Saturday, September 04, 2010

A Laffer curve for government spending

Conservatives are fond of the following oxymoronic proposition: cut taxes and more revenue will flow into the government's coffers. If the government taxes less, then people will work more and even with lower tax rates, there will be a larger government take because of all the extra work to be taxed.

It's a ridiculous proposition on its face, particularly given the historically low tax rates on high-incomes in the United States (the highest marginal tax rate during World Word Two was 91 percent -- it's 35 percent on income above $340,000 or so today). But this ridiculous idea is at the heart of most Republican proposals to balance the budget and reduce our long-term debt.

An economist named Arthur Laffer who worked in the Reagan Administration popularized the idea enough that the idea bears his name: a Laffer curve exists for taxation like an upside-down U. The vertical axis is government revenue and the horizontal axis is the tax rate. At a tax rate of zero percent, raising the rate to 1 percent will raise more revenue, so the curve goes up from left to right. On the other side, at a tax rate of 100 percent, no one would work so no revenue would be collected (although I can probably think of examples where that doesn't apply, but stick with the theory). So lowering the tax rate from 100 percent to 99 percent would allow people to take home 1 percent of their money, which would give them a reason to actually work. Since some people would work and earn money that wouldn't have done it before, government revenues increase, and the curve goes up from the right to left.

This curve, raising from left to right and from right to left, then meets in the middle, like an upside down U. So if we happen to be on the right side of the peak, we can raise more government revenue if we cut the tax rate, and if we're on the left side of the peak, we can raise more government revenue if we raise the tax rate. That's the theory.

Even if true, we're almost certainly on the left side of the peak, since our tax rates our relatively low (except, perhaps, on low-income earners if one considers local and state taxation). That means today, the way to raise more reveue is to raise the tax rate.

But I've got a better idea.

We need a Laffer curve for government spending.

See, government spending generates more economic activity. When the government spends money, like on hiring a teacher or a bureaucrat, someone has a job. And that person has income. So that person pays taxes on that income. Immediately, there is a return to the government of some of their spending in the form of tax revenue. That person with the government job then spends their income on things. The retailer pays a sales tax and a property tax on her store. More government revenue based on the first burst of government spending. And when the person spends their money, then someone else has more income. And that someone else then pays taxes on that income. The government gets even more revenue from the original spending.

At some point, the government gets back all the money it spent. And after that, the government gets more money back in revenue then it spent in the first place.

That's a Laffer curve for government spending.

So we should be able to say the same thing about government spending that the conservatives say about tax cuts -- if we increase spending, we'll get more revenue back. And the converse: if we cut government spending, we'll get less revenue and be worse off from a deficit perspective.

Conceptually, it makes as much sense as the Laffer curve on taxes.

Now some government spending will work better in generating more revenue for the government than others. Hiring a cook in South Korea to work on the military base by the DMZ won't generate any revenue to American governments. But hiring a teacher who not only spends her money and generates more economic activity in her community (paying her own local and state taxes and also bringing more income to the retailers and restaurant owners and grocery store owners and utility owners that she buys things from who then pay local, state and federal taxes on that additional income) would bring in more revenue. Plus, that teacher will teach students, making them smarter and thus more employable, which will generate more revenue from the government.

In my next post (after I think about it some more), I'll talk about the multiplier effect that shows some government spending brings in more revenue than other types of government spending, and try to come up with a better way to talk about government spending that resonates as well as the Laffer curve does.

We've got to hand it to the conservatives - they've got great language to advance their agenda, no matter how ridiculous their ideas turn out to be in practice. Now that President Obama and the Democratic Congress are actually implementing policies that work in practice, we need the best possible language to describe why and how they are working so that average voters will keep them in power and not let the party that believes cutting taxes today will bring in more revenue run the government.

Government spending as a concept seems to taking a beating these days, but in practice, it is one of the best ways to make our lives better and strengthen our economy. There is a big gap between how well government spending works in practice and the view of government spending in the mind of the average voter. It's our job to close that gap and explain how government spending makes our lives better in a common-sense way. Just because it happens to be true doesn't mean that people understand it -- or that we're explaining it well.

A Laffer curve for government spending might address the concerns about the debt and the deficit, leeching the strength away from "runaway, out-of-control spending" because all the spending comes back to the government anyway in more tax revenue -- if we focus on the best government spending that actually does it.

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