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Posts Tagged ‘Rahn Curve’

Since it is tax-filing season and we all want to honor our wonderful tax system, let’s go into the archives and show this video from last year about the onerous compliance costs of the internal revenue code.

Narrated by Hiwa Alaghebandian of the American Enterprise Institute, the mini-documentary explains how needless complexity creates an added burden – sort of like a hidden tax that we pay for the supposed privilege of paying taxes.

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Alberto Alesina of Harvard’s economics department summarizes some of his research in a column for today’s Wall Street Journal. He and a colleague looked at fiscal policy changes in developed nations and found very strong evidence that spending reductions boost growth. This, of course, contrasts with the lack of evidence for the Keynesian notion that growth is stimulated by a bigger burden of government spending.

Politicians argue for increased stimulus spending, as opposed to spending cuts, on the grounds that it would speed up economic recovery. This argument might have it exactly backward. Indeed, history shows that cutting spending in order to reduce deficits may be the key to promoting economic recovery.

…[R]ecent stimulus packages have proven that the “multiplier”—the effect on GDP per one dollar of increased government spending—is small. Stimulus spending also means that tax increases are coming in the future; such increases will further threaten economic growth.

Economic history shows that even large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions, not recessions. Fiscal adjustments based on higher taxes, on the other hand, have generally been recessionary.

My colleague Silvia Ardagna and I recently co-authored a paper examining this pattern, as have many studies over the past 20 years. Our paper looks at the 107 large fiscal adjustments—defined as a cyclically adjusted deficit reduction of at least 1.5% in one year—that took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007.

…Our results were striking: Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases.

…In the same paper we also examined years of large fiscal expansions, defined as increases in the cyclically adjusted deficit by at least 1.5% of GDP. Over 91 such cases, we found that tax cuts were much more expansionary than spending increases.

How can spending cuts be expansionary? First, they signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts people’s behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time.

On the other hand, fiscal adjustments based on tax increases reduce consumers’ disposable income and reduce incentives for productivity.

…Europe seems to have learned the lessons of the past decades: In fact, all the countries currently adjusting their fiscal policy are focusing on spending cuts, not tax hikes. Yet fiscal policy in the U.S. will sooner or later imply higher taxes if spending is not soon reduced.

The evidence from the last 40 years suggests that spending increases meant to stimulate the economy and tax increases meant to reduce deficits are unlikely to achieve their goals. The opposite combination might.

Alesina’s research echoes the findings in dozens of other studies, a few of which are cited in this Center for Freedom and Prosperity video I narrated.

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I’m used to being attacked, but usually by statists. In a man-bites-dog development, here’s a 12-1/2-minute video dedicated to the proposition that I was hopelessly squishy in my Rahn Curve video.

What makes this situation rather ironic is that I agree with the guy tearing me a new you-know-what.

But this is also my defense. At the risk of oversimplifying, his critiques fall into two categories.

One category could be called sins of omission. To cite an example, he correctly points out that the growth-maximizing level of government may or may not be accurate, depending on how the money is being spent. For instance, if government only consumes 5 percent of GDP, but spends that money on law enforcement, that might be good (the video also notes, quite accurately, that law enforcement can be bad if the police are enforcing oppressive policies). If that modest level of government is devoted to welfare, by contrast, that would be bad. At the risk of stating the obvious (or at least what I hope everybody who reads this blog has already figured out), I obviously agree. But when I put together these videos, all sorts of simplifying assumptions must be made to keep them to a reasonable length. In many instances, the final video only includes about one-half of what was in the original script. So I plead guilty of not fully elaborating, but I limit details because I think too much information would undermine my goal of reaching people who are not already true believers.

The other category could be called bad assumptions, and here’s where I would argue that my critic is being a bit unfair. My main example is that he implies that I support a government that consumes 20 percent of GDP. Yet I think a careful viewer would agree that all I’m saying is that the existing academic research identifies this level of government spending as being consistent with maximum growth. But the last part of the video is my (hopefully compelling) argument that the actual growth-maximizing level of government spending is much lower than 20 percent of economic output.

That being said, it is always a good idea to be suspicious about anybody from Washington. I haven’t sold out yet, but that certainly happens quite often in Washington. So I welcome readers to pick through my blog posts with a fine-toothed comb.

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President Bush was a big spender, but President Obama is taking profligacy to the next level. In his first year in office, Obama pushed through a pork-filled “stimulus” that was supposed to increase jobs and prosperity (at least according to the discredited Keynesian theory). Instead, the economy has been weak and unemployment increased. In his second year in office, Obama rammed through a giant new healthcare entitlement, in part based on the absurd claim that bigger government would reduce red ink (the Congressional Budget Office should be abolished for aiding and abetting that fraud). Now we just witnessed the amazing spectacle of Obama actually getting to the left of Europe’s socialist leaders and arguing with them at the G-20 summit that government spending should be even higher.

Unfortunately for taxpayers, government already is too big, and that is true on both sides of the Atlantic Ocean. This new Center for Freedom and Prosperity video explains that there is a spending version of the Laffer Curve, and that it shows that government is much larger than the “growth-maximizing” level. As shown in the mini-documentary, academic research reveals that government spending should consume only 20 percent of gross domestic product. Thanks to the Bush-Obama spending spree, however, total government spending in America now amounts to about 40 percent of economic output.

It is quite likely, by the way, that the real growth-maximizing level of government spending is much lower than 20 percent of GDP. As noted in the video, the academic research is constrained by a lack of data for nations with small government. Free-market jurisdictions such as Hong Kong and Singapore enjoy the fastest growth, and they both have public sectors that consume about 20 percent of economic output,  so it should come as no surprise that scholars conclude that growth is maximized when government is about that size.

But what if there were nations with smaller levels of government? Indeed, the video shows that most nations in North America and Western Europe did have very small governments in the 1800s and early 1900s – often amounting to less than 10 percent of GDP. Does anyone actually think that the United States would have grown faster 100 years ago if the burden of government spending was doubled?

We’ll never know the answer to that rhetorical question, but one thing we surely know is that government today if far too large. It doesn’t really matter whether the growth-maximizing level of government is 10 percent of GDP or 20 percent of GDP. We have a bloated public sector today that is consuming 40 percent of GDP and the long-run projections indicate that the problem will get much worse because of entitlements and demographic changes.

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