A Smothering Burden

Wednesday, April 21, 2010

A few months back, President Obama proposed a three-year spending freeze on what amounts to one-sixth of the federal budget. Our biggest entitlement programs, Social Security and Medicare, would be excluded. These changes are an exercise in image rather than substance. Given the spending agenda that is already in place, we can expect to see large increases in the proportion of gross domestic product that is spent by our government for years to come.

From 2008 to 2009 we saw the greatest annual increase in federal spending in the past thirty years. In the name of stimulating job growth, the ratio of spending to GDP rose by about 14 percent. The share of federal spending is now 24 percent of the economy, up from 21 percent in the last year of the Bush administration.

My analysis of data from 1950 to the present shows that periods with high tax-to-GDP ratios exhibit much slower economic growth than those with lower tax ratios. The GDP growth in high-tax years (defined as years during which the ratio of tax to GDP was above 18 percent, the sixty-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 percent tax-to-GDP ratio over the next twenty-five years, GDP per capita in 2035 would be about 50 percent less than if we were to tax below the 18 percent ratio. (A 50 percent per capita GDP differential is about as large as the difference between the United States and Greece today.)

The recent growth in spending has been camouflaged by a focus on deficits. Budgets and legislation, such as the recently passed health care overhaul, 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.

The rhetoric surrounding the health care overhaul misses this point. It invariably points toward more spending, more taxes, and less growth. Both the White House and Congress have discussed fiscal responsibility in terms of the law’s effect on the deficit, overlooking the effect of new spending, which would contribute to the ballooning federal budget and, when financed, is the major impediment to economic growth. Arguments over whether the legislation would increase or decrease the deficit, or bend the cost curve down or up, are secondary as far as growth is concerned. The heaviest impact comes from levying more than $500 billion in new taxes to pay for the increased spending.

The share of federal spending is now 24 percent of the economy, up from 21 percent in the last year of the Bush administration.

Despite all the talk about reducing the deficit, the irony is that there is little likelihood of eliminating or reducing it. Obama’s target is to lower the deficit to 4 percent of GDP by 2013. That is twice the level of the Bush deficit in the average year and larger than any Bush-year deficit. During President George W. Bush’s term, the ratio of federal spending to GDP averaged 20 percent. Obama’s budget aspires to reduce the spending ratio to 23 percent by 2013 from 24 percent today.

It is true that Obama inherited much from his predecessor, as the president and his surrogates are wont to remind us. There is no doubt that when the new team came in, the economy was in a deep recession and job losses were large. He inherited an unemployment rate that was over 7 percent. It now stands at 10 percent. The job growth that was the promised outcome of the $787 billion stimulus bill has not materialized. And when job growth does return and unemployment falls, the results will owe little to the stimulus.

Consider the legacies Obama will leave his successor. His own inheritance included low personal tax rates, an average ratio of taxes to GDP of about 18 percent, low rates on capital gains, and a period of low estate taxes. But Obama increased the deficit he inherited; he increased the government spending ratio; and he has already promised to repeal the low tax rates. At this point, the question is how much and what form the tax increases will take. It will be virtually impossible for 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 percent deficit figure that the White House wants.

Medicare tax increases on wages and dividends, and new levies on businesses, are already in the works. In the longer run, we may see a push to introduce a federal value-added tax.

Let us not be confused by promises of jobs, coupled with fiscally responsible-sounding language that masks the underlying irresponsibility of budget decisions. Proposals that increase taxes and spending, even if they do not increase the deficit, will place a substantial burden on our recovering economy and on future economic growth.