How To Downsize the Government

Thursday, January 30, 1997

I played a minor role last spring as an economic adviser in devising Bob Dole's economic agenda. At that time, the form of the economic plan was unclear, and I was therefore eager to learn the details of the program as announced by Mr. Dole last summer. Democratic complaints notwithstanding, the final result was impressive, especially in its focus on policies that would have contributed to long-term economic growth.

The 15 percent across-the-board income tax cut, a central part of the Dole plan, was attractive because it would have created pressure for reductions in federal spending and for meaningful tax reform. Since broad tax cuts would result in lower revenues, lower tax rates today would-if not accompanied by eventual spending reductions-have to be balanced by higher rates in the future (to finance the larger accumulated public debt). Hence any benefit from expanded economic activity today would be offset by losses from reduced output tomorrow. Even if the current response to the tax cut is large, such a rearrangement of activity over time tends to be undesirable.

The Dole plan recognized that spending cuts were an essential part of the program. If spending declines along with taxes, then the economy benefits from the switch of resources to private use and from permanently reduced tax distortions. My estimate from studies of economic growth across a large number of countries is that a 10 percent cut in the size of government-that is, in spending and taxes-would raise the long-term growth rate by about 0.1 percent a year. Although this growth effect seems small, it means that U.S. gross domestic product would be higher by about $8 billion in the first year and by $41 billion after five years. More-substantial growth effects-perhaps as much as 0.3 percent to 0.5 percent a year-would have been expected from implementation of the full Dole package, which included basic tax reform, a school choice initiative, deregulation of labor and other markets, and an overhaul of the legal system.

One reason that the Reagan tax cuts of the early 1980s were effective was that the resulting budget deficits forced some restraint on federal spending. Additional benefits came from the movement toward a more efficient tax system, especially with the reforms (other than the rise in the capital gains rate) of 1986. Since 1990, however, the deficit has been used mainly as an excuse to raise or not lower taxes. In this light, Dole's 15 percent tax cut would have represented a return to the Reagan approach of using revenue starvation to force a downsizing of the government. All things considered, this was a pretty good idea.

An even better idea would be a thorough reform that taxed consumption rather than income, lowered marginal tax rates by flattening the rate structure, eliminated a variety of deductions, and simplified the overall system. A number of good plans exist, such as the one proposed by Robert Hall and Alvin Rabushka of the Hoover Institution. One attractive feature of their plan is that it permits a shift to consumption taxation while allowing for any desired structure of tax rates on wage income (including a generous family allowance). The Dole plan included an endorsement of this kind of reform, with the 15 percent rate cut viewed as a way station on the route to fundamental change. If a more efficient tax system were coming, then it would make good economic sense to have a tax cut immediately-even if it caused a temporary budget deficit-in order to reduce the amount of taxes collected under the old, inefficient system.

Other tax proposals can be evaluated in terms of whether they would move the system closer to the desired reform. The $500-per-child tax credit seems to be popular with both political parties, for instance, but its only incentive effect is the subsidy for bearing children. Although my own high-quality off-spring doubtless warrant taxpayer subsidy, I would not apply this reasoning more generally to other people's children.

Another frequent suggestion-income tax deductions for Social Security "contributions"-would shift collections from a flat-rate payroll tax to a graduated-rate levy on all income. This change is inadvisable because it worsens the problematic features of the existing system: Average marginal tax rates would rise, and rates on capital income would increase relative to those on labor income.

Cutting capital gains rates, expanding Individual Retirement Accounts, and subsidizing education and training are generally good ideas but are only partial steps toward a consumption-based setup in which all saving is exempted from taxation. It would be far better to get the overall system right rather than to erect piecemeal provisions that favor designated kinds of investment and are politically difficult to eliminate later. Some of these provisions-though not the capital gains tax cut-make the system more complicated and create distorted incentives favoring some investments over others.

How does this all relate to "supply-side economics"? Critics of President Reagan and his intellectual followers try to ridicule this phrase by applying it to the extreme proposition that tax cuts pay for themselves by generating a sufficiently dramatic expansion of the tax base. (This view may be correct in certain cases-for example, for historical cuts in the top marginal income tax rate, for elimination of the luxury tax on boats, and, more conjecturally, for reductions in capital gains rates.)

For me, supply-side economics encompasses a variety of influences on an economy's ability and willingness to produce goods and services. Included here are increases in stocks of physical capital, education, training, and health; incentives to invest and work from low tax rates and institutions that maintain property rights and foster free markets; stimulants to technological progress; provision of core infrastructure services; and so on. The supply-side approach was born as a reaction to the narrow concentration on aggregate demand in the standard Keynesian macroeconomic model. For analyses of economic growth beyond the very short term, supply-side economics is basically a synonym for sensible economics.