Raise Taxes and Reduce Spending? Not Really.



October 21, 2012


(This item originally appeared at Forbes.com on October 21, 2012.)

http://www.forbes.com/sites/nathanlewis/2012/10/21/raise-taxes-and-cut-government-spending-to-reduce-debt-not-really/

At some point, the U.S. government will have to deal with its exploding debt load. Typically, we hear that the solution involves “some combination of reduced spending and higher taxes.” Proponents often claim that this solution is “mathematically inevitable.”

Oh really? There are two great examples in history of governments that got out of huge debt commitments without either defaulting or devaluing the currency, which is essentially another form of default. One was Britain after the Napoleonic Wars, ending in 1815; the other was the United States, after World War II. This was quite unusual. Most governments, when faced with excessive debts, have defaulted either legally or via currency devaluation.

After World War II, the U.S. government had a debt/GDP ratio of about 125%. In 1970, this had fallen to 25%. During this entire period, the dollar was pegged to gold at $35/oz. under the Bretton Woods system.

Did spending go down during this period? It did immediately after the war, dropping from $93 billion in 1945 to $30 billion in 1948. Then, it went up, reaching $195 billion in 1970.

Did taxes go up? No, they did not. Immediately after the war’s end, wartime tax rates were reduced slightly. The Revenue Act of 1945 repealed an excess profits tax, and reduced income and corporate tax rates. Tax rates were reduced further in the Revenue Act of 1948, although they went up slightly in the early 1950s. A fairly large tax rate reduction took place in 1964. The overall trend was a modest decrease in tax rates.

Was the debt paid off? Nope. In 1948, the federal Government had gross debt outstanding of $252 billion. In 1970, it was $381 billion.

Apparently, when “mathematically inevitable” meets reality, reality wins.

So, what happened? Mostly, GDP increased, so that the debt/GDP ratio declined as a result of the expanding denominator. GDP was $233 billion in 1947 and $1,103 billion in 1970.

How do you get GDP to expand? You use the Magic Formula: Low Taxes, Stable Money. Stable Money was provided through the Bretton Woods gold standard system. Tax rates weren’t as low as we would like in that period, but they were, in many ways, lower than today. Top income tax rates were very high, but they applied to very high incomes and were riddled with loopholes, which is inevitable whenever you see high tax rates. Sales taxes and payroll taxes were much lower. The general trend was for tax rates to decline during this period. There was no “austerity” involving big tax increases, as we have been seeing in Europe recently.

When GDP expands, tax revenues go up, which allowed the federal government to spend more and more money. However, the government was fairly disciplined, in those days, about not spending more than it took in. From 1950 to 1970, the government, on average, had an annual deficit of 0.6% of GDP.

Because GDP was rising, and the total debt wasn’t growing much, people could see that the debt/GDP ratio was falling. The situation was getting better and better. Thus, they weren’t particularly worried that the government would not be able to pay back its debts.

From this example, I conclude that the solution today for the U.S., or other governments with similar issues, is: Lower Spending, Lower Taxes, and Stable Money.

The Lower Spending is to get expenditures in line with revenues. Stop the bleeding. However, in the longer term, as GDP expands and revenue expands, spending can increase by a large amount. In a surprisingly short time, the government might be spending more than it was during the days of big deficits. In 1945, the federal government spent $92.7 billion and ran a deficit of 21.5% of GDP. In 1960, the federal government spent $92.2 billion and had a surplus of 0.1% of GDP.

Lower Taxes, in the first instance, means a plan to raise the same amount of revenue, as a percentage of GDP, with a much more efficient and business-friendly tax system. This basically means much lower tax rates, like the Flat Tax programs that have been popular throughout eastern Europe. In ten recent examples, Flat Tax implementation did not lead to a meaningful decline in revenues in either nominal terms or as a percentage of GDP. The increase in GDP, however, was impressive.

Later, we can have a discussion about even lower taxes, with the goal of lowering the amount of tax revenue the government collects as a percentage of GDP. Places like Singapore (14.2%) and Hong Kong (13.0%) provide all the government services we are familiar with in the United States (26.9%) — plus universal healthcare! But first, let’s aim for the first goal, of collecting the same percentage in a more efficient manner.

Stable Money, ideally, means a gold standard system. (For smaller countries, it can mean a link to a reliable international currency.) Although it is possible to devalue the debt away, unfortunately you also devalue your economy away at the same time. If you are going to default – countries like Greece and Spain are probably too far gone at this point — then just default plain and simple, but keep the Low Taxes and Stable Money so that the private sector can continue to thrive.

Today, U.S. economic thinking alternates between “stimulus,” with big deficits, and “austerity,” with higher taxes. Both will lead to eventual disaster. Usually, spending doesn’t even decline much with “austerity,” because, as the economy crumbles, the demands on the government to provide some kind of support intensify. This has been true of Greece recently, and was true in the U.S. in 1932.

The most sophisticated thinkers will see that major tax reform is actually a path toward spending reduction. As the private sector thrives, demands on the government dwindle and spending reduction becomes politically easier. Margaret Thatcher cut back the British socialist state, but first she reduced tax rates to get the private economy to flourish.

As the “fiscal cliff” approaches, Congress needs to think about its economic strategy going forward. Remember the Magic Formula: Low Taxes and Stable Money. Reduce spending to bring it in line with revenues.