Posts Tagged ‘Fiscal Policy’

Way back in 2009, I narrated a video explaining that people worry too much about deficits and debt. Red ink isn’t desirable, to be sure, but I pointed out that the real problem is government spending.

And the bottom line is that most types of government spending are bad for an economy, regardless of whether they are financed by taxes or borrowing.

It is possible, of course, for a nation to have a debt crisis. But keep in mind that this simply means a government has accumulated so much debt that investors no longer trust that they will receive payments on government bonds.

That’s not a good outcome, but replacing debt-financed spending with tax-financed spending is like jumping out of the frying pan and into the fire. Or the fire into the frying pan, if you prefer. In either case, politicians are ignoring the real problem.

Greece is a cautionary example. Thanks to a period of overspending, Greek politicians drove the country into a debt crisis. But this dark cloud had a silver lining. The good news (at least relatively speaking) is that the government no longer could borrow from the private sector to finance more spending.

But the bad news is that Greek politicians subsequently hammered the economy with huge tax increases in hopes of propping up the country’s bloated welfare state. And the “troika” made a bad situation worse with bailout funds (mostly to protect big banks that unwisely lent money to Greek politicians, but that’s a separate story).

In other words, Greece got in trouble because of too much government spending and it remains in trouble because of too much government spending. As is the case for many other European nations.

And I fear the United States is slowly but surely heading in that direction. I elaborate about the problem of government spending – and the concomitant symptom of red ink – in this interview with the Mises Institute.

For all intents and purposes, I’m trying to convince people that deficits and debt are bad, but they’re bad mostly because they are a sign that government is too big. Sort of like a brain tumor being the real problem and headaches being a warning sign.

I feel like Goldilocks on this issue. Except instead of porridge that is too hot or too cold, I deal with people on both sides who think red ink is either wonderful or terrible.

For an example of the former group, here’s some of what Stephanie Kelton wrote for the New York Times last October.

…bigger deficits wouldn’t wreck the nation’s finances. …Lawmakers are obsessed with avoiding an increase in the deficit. …It’s also holding us back. Politicians of both parties should stop using the deficit as a guide to public policy. Instead, they should be advancing legislation aimed at raising living standards and delivering…long-term prosperity.

Hard to disagree with the above excerpt.

But here’s the part I don’t like. She’s a believer in the perpetual motion machine of Keynesian economics. She thinks deficits are actually good for the economy and she wants to use debt to finance an ever-larger burden of government spending.

Government spending adds new money to the economy, and taxes take some of that money out again. …we should think of the government’s spending as self-financing since it pays its bills by sending new money into the economy. …the deficit itself could be deployed as a potent weapon in the fights against inequality, poverty and economic stagnation.


Now let’s check out the view of the so-called deficit hawks who think red ink is an abomination.

Here are some passages from a Hill report on the battle over last year’s tax plan.

A handful of GOP deficit hawks are worried that their party’s tax plan could add trillions to the deficit, deepening a debt crisis for future generations. …The tax plan could cost the government $1.5 trillion in revenue over the next decade… Sen. Bob Corker (R-Tenn.), who recently announced his retirement at the end of this Congress, has warned he’ll oppose the tax plan if it adds to the deficit. …In a separate interview, he told The New York Times that the debt is “the greatest threat to our nation,” more dangerous than the Islamic State in Iraq and Syria, or North Korea.

Ugh, again.

The threat isn’t the red ink. The real danger is an ever-increasing burden of government spending, driven by entitlements.

Besides, the GOP tax bill actually is a long-run tax increase!

Let’s close with a video on the topic from Marginal Revolution. It has too much Keynesianism in it for my tastes, but the discussion of Argentina’s default is useful for those who wonder about whether the United States is going to have a debt meltdown at some point.

P.S. I don’t agree with Keynesians and I don’t agree with the self-styled deficit hawks. But I can appreciate that both groups have a consistent approach to public finance. What really galls me are the statist hypocrites who are cheerleaders for debt when there are proposals to increase government spending, but then do a back flip and pretend that debt is terrible and must be reduced when tax increases are being discussed.

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I’ve narrated a video on why big government is theoretically bad for an economy, another video looking at the empirical evidence on government spending and economic performance, and also a video on the growth-maximizing size of the public sector.

But if you want to see a lot of what I said condensed into one video, here’s Dennis Prager talking about differences in how the left and right view government. The opening part of the video is interesting, though I suspect his descriptions only apply to philosophically motivated activists on each side.

The part I want to focus on begins about 1:15, when he outlines seven adverse consequences of ever-growing government.

I think he put together a very good list. Here’s my two cents on his seven points.

  1. More Corruption – He points out that a government with lots of power and control will be very susceptible to misbehavior as interest groups and politicians figure out ways of scamming the system. Very similar to the message in one of my videos.
  2. Less Liberty – It is basically a tautology that ever-larger government necessitates a reduction in liberty. Not in a totalitarian sense, but taxes and regulations constrain the freedom of individual to earn and control income.
  3. Fiscal Crisis – He warns that big government is a recipe for fiscal crisis. I’m not sure if this has to be inevitable, but from a practical perspective, he is right. Demographic change and entitlements are a poisonous combination.
  4. Punitive Taxation – If government consistently expands faster than the productive sector of the economy, that almost certainly means ever-higher taxes, which ultimately will be self defeating because of the Laffer Curve.
  5. Unsustainable Debt – An expanding burden of government spending also will mean ever-higher levels of red ink, especially once the tax burden is so high that additional levies don’t produce much – if any – revenue.
  6. Totalitarianism – This is probably Prager’s weakest point. He’s right that bad people do very bad things when they control a government, but I suspect western nations will suffer societal breakdown rather that dictatorship.
  7. Dependency – He closes very strong with observations about the danger of luring people into reliance on government. This concern about the erosion of societal capital is much more important than most people think.

For all intents and purposes, Prager’s video is a very good description of “goldfish government.”

This is the term I use to describe the unfortunate tendency of politicians to over-tax and over-spend until a society faces a crisis.

For what it’s worth, I don’t think western nations necessarily will collapse (though some almost certainly will depending on the degree to which societal capital has been destroyed).

But I will acknowledge that politicians generally don’t like taking the necessary steps to avert fiscal crisis.

Which is one of the reasons I’m such a big fan of tax competition. I don’t want politicians to think that endless tax increases are a way of postponing the fiscal day of reckoning.

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Every time I write a column criticizing Trump’s protectionism, I get pushback. Some of the resistance is from people who genuinely think trade barriers are a good thing, and I routinely respond by asking them to ponder these eight questions or these five charts.

But I also get negative feedback from people who point out that the United States imposed significant import taxes in the 1800s, a period when the United States transitioned from agricultural poverty to middle-class prosperity.

Doesn’t this prove tariffs are pro-growth?

That’s sort of what Brian Domitrovic asserts in a recent column for Forbes.

There is an indisputable chronological correlation between the tariff and phenomenal economic growth. From the late 18th to the early 20th twentieth centuries, the United States steadily developed into the most successful economy in the world.

Brian’s column explores how trade taxes worked in the early history of the United States, but let’s skip to the part that is relevant to today’s discussion.

From 1789 to 1913, the size of the federal government in the economy as a whole averaged about 3%, with variation in time of war. Today, that number is over 20%—a 7-fold increase. State and local government was another 3% back then, and is another 12% today. Where total government was 6% of economic output in the era of the tariff, it is five times larger at over 30% today.

In other words, the real lesson to be learned is not that trade taxes are good for growth, but rather that an economy can prosper if the public sector is very small. And Brian is right that the federal government used to be only a tiny burden in the United States.

Brian even makes the case that government may have stayed small during the 1800s precisely because import taxes were seen as naked cronyism.

The quid pro quo the populace made with the tariff is that Congress and its conspirators in business got their favors, but in turn Congress’s realm, the government, had to stay small. Therefore, the private economy was free… Boundless growth at the hands of entrepreneurs and a talented and ambitious workforce built up year after year as Congress got to curry its petty favors on the condition that government stayed limited in size.

He also explains that politicians back then were very cognizant of the Laffer Curve.

A tariff “for revenue” was one where a rate was set low enough for the good in question to flow into the country in sufficient quantity to bring in increasing receipts to the government. A “prohibitive” tariff was one that was so high, receipts would go up if a rate were lowered. The “Laffer curve” concept was the most discussed theorem in political-economic debates in the United States in the 19th century.

The same principle applies to the income tax today. A modest rate generates lots of revenue, whereas a punitive rate can actually cause a drop in tax receipts.

And, speaking of the income tax, the introduction of that awful levy actually gave Hoover and other politicians the fiscal leeway to impose “prohibitive” tariffs…with very bad results.

After the income tax was put in place in 1913, the tariff shed its revenue purpose and became exclusively a vehicle for cronyism. Therefore it got very high—so high, in 1930, that…the…system was ruined and the result was the Great Depression.

For what it’s worth, I think there were lots of other bad policies from Hoover and Roosevelt that caused – and then exacerbated – the economic damage of the 1930s, so high tariffs don’t deserve all the blame.

But let’s not digress from our main topic of whether trade taxes can be justified.

Brian’s column doesn’t say that tariffs are good, but he does point out that such a system was only capable of financing a very small government. And that meant the private sector had lots of breathing room to operate.

But a “sin of omission” is that he also could have elaborated on the economic benefits of having no income tax. During the 1800s (with the exception of Lincoln’s income tax during the Civil War and an income tax in 1894 that was declared unconstitutional in 1895), there was no personal income tax. And no corporate income tax. And no payroll taxes. Or death tax. Or capital gains tax.

Dean Clancy highlighted these benefits when considering the conditions that would be necessary for him to support trade taxes.

I sort of agree. But I hope Dean would agree to a friendly tweak to his tweet, so that it read “McKinley-size tariffs were a less-worse option because of…”, and then list the polices that actually were good, such as no taxes on income and very small government.

Sadly, I don’t see any practical way of unwinding all the bad policy of the past 100 years.

So the case for trade taxes is very similar to the market-friendly case for a value-added tax. Yes, there is a theoretical argument to replace all income taxes with a VAT, but it’s not realistic.

Likewise, I’m open to the argument that higher tariffs might be acceptable, but only if someone first shows me a practical plan to 1) shrink the federal government back down to what the Founding Fathers envisioned, and 2) get rid of the IRS and all taxes on income.

P.S. Alexander Hamilton, writing about tariffs and excises in Federalist 21, clearly appreciated the insights of the Laffer Curve: “It is a signal advantage of taxes on articles of consumption, that they contain in their own nature a security against excess. They prescribe their own limit; which cannot be exceeded without defeating the end proposed, that is, an extension of the revenue.”

P.P.S. The Cayman Islands is the closest example of a successful modern economy that finances a big chunk of government with import taxes. But that example is somewhat limited since almost all goods are imported. For such an economy, tariffs are basically the same as a sales tax. For what it’s worth, I would argue Cayman’s fiscal system has more in common with Monaco today than with the United States in the 1800s.

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I’m not a fan of international bureaucracies, but they’re not universally bad. Yes, we almost always get a bad policy agenda from the left-leaning political appointees who run these organizations.

But it’s also true that the professional economists at these bureaucracies oftentimes produce solid reasearch. A good example is the new study of the American fiscal system by three economists at the International Monetary Fund.

They start with an observation that should be uncontroversial, but is nonetheless surprising given the tendency of the IMF’s leadership to advocate more taxes.

The consensus is that reducing distortionary taxes on labor and capital income can stimulate economic activity by encouraging an increase in labor supply and higher savings. Indeed, the empirical literature on tax multipliers is vast and points to measurable effects of reducing taxes on output and employment.

I’m delighted by these two sentences. Makes me wonder why the political types who run the IMF overlook these basic insights when they’re bullying governments into enacting higher tax rates!

But let’s set that aside and look at the specific findings in this report. Here’s what the IMF tried to calculate.

We simulate three types of tax policy changes (i) A “middle-class tax cut” which reduces the effective tax rates for households earning between 0.5 to 4 times the median income and is offset by lower government spending; (ii) A “middle-class tax cut” and an EITC expansion that is fully financed by an increase in consumption taxes; (iii) tax cut for high income groups that is also combined with an EITC expansion and financed by a higher consumption tax.

Since I’ve pointed out that not all tax cuts are created equal, I think this kind of research can be very helpful.

Here are the core findings from the IMF’s analysis.

The model generates positive effects on growth, consumption and investment that are broadly in line with the recent empirical literature on PIT multipliers. Despite the positive macro response, supply side effects are never strong enough to prevent cuts from being revenue losing (i.e., tax cuts do not “pay for themselves”). …A tax cut for the middle-class, financed from a lump-sum reduction in government spending, results in a loss of revenues of 0.8 percent of GDP but raises the steady state GDP by just under 1 percent after 5 years (i.e., a personal income tax multiplier of 1.1). …growth effects are smaller when lower personal income taxes are paid for with a VAT. …Tax cuts for higher income groups tend to have a stronger aggregate impact than tax cuts for the middle class. Indeed, in the simple case where the tax cuts are paid for by lump sum cuts in government spending, the personal income tax multiplier is around 3. … tax cuts that are incident on high income households increase income polarization.

This all makes sense. Lower tax rates are good for growth, particularly if offset by reductions in the burden of government spending.

And since lower tax rates are only self-financing in very rare circumstances, I have no problem with the conclusion about lower revenues.

Indeed, the concluding section about “income polarization” was the only part of the above excerpt that rubbed me the wrong way. And even then, I’m only irked because of the implication that lower tax rates might be a bad idea if the rich get richer faster than the poor get richer.

While I like the overall findings, I want to focus on two details from the study.

First, let’s look at the results for middle-class tax cuts. The IMF researchers looked at two versions, with one tax cut financed by lower spending and the other tax cut financed by higher consumption taxation.

As you can see from these two charts, you get more growth and higher wages when you simultaneously reduce taxes and spending.

Second, let’s look at the IMF’s comparison of middle-class tax cuts and tax cuts for high-income people. The conclusion is that you get more bang-for-the-buck when lowering tax rates at the top.

…there are larger growth effects when the tax cut is incident on the higher income groups. The reasons behind this are two-fold: First, the top quintile responds to lower taxes by saving more which, in the closed economy version of the model, leads to more capital formation and a decline in the equilibrium real interest rate. Second, those receiving a reduction in their tax rate supply more high-skilled labor which helps boost output.

By the way, I should hasten to add that this isn’t an argument against middle-class tax relief. As far as I’m concerned, all taxpayers are sending too much money to politicians.

I’m merely highlighting this analysis because some types of tax cuts have larger growth effects. For what it’s worth, I’m not even sure I agree with the IMF’s analysis of why lower tax rates on the rich produce more growth. I suspect the main reason for the stronger results is that high-income taxpayers have much greater ability to change their behavior in response to altered incentives.

In any event, here’s the IMF’s comparison of the two types of tax cuts and what happens to output, consumption, and investment.

P.S. Since we’re discussing the occasional good work of international bureaucracies, here’s my favorite World Bank study and here’s my favorite OECD study.

P.P.S. I’ve never seen any good research from the United Nations. I’m not claiming there’s never been an economically sound study from that bureaucracy. All I’m saying is that I’ve never run across an example.

P.P.P.S. I don’t know if the European Central Bank should be characterized as an international bureaucracy, but it definitely has the highest percentage of quality research (see here, here, here, here, here, and here for examples).

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The Swiss people are normally very sensible when asked to vote in national referendums. Here are some recent results.

Though my favorite referendum result occurred several years before I started writing on this site.

Given all these results, you won’t be surprised to learn that Switzerland is near the top in rankings of economic freedom, trailing only Hong Kong, Singapore, and New Zealand.

But this does not mean that Switzerland is a libertarian nation. At least not in an ideological sense. And we have two new referendum results that underscore this point.

This past weekend, Swiss voters had an opportunity to get rid of the central government’s value-added tax, personal income tax, and corporate income tax.

Ending those taxes would be a libertarian fantasy, but the initiative to extend the levies was easily approved.

More than 84% of voters have renewed the government’s right to tax its citizens and companies for another 15 years. This is a unique feature of Switzerland’s political system of direct democracy and federalism.  …rejection would have been a nightmare for the government. …said Finance Minister Ueli Maurer in January. “If voters were to say no, the Swiss government wouldn’t have enough funds and there’s no way we could find another source of revenue or introduce spending cuts of the same order.”

Voters were swayed by arguments that a no vote would cause too much fiscal disruption. Slashing the central government’s budget by 60 percent might appeal to ideological libertarians, but it didn’t fly with don’t-rock-the-boat Swiss voters.

The direct federal tax and the sales tax together contributed about two-thirds of the Swiss central government’s budget, bringing in around 43.5 billion Swiss francs ($44.25 billion) in 2016. …Should voters reject the measure, the government would have to slash spending by more than 60 percent practically overnight or find new sources of revenue, Maurer told reporters.

Here’s a pie chart showing the revenue sources for the central government.

I would have voted no, of course, and I wish more Swiss voters had lined up against the initiative.

Not because I would have thought that an immediate 60-percent reduction in the size of the central government was feasible. But a larger share of no votes at least would have sent a signal to politicians in Bern that frugality is a good idea.

There was another referendum over the weekend that also produced an unfortunate result. Swiss voters approved continuing subsidies for state-run media.

The Swiss Broadcasting Corporation, Switzerland’s public broadcaster is largely funded by a broadcasting fee. This fee, known colloquially as Billag, the name of the agency that collects it, is paid by most companies and essentially every household. The No Billag initiative, is a bid to do away with fee. …the No Billag vote was rejected by 71.6% of voters.

The margin of defeat is especially disappointing since libertarians actively campaigned for this initiative.

Switzerland, like many European nations, has certain television and radio channels that are run by the government. …Together with other classical liberals in Switzerland, Frédéric Jollien is fighting against the royalties imposed by the government for media consumption. 450 Swiss Francs, the equivalent of €382 or $456, is the annual fee that consumers are required to pay, regardless if they want state-run TV and radio channels or not. …Journalists (who, by the way, are exempt from paying this fee) are releasing heavy verbal fire on the campaigners. They claim it would cause massive unemployment in the media sector, that it is anti-democratic, and that it would enable big foreign companies to take over the Swiss market.

Alas, the fear campaign succeeded.

But I hasten to add that this doesn’t mean Switzerland is turning towards statism. I suspect the real story is that the Swiss are content with the status quo.

And the status quo (especially by European standards) is a practical form of libertarianism.

Here’s some of what Dan Hannan wrote last year.

I have always loved Switzerland…its devolved decision-making, its entrenched Euroskepticism. …I am a Helvetophile for many of the same reasons as America’s Founders. James Madison was fascinated by the way Switzerland had “no concentered authority, the Diets being only a Congress of Delegates from some or all of the Cantons.” …George Mason was entranced by the militia system: “Every Husbandman will be quickly converted into a Soldier, when he knows & feels that he is to fight for his own. It is this which preserves the Freedom and Independence of the Swiss Cantons, in the midst of the most powerful Nations.” …Switzerland has stubbornly retained its sovereignty, despite being surrounded by the EU. …Swiss democracy is direct, decentralized and devolved. Most fiscal decisions are taken locally. Result? Swiss voters are the happiest in Europe, their economy is the freest, and their state budget the smallest.

And let’s not forget that Switzerland is still a bright spot on gun rights.

In February 2011, Swiss citizens voted in a referendum that called for a national gun registry and for firearms owned by members of the military to be stored in public arsenals. …Hermann Suter, who at the time was vice president of the Swiss gun-rights group Pro Tell, told the BBC then. “The gun at home is the best way to avoid dictatorships—only dictators take arms away from the citizens.” Apparently many of his fellow Swiss agreed. The referendum was easily defeated. Gun ownership in the country has deep historic roots… guns are popular… Children as young as 12 are taught how to shoot…and are encouraged to participate in highly popular target-shooting competitions. The country’s cultural attachment to firearms resembles America’s in some ways…it has the third-highest rate of private gun ownership in the world… The Swiss Defense Ministry estimates that there are 2 million privately owned weapons in the country of 8.3 million people.

Yet there’s almost no gun-related crime.

Switzerland has a low rate of gun crime, and hasn’t seen a mass shooting since 2001.

And let’s not forget that the fiscal burden of government in Switzerland is comparatively modest.

Not by libertarian standards. Not by historical standards.

But compared to other European nations, Switzerland is a fiscal Shangi-La. The tax burden is lower, and spending consumes a smaller share of economic output.

And this translates into lower levels of red ink.

P.S. I find Switzerland to be a very interesting case study, for reasons noted above and also on issues such as decentralization, privacy rights, gun rights, and private retirement savings. But I’m a policy wonk, so I’m drawn to unusual examples. What does surprise me is that other people must be interested in the country as well. My 2011 column comparing Switzerland and the United States is the 7th-most-viewed piece in the history of this site.

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I write constantly (some would say incessantly and annoyingly) about entitlement spending. And I occasionally write about discretionary spending.

It’s time to address the budget in a comprehensive fashion. Let’s look at five charts to put everything in context and to show how we got into our current mess.

Our first chart (based on Table 8.2 from the Office of Management and Budget’s Historical Tables) shows what has happened to major spending categories from 1962 to 2017. And all the data is in inflation-adjusted dollars (2009 benchmark) to accurately gauge how and why the burden of federal spending has grown.

This next chart shows the actual percentage increases in the major spending categories during this time period. The two big takeaways are that 1) the defense budget is not the cause of our long-run fiscal problems (though that doesn’t mean it should be exempt from cuts), and 2) entitlement expenditures have exploded.

And if you look at the data I shared from the Congressional Budget Office’s long-run forecast, you would see that these same trends will prevail for the next three decades.

In other words, our fiscal problems start with entitlements and end with entitlements.

If you want to look at the problem with a broader lens, this next chart shows that the problem is domestic spending (i.e., the combination of entitlement and domestic discretionary outlays).

If you’re pressed for time, you can stop reading now. You have the key information already.

But if you want to get a bit wonky, here are two other charts that help explain the intricacies of how budgets work (or don’t work!) in Washington.

The first thing to realize is that there are two budget processes in Washington. There are entitlement programs, which basically operate on autopilot. For all intents and purposes, the President and Congress could go on vacation for the next three years and programs such as Social Security, Medicare, Medicaid, and Obamacare would mechanically continue. But there is also “discretionary” spending for the Pentagon and various domestic programs, all of which is determined through an annual “appropriations” process. Whenever you read about a government shutdown, it’s because politicians can’t agree on the level of funding for the discretionary part of the budget.

Now let’s get to my favorite part, which is figuring out how to limit the size of the federal leviathan.

This last chart shows that net interest spending is genuinely untouchable (unless one wants a Greek-style or Argentine-style default). The rest of the budget, however, can be addressed. Entitlements can be changed through “reconciliation”, which is a legislative process designed to minimize procedural roadblocks (in general, tax bills also use reconciliation legislation). And discretionary programs can be changed via annual appropriations legislation.

I should add that net interest may not be directly touchable, but interest payments can be reduced by controlling spending and thus reducing red ink.

Another thing to understand is that the budget caps (yes, the ones that were weakened in 2013, 2015, and earlier this year) only apply to discretionary spending.

And the most important thing to realize is that the only solution to our budget mess is genuine entitlement reform. Which is why we need constitutional (and comprehensive) limits on total outlays. Politicians will only do what’s right if every other option is off the table.

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I sometimes sardonically comment about Democratic politicians playing Santa Claus, but Republicans can play that game as well.

Trump and his allies in Congress recently agreed on a big-spending budget deal that lavishes more money on both the Pentagon and domestic programs, and that was only a few weeks after agreeing on a tax reform plan that lower taxes (though only for nine years).

Even if I like part of what’s been happening, that kind of populist approach at some point becomes unsustainable. And when the D.C. swamp ultimately has to choose between lower taxes or higher spending, they’ll go with the latter and make things even worse by jacking up the tax burden.

My frustration is apparent in this recent interview.

And I’m not the only one who sees the long-run dangers.

In a column for the Wall Street Journal, Professor Edward Lazear of Stanford explores the economic damage of ever-expanding government.

The budget deal President Trump signed earlier this month will send federal spending and the deficit skyrocketing. On top of this spending explosion, the administration now plans to add a $500 billion infrastructure bill. …over time high spending necessitates high taxes, and high taxes reduce work and restrain growth. Economic trends in developed nations consistently show that low taxes and hard work are linked to robust growth.

He looks at some of the cross-country evidence.

European countries trail the U.S. in working hard and controlling taxes, and their economies have lagged in comparison. France has a tax-to-GDP ratio of about 44%, and in Italy it’s 43%. The French and Italians work almost 30% fewer hours per person than Americans. Notably, the French economy has flatlined since 2010 while Italy’s has contracted. …Data from the Organization for Economic Cooperation and Development suggests that a 1% increase in a nation’s tax rate is associated with a 1.4% decrease in hours worked per person in the working-age population.

Here’s the part that resonated with me. It’s excessive spending that ultimately is the problem.

…taxes are ultimately dictated by spending. Countries can borrow to finance short-run spending, but they must eventually levy taxes to repay the loans. Whether a government raises taxes now or later to pay for expenditures is a minor consideration compared with its decision to spend in the first place. …Higher spending goes hand in hand with higher taxes, higher deficits, fewer worked hours and less growth. The international comparisons suggest that a 4% increase in spending is associated with a decrease of roughly 0.5 percentage point in the average annual growth rate. Furthermore, it is spending—rather than the deficit—that correlates with sluggish growth. …Deficits often coincide with low growth because deficit increases are usually caused by heightened spending, not reduced taxes. Raising taxes, or keeping them high without lowering spending, stifles growth.

Heck, even the OECD has produced research on the negative impact of government spending on economic performance.

And this approach can lead to a downward spiral.

To the extent that government spending goes to programs such as welfare that directly discourage work, it has an additional growth-reducing effect. When fewer people work, those who do must be taxed even more to cover public expenses. These heightened taxes on labor discourage work in turn, pushing more potential workers toward government support.

In other words, if we stay on this path, we’ll eventually become Greece. Not a good idea, to put it mildly.

Since we’re on the topic, let’s look at some additional evidence. Three economists from Australia and the United Kingdom did a meta-analysis of studies on the relationship between government spending and economic growth. Here are some of the findings.

One of the most contentious issues in economics is whether ‘big government’ is good or bad for economic growth. …Theoretically, big government can have both negative and positive effects on growth. …In this study, we include all effect-size estimates reported by empirical studies that examine the direct effect of government size on growth.

Here’s what they found.

… findings indicate that: (i) total government expenditures have a medium and adverse effect on per-capita income growth in developed countries only; (ii) the effect of government consumption on per-capita income growth is also medium in developed countries and in developed and LDCs pooled together; and (iii) neither total expenditures nor government consumption has a significant effect on per-capita income growth in LDCs.

I’m not surprised that they didn’t find a strong link in poor nations. The data show that those countries are generally too mismanaged and corrupt to collect much revenue. Therefore, as I noted in my recent analysis of Indian economic policy, they can’t spend much.

What’s primarily holding back those countries is weak rule of law, excessive regulation, and protectionism.

But I’m digressing. The study also acknowledges the Rahn Curve, though they call it the Armey Curve.

…government size tends to have a negative effect on per-capita income growth as the level of income increases. This finding ties in with the Armey curve hypothesis (Armey, 1995), which posits an inverted-U relationship between government size and economic growth. The theoretical argument here is that government size may be characterised by decreasing returns. Another theoretical argument relates to the distortionary nature of taxes, which is minimal for low levels of taxation, but beyond a certain threshold, they grow rapidly and become extremely large.

Quite true.

Sadly, some people mistakenly conclude that if a little bit of government is associated with more prosperity, then a bloated public sector must be even better.

On a related note, Professor Alexander Salter dismisses the assertion (pushed by international bureaucracies) that big government is a pre-condition for prosperity. Here’s some of what he wrote.

Why are Western countries like the United States and Germany so much richer today than other countries around the world? …One explanation for the success of the West is, in a word, liberty. Over the last few hundred years, classical liberal ideas such as the rights of man and the rule of lawput constraints on European governments’ power, which resulted in a strong protection of private property rights. This resulted in meteoric economic growth, which delivered the modern cornucopia of wealth. …Free countries get rich; unfree countries stay poor.

But there’s a competing theory.

…another explanation — state capacity…is the idea that economic development requires strong, centralized states to uphold the rule of law and provide crucial public goods. …The state capacity literature in economics…places heavy emphasis on a single, strong, central legal authority. In this framework, the fractured and decentralized legal authorities in medieval and early modern Europe are now seen as antithetical to economic development.

Salter is skeptical of the second theory.

…it is undeniable that economic growth in the West did not take off until the rise of modern nation-states. … While governance institutions obviously began centralizing at the beginning of the modern era, …that’s insufficient as a causal explanation. …the state capacity literature has a hard time dealing with a very troubling counterexample: the totalitarian states of the 20th century: like the USSR and China. These states had plenty of capacity, as evidenced by their ability to murder millions of their own citizens… Needless to say, these kinds of things aren’t conducive to economic development.

So he concludes that the first theory must be the answer, at least in part.

…whatever is “doing the work” of promoting economic growth, it is upstream of the creation of states. …State capacity may or may not be a valuable steppingstone to an explanation, but it is not itself an explanation that social scientists should accept. …it seems the old hypothesis — that the big ideas of classical liberalism created Western economic growth — is worth another look!

My bottom line, for what it’s worth, is that the classical-liberalism approach is the necessary condition, but that doesn’t automatically make it a sufficient condition.

In a column last year on the emerging micro-state of Liberland, I tried to square the circle. Here’s some of what I wrote after looking at the literature on state capacity.

…the key to prosperity is having a state strong enough and effective enough to provide rule of law, but to somehow constrain that state so that it doesn’t venture into destructive redistribution policies. This is why competition between governments played a key role in the economic development of the western world. When governments have to worry about productive resources escaping, that forces them to focus on things that help an economy (i.e., rule of law) while minimizing the policies that hinder prosperity (i.e., high taxes and spending). …America’s Founding Fathers dealt with the same issues… Their solution was a constitution that explicitly limited the size and scope of the federal government. …that system worked reasonably well until the 1930s.

I find this issue fascinating, but I suspect most people are more concerned about the real-world consequences rather than the theoretical underpinnings.

So I’ll end on a pessimistic note by observing that we normally get bad fiscal policy from Democrats and worse fiscal policy from Republicans (Reagan being the only modern-era exception).

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