Now that Bush has been reelected, and has comfortable majorities in both the House and Senate, we will have at least a two-year unambiguous test of Republican fiscal policies. My prediction? Massive spending and massive deficits. After all, that’s what Republican presidents do, if history is any guide.
Of course, the immediate retort is that at least Republicans are good on taxes. Sure, spending may have gotten out of hand under Reagan and both Bushes, but at least two of them cut taxes. And what’s the harm of a deficit, so long as taxes are low?
Well, the problem is that government spending—whether financed through taxation, deficits, or inflation—siphons resources from the private sector. When the government spends money to send troops to Iraq, put satellites into space, or send students to college, it diverts real resources (labor, raw materials, and capital equipment) into these activities, leaving less available for entrepreneurs to hire and purchase. There’s simply no way around it: Scarcity implies that government spending corresponds to private sector curtailment.
Normally you would think that a party claiming to be fiscally conservative would endorse this type of analysis. But alas, because Republicans in practice have been unable to contain their voracious appetite for larger and larger budgets, their apologists have devised all manner of clever arguments to downplay the importance of government spending and deficits.
The Laffer Curve
Named after Arthur Laffer (who allegedly first drew the curve on the back of a napkin), the Laffer Curve demonstrates the theoretical possibility that lower tax rates can lead to higher tax receipts. Hence, the government can cut taxes (politically popular) without worrying about cutting spending (politically unpopular). The typical Laffer Curve looks something like this:
The theory behind the Laffer Curve is quite simple. At a 0 percent tax rate, the government will (of course) take in $0 in tax revenue. On the other hand, at very high tax rates, the government will also take in very little total revenue, because no one has any incentive to earn income. Hence, there must be an intermediate tax rate (labeled R* above) that maximizes total tax revenue. Now if the current tax rate happens to be higher than this critical rate R*, the government can actually “cut taxes” and have more revenue to spend! Everybody’s happy!
There are some problems with the Laffer Curve. On the one hand, it’s too simplistic; there need not be a simple functional relationship between tax rates and tax revenue. To see this, consider the following: At very low temperatures (near zero degrees Kelvin), people will freeze to death and hence tax revenue will be zero. At very high temperatures (thousands of degrees Kelvin), people will burn up and hence tax revenues will be zero. Therefore, there must exist a temperature that maximizes tax revenue…
A different objection to the Laffer Curve is its implicit endorsement of government spending. As argued above, the damage of government spending isn’t merely that it’s often financed through taxation. No, government spending in and of itself is unproductive.
Beyond this, there is a strategic concern. By placing so much emphasis on the Laffer Curve, supply-siders concede that the government has the right and the competence to spend tax dollars. Furthermore, what happens if we heed the supply-siders and cut taxes to the Laffer point? From then on, further tax cuts will indeed reduce government receipts. So if our argument in the past was that tax cuts will be “revenue neutral” or even “revenue enhancing,” we will be hard pressed to convince big spenders in Congress to move beyond this point, even though it may well be twenty, thirty, or forty percent.
The Reagan Record
Talk of deficits and tax cuts invariably returns to the example of Ronald Reagan, who took office and pushed through the Kemp-Roth tax cuts that slashed marginal rates 25 percent across the board. Typical liberals point to the unprecedented Reagan deficits as proof that his tax cuts were “irresponsible.”
Now this is pure nonsense. As the typical conservative pundit will quickly tell you, federal tax revenues went up under Reagan’s two terms, from $517 billion in fiscal 1980 to $909 billion in fiscal 1988.1 Hence, the massive Reagan deficits were due to spending that grew even faster than revenues.
However, the “real Reagan record” (to steal the title of a National Review symposium from several years back) is not the clear cut vindication of supply-side economics that the conservative pundits would have us believe. Yes, tax receipts rose by roughly 75.8 percent over the eight-year period, for a growth rate of about 7.3 percent per year.
But how do we know that this was due to the magic of “tax cuts”? After all, there are all sorts of reasons federal nominal tax receipts might rise over time: inflation, population growth, the upswing of a business cycle, etc. Indeed, federal receipts under Carter’s term (fiscal 1976 to 1980) rose from $298 billion to $517 billion. This represents a 73.5 percent overall increase, but since it happened over four years it represents a growth rate of 14.8 percent per year, more than double the average rate under Reagan.
Of course, the rate of inflation was higher in the Carter years than under Reagan. But even if we switch from nominal to constant (2000) dollars, federal tax receipts rose at an annual rate of 6.5 percent under Carter, while only at a 2.7 percent rate under Reagan.2
Now if I haven’t lost the reader completely, let me throw in yet another curve ball: It’s not at all clear that Reagan “cut taxes” on net! Yes, he cut tax rates when he first came into office, but in his second term he signed an “emergency deficit reduction act” that “closed loopholes” (and destroyed the real estate market). Thus it is difficult to assess the overall tax drain on the economy.
Let’s be honest: We can bicker about statistics all day. But here’s something that I bet will surprise you. Surely a roughly fair measure of the total amount of taxes (we’re not even talking about spending, remember) taken by the government would be the percentage of gross domestic product. This particular statistic is not very sensitive to inflation, and it also incorporates the possible benefits of a booming economy. Now if the supply-side version of the Reagan years is generally correct, surely federal tax receipts as a percentage of GDP should be much lower under Reagan than under Carter, right?
Not really. For the fiscal years for which Carter can be held responsible (i.e. 1977 through 1980), tax revenues as a percentage of GDP were 18.0, 18.0, 18.5, and 19.0. The figures for Reagan’s fiscal years (1981 through 1988) are 19.6, 19.2, 17.4, 17.3, 17.7, 17.5, 18.4, and 18.1. Yes, some of the lowest years occurred under Reagan, but the following is also true: The two years in which the greatest fraction of the economy was taxed occurred under Reagan,3 and two of Carter’s yearly figures were both lower than four of Reagan’s yearly figures. (In fairness, I admit that the average of the above numbers for Carter is 18.4 percent, while for Reagan it is 18.2 percent. But hardly something to write Thomas Jefferson about.)
Conclusion
The typical liberal explanation of tax cuts and deficits is silly, and the conservative Republican pundits have justly exploded these myths. However, the supply-siders have their own convenient version of history, too. Simply put, the Reagan experience does not prove that tax cuts are the way to balance the budget, because (a) tax revenues increased faster under Carter than under Reagan and (b) it’s not even clear how much Reagan “cut taxes” in the first place.
Government spending is wasteful, regardless of how it is financed. Cutting taxes is an important component of rolling back Leviathan, but Republicans need to realize that cutting spending is just as crucial. Massive deficits siphon savings away from private investment, and moreover they discredit the Republican conservative ideology that condones them.
- 1Data from the Statistical Abstract of the U.S. To evaluate a given president, I am starting with the fiscal period ending in the calendar year of his election, to capture what he inherited from his predecessor. (Note that the federal government’s fiscal year ends on September 30 of the same calendar year.)
- 2To arrive at these figures, I converted the nominal tax receipts into constant (2000) dollars using this online calculator, and then computed the percentage increases accordingly.
- 3In case the reader is baffled, remember that there was a severe recession in the early 1980s, whereas the economy boomed later in the decade.
