Wednesday, 21 November 2012

Steve Landsburg on debt & taxes

Landsburg's latest post has put a cat amongst the loony right, Tea Party, pigeons.
How high should taxes be? High enough to cover expected outlays going forward — but no higher. That’s because any additional revenue would be used to pay down the federal debt, which is a bad idea...Because deadweight loss (i.e. the economic damage due to the disincentive effects of taxes) is roughly proportional to the square of the tax rate, it turns out that the latter — the policy of paying interest forever without ever making a principal payment — is (at least roughly) the policy that minimizes the present value of deadweight loss.
There are two types of errors in this argument
1) During a National Emergency or a Recession, Taxes shouldn't be 'high enough to cover expected outlay'. Governments should run a deficit. Not to do so is to risk making everyone radically worse off. Thus, not borrowing during a War runs the risk of defeat and conquest, and trying to balance the budget during a recession may cause mass unemployment and a 'liquidity trap' such that Investment remains depressed though interest rates are very low. However during Peace time and/or during a boom, tax revenues should be higher than spending and the Debt should be allowed to fall so as to put the breaks on Aggregate Demand and act as an 'automatic stabilizer'.

2) That deadweight losses of taxation are the only relevant efficiency cost.  The 'crowding out' effect of Govt. spending, or the burden of servicing Govt. debt, does not matter because of 'Ricardian Equivalence'- i.e. the notion that consumers save more if they anticipate higher taxes in the future.
The problem with this line of argument is that it begs the question. It assumes the very result it sets up its equations to solve for. It's a case of garbage in, garbage out.
If consumers were the perfectly rational creatures assumed by Ricardian Equivalence, there would be no lasting deadweight loss of taxation. Elasticities of Supply and Demand would be zero in the short run and infinity in the long run. There would also be no citizens left to pay Govt. debt. They'd all have emigrated or formed a new country. 
Why does this not happen in practice? The answer is that there is uncertainty in the Economy. A fully anticipated Budget Deficit or Surplus wouldn't matter. It would tell us nothing new. But an unanticipated level of Debt does tell us something new. It tells us that we as a nation aren't as wealthy as we thought we were. We have to scale back our consumption of both private and public goods and services. We expect to see the Govt. tightening its belt same as the rest of us. During a War, or during a Depression, we may see the necessity of the Govt. running large deficits and incurring high levels of debt- but we still won't be sympathetic to measures which we consider wasteful or ostentatious. Why? Well, we may not have perfect information or rationality, but we do have some information and some rationality. If the Govt. spends money in an unproductive way, we become fearful that the productive capacity of the Economy will suffer in the long run. Our country will have lower income and worse infrastructure. To compensate, we might save more or emigrate or simply scale back our own aspirations and levels of economic engagement and interaction, preferring to be self-sufficient as far as possible or else to adopt a feckless attitude to life- indulging in more alcohol or drugs or crime than we would otherwise have done.
The problem with 'deadweight loss' type arguments is that human beings have a lot of in-built behavioral plasticity. They can side-step markets  controlled by the 'stationary bandit' of the State and find unregulated or illegal markets or types of production and exchange which they may choose to see as hedonically rewarding precisely because it frustrates what they may perceive as an inequitable or irksome State policy or practice.

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