May 10, 2017

“Starve the Beast” Enables the Bankrupt-in-Chief

Other than containing less detail, Donald Trump’s notes toward a sketch of a “tax plan” is similar to his campaign tax proposal, which analysts estimated would add $3-5 trillion to the budget deficit. That is to say, Trump does not have a corresponding plan to reduce spending. Republicans often rail against deficits, but when the rubber hits the road, they reliably increase deficit spending by cutting taxes. This has often been rationalized by the idea that reducing revenue and driving up deficits creates pressure to “Starve the Beast” and reduce spending. But big tax cuts create no pressure at all to balance the books. On the contrary, they ease the main pressure that keeps spending and the size of government in check.

In the hands of a big-spending, serial bankrupt like Donald Trump, Republican supply-side fiscal policy dogma, of which Starve the Beast is a central element, poses a serious threat to the growth and stability of the American economy.

As our namesake William Niskanen argued over a decade ago, Starve the Beast is bad economics and there’s very little empirical evidence for it. Moreover, conservative and libertarian commitment to this myth has “diverted attention away from the political reforms needed to limit government growth,” as Niskanen put it. Now’s an excellent time to  remind ourselves why big tax cuts are more likely to fatten than starve the beast.

The Demand Side of Big Government

Let’s start with the fact that the government of the world’s largest economy has a more or less indefinite line of relatively easy credit. When revenue falls short, spending can be financed with debt (which can be financed with inflation, but I’m going to bracket monetary complications to keep this post manageable.) This is the key to why, as Niskanen pointed out, Starve the Beast gets things exactly backwards.

The most important variable in democratic public finance is the political demand for spending. This demand encompasses public support for entitlement and defense spending, which are the biggest spending categories in the budget, as well as the cumulative effect of the pressure on spending exerted by interest groups and members of Congress seeking re-election. At any given time, there’s great pressure on policymakers to spend more on a lot of specific things. There’s usually some pressure to spend less overall, but not so much targeted pressure to spend less on specific things. (Here’s Ben Powell pithily explaining the political logic of “concentrated benefits and dispersed costs.”) Libertarians and conservatives love to think that political demand for spending is something you can manipulate through propaganda and fiscal policy wizardry. However, as I argue in another post, the evidence suggests otherwise.

People love to get stuff from the government, and tend to want more rather than less of it. But they hate to pay for it. In principle, widespread loathing of higher taxes can hold spending down. In practice, this only works when there’s a widespread cultural norm, legal rule, or both that requires paying for current spending with current revenue. In that case, an increase in spending is likely to entail an increase in taxes. People don’t like paying taxes. If they dislike a tax increase more than they like the government spending it buys, they’ll resist the spending hike. That is to say, when there’s a fiscal responsibility norm in place — when we’re not the sort of people who run up the credit card — political demand for lower taxes works as a check on political demand for higher spending.

Unfunded Tax Cuts Create a Fiscal Illusion

But debt offers a way to detach the level of taxation from the level of spending. If you offer voters an opportunity to enjoy lower taxes without corresponding cuts in spending, they’ll lap it up. Voters hate taxes and love spending! Tax-financed spending makes spending feel expensive. You have to pay for it. Ugh! But debt-financed spending makes spending feel cheap. As Christina and David Romer nicely put it, “a tax cut without an associated spending cut weakens the link in voters’ minds between spending and taxes, and so leads them to demand greater spending.” The weakening of this link creates what Nobel Laureate economist James M. Buchanan called a “fiscal illusion.” Spending feels cheaper than it really is. The cheaper spending feels, the more spending people want.

And that’s why big unfunded tax cuts, in addition to having the obvious first-order effect of widening the deficit, create pressure to increase spending. Political demand for spending goes up, not down, when taxes go down. And that makes both government and deficits bigger.

Niskanen didn’t think there was a shortcut to smaller government through tax cuts. He thought that if you want to reduce the size of government, you’ve got to get people to want less spending. The political psychology of fiscal illusion suggests that the best way to do that is to make people pay for government through current taxes. Under current circumstances, that would mean significant tax increases.

Raising taxes to shrink government is only counterintuitive until you think about it for a minute. Charging taxpayers something approaching the going rate for government forces them to ask if the benefits are really worth the expense. Forcing this question is one of the few things you can do to push down political demand for spending.

When Ideology Trumps Evidence

The idea that tax cuts make government grow isn’t just theoretical. Romer and Romer looked at four major, long-term tax cuts stretching back to Truman and found that the “behavior of spending in all four episodes provides no support for the starve-the-beast hypothesis. In no episode was there a discernible slowdown in spending following the tax cut. Indeed, all of the episodes saw an acceleration of spending.”

Political scientists Joseph Daniel Ura and Erica M. Socker found that demand for spending does go up as cheap-feeling deficit spending increases, just as Buchanan and Niskanen argued:  

Increased deficit spending predicts greater demand for government services and benefits. This result supports the key behavioral prediction of fiscal illusion theory and indicates a political mechanism by which massive and problematic public debt has emerged, persisted, and accumulated in recent decades.

So there you have it. Big Republican tax cuts whet the democratic public’s appetite for bigger government and increase deficit spending and government debt. Yet the “small government” right persists in its fervid tax-cutting monomania. Why? Because it remains locked into an appealing yet incoherent ideology that says tax cuts are pretty much always good.     

According to this ideology, smaller government is a golden key that will unlock the latent productive capacity of the economy. The idea is that capital is more productive in the private sector and that lower tax rates encourage investment, innovation, and work. And there’s good reason to believe that, other things equal, lower taxes and smaller government are better for growth. If you think everything’s always equal (and you’re willing to make some heroic assumptions about the sensitivity of human behavior to tax rates) you might think that the pro-growth effects of tax cuts means that it’s often the case that we can get the same level of revenue with lower rates. I call this view “Dogmatic Lafferism.”

The problem is that nothing is ever equal. If you’re past the inflection point on the Laffer Curve, a tax cut can have a big growth effect and increase revenue. But if you’re already at the revenue-optimizing tax rate, cuts by definition reduce revenue. Of course, there’s more to economic performance than tax rates. There’s also, for example, the regulatory climate. When over-regulation is choking off economic activity, cutting taxes is like watering plants that are dying from a lack of sunlight. Watering the plants would help if the plants were getting light, but they aren’t, so it doesn’t. And then there’s the other side of the fiscal ledger. If government borrowing has grown massive, a tax cut that makes the addiction to debt even worse can be totally counterproductive.The extent to which tax cuts promote growth and pay for themselves depends on a lot things.

Deficit Cognitive Dissonance

It ought to be obvious that Dogmatic Lafferism and Starve the Beast are in tension. But if you’re willing to hop from one to the other in a totally incoherent way, you can convince yourself that tax cuts have no budgetary downside. From one side of your mouth you can say that tax cuts pay for themselves. From the other side you can admit that they totally don’t pay for themselves, but say that that’s cool, because deficits create pressure to starve the beast and cut spending. However, as we’ve seen, cutting taxes doesn’t make government smaller. Because people want more government, not less, making government feel cheaper through tax cuts just makes government bigger and drives up public debt. At some point, government borrowing drives up interest rates, crowds out private-sector investment, and creates a drag on growth that offsets some and potentially all of the positive effects of tax cuts.

Rational people who are not experts should believe what most experts do. I think Andrew Samwick and William Gale are fairly representative of the expert consensus of the economics profession in their Brookings paper on the “Effects of Income Tax Changes on Economic Growth.” They write:

Tax cuts financed by immediate cuts in unproductive government spending could raise output, but tax cuts financed by reductions in government investment could reduce output. If they are not financed by spending cuts, tax cuts will lead to an increase in federal borrowing, which in turn, will reduce long-term growth. The historical evidence and simulation analyses suggest that tax cuts that are financed by debt for an extended period of time will have little positive impact on long-term growth and could reduce growth. (Emphasis added.)

Harvard’s Greg Mankiw, who is about as sympathetic to conservative supply-side fiscal thinking as mainstream economists come, recently said that “A reasonable rule of thumb, in my judgment, is that about one-third of the cost of tax cuts is recouped via faster economic growth.” But rules of thumb are “other things equal” as well, and we should expect the supply-side effects of tax cuts to pay for less and less of their cost as deficits and public debt balloon. So I’d say a reasonable rule of thumb is that we should expect tax cuts to create a hole in the budget that is at least two-thirds the size of the cut, and becomes bigger as the total amount of government debt increases.    

The combination of Starve the Beast and Dogmatic Lafferism produces conservative insouciance about the budgetary effects of tax cuts. But Starve the Beast is false. Big tax cuts drive deficit spending and goose demand for government services, which increases deficit spending even further. The more government borrowing increases, and the more the size of the public debt expands, the less we should expect tax cuts to self-finance through growth. Indeed, at a certain point of indebtedness, we should expect tax cuts to hurt growth over the long term.

When Self-Sabotage Meets Moral Imperative

As long as Republicans remain in the grip of cartoon supply-side thinking, they pose a real threat to American (and therefore global) fiscal stability and growth. But it gets worse.

The libertarian idea that taxation is theft creates a moral frame within which tax cuts amount to the restoration of stolen property. This, too, tends to justify an exceedingly blasé attitude about the cost of tax cuts. But deficit-financed tax cuts create debt that has to be serviced with current tax revenue, and either paid down through future tax increases, politically impossible massive spending cuts, inflation (a “hidden tax” on savings), or by defaulting on the debt, which is at least as theft-like as taxation, and which would throw the world’s economy into disarray.

If libertarians and libertarian-leaning conservatives were forced to explicitly defend the proposition that the government must “steal” less tax money though the heavens may fall, I think most of them would blanch. But they don’t think that the heavens may fall because they have been taken in by Starve the Beast and/or Dogmatic Lafferism, and therefore assume that a reduction in the rate of tax theft is either positive-sum, and comes out of no one’s hide, or that it forces a reduction in redistributive spending, which is morally illegitimate anyway, and comes out of the hide of “parasites” living off expropriated wealth.  

Libertarian views about the injustice of taxation morally weaponize cartoon supply-side theory. Not only do tax cuts rarely-to-never have bad fiscal and economic consequences, they are also morally mandatory.

The King of Debt

This is dangerous enough when it’s the ruling ideology of the party controlling both houses of Congress. But it could lead to disaster when combined with the populist, cronyist, kleptocratic instincts of Donald Trump, who proudly refers to himself as “the king of debt,” and thinks running up massive debts and then stiffing your creditors makes you a genius at business and life.

As Niskanen wrote, “the starve-the-beast perspective has led too many conservatives and libertarians to be casual about the sustained political discipline necessary to control federal spending directly, succumbing to the fantasy that tax cuts would solve this problem.” And this is so despite the fact that most Republicans claim to be committed to deficit reduction, balanced budgets, and fiscal prudence.

But now their party is headed by a professional scammer and serial bankrupt who seems to believe that the key to success is to do whatever it takes to get another line of credit and steal as much as you can carry. Trump’s personal financial incompetence and addiction to debt appears to be at the center of his shady ties to Russia, which the president is furiously and suspiciously attempting to conceal. Whatever the story turns out to be, it will always be true that creditors have leverage over debtors. Trump’s “tax plan” amounts to a plan to hand America’s creditors, China foremost among them, more sway. If his personal philosophy is any indication, Trump couldn’t care less if his tax policy blows a ruinous hole in the economy or weakens America’s geopolitical position. Most Republicans do care, but their supply-side nonsense about the long-term revenue neutrality of tax cuts offers Trump convenient cover for the debt-financed cash grab of his dreams.

If there was ever a time for Republicans to give up on their debunked articles of faith, step back from the precipice of disastrous fiscal imbalance, and consider a fresh economic policy agenda that stands a chance of working for the American people, it’s now.