Tax debate should bypass old German theory

October 1, 2010

The expiry of Bush-era tax cuts at year end, as originally legislated, could knock back the already anemic U.S. recovery. Deficit hawks reckon that’s an acceptable risk, saying America just can’t afford to extend them. But that viewpoint assumes some belief in Wagner’s Law, which posits ever-higher public spending — a bit of dogma in need of debunking.

If Congress can’t agree to extend the 2001 and 2003 tax cuts on labor and investment income, real GDP growth in 2011 might be as much as 1.7 percentage points lower and the unemployment rate 0.8 percentage point higher than otherwise, according to the Congressional Budget Office. But those who worry about the growing U.S. budget deficit fret that even a temporary extension would eventually turn permanent and boost the cumulative shortfall by some $3 trillion over the next decade.

The wrinkle is that by historical standards, the feds would still have full pockets. Revenue as a proportion of GDP has historically averaged about 18 percent. Even if all the tax cuts were permanently extended, revenue would average around 19 percent in coming decades.

That’s really anomalous is spending, headed to 35 percent of GDP by 2035 according to the CBO, half as high again as its historical average. Medicare is a big chunk of the problem. To keep the government’s health program for retired people at its current cost of 3.1 percent of GDP would mean slashing expected spending increases by more than a third.

That’s unlikely to happen, some budgeteers say, citing Adolph Wagner, the turn-of-the-20th-century German economist. He theorized that as nations get wealthier, citizens demand more government services even it means higher taxes. But the rise of the Tea Party movement hints that the public may be coming around, grudgingly, to the idea of less spending — as long as it keeps their taxes down. Even the Democratic head of President Barack Obama’s budget commission thinks outlays should be held down at around 21 percent of GDP.

Some academic research also suggests reducing debt through spending cuts is less injurious to growth than using tax increases to raise cash. Call that the Austrian School way. But neither that nor Wagner’s German School approach is pain-free. That is why, so far at least, U.S. politicians have shied away from committing to either.

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The history of ROI on marginal investments actually supports Wagner quite well. As societies expand their wealth and use of resources, greater amounts of the GNP are invested in economic and social activities intended to solve global social problems and to control economic activities: transportation, extraction, manufacturing, agriculture, etc. Eventually, the return on these marginal investments must, and will, become negative. The government’s role is pivotal: to collect taxes at an increasing total amount needed to fund an increasing amount of activity, including control and regulation.

For good overview of this in action – Roman Empire to present – see Tainter, J., “The Collapse of Complex Societies,” 1991. Although Tainter approaches his thesis from an archaeologist’s point of view, his research is solid and he includes numerous economists in his citations.

It is almost universally thought that taxes should be less and, by corollary, that government should spend less and be smaller. Similar general agreement will not be found on what and where to make those spending cuts.

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