In a column in the Wall Street Journal David Ranson points to a limit on the size of government and, effectively, on government action in the United States:
The nearby chart shows how tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution’s W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. “Hauser’s Law,” as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP.
What’s the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue.
In The New Republic Jonathan Chait produces one strong response to Mr. Ranson’s observations and one weak response. First, the weak retort:
Second, the vast majority of advanced countries have tax revenues well above 20% of GDP. So what is it about the U.S. that makes its economy uniquely sensitive to tax rates such that it cannot collect more than this amount?
I think that’s a weak argument because, as should be obvious, different cultures have different views of what’s acceptable, tolerable, or just. Their politics is different. They’re different countries. Most of the countries of the world have official languages and IIRC we’re the only country in the world with birthright citizenship. Many of the countries in the world have state religions. I’m not claiming that any of these causes our apparently different view of the limits of government. I’m just saying that we’re not France or Germany or any other country. We are ourselves and the burden of proof that a larger and more activist government can be fiscally responsible lies on those arguing for it. Clearly, the historical evidence doesn’t support the proposition.
Mr. Chait does make a stronger argument:
There are numerous problems with this thesis. One is that it doesn’t consider the possibility that no government ever tried to set tax rates at such a level that they’d be expected to produce revenues much higher than 20% of GDP.
If any American administration had tried to increase the size and actions of government abruptly they’d have run into political, legal, social, and practical problems. The Obama administration has run into such problems with ARRA. To their dismay they learned that “shovel-ready” actually meant “shovel-ready after some indefinite period of lead time”.
Or, alternatively, they’d have needed to run a surplus. Which brings up what seems to me the strongest critique of Keynesian attempts at engineering the business cycle. If you respond to economic downturns with counter-cyclical deficit spending, to maintain fiscal stability you must respond to upswings with pro-cyclical real spending cuts or increase revenue so that you run surpluses and no administration has had the political will or, possibly, the ability to do so.
There is an ancient fable usually (although not exclusively) associated with the invention of chess. I’ve heard versions with a Chinese sage, a Persian vizier, and a Roman general as its protagonist. In the version I’ve heard most frequently the king offered the Hindu sage Sissa whatever his heart desired as a reward for creating the game of chess. Sissa responded with a modest request: place one grain of wheat on the first square of the chessboard, two on the second, four on the third, eight on the fourth, and so on, doubling the number of grains placed on each successive square. What seems initially a small amount by the 64th square has become an impossibly large amount, 264 (18,446,744,073,709,551,615), plus, of course, the amounts on all the previous squares.
This fable illustrates a principle that completely eludes most people, the power of compounding. It seems particularly difficult for the mathematically illiterate which, unfortunately, includes most of our political class who in all likelihood haven’t taken a math course since junior high trig and that was a couple of generations ago.
Borrowing an additional amount each year, even if it’s a seemingly small 2% or 3% a year doesn’t result in a linear progression. By the power of compound interest it’s significantly more than that and over time will eventually result in interest payments that are impossibly high, regardless of how rich we may become. Compounding also explains why we’re richer than our European cousins: our economy has grown just a little bit faster than their economies have every year. Over time that becomes quite a gap.
If doing more by taxing more is not a politically possible strategy for doing more through government, doing more by borrowing is not a physically possible strategy for doing so. Think of the grains of wheat.
There are limits to the size of government, the limit is conditioned by political, social, and physical reality, and, since different countries have different cultures, the limit will vary from country to country. If the rule of thumb represented by Hauser’s Law is as true as it certainly appears to be, we may have reached that limit. If there’s something else you want to do, you must find something that we’re doing now that costs the same or less than what you want to do and figure out a way for us to stop doing it.
Update
After writing this post it occurred to me that I’d neglected one way other than increased revenues or borrowing that the federal government could increase its scope of operations. Growth. If revenues remain a fixed proportion of GDP, as GDP rises so will revenues.
Growth is not a solution for our fiscal problems. There is no foreseeable rate of growth that meets the foreseeable growth in spending. The numbers simply don’t support it.
The thing with Hauser’s law is that I don’t think it measures the full size and scope of government. If government imposes a mandata (smog checks) on drivers that is a cost that should, IMO, be counted in the government column but likely is not. As such looking just at tax reciepts will likely understimate the magnitude of government. In fact, its a great way for politicians to claim to being doing something about the environment without having explicit taxes.
Another thing suppose we looked at government an applied GAAP to government spending. I think we’d see alot more spending than we currently do. For example, are all the expenditures for Iraq and Afghanistan on the government books are are they pulling an Enron and moving those expenditures to offshore entities to make the bottom line look better than it is?
Steve,
I don’t think mandates are a reasonable or viable addition to measuring the “size” of government (what does “size” mean anyway?) How do you determine the cost of building codes, auto liability insurance requirements, food labeling requirements, etc.? Even if it’s reasonable to include those costs (which I think is debatable) they are nearly impossible to estimate.
Exactly my point, the part about estimating, it is a great way for the government to do stuff without having to pay for it. It is like me saying, I spend on a $1 a day on living expenses and ignore that you buy my food, clothing, gasoline, pay my rent, etc. My living costs are clearly not $1/day.
As for the cost of such things, the Cato Institute tries.
http://www.cato.org/pub_display.php?pub_id=4271 and more at,
http://www.cato.org/tech/pubs/10kc_2002.pdf
And you are not stating my point correctly in that I didn’t say mandates are the true measure, but that they should be counted. Right now the government, because it is the government and has a monopoly on violence and makes the rules, does things that if a private business were to do them in terms of accounting the people running that business would be in prison. But not our Senators, Representatives or President.
Glad you added growth. We had functioned, sort of, on a Keynesian model until the 70s. We spent or cut taxes during recessions, then grew while not excessively spending the increased revenues during the positive part of the cycle. This let us work down our huge debt at the end of WWII. With the advent of the conservative Republican presidents, we stopped this behavior and engaged in only tax cutting without the fiscal restraints of the past.
Steve
I don’t think so. Quite to the contrary I think the post-war period to date is a pretty good example of compounding. See this graph for example. The early part appears to be vaguely linear downwards. Then, following the anomaly of the dot-com boom, there’s a sharp plunge. That’s exactly the behavior that compounding shows—during the early period it appears nearly linear and then what looks like a sharp acceleration.
Compare it with GDP.
Steve
Try this out. Same phenomenon. Since roughly 1950 the deficit as a percentage of GDP shows the same greater than linear behavior once the dot-com anomaly is removed.
Dave,
I think your point is made even better by looking at the per-capita deficit in constant dollars.
I still think you are better off looking at debt rather than deficits if you are claiming compounding. Compounding, as you define it, should also affect GDP as it grows about 3% per year. The very large swings of the last two years are a reaction to a crisis IMHO. At any rate, after WWII, debt grew at X percent per year, but up until 1980 GDP grew at X+1 (rough numbers). Prior to 1980 we did not engage in extra spending or cut taxes in such a way as to let the debt increase as a percentage of GDP.
http://zfacts.com/p/318.html
Steve
“In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes.”
So the only explanation you can come up with is, that if you try to tax the rich, they are able to avoid it because the have enough control over the government to avoid taxes.
Probably factor is the hold the right has on the US media enabling the rich to spread anti tax propaganda virtually unopposed.
I’m not sure who you’re addressing with that comment, emusia. If you look closely you’ll find that what you’re quoting is itself a quotation from David Ranson from the WSJ, not something I wrote.
If you’re addressing me, you might want to look around here. I opposed the “Bush tax cuts”, opposed their extension by President Obama and the lame duck Democratic Congress, and believe that tax increases, particularly a return to the Clinton era tax rates on the incomes of higher earning taxpayers, are a necessary part of bringing our fiscal house in order.
However, I also believe that believing that we can tax our way to prosperity is either delusional or political pandering. We need to make major spending cuts including cuts in Medicare and defense spending to get onto the right track.