To Cut The Size of Government, We Should…Increase the Tax Rate?

Let’s say you are one of the sizable number of people who’d like the federal government of the US to decrease in size.  Maybe you’re worried about encroachment on personal and corporate liberties, maybe you think that the government has gotten too expansive for the good of the nation, maybe you simply feel that we should depend on private benefactors for more of the functions currently being performed by the government; for whatever reason (or combination thereof), you think the federal government (and possibly state and local governments, but we’re going to focus on the feds for this article) should be downsized.

Given this view, how would you alter the current tax rate?  Would you raise it or lower it?  For most of the people who want to shrink the government, the answer is clearly the latter; if you cut taxes, you can ‘starve the beast’, by depriving the government of the money it requires to grow.  It seems like a logical conclusion: if you had a child who was spending all his allowance money on loud, annoying, profane music, cutting down his allowance would end the music purchases.  No money, no misspending.

But…that’s not quite how it works with the government.  The chairman of the Cato Institute (a right leaning think tank; not a big pro-government organization, there) noted back in 2004 that “‘Starve the Beast’ Doesn’t Work”.  In a professional paper he looked at the correlation between government spending as a percentage of Gross Domestic Product (GDP) and tax rates between 1981 and 2000, and found a negative correlation (that is, as tax rates decreased, government spending increased as percentage of the total economy); lower tax rates led to MORE, not less, government.

What the Heck…?

To understand how this could happen, let’s look at a smaller scale example, two towns.  These two towns, which we’ll call Alpha and Beta (no relation to any actual towns with those names), are nearly identical.  They have similar populations in terms of both numbers and demographics, similar sizes, and similar amounts of spending (at least at the start of our thought experiment).

The one big difference between the two is how they go about paying for their spending.  The city council in Alpha is fairly old-fashioned, and insists that any spending increase be paid for by increasing taxes to derive the needed revenue.  In Beta, on the other hand, it’s common practice to provide much, if not most, of the city’s funding by issuing municipal bonds, and using a sizable portion of tax revenue to pay off the interest owed.

Now let’s say that a monorail salesman comes to each town, offering to sell a clean and efficient form of public transportation (for an admittedly sizable upfront cost).  For Alpha, doing so means increasing taxes on its citizens, immediately exposing the council members to negative attack ads and other criticism.  In Beta, the council members can pay for the monorail with another bond issue, and simply shift some more tax revenue to paying interest; there’s no need (for the time being, anyway) to increase taxes at all.  Now, which town is more likely to have a brand-new monorail a year from now?

Yup, I stole this hypothetical example from The Simpsons(R); what can I say, it's a good show.

If you answered ‘Beta’, congratulations on your reasonable understanding of human nature, politics, and economics!  Yes, people are much more likely to agree to increased spending if the pain of payment can be put off to another day (week, month, year, decade…).  As with this monorail example, so it goes with just about every type of spending.  While the city council members in Alpha will have to justify every spending increase and convince the townspeople that their taxes are well spent, Beta can play Santa Claus, giving ‘gifts’ to the citizens whenever they ask without demanding the pain of higher taxes in return.  In time, Beta’s spending will end up much higher than Alpha’s; what person doesn’t want more when they don’t have to pay for it?

What does all this have to do with the national debt?  Well, as most of you probably already realized, the United States is essentially Beta in our example.  Since we don’t increase taxes to cover our increased spending (opting to go into greater and greater debt instead), and don’t decrease spending to be in line with our tax revenue, we rely on our ability to borrow to cover our spending.  And since we don’t have to pay out of our pockets for our spending, there’s little, if any, incentive to spend less.

How to Fix Things

I probably don’t need to tell you, but borrowing endlessly is not a good idea.  At some point, your creditors start to worry, the amount of interest you need to pay to borrow more gets prohibitive, your ability to find new takers for your debt decreases and, if you don’t manage to right your financial ship in time, you end up defaulting.  (Like Orange County.  Or Russia.  Or..any number of other places that have had to default.)  If we want to repair things here, we need to take a few steps to head off that possibility, like:

1) Balance the Budget: This is definitely a biggie; as anyone who’s had any experience with budgeting can tell you, it’s hard to get into debt when you only spend what you take in (or preferably less).  (Personally, I like the idea of an automatic increase to ALL federal tax rates on all tax types (income, investment, estate, etc.) to bring the projected revenue up to the level of spending; if the thought of an automatic increase for all taxpayers if they can’t keep spending under control doesn’t motivate some smart spending reductions by our law makers, nothing will.)  Of course, just because most people agree that’s it’s important to do, doesn’t make it any easier; choose a random sampling of 100 Americans, and you’re all but certain to get at least 100 different methods of getting the budget to balance, from all spending cuts to all tax increases.This isn’t a bad thing; having a serious conversation about where to modify our budget to make it more balanced is an important task, and to make sure that everyone conversing has some ‘skin in the game’…

2) Spread the Tax Burden: You’ve probably heard that 47% of Americans don’t pay taxes.  This isn’t quite the truth (that figure only takes into account federal income taxes, not the myriad other taxes that we pay at all levels of the government), but it raises a fair point: if you aren’t paying taxes (or are getting more from the government than you pay in taxes), you don’t have much of an incentive to keep the tax burden low.  After all, it’s not really a burden to you.  Modifying the tax laws so that everyone has to pay something (even if those earning more still pay a much larger percentage), will help ensure that nobody urges spending just because it’s not on their tab.  And while we’re remaking the tax code anyway…

3) Make Taxes (and Tax Rates) More Transparent: Quick, tell me the percentage of your income that went toward taxes last year.  If you’re pretty good, you might remember your tax bracket (mine was 25%), but as I’ve discussed before, that’s not really how much you pay in federal income taxes (your real percentage that goes to the IRS is lower).  And that’s just the tip of the iceberg; it doesn’t include capital gains taxes, FICA taxes, Social Security, sales taxes, property taxes, or even state and local income taxes, just to name a few.  And without knowing how much of your income is going to fund the government, how can you decide if you’re getting a good value for your money?  There’s certainly a reasonable price that should be paid to an organization that provides everything from national armed services to Social Security benefits, but are you paying it?  A complete list of how to remake the tax system to make it more transparent is a bit beyond the scope of this (already rather long) article, but one goal for any redesigned tax system is that most everyone should be able to say, “Hello, my name is Roger, and XX% of my income goes to funding the federal government.  Wow, what a steal!/I’m being cheated!/That’s…about what I’d expect, given my income level and the services I rely on from the feds.”

There, a few simple suggestions on how to improve the tax situation in this country, and possibly decrease the size of government, to boot.  They should work much better than continuing to try to ‘Starve The Beast’.  To quote John Hodgman, “You’re Welcome”.

2 Responses to To Cut The Size of Government, We Should…Increase the Tax Rate?

  1. Interesting thoughts. So long as spending can remain as high if not higher, then I agree, lowering taxes does not really “starve the beast”. The key here is having honest money. This is why it’s important to return to an honest account of money so that the central government cannot get around taxes (and selling debt for that matter) by simply issuing money and manipulating account balances.
    Invest It Wisely´s last blog post ..Importance of Financial Literacy Education – Get Some Here with Ramit Sethi’s Book- I Will Teach You To Be Rich

    • @Invest It Wisely: Yeah, trying to cut down federal government spending by cutting taxes always struck me as trying to get your teenager to keep to a budget by cutting down their allowance, but then giving them a credit card with no limit. They’ll spend less money out of pocket, but they’ll still end up spending more than they should (and with credit available, more than they have) overall. It’s just counter productive.

      As to returning to an honest account of money, that would probably help (and, given how the world works, definitely couldn’t hurt), but good luck getting the government to relinquish the power to print money at will…

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