Republicans are fretting about the fallout if they fail to reach a spending agreement with Democrats before year’s end. Automatic spending cuts and tax increases will go into effect on January 1 without legislative intervention, and both sides are so concerned that they've labeled the changes the “fiscal cliff.” Despite the media frenzy over this so-called cliff, fiscal conservatives and libertarians, particularly those younger than 30, shouldn't worry. In fact, gridlock may be the best possible policy outcome given current political constraints.
On the spending side, roughly equal cuts will automatically be made to defense and discretionary spending, though the size of the cuts are small — less than 3% of total federal spending next year. However, the cuts are only on baseline spending. That is, a cut to what projected spending would have been. Spending will still go up every year.
The tax policy changes are more significant. Without a deal, the Bush tax cuts will expire, which would increase federal taxes on income, capital gains, and dividends. Payroll taxes are scheduled to increase on the same day. These are projected to bring in around $400 billion according to the CBO. However, more than twice that would be needed, in concert with the above spending cuts, to eliminate this year's $1.17 trillion deficit.
Fiscal conservatives are usually opposed to tax increases by nature, and for good reason. For one, higher taxes mean more money will be taken from individuals and given to the government to be spent on programs of dubious legitimacy or value.
Some fiscal conservatives subscribe to a theory called “starve the beast.” The idea is that by depriving the government of tax revenue, Congress will be constrained in how much it can spend. This, in turn, maximizes the size of the productive sector of the economy relative to the size of the “beast,” that is, the government.
Many smart people, including the late, libertarian Nobel Laureate Milton Friedman, agree. While I am sympathetic to their dim view of government, those who believe tax cuts will shrink the size of government have been proven incorrect by current policy. Government spending is the problem, not taxes themselves. Rather than depriving the government of revenue, tax cuts without a proportional cut in spending simply increase the amount government borrows.
According to the late economist Bill Niskanen, long-time chairman of the libertarian Cato Institute and economic adviser to President Ronald Reagan, borrowing itself leads to higher levels of spending.
“Federal spending is better described as buying government services at a discount equal to the deficit, the costs of which will be born by someone sometime in the future,” he wrote in a 2006 paper. “Starve the beast just does not work.” Empirically, past behavior by Congress supports his view. Not only have tax increases led to spending cuts in the past, but tax cuts have usually led to higher government spending.
Niskanen wasn't alone. Free-market economist and Nobel laureate James Buchanan wrote about a “fiscal illusion” that biases taxpayers to support more government services because the connection between spending and taxation can be obscured. In a later paper, Berkeley economists Christina and David Romer confirmed Niskanen's empirical results.
Critics of tax increases often make the case that higher levels of taxation will lead to lower levels of investment, lower productivity, lower economic growth, and yield lower revenue than the CBO predicts. Eliminate the deficit with spending cuts instead, they argue.
These assessments are all correct, and a spending cut to match revenues at current levels of taxation would be better than a tax hike. However, no reasonable person should expect Republicans to cut spending for one simple reason: they don't want actually want to. As George W. Bush demonstrated, Republican commitments lie with Social Security and Medicare, two programs whose financial health are going to seriously deteriorate over coming years.
Without drastic cuts in current spending and future entitlements we'll still experience all the problems budget hawks forecast, just further in the future. After all, a dollar borrowed now is simply a dollar to be taxed later. By then current beneficiaries of government largesse will either be dead or past their prime earning — and tax-paying — years.
On average, young people earn significantly less than older people, and therefore pay lower taxes. The tax hikes associated with going over the cliff will fall most heavily on older taxpayers. Tax hikes now will simultaneously mitigate the intergenerational transfer of wealth that is being imposed on us by deficit spending, and lower the overall level of spending preferred by the general voting population.
Low taxes and low spending is the ideal fiscal arrangement, but in the absence of any credible plan to cut entitlements and current spending, fiscal conservatives, especially the young, should hope we go over the fiscal cliff.