More Evidence That Spending Cuts Are the Best Way to Shrink Our Debt

by Veronique de Rugy

I was intrigued by this new Pew piece/poll (hat tip to Bruce Bartlett) called “Yes, the Rich are Different” that finds that 58 percent of people think the rich don’t pay their fair share of taxes. Polls like this one always makes me wonder what do people think would be accomplished (apart from the pleasure of soaking the rich I guess) if high-income taxpayers paid more in taxes than they do now.

As I have explained in the past, increasing taxes on rich people is unlikely to address concerns about income inequality. The U.S. federal tax code (not just the income tax) is one of the most progressive tax codes of the OECD countries. It is more progressive than countries with lower levels of income inequality, and making it even more progressive won’t address this issue.

But further, increasing taxes on the rich alone won’t address out debt problems moving forward. For one thing, there just aren’t enough rich people to pay off all the debt the government has accumulated; you can’t balance the budget just by taxing the 1 percent and any successes on that front are likely short-lived. My colleague and Duquesne University professor Antony Davies explains:

Want to balance the budget on the backs of the top 1 percent? According to CBO figures, the government would need to tax them at a rate of almost 100 percent. But doing so would make the top 1 percent poor — so, next year, the government would have to tax the top 2 percent.

This is where the middle class comes in. Politicians know the real potential for tax revenue lies with the middle class. Middle-income Americans far outnumber the rich and, at least for now, are taxed at relatively low rates. But even if we tapped the middle class, we’d have to raise tax rates by a staggering amount.

To balance the budget, we’d have to triple tax rates on every household earning over $100,000. Alternatively, we could merely double tax rates, but we’d have to do it on every household earning over $75,000. Not only are there not enough rich households to tax, there are barely enough middle-income households.

With the top 2 percent taxed into poverty, the year after that, politicians would need to go after the top 3 percent. Keep going down that path and, eventually, they’ll come for you.

Finally, this new paper by Harvard University’s Alberto Alesina, Carlo Favero and Francesco Giaviani  of  the University of Bocconi makes the case that increasing taxes on the rich (or anyone else for that matter) won’t help our country get out of the slump. The two economists show that the best way to get into a new recession is to try to reduce our debt-to-GDP ratio by raising taxes. They write:

Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax based ones. In particular, spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all.Instead, tax-based adjustments have been followed but prolonged and deep recessions. The difference is remarkable in its size and cannot be explained by different monetary policies during the two type of adjustments. In fact,we find that the mild asymmetric (and lagged) response of short-term rates cannot explain the difference between the two types of adjustments: heterogeneity in the response of monetary policy appears with a lag of one to two years, while the heterogenous response of output growth to EB and TB adjustments is immediate. We find that the heterogeneity in the effects oft he two types of fiscal adjustment (tax-based and spending-based) is mainly due to the response of private investment, rather than that to consumption growth.

If they are right, it means that comes January we should let sequestration follow its course (especially considering that for the most part the spending cuts are mainly reductions in growth rates rather than literal cuts; see this chart about defense spending) but prevent taxes from going up.

Another interesting finding in the Alesina/Giaviani paper is the correlation between spending cuts and business confidence. They find that “business confidence (unlike consumer confidence) picks up immediately after an expenditure-based adjustments.” They are going to look more into this question in order to determine whether there is a direct causation or simply an interesting correlation.

Update: Over at the New York Times’ Economix, Catherine Rampell comments on the same Pew Center poll and notes that Americans’ attitude toward rich people’s tax burden has changed over the years:

If that sounds like a lot of people complaining that the wealthy don’t contribute enough to Uncle Sam, note that Americans’ attitudes toward the tax obligation of the rich have become much less demanding over the last two decades.

When this question was first asked by Gallup, in March 1992, 77 percent of respondents said upper-income Americans paid too little in taxes. Yet the average income tax burden of the wealthy was actually higher then.

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