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Let's not miss the fiscal forest for the deficit trees






Ed Lazear, an excellent economist who also has Washington experience, has a great article in today's WSJ that puts taxes, spending and deficits into sharp focus. Like me, he agrees with Milton Friedman that it's not the deficit that really matters, it's the level of spending. Obama & Co. have been working very hard to camouflage the huge increase in government spending they are promoting by insisting that they won't grow the deficit. But that of course means that they plan to grow taxes—by a lot. The chart above highlights the stakes involved, and is a useful companion to Lazear's article.

Today both spending and tax revenues are in uncharted post-war territory. Tax revenue as a % of GDP hasn't been this low on a sustained basis since the early 1940s. Spending relative to the economy hasn't been this high since the wartime expenditures of the early 1940s.

Here are some highlights from his article:

My analysis of data from 1950 to the present shows that periods with high tax-to-GDP ratios exhibit much slower economic growth than lower tax ratio periods. The GDP growth in high tax years (defined as years during which the ratio of tax-to-GDP was above 18%, the 60-year average) was about 1.5 percentage points lower than the growth rate in low-tax years.

High taxes are clearly bad for the U.S. economy. For example, were we to tax above the 18% tax-to-GDP ratio over the next 25 years, GDP per capita in 2035 would be about 50% less than if we were to tax below the 18% ratio. A 50% per capita GDP differential is about as large as the difference between the U.S. and Greece today.

The recent growth in spending has been camouflaged by a focus on deficits. Budgets and proposed legislation, like that on health care, are being judged not by their impact on spending and taxation, but by their projected effect on the deficit. Equal increases in spending and taxes reduce economic growth, even if they do not alter the deficit.

So the rhetoric surrounding the health-care bills misses this point. Were they to pass, it would mean more spending, more taxes and less growth.

It will be virtually impossible for Mr. Obama to keep his promise not to raise taxes on the middle class while paying for an enormous increase in spending. Given the planned spending levels, taxes will have to rise substantially to get to the target 4% deficit figure that the White House wants.

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