates of inflation and population growth. …That has, in turn, allowed legislators to rebuild the state’s savings reserves, pay off state debt, and finance several rounds of growth-enhancing tax cuts.

I fully agree that the goal should be to reduce state spending as a share of GDP, so kudos to North Carolina lawmakers.

By limiting annual spending increases, they have strengthened the private sector.

Here’s a chart, based on data from the National Association of State Budget Officers, showing what has happened to state spending since 2010. For background, a simple rule of thumb is that the “general fund” is money a state raises and spends while “total spending” includes that spending plus money that comes from Washington.

By the way, population has increased by about 1 percent annually in North Carolina, so per-capita state spending is only growing by about 1.5 percent per year.

All things considered, a very good job. Too bad Republicans in Washington don’t push for similar policies (to be fair, they did restrain spending during the Tea Party era).

I’ll close with a worrisome observation that North Carolina does not not have a TABOR-style constitutional spending limit.

So while it’s admirable that state lawmakers have restrained spending over the past decade, there are no guarantees that the Tarheel State will enjoy spending restraint in the future.

So North Carolina should copy Colorado and adopt something like TABOR. Or, they can demonstrate their worldliness by copying Switzerland’s “debt brake,” which is another constitutional provision to limit spending.

The goal – for the state and the nation – should be some sort of spending cap.

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Motivated in part by an excellent graphic that I shared in 2016, I put together a five-column ranking of state personal income tax systems in 2018.

Given some changes that have since occurred, it’s time for a new version. The first two columns are self explanatory and columns 3 and 5 are based on whether the top tax rate on households is less than 5 percent (“Low Rate”) or more than 8 percent (“Class Warfare”).

Column 4, needless to say, is for states where the top tax rate in between 5-8 percent.

The good news is that the above table is better than the one I created in 2018. Thanks to tax competition between states, there have been some improvements in tax policy.

I recently wrote about Louisiana’s shift in the right direction.

Now we have some good news from the Tarheel state. The Wall Street Journal opined today about a new tax reform in North Carolina.

The deal phases out the state’s 2.5% corporate income tax between 2025 and 2031. …The deal also cuts the state’s flat 5.25% personal income tax rate in stages to 3.99% by July 1, 2027. …North Carolina ranks tenth on the Tax Foundation’s 2021 state business tax climate index, and these reforms will make it even more competitive. …North Carolina has an unreserved cash balance of $8.55 billion, and legislators are wisely returning some of it to taxpayers.

What’s especially noteworthy is that North Carolina has been moving in the right direction for almost 10 years.

P.S. Arizona almost moved from column 3 to column 5, but that big decline was averted.

P.P.S. There are efforts in Mississippi and Nebraska to get rid of state income taxes.

P.P.P.S. Kansas tried for a big improvement a few years ago, but ultimately settled for a modest improvement.

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