sense that they are taxpayers. But even as individual taxpayers they have very little say in how the government spends tax dollars. In addition, most of the time they cannot take their business elsewhere. For a government office, the ones who provide the money to pay the bills are the politicians who appropriate the funding for the program. They are the ones that must be kept happy.
Ultimately the problem with taxes is that they act as a burden on the economy. As we saw earlier, a business or an employee can get increased revenue by providing additional value for a lower cost and the net effect grows the economy. Taxes have the opposite effect; they reduce the spending ability of those being taxed while not providing any direct additional value, or at least a value that is less than the amount paid. If your taxes increase, your ability to spend is reduced.
I am not saying that nothing government does has value, it does. However, this is an issue of value in relation to cost. Given the competition in the marketplace, a primary concern for business must be providing the best value for the lowest cost, lest customers go elsewhere. For government there is no competition and as a result government tends to be very wasteful.
Thus there is little incentive to keep costs down, and in fact for most of government, the incentive is reversed. An agency or department that works hard to reduce costs and save money, will be “rewarded” by having their budget cut, while those that waste money will often have their budgets increased. This is why so much of government spending occurs at the end of the fiscal year, as large amounts of moneys are spent to demonstrate that they were really “needed.” Furthermore the government budgeting process often has built in automatic yearly increases, which further insulates government from any pressure to cut costs.
Thus government does not “price” their services based on a willingness to pay in the market place but instead based on how much money they think they will need. Because of these different incentives, and ways of thinking, any value provided by government will come at a greater cost, often a much greater cost than that provided by private business.i Taxes are then set accordingly.
While getting a better job has a net positive effect on the economy, taxes, because of the inefficiencies, act as a burden on the economy that will slow economic growth.
Taxes in Action
This effect has been demonstrated time and time again when tax increases depressed the economy and thus failed to bring in the expected amount of revenue as a result. While many examples of this effect could be given, one clear example of this occurred in California during the early 1990s.
Like many states California spent freely during the good times of the 1980s. During the decade, economic growth was strong and as a result revenues to the state increased at a very healthy eight percent per year. With all that money flowing in, politicians spent freely, so freely in fact that, as often is the case, the increases in spending outstripped the increases in income. While income increased at an average rate of eight percent per year, spending increased at about eleven percent per year. As a result the state budget grew from $32.8 billion in 1980 to $72.6 billion by 1989, an increase of 121 percent.
Now while the economy was strong, California could get away with this. The problem was that such economic growth can’t last forever. When the economy eventually did begin to slow, so did revenues and California ended up with a huge budget deficit of $8 billion, the largest state budget deficit in the country at that time.16
In response to the deficit, California did what governments tend to do when there is a shortage of money; they ‘asked’j the taxpayers to give them more. While in this case they did make some ‘cuts’ in the state budget the majority of the shortfall in revenue was to be made up by new taxes. Thus California passed a mixture of sales tax and income tax increases on ‘the rich,’ i.e., on those in the upper tax brackets, and these tax increases were supposed to produce $7 billion of the $8 billion needed to close the deficit.
While it may have looked good on paper what the politicians failed to take into account was the negative effect that taxes have on the economy. Rather than bringing in the expected $7 billion in new revenues and thereby closing the budget deficit, the increased taxes caused the economy to slow even more. In fact it slowed so much that not only did the state fail to increase revenue by the expected $7 billion, revenues actually went down by $1 billion per year over the subsequent two years.17
To make matters even worse, while the rest of the nation was recovering from the recession that had initiated the problem in the first place, the burden from the 1991 tax increase slowed California’s recovery such that real per capita personal income fell 5.6 percent over the next three years.18 In short, increasing taxes, rather than bringing in more money, cost the state money and reduced people’s incomes.
Update: It would seem that California politicians learned little from this experience. After getting out of this hole, politicians once again went on a spending spree as if nothing had happened. When the current economic down turn hit budget deficits once again soared, to become once again the largest in the country. Yet rather than the $8 billion deficit that they faced last time, this time the short fall exceeded $40 billion.19
Lessening The Burden
Now if increasing taxes can depress the economy thereby resulting in less tax revenues than expected, should not cutting taxes conversely stimulate the economy? If the economy is stimulated won’t that mean that the government will get more money in tax revenues than it had expected; that the tax cuts will not “cost” the government as much as predicted?k
The answer is yes and this also has many historical examples, such as the Kennedy tax cuts in the 1960s, the Reagan tax cuts in the 1980s, and more recently the Bush tax cuts that took effect in 2003. As a result of the Bush tax cuts, for example, by mid 2005 the economy had recovered such that revenues were 14 percent higher than what had been expected, while the budget deficit was reduced by nearly $100 billion more than had been projected.20
While it is not always the case, some tax cuts have resulted not only in more revenues than had been predicted but in actual increases over even the pre-tax cut projection. Part of the Bush tax cuts, involved cutting the capital gains tax from 20 percent to 15 percent. At the time the Congressional Budget Office (CBO) predicted this cut in the capital gains tax would correspondingly reduce the amount of money the government would receive. Without the tax cut, the CBO estimated that the government would receive $186 billion in revenues from capital gains taxes over three years.21 But when the tax cut was passed the CBO reduced this to $147 billion; a reduction of $39 billion dollars because of the lower rates.22
Once the tax cuts actually took effect the results were somewhat different. Rather than the reduction in revenues that the CBO had expected, revenues actually increased, not just over the $147 billion predicted following the tax cuts, but even over the $186 billion that had been predicted before the tax cuts were passed. By the time that the CBO finished its analysis of the results, the CBO noted that the actual revenues received from capital gains taxes over the three years following the tax cuts were $216 billion. This was $30 billion more than had been expected prior to the tax cuts and $69 billion more than expected as a result of the tax cuts.23 In this case cutting taxes actually resulted in more money.
Theoretical Limits
Now there is, at least in theory, a limit on a democratic government’s ability to raise taxes, and that is the people’s willingness to pay them. If taxes are increased too much, people will complain, politicians will get worried, and the new programs the taxes were supposed to pay for will be seen as unnecessary. At least this is the theory.
The Founding Fathers understood this well. One of the main issues that sparked the Revolution had been taxes, and the subject of taxation
