The so-called “fiscal cliff” has created quite a stir. At issue is a set of automatic spending cuts and tax increases scheduled to go into effect on January 1, 2013. The news networks (particularly CNBC) have been hammering on this voguish topic for weeks, urging Congress and the President to DO SOMETHING! The impression is given that disaster is inevitable if an agreement isn’t reached, and fast.
For our own part, we hope we go over the cliff. It’s not that we’re big proponents of tax increases. But we do understand what the effective tax rate really is. When trying to decide whether taxes are high or low, it is not necessary to examine marginal tax rates applied to personal income or corporate income, or to do a careful analysis of gasoline taxes, or tariffs, or any other of the myriad of federal government taxes. We need not debate supply-side effects or the absence of them or whether one type of tax is to be preferred to another. One need only look at the ratio of government spending (G) to GDP (Y). When the ratio of G/Y is high, then the tax rate is high—if G/Y is low, then the tax rate is low (of course, “low” doesn’t happen much anymore).
Professor Steve Hanke of The John Hopkins University recently published an informative article examining the growth of federal government spending (see “An Age of Illusionists,” in GlobeAsia, December 2012). Professor Hanke calculated federal government spending as a percentage of GDP going back to 1952. Not surprisingly, today’s ratio of approximately 25 percent is higher than existed in any previous presidential administration during the period Professor Hanke considered. The low of 16.5 percent was recorded during the Eisenhower Administration. Interestingly, when the total federal take from the private sector exceeds the threshold of 19-20 percent, it has corresponded to periods of particularly tough sledding for the U.S. economy—that is inflation, stagflation, slow real growth and high unemployment. This has been noted as kind of a “spending limit” by a number of economic observers, including several members of previous administrations’ Council of Economic Advisors.
In case it is not obvious, perhaps we should clarify why the 25 percent figure is the real tax rate faced by the average person. GDP is the total amount of goods and services produced in an economy during a year. Clearly, the federal government can purchase 25 percent of the stuff that is produced only if private purchases are reduced by 25 percent. It is really that simple; if one party gets to eat 25 percent of the pie, then 75 percent is left for others to consume. Government finances its spending in one of three ways, which are direct taxation, new money creation, and borrowing. The various approaches to finance government spending differ in how goods and services are transferred from the private sector to the government, but in all cases the end result is that less private spending is required in order for there to be more government purchases.
Imagine a government that finances its spending entirely through the direct taxation of the income of its citizens. This would be an honest way for a government to finance itself and, of course, a government could purchase 25 percent of an economy’s GDP only if the tax rate was, on average, 25 percent. If the government wanted to increase its purchases to 30 percent of GDP, then a 30 percent tax rate would need to be applied.
Most people don’t like taxes (especially when they fall specifically on them), so the government often turns to a second approach for financing itself: it buys goods and services through expanding the money supply. Money financing occurs whenever the Federal Reserve creates new money in order to buy government bonds. From the government’s perspective, this approach to financing its purchases is appealing because it might fool some people into thinking the tax rate is less than it really is. But there is no magic associated with the printing of new money. As is the case with income taxes, government can consume 25 percent of the economy’s GDP only if it is taken from the private sector. In the case of printing money, the GDP is stolen from the private sector through the mechanism of higher prices. As prices rise, the typical person can purchase less—25 percent less to be precise. The inflation tax might fall on different people than a more honest income tax, but in the aggregate the end result is the same.
Finally, the third way government can finance itself is by borrowing from its citizens. Of course, the problem with this approach is that those citizens who are being borrowed from will necessarily have to pay themselves back through higher taxes in the future. Again when all the dust settles the outcome is the same—government consumes 25 percent of the economy’s total production only if the private sector consumes 25 percent less. The simple way to visualize bond financing is “ tax me later rather than tax me now.”
So, let’s get back to the fiscal cliff. Why do we hope a deal isn’t reached? Simply because of the automatic spending cuts that are scheduled to occur if there is no deal! We’d like to see government spending decline as a percentage of GDP. In fact for the long-term health of the U.S. economy we think a federal spending decline is imperative. Any other sort of deal that is struck between the President and Congress is likely to involve a few symbolic gestures such as a higher tax rate on “rich” people, while diverting attention away from the one real concern, which is the size of the overall bite the federal government is stealing from the GDP pie.
What would the original writers of the U.S. constitution think of a federal elected government that was stealing 25 percent of total output? They would no doubt be shocked and awestruck that the game “of rewarding those who voted for you by taxing those who voted against you” had come to this sorry point. They would probably hurry back to their draft and put in the missing part of our constitution. The missing part, which is desperately needed, would define the scope of government spending and functions and provide a reasonable limit on what can be stolen or spent. Twenty-five percent? We like a number such as 7 percent better. Surely a trillion dollars (2012) is enough to provide for the national defense and to protect citizens rights, freedoms and property.