Wednesday, 9 June 2010

Cut expenditure or raise taxes?

Jeffrey Miron has an excellent piece on the best way to reduce government deficits. The principles are universal.
As countries around the world struggle to get their fiscal houses in order, the crucial debate is whether to raise taxes or cut expenditure. Either approach generates winners and losers, so it might seem difficult to choose. Yet tax hikes differ from expenditure cuts in one key respect: tax increases will shrink the economic pie, but expenditure cuts can expand it.

A fundamental conclusion of economic theory, consistent with common sense and mountains of evidence, is that high tax rates are bad for the economy. Taxes on wages or salaries discourage work versus leisure, while taxes on capital income – interest, dividends, and capital gains – discourage savings relative to consumption. The implication is that taxes distort economic decisions, implying a less efficient economy and a lower level of output.

Thus higher tax rates raise revenue for any given amount of output, but this is partially offset by lower output. Research by my colleagues Greg Mankiw and Matthew Weinzerl, for example, suggests that the increased revenue from capital income taxes might be only 50 percent of what would be raised absent the output-depressing effects of these taxes. Mankiw and Weinzerl do not account for tax evasion and avoidance, moreover, which would lower net revenue even more. Large tax hikes can even reduce revenue by moving the economy to the wrong side of the Laffer curve.
The dynamic nature of the economy is appreciated by some in the British mainstream media, but our politicians aren't doing nearly enough to advance this case, as Simon Heffer laments:
They chose not to say to the Keynesians that, indeed, there might be a double-dip if public spending cuts were all that would happen; but that it might be avoided if part of those cuts was used to finance reductions in personal and corporate taxation. These, in turn, might stimulate demand and encourage private enterprise to mop up some of those who risk losing their jobs in a restructuring of the public sector.
Aside from the obvious efficiencies to be gained by shifting employment from the public to the private sector, there is the fact that some public sector work is actively harmful, as Miron explains:
Many other cuts, such as for agricultural subsidies or pork barrel spending, can also improve economic efficiency while shrinking the deficit. Some of these programs are small potatoes, but since they are bad for the economy regardless of the debt, cutting them is a no-brainer. Other significant cuts – in drug prohibition enforcement or the occupations of Iraq and Afghanistan – should also be on the table, although these will be more controversial.
For us, avoiding agricultural subsidies means leaving the EU, but even while we remain in that corrupt club, there are plenty of options for savings, including our own wars on drugs and terror. Gerald Warner highlights another big candidate:
Since the Climate Change Bill in 2008, Britain has been signed up to a mind-boggling expenditure totalling £205bn over the next decade, or £10,000 for each family in the country. This to “fight” a non-existent threat, the great carbon phobia of man-made global warming.
Even if global warming is real, and we are causing it, that does not justify UK government action. Any steps we take will be meaningless unless they are matched by the US, China, and India. In any case, adaptation will be far less expensive than prevention. Left alone, the free market will adapt to changing conditions just fine.

Miron concludes with a message to his fellow Americans, which applies equally well to the entire western world:
A fact everyone must accept is that the United States has made promises to future generations that it cannot keep, so someone has to take a hit to restore fiscal balance. In choosing where to impose this burden, we should recognize that expenditure cuts expand the economic pie, while tax hikes shrink it. That should make the choice easy, from both economic and political perspectives.

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