One of the many things I learned from Milton Friedman isthat the true cost of government is its spending, not its taxes. To put itanother way, spending is financed either by current taxes or through borrowing,and borrowing amounts to future taxes, which have almost the same impact oneconomic performance as current taxes.
We can apply this reasoning to the United States’unsustainable fiscal deficit. As is well known, closing this deficit requiresless spending or more taxes.
The conventional view is that a reasonable, balancedapproach entails some of each. But, as Friedman would have argued, the twomethods should be considered polar opposites. Less spending means that thegovernment will be smaller. More taxes mean that the government will be larger.Hence, people who favor smaller government (for example, some Republicans) willwant the deficit closed entirely by cutting spending, whereas those who favorlarger government (for example, President Barack Obama and most Democrats) willwant the deficit closed entirely by raising taxes.
As the economist Alberto Alesina has found from studies offiscal stabilization in OECD countries, eliminating fiscal deficits throughspending cuts tends to be much better for the economy than eliminating themthrough tax increases. A natural interpretation is that spending adjustmentswork better because they promise smaller government, thereby favoring economicgrowth.
For a given size of government, the method of raising taxrevenue matters. For example, we can choose how much to collect via a generalincome tax, a payroll tax, a consumption tax (such as a sales or value-addedtax), and so on. We can also choose how much revenue to raise today, ratherthan in the future (by varying the fiscal deficit).
A general principle for an efficient tax system is tocollect a given amount of revenue (corresponding in the long run to thegovernment’s spending) in a way that causes as little distortion as possible tothe overall economy. Usually, this principle means that marginal tax rates should be similar at different levels of laborincome, for various types of consumption, for outlaystoday versus tomorrow, and so on.
From this perspective, a shortcoming of the US individualincome-tax system is that marginal tax rates are high at the bottom (because ofmeans testing of welfare programs) and the top (because of the graduated-rate structure). Thus, the government hasmoved in the wrong direction since 2009, sharply raising marginal tax rates atthe bottom (by dramatically increasing transfer programs) and, more recently,at the top (by raising tax rates on the rich).
One of the most efficient tax-raising methods is the US payroll tax, for which the marginal tax rate is closeto the average rate (because deductions are absent and there is little graduation in the rate structure). Therefore, cuttingthe payroll tax rate in 2011-2012 and making the rate schedule more graduated(on the Medicare side) were mistakes from the standpoint of efficient taxation.
Republicans should consider these ideas when evaluating taxand spending changes in 2013. Going over the “fiscal cliff” would have had theattraction of seriously cutting government spending, although the compositionof the cuts – nothing from entitlements and too much from defense – wasunattractive. The associated revenue increase was, at least, across the board, rather than the unbalanced hike inmarginal tax rates at the top that was enacted.
But the most important part of the deal to avert the fiscalcliff was the restoration of the efficientpayroll tax. I estimate that the rise by two percentage points in the amountcollected from employees corresponds to about $1.4 trillion in revenue over tenyears. This serious revenue boost was not counted in standard reports, becausethe payroll-tax “holiday” for 2011-2012 had always been treated legally astemporary.
It is true that some macroeconomic modelers,including the Congressional Budget Office, forecasted that going over the cliffwould have caused a recession. But those results come from Keynesian modelsthat always predict that GDP expands when the government gets larger. Entirelyabsent from these models are the negative effects of more government anduncertainty about how fiscal problems will be resolved.
Another recession in the US would not be a great surprise,but it can be attributed to an array of bad government policies and otherforces, not to cutting the size of government. Indeed, it is nonsense to thinkthat cuts in government spending should be avoided in the “short run” in orderto lower the chance of a recession. If a smaller government is a good idea inthe long run (as I believe it is), it is also a good idea in the short run.