From: thant@void.esd.sgi.com (Thant Tessman)
Newsgroups: alt.politics.libertarian
Subject: Taxes and the Ratchet Effect
Date: 14 Sep 92 18:57:08 GMT
Organization: Silicon Graphics, Inc.  Mountain View, CA


Dated, but interesting...

thant



From _Reason_ magazine, October 1990:

Liscense to Spend
by Stephen Moore


Now that George Bush has explicitly renounced his campaign pledge, the
prescription for budget deficits is the same in Washington as in Albany,
Boston, and Trenton: higher taxes.  Such prominent Americans As Nobel
laureate in economics Franco Modigliani of MIT and Citicorp Chiarman John
Reed believe that a tax hike is just the remedy needed to jump-start a
sluggish American economy.  The process is supposed to work as follows:
Higher taxes will cause the deficit to fall, which will raise the national
savings rate, which will lower interest rates, which will spur investment
and ultimately generate economic expansion.

The proponents of higher taxes accept as a matter of faith that deficits
will fall if taxes are raised.  But recent historical experience at both
the state and the federal levels demonstrates convincingly that there is no
such iron law of politics.  Indeed, a sizable body of statistical and
anecdotal evidence shows that trying to reduce deficits by increasing taxes
is an exercise in futility:  Lawmakers invariably respond to higher taxes
principally by raising spending by an amound about equal to the additional
revenue, thereby leaving the deficit fundamentally unchanged.

The description of this effect is often called the "tax-and-spend
hypothesis."  Many years ago Milton Friedman stated the point this way:
"You can't reduce the deficit with higher taxes.  Political rule number one
is: government spends what government recieves plus as much as it can get
away with."  Not surprisingly, the Washington establishment dismisses
Friedman's "rule."

Nonetheless, several studies have verified the tax-and-spend hypothesis.
In 1986 economist Paul Blackley published a study in 'Public Finance
Quarterly' that examined the relationship between federal taxes and
deficits during the period 1929 to 1982.  Blackley found that revenue
increases led to spending increases, not to smaller deficits.  A subsequent
study by Neela Manage and Michael Marlow, formerly with the U.S. Treasury
Department, supported this finding.  The authors found statistical evidence
of "one-way causality from tax receipts to spending, suggesting that tax
increases result in higher spending levels - and possibly larger deficits."

Perhaps most controversial was a 1987 paper published by the Republican
members of the Joint Economic Committee (later disavowed by Democrats),
which examined federal revenues and deficits from 1947 to 1986.  The
authors JEC staff members Richard Vedder, Lowell Galloway, and Chris Frenze
- concluded that each dollar of new taxes had triggered $1.58 in new
spending.  In other words, the deficit has tended to *rise*, not fall,
after a tax hike.

Predictably, this report came under immediate and intensive attack from the
Democrats in Congress, who asked the Congressional Budget Office to rerun
the numbers and discredit the report.  The CBO fond that the Veddr et al.
study was "extremely sensitive to the time period" and "privides no
persuasive evidence in favor or the tax-and-spend hypothesis."

Yet the CBO made four statistical tests of its own, using various
assumptions.  In its first test, it found that an extra dollar of taxes led
to $1.55 in new spending; in its second test, the result was $1.05 in new
spending;  in its third test, 83 cents; and in its final test, 8 cents.
Only the last test supported outright rejection of the tax-and-spend
hypothesis.  The CBO economists failed to make a strong case that increased
taxes reduced deficits, even though they put forth their best efforts to
validate that conclusion.

The most recent case of a large federal tax hike expressly intended to
reduce the deficit was the $100-billion tax package called the Tax Equity
and Fiscal Responsibility Act (TEFRA).  This was the 1982 grand compromise
that Ronald Reagan was talked into supporting because he had received
assurances from Congress that "every one dollar in new taxes will be
matched with three dollars in spending cuts.

In fact, spending skyrocketed by $200 billion over the next four years.  An
analysis of TEFRA by Richard Rahn of the U.S. Chamber of Commerce revealed
that the deficit in 1986 was no smaller than it had been projected to be by
the CBO without the passage of TEFRA.  In other words, the largest tax hike
in history failed to reduce the budget deficit at all.

Despite this experience, the tax-and-spend lobby has succeeded in
convincing Bush that another grand-compromise budget deal is the only way
to stifle deficit spending.

The fiscal experiences of the states also confirm the tax-and-spend
hypothesis.  The relationship is slightly harder to detect at the state
level because 18 states have statutory tax and expenditure limitations,
which place constitutional restraints on legislators who might wish to
spend away additional revenue resulting from economic growth or tax
increases.

For example, in 1989 California had a windfall of $2.5 billion in state
revenue, but the legislature was prohibited by law from spending the funds
on new or post existing programs.  The law limited expenditures to the 1978
level plus an adjustment for inflation and population growth.  This kind of
constitutional limit is an effective deterrent to runaway spending during
periods of rapid revenue growth.

But even with the widespread adoption of such limitations in the states,
studies have uncovered a statistically significant positive relationship
between tax receipts and subsequent spending levels.  Former Treasury
Department economists Manage and Marlow followed up their study of the
federal tax-and-spend relationship with a similar investigation of the 50
states, covering the 30-year period 1952 to 1982.  Their overall conclusion
was that "tax receipts cause expenditures at the state level of
government."

Perhaps even more powerful evidence from the states that taxes invite
higher spending is the fiscal crisis that confronts the Northeast.  The
national economic expansion of 1983-88 produced unprecedented revenue
windfalls for the treasuries of most state governments - and nowhere was
this more true than in the eight northeastern states.  Income in the region
grew roughly four times faster than in the nation as a whole between 1978
and 1987.  The region's unemployment rate dipped to 2.5 percent in 1987 -
less than half the national average.  In short, these states are precicely
the ones that we would expect to be the most fiscally sound in the nation.

Yet precicely the opposite is true; each is sinking under a sea of red ink.
New York, New Jersey, and Massachusetts are each running deficits of nearly
$1 billion this year.  The fiscal outlook is only slightly less gloomy in
Maine, New Hampshire, Rhode Island, and Vermont.  Governors Mario Cuomo of
New York, Michael Dukakis of Massachusetts, and James Florio of New Jersey
have endorsed tax hikes of $1.4 billion, $1.2 billion, and $1.4 billion,
respectively.  Steven Gold, former budget director for the National Council
of State Legislatures, says 1990 could see $10 billion in new state taxes -
an all-time record.

State legislators in the region have blamed their budget ills on a variety
of factors beyond their control.  They say that the regional economy has
cooled off unexpectedly, that the federal government is mandating new
spending, and that the 1986 Tax Reform Act has caused a loss of revenue.

None of these explanations is plausible.  Seven of the eight states in the
region have experienced faster revenue growth from 1987 through this year
than the average for all other states.  Although revenues in the region
have grown 25 percent faster, these states' year-end reserves have
plummeted, while reserves in less revenue-rich states have climbed.  The
evidence flatly contradicts the notion that the recipe for fiscal balance
is higher taxes.

Even the most liberal of commentators have correctly assessed the problem
of the Northeast, which is not insufficient revenues but unbridled growth
in new spending programs.  The 'Washington Post' reported last year:  "The
main reason for budget shortfalls from Connecticut to Maine has been ...
mushrooming spending programs that doubled and even tripled budget outlays
in these prosperous states."  To substantiate the point, the Post cited
figures for spending growth between 1987 and 1989: Outlays escalated 37
percent in New Hampshire, 31 percent in Connecticut, 20 percent in New
Jersey, 18 percent in Massachusetts.

The plight of the Northeast has been a classic case of the ratchet effect
of government spending, which might be called a corollary to the
tax-and-spend hypothesis.  Higher revenue triggers new spending that
quickly becomes and indispensable fixture of the government.  When revenue
is expanding at a healthy pace, the legislature feels free to find new and
creative ways to spend the funds on government services.  When the budget
situation turns sour, as now in the Northeast, the prescription is
inevitably to pass tax bills to support the new higher level of spending -
hence, the ratchet effect.

New Hampshire state Rep. Donna P. Sytek, the Republican chairman of the
state Ways and Means Committee, explained how the process works when she
said: "We did a lot of good things in the years we had the money.  But
there's a constituency that now perceives these programs as essential, and
we can't take them away.  We should have known the boom wouldn't last
forever."

What are the lessons, then, from the fiscal crisis in the Northeast and the
failure of deficit-reduction schemes such as TEFRA?  The first is that a
new plate of federal or state taxes may in the short term provide fiscal
relief, but over the long term it will usher in budget crises worse than
the one we now face.  The second is that if, as the evidence suggests, the
tax-and-spend hypothesis is correct, then Congress and the state
legislatures should be cutting taxes, not raising them.

-----------------

Stephen Moore is an adjunct fellow with the Indianapolis-based Hudson
Institute.
Newsgroups: alt.politics.libertarian