As the new Congress and the Minnesota Legislature begin their work this week, their members should heed one of economist Milton Friedman’s basic warnings: If a tax cut is not accompanied by a decrease in government spending, then it really isn’t a tax cut. Instead, it is just a shift of the tax to another generation or to a less transparent form. But someone at some time will have to pay the bill.
While Friedman reminded us of this with particular vigor, it was not an original observation on his part. British economist David Ricardo made the same point centuries ago.
Their warnings are unwelcome to many members of state and federal legislative branches. While they may argue for lower taxes on the campaign trail, it is understandable that such officials tend to spend more than they bring in via taxes.
Some candidates called for cuts in spending, but virtually none were specific about just what programs they would sacrifice. Indeed, while many decried government waste, most still wanted increased spending in some particularly popular category.
History demonstrates that once in office, the temptation to increase spending has broad support across party lines.
The two major parties have taken different approaches to tax issues. Over the past quarter-century, cutting income-tax rates has been the Republican Party’s economic policy keystone. Democrats want to tax the rich, but fuss about an overtaxed middle class. At the state level, both parties have voiced support for property-tax reductions.
The business cycle can have a ratcheting effect. When the economy is booming, as in the late 1990s, revenue from income and sales taxes rise substantially. Falling deficits or even budget surpluses give giddy lawmakers a rationale for cutting taxes and increasing spending. But the effect is asymmetric. When the economy slows, there is no proportional willingness to increase taxes and cut spending.
At the national level, borrowing can finance deficits. U.S. Treasury bonds have been the world’s safest investment. We have always been able to sell as many as we want. At times, government borrowing has driven up interest rates, but we have never failed to find buyers for all the bonds we choose to issue.
Right now, borrowing seems easy since the world is awash in dollars pumped out to pay for U.S. imports. OPEC nations and East Asian central banks gladly lend these dollars back to us at moderate interest rates.
Most states, including Minnesota, are less able to borrow to cover deficits. Some require balanced budgets in their constitutions or can issue bonds only to construct long-term infrastructure. Unlike the federal government, states that sharply increase their indebtedness quickly face higher interest rates as bond rating agencies drop their credit scores.
Many states do, however, have a “budget balancing” option that is not as available to the federal government: restricting the revenue they pass on to local governments.
When states have boatloads of money, legislatures generously pledge to pick up increasing shares of local expenses. When surpluses disappear, however, the same legislators find it easier to cut such intra-governmental transfers than to reduce the state’s own direct spending.
Having passed the problem on to another level, state elected officials then can piously congratulate themselves on their budget-balancing skills and castigate city, county and school-district officials for not doing the same.
But covering a deficit by borrowing or cutting intra-governmental transfers has not solved a problem. It has just pushed the problem off on another generation or another jurisdiction.
The intra-governmental shift is more visible at the state level. The last two Legislatures in Minnesota closed deficits in great part by reneging on earlier pledges to pick up an increased share of local government spending. The state also has chosen to keep apparent spending down by allowing our roads to depreciate.
The federal government simply continues to borrow. It continues to use surplus Social Security revenue to mask the true deficit in its general accounts.
President Bush has just announced that the budget can be balanced by 2012. There is some irony in that year. Shortly after his inauguration in 2001, administration economists said 2012 would be the year when the entire national debt would be paid off.
But it is not clear that the new Democratic majorities in the House and Senate have any more enthusiasm for true deficit reduction than the president.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.