Those who have the weakest connection to our economy and the least understanding of how a market economy actually works and grows seem to think of production, wealth and income as a zero sum game. “You do not have enough because somebody else has too much” is a popular socialist/populist refrain. For example, most politicians and governments appear to view taxes in this way. If the resulting deficit from current government spending and entitlements is too large, simply reduce it by raising tax rates (capital gains, payroll taxes, and push up income tax rates on the “wealthy”). Surely, if we do this, more tax revenue will be collected and the deficit will shrink without forcing hard spending decisions on subsidies and entitlements. After all, incumbent politicians view subsidies and entitlements as necessary rewards and bribes to the constituencies that elected them.
The problem is that economies are dynamic, growing and behavioral. Thus, when tax rates are selectively raised, there is no assurance that individuals will not simply alter their behavior in order to avoid those rate increases as far as possible—in exactly the same way that if a popular restaurant doubled its prices, it would be naïve to assume the same number of customers would choose to eat there. Two major budgetary harms can befall a government that simply raises tax rates to deal with the problem of a rising current and future debt burden. First, the rise in tax rates may simply result in a disappointingly small increase or even a reduction in tax revenue actually collected (the traditional “supply-side” argument, often ridiculed but not refuted). Second, the growth path of the economy may be damaged by tax increases paid out of private funds that would otherwise have been productively invested. Private funds invested in capital could have resulted in the future growth of output, prosperity and employment. Since, this growth trajectory will never be observed after a tax increase, it is sadly impossible to know exactly what opportunity we will have lost. What is true for taxes, of course, is also true for debt or inflation-financed government spending as well. When discussing the government budget, we have pointed out previously that the ratio of government spending to output (G/Y) is the one to watch.
As of January 10, 2013, the stock of government interest-bearing debt had risen to just over 100 percent of GDP. This was highest level of that ratio within most of our memories and it resulted from bailouts, entitlement spending growth and new government programs following the credit collapse of 2008. However, going back in history to a previous real emergency, the peak stock of federal debt in U.S. history actually reached its high point of 120 percent of GDP (http://useconomy.about.com/od/usdebtanddeficit/a/National-Debt-by-Year.htm). The high water mark was the result of debt financing of the armed forces and war material required for the allied victory during WWII.
How did we extricate ourselves from such a mess at that point in time? Did we courageously cut federal expenditures and programs to the bone in order to rapidly pay down the stock of government debt? Largely, we did nothing. Of course, the spending in the defense sector immediately declined following peace, though it was still large and growing during the “Cold War” period. The budget and debt problem was solved much less dramatically because, on average, during the 25 years following 1945, the growth of the U.S. economy exceeded the growth rate of the stock of debt—of the cumulative government deficits. Simple economic growth forgives many sins.
Politicians would do well to remember that. Cold courage is not required of them. Outright expenditure cuts and program elimination is not necessary to get the government’s financial house in order (although we would love to see it). A much wimpier solution is possible. If our government could simply restrain its greed to allowing existing government programs and cumulative expenditure to simply grow only by 1% to 2% per year, while the economy is growing at 3%, then the debt problem will be cured within a generation. Then the politicians can take unearned credit and pat themselves on the back for political courage and good, hard-nosed management. Will this slower-relative-growth solution happen? Well it happened before, but in today’s political climate we shouldn’t be too hopeful. After all, sustained slower growth of the government sector makes politicians less relevant to a robust market economy—the spoils system would be devalued.