Friday, April 1, 2011

Tax hikes or deficit spending: Which one is better?

Inspired by Pablo's post, where he asked us readers and contributors of Rightspeak to choose between raising taxes and running deficits, I am now going to explain the effects of both.

For those who have followed me (and Pablo) for some time, you may recall that back on ROS, we had quite a debate about tax cuts and whether they can lower the deficit; I argued that they can, while Pablo argued that they can't. For someone who followed that debate, it may be surprising to read that I prefer tax hikes.

Someone in the comment field remarked that when government raise taxes, private sector investment is choked, and growth decreases. And, we need growth to be able to raise revenue and pay back the debt.

All those points are correct.

Still, tax hikes are better.

The commenter ignores the other side of the coin; deficits does the exact same thing! The federal government is borrowing from the same pool of money as the private sector, so when the government borrows more, that means there is less money left over for the rest of us. It means that mortgages become more expensive, that you'll have to pay more interest if you want to borrow to start a company and that companies may have a hard time finding anyone willing to lend them money and so they'll have to issue shares instead.

A tax hike, on the other hand, which leads to a lower deficit will make borrowing easier. This will spur investment, which leads to higher growth.

Some may say that you shouldn't encourage borrowing by lowering the interest rates, but really what leads to the kind of borrowing hysteria that we saw in the early-to-mid 2000's was the printing of money out of thin air, not tax hikes (as a matter of fact, the federal reserve may sometimes feel forced to print money to lower the interest rates which goes up as a consequence of a tax cut).

If a company cannot borrow money, that means they will have to issue equity (shares) instead. This is often seen as a last resort and a sign of desperation; shareholders in general prefer to borrow money rather than issue new shares since issuing new shares causes the price per share to fall. So it's typically a last resort, and sends bad signals to the market (this only goes for companies which already have gone public). If enough companies do this, investors are going to assume that american companies are in a really bad shape, and the stock market will fall.

So is all fine then? No, of course not. Tax hikes does mean less consumption and private sector investment. The point is; both tax hikes and deficit spending can choke the private sector.

Why are tax hikes preferable? Because they are easier to reverse. If you have raised taxes and want to cut them, that's very easy politically speaking, since most people do like to get more money in their pockets. If you have run a deficit on the other hand, and you want to convince people about the need to pay it off by cutting the budget, that's a much harder thing to do. Don't believe me? Look at the polls; how many people want to cut social security? Medicare? Medicaid? You may tell them that cutting the deficit will lead to long-term growth, higher pensions and so on (and it would), but that's not going to help. Now, offering them money straight in their pocket in a tax cut, that's something they might actually accept even if it means some kind of entitlement reform.

But why not just lower the taxes? Wouldn't that cut the deficit? Isn't that the case I made on ROS? Yes, and supposing you cut the right taxes, or replaced the whole tax system with something better, you could definitely do that. However, many (most?) taxes are still low enough so that tax hikes would raise revenue, especially in the short term. The big exception is the corporate tax, which is higher than what most European countries have.

This however does not mean that you can suddenly raise taxes enough to cover the deficit; that would mean raising them by something like 50 %. My point is that tax hikes are not to be ruled out and are not to be seen as immoral in themselves. And to those of you who point out that without cutting spending, raising taxes won't work, I just want to say that you're completely right. But that doesn't mean tax hikes can be taken off the table.

I hope you understand the way I think. I realize it's pretty academical stuff, but it's important to understand. I didn't write this post to bash the guy who said that tax hikes would lead to lower private sector investment, so I really hope that neither he nor anyone else who believes similar things are offended. I merely wanted to explain my point of view. Ultimately, I believe the current tax system should be replaced with the FairTax, but that's for another post.

John G


Noelle said...

Until wasteful spending is stopped, tax hikes should be off the table. As long as tax hikes are the method to balance the budget, the politicians in Washington will always find a "worthy" way to spend money that does not belong to them. It is essential to STOP THE SPENDING. Then, and only then, if tax hikes are needed, we can look into it.

John said...

Noelle, I agree tax hikes alone can't solve anything, I wrote that at the end of the post. But I'm not sure if it's politically possible to cut as much money as needed, or if it's even practically possible to do so.

Noelle said...

My point is that tax hikes should not even be considered until spending is brought under control. As I said, I am willing to talk about tax hikes if and when the politicians learn to stop spending like drunken sailors.

John said...

Can't wait that long I'm afraid. You could lose your credit rating any moment and suddenly you'd find yourself paying outrageous interest rates. That's when you'll have to default. I got a post planned about that actually, outlining the options the US has.

DanL said...

John, this is the best stuff you've ever written.

Noelle said...

We don't have to default if we will STOP WITH THE WASTEFUL SPENDING ALREADY!!! We had better make the time to stop wasting the money of US citizens. I don't want to give one more red cent to the people in Washington who think they can spend my money any ridiculous way they want, with no consideration to being responsible. That is why I want Romney. And it explains why you like Huckabee.

John said...

Thanks, DanL, I'm glad you can be positive sometimes too (I hope that compliment wasn't an April fool's joke) ;)

Noelle, I understand your anger, I really do. Yet, it's simply not likely you can cut that much money out of the budget at once. Politically, it's hard because of the possibility of a filibuster, and economically, it causes a recession (temporarily while the economy restructures, but could still be tough politically).

Noelle said...

You are not hearing what I am saying. I am not talking about balancing the budget on budget cuts. I am talking about eliminating wasteful spending. As soon as we increase the tax revenue, the politicians will find 10 more ways to spend it and the spending problem will continue. My point is BEFORE adding taxes, correct the spending problem. You have the order all wrong. Stop the wasteful spending. Establish fiscal discipline, then, if needed, let's talk about tax hikes. If you start with tax hikes, the spending problem will get worse and the deficit will get worse, and the debt ceiling will have to be raised yet again and again and again.

Back during the so-called debate about the federal health care legislation, I heard some liberal talking about how they were going to save money to pay for the health care reform by eliminating waste in medicare and medicaid. You see, they were spending money before they even had it in their hot little hands. I want them to find and eliminate the waste in medicare and medicaid, as well as all of the other programs, and use that money to pay down our debt. They would rather find another place to spend it.

The politicians have proven over and over again that they have ZERO respect for our money, and our hard work. They take it and spend it with no consideration whatsoever. I REFUSE to support any additional taxes until I see fiscal discipline in Washington.