Garett Jones  

Tax Hikes and Spending Cuts: Friends Across Europe

Three Laws of Major Mismatch... Hummel on Bernanke's New Centr...
The "Starve the Beast" theory predicted that if you gave politicians more revenue, they would just spend it.  However, the last few years in Europe have provided example after example that tax increases are quite compatible with relative spending restraint in the real world.  We've all heard about the large tax increases--the genuinely bad austerity--but we aren't seeing the waves of new spending programs that Starve the Beast predicts.  

Yes, the automatic safety net programs are spending more, presumably because these economies are weak, but if there's a binge of bridge-building, school-expanding, and needless ditch-digging going on in the wake of the tax increases I'd welcome the evidence.  Surely there are some Clinton-style small-bore programs that grab media attention, but instead what we hear from the critics I agree with is that the spending cuts in Europe are too small--not that spending is exploding.  

The alternative story of the Ant and the Grasshopper is a theory of political equilibrium: When politicians get their act together, they run the government on a sound business basis on both the revenue side and the spending side.  And when politicians lose self-control, it shows up as more eating and less exercise.  

A&G isn't a unified theory of behavioral political budgeting, but I suspect it explains a lot of what's been going on in democracies for the last few decades.  

Summary: A government is run by the id or by the bondholders.  

Coda: A&G is a theory of political equilibrium--so asking if an exogenous tax hike causes a spending hike is interesting but we don't elect people who give exogenous tax hikes. 

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COMMENTS (6 to date)
david writes:

Tabellini & Alesina 1990: parties which openly disagree about the desirable composition of government spending, deliberately run deficits to constrain the other party's options (if Clinton had created more debt, would W Bush have invaded Iraq?). Increasing polarization increases the propensity toward deficits. Why leave your opponent any money, if you foresee them spending it on bads?

Jim Chappelow writes:

So, it's been what. maybe 3 years since any European governments started serious austerity. Do you think this is really a fair time horizon over which to judge a long term fiscal strategy like "Starve the Beast"?

Jim Glass writes:

However, the last few years in Europe have provided example after example that tax increases are quite compatible with relative spending restraint in the real world.

I don't understand.

Starve the Beast doesn't say "tax cuts reduce spending" or "tax increases boost spending", it says *serious deficits* restrain spending, and lack of same don't. It's the deficit that is the lack of nutrition, as a surplus is food to gorge.

Has Europe had any fiscal deficit issues lately? I mean, c'mon.

Now as a voter one doesn't have much influence over the business cycle and whether a boom economy will slash a deficit and produce a surplus, but one does have a say in the tax contribution to the revenue line. Which is why when the USA was running a surplus back circa 2001 Milton Friedman strongly urged that it be reduced via tax cuts, because otherwise it would be reduced by spending increases growing the government larger -- which to the extent it exceeded the actual tax cuts, it certainly was!

So it hardly makes sense to say, "Bush II cut taxes yet spending grew, thus Starve the Beast is refuted", when the beast was gorging on the surplus, exactly as Feed the Beast predicts. Yet so many people do it. Go figure.

The issue is simple. Do politicians happily profit by growing the govt by buying votes via, in Friedman's famous example, wantonly spending other people's money on yet other people, when they have that money readily at hand to spend at no political cost to them? Versus them being less likely to increase such spending when they instead have to incur a political *cost* of doing so, via an adverse market and/or political response to growing debt?

(Hey, I spend more money when I have more cash on hand, and that's *my* money I'm spending. I'm not a politician spending for my own benefit free money from other people handed to me by a surging economy.)

That is: Is the level of spending by politicians positively related to the level of revenue?

For anyone who answers "yes" Starve/Feed the Beast is logically unavoidable.

Anyone who wants to say "no" can explain to me what happened to the $2.5 trillion Social Security surplus, a beautiful natural experiment on how politicians spontaneously respond to a big unexpected revenue flow, totally unanticipated by its political creators. (Check out the oral history of Robert Myers, long time Chief Actuary of the SSA and Executive Director of the Greenspan Commission about that.)

I mean, why is there a sequester today? *Not* because of the deficit? Why was there a Budget Enforcement Act enforcing serious PAYGO rules to constrain spending in the 1990s, which was abandoned (according to CBO-head back then Penner) because the surplus arrived to end the Reagan era deficits?

I just don't see how one argues that significant deficits and debt problems *aren't* a restraint on govt spending -- Europe post-2008 being a superb example of how they are.

If one does admit that they are a restraint on spending, then removing them with tax increases removes a restraint on spending, which facilitates increased spending, QED. No?

**IF** one's strong belief, as per Friedman, is that govt is too big as it is, and thus its further growth is inherently inefficient and harmful to the polity and therefore should be restrained, then one wants that restraint increased, not removed. Which is why Friedman said during the surplus years that while there are bad taxes and less bad taxes, there's no such thing as a bad tax cut.

OTOH, if one believes that politicians usually "have their act together" and enact new programs "on a sound business basis" in an efficient, socially beneficial way, then one will have a different point of view and be open to a lot more taxes. (And we can disagree about that.)

But that's a very different point of view, forming one's opinions. Even so, how will one say spending isn't related to revenue? Even Krugman has written columns bemoaning that the Bush-now Obama tax cuts have set a new revenue base line that works to constrain all the good, beneficial increases he'd like to see. E.g.:

the tax cuts enacted by the Bush administration are, in effect, a fiscal poison pill aimed at future administrations...they will make it hard for the next president to change the country’s direction.
Barack Obama’s tax plan ... proposes rolling back tax cuts for those making more than $250,000 a year.
the Obama plan would raise revenue by $700 billion over the next decade ... But while $700 billion may sound like a lot of money, it’s probably not enough to pay for universal health care, which was supposed to be the overriding progressive priority in this election.
Why doesn’t Mr. Obama propose raising more money? Blame the Bush poison pill.
Krugman there sure seemed to think that limited revenue restrains spending -- and that Friedman was exactly right and correct when he said cutting taxes during the surplus years would restrain govt spending growth in the future when the surplus had passed.

Brandon Berg writes:

It seems to me that the kind of tax increases which US Democrats have been promoting in recent election cycles (higher taxes on the top 1-5% of taxpayers, but not on anybody else) are essentially grasshopper behavior. There's no sacrifice in pushing the cost of spending off onto a small minority of unpopular voters.

BC writes:

I usually think of Europe as supporting Starve the Beast. Taxes are much higher in Europe than in the US and, for that matter, defense spending is much lower. Does that budget "savings" translate into reduced debt or more social spending?

I think it's a question of time scale. The European tax hikes may not have translated into increased spending *yet*. However, the tax hikes, or lack of tax cuts, over the last several decades *have* led to higher levels of spending. At some point, higher tax levels have been around long enough that they become viewed as the "normal" levels. People start using the high level of taxes, rather than zero, as the baseline and start using phrases like "paying for tax cuts", as if the tax revenue started in the hands of the government instead of as private wealth. At that point, it becomes a lot easier politically to increase spending to soak up any surplus rather than returning the surplus to the original tax payer.

Jim Glass writes:

Let us compare theories of political equilibrium.

"Starve the Beast" is a policy prescription, not a such a theory that makes predictions, so it is unpersuasive to criticize it on the basis of supposed predictions it doesn't make.

However, "Starve the Beast" as policy advice is derived from a theory of political equilibrium, one that we might call "the Grasshoppers", that can be used to make predictions.

That theory is, in a nutshell, as Friedman put it: "In the long run government will spend whatever the tax system will raise, plus as much more as it can get away with."

That is, all politicians are Grasshoppers, there are no Ants among them. They never "run the government on a sound business basis on both the revenue side and the spending side", because government is *not* a business, and not one politician anywhere -- literally, not one! -- faces the incentives that a business owner faces to operate his organization on a sound, business-like manner that is cost-effective, financially balanced, and as productive as possible to maximize its long-term value.

Or to put it another way: the "business" of politicians is firstly to get themselves elected/re-elected, and secondly to advance the interest of their party & affiliated interest groups, as this feeds back directly into their own personal welfare. To do this they will (entirely rationally) buy votes/political success by "spending all the revenue available to them plus as much more as they can get" to do so, *regardless* of "business-like" considerations. This continues until they run out of revenue and can't get any more -- when they are forced to retrench via painful budget-rebalancing actions that they delay and strive to minimize for as long as possible ... just exactly as we see both in the Euro nations today and the fight over the trillion-dollar deficit and sequester in the USA today, and as we all are headed to on a much larger scale via the entitlement funding crisis of 20 years from now.

These two models of political equilibirium -- "A&G" and "Pure G" -- each make predictions, which ISTM are rather different, and so are open to testing.

[] "A&G" states that *sometimes* polticians "get their act together and run the government on a sound business basis on both the revenue side and the spending side" and that *at some other times* "politicians lose self-control", and face fiscal problems that result.

This would seem to predict that looking at a large number of governments over the long run, in *some* cases Ants would have governed well producing budget surpluses, fully and soundly funded retiree entitlements, and so on, while in other cases Grasshoppers would unhappily have done the opposite, with a wide distribution of cases betweem those two end points.

For instance, as European politicians repeatedly adopted new VATs promising to keep rates low and use them to balance their budgets, some would have fully kept that promise (and today have low VATs and balanced budgets with fully funded entitlements), and some utterly violated them, with others spread along the middle.

[] "Pure G" says contrawise that the pure-Grasshopper politicians *always* have *all* modern democratic governments on a course headed to crash against fiscal limits in the long run. In the short run they may get a fiscal boost, even a surplus, from a boom economy and/or the results of their last retrenchment deal -- but it will never last, any surplus will be rapidly more than consumed, and the course to a future retrenchment crisis quickly re-set.

What do the facts say?

Looking at the all OECD nations for the 40 years since the 1970s what I see is a picture of striking consistency: ALL of them (apart from little Norway with its big oil endowment) have run long-term budget deficts remarkably close to 3% GDP. Moreover, all of them, regardless of local political alignments, have massive unfunded retiree liabilities headed at them -- with many of the govts with the largest tax collections and biggest VATs being in the very worst long-term fiscal circumstance. (The US is in a less bad situation on average, due to both lower unfunded liabilities and greater revenue-flexibility going forwards, due to lower tax rates here and, e.g., the revenue raising potential of a VAT having not having already been squandered away).

Why that average 3% deficit number over the long run for all? Because 3% has been the average GDP growth rate for them, making 3% deficits the maximum sustainable number. Larger deficits are unsustainable, and force retrenchment deals. Lower deficits leave a free lunch for the politicians on the table, so they quickly increase spending up to that number. That 3% is the "as much more as they can get away with", the equilibrium.

Putting these facts up agaist the predictions of the two equilibrium models, it looks like "G" beats "A&G" by a knockout, to my eyes.

From there, "Starve the Beast" as a policy prescription -- goals: to minimize the constant growth of wasteful (at best) government spending, while maximizing fiscal flexibility to meet the mother of retrenchment crises we plainly see coming right at us -- follows.

As Friedman put that...

I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible. The reason I am is because I believe the big problem is not taxes, the big problem is spending. The question is, “How do you hold down government spending?” Government spending now amounts to close to 40% of national income not counting indirect spending through regulation and the like. If you include that, you get up to roughly half. The real danger we face is that number will creep up and up and up. The only effective way I think to hold it down, is to hold down the amount of income the government has. The way to do that is to cut taxes.

Of course if one believes increasing government size and spending is generally beneficial, then the policy prescription does not follow.

But even so, as to competing models of equilibrium, it sure looks to me like All Grasshoppers trumps Ant & Grasshoppers. I mean, how many "Ant-Governments" and prominent "Ant-Politicians" could one actually name? Compared to the list on the other side??

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