Carolina Journal

by John Hood

RALEIGH – If you want to understand why the fiscal politics of Raleigh and Washington got so heated this summer, you have two choices.

One is to delve deeply into the details of each Democratic and Republican proposal to balance government budgets. I’m certainly not going to dissuade you from doing so. For North Carolina’s budget, the John Locke Foundation offers you some handy spades and shovels.

Another way to examine the issue, however, is to stay general and conceptual. At its core, what the debate is really about is whether our fiscal problems are driven by too much spending or too little revenue.

As I have previously observed, there is some evidence for both propositions. At the federal level, for example, expenditures as a share of gross domestic product have been way above the historical norm for several years. Score one for the GOP. But it’s also true that federal revenues as a share of GDP have been significantly below the historical norm. Score one for the Dems.

The reason the conservatives ultimately have the better argument here is that if you turn your attention away from the 2008-11 period, looking at historical trends back in time and at fiscal projections forward in time, you will see that budgetary balance is impossible without spending restraint. It is possible without tax hikes.

Recessions make deficits bigger in two ways. First, they lead to spending increases on programs such as unemployment compensation. Second, they lead to lower-than-expected revenues because some taxpayers lose their jobs and others lose enough income to fall into lower tax brackets.

When the economy recovers, these effects on state and federal budgets will dissipate. Higher employment will bring somewhat-lower expenditures and somewhat-higher revenues.

In Washington, the longtime trend has been a persistent gap between historical rates of revenue collection (between 18 percent and 19 percent of GDP) and historical rates of spending (between 20 percent and 21 percent of GDP). There was a brief period of operating-budget balance in the late 1990s, driven primarily by Pentagon cuts and dot.com-era tax collections. The economic and national-security events of 2000 to 2003 ended both phenomena.

At the current, Bush-era tax rates, federal revenues were at the historical norm as recently as 2007. Economic recovery will, in other words, bring us back to that level without having to jack up federal tax rates.

But on the spending side, most of the deficits projected for the next two decades reflect growth in Medicare, Medicaid, and other entitlements that are not closely tied to the economic cycle. Economic recovery won’t change the forecasts much.

To broaden the picture a bit, remember that a significant share of federal borrowing over the past two decades has really been to finance state and local spending – thus evading balanced-budget requirements at those levels of government. That means that we really ought to be thinking about the total burden of government taxes and spending.

According to data from the Tax Foundation, Americans will pay about 28 percent of their personal income in total taxes in 2011. That’s the average. Poorer households will pay less (around 16 percent to 20 percent is a reasonable estimate) and wealthier households will pay more (about 29 percent to 31 percent), with middle-income households paying somewhere between 20 percent and 25 percent.

Keep in mind that these statistics are for taxes alone. Government imposes other costs on households, such as regulatory compliance and fees. But for now, let’s focus on the tax measure.

If you compare the overall 2011 tax burden, 28 percent, to past levels, you can certainly see it as a recessionary drop. In 2006 and 2007, for example, taxes totaled about 31 percent of personal income. That’s similar to the total tax burden Americans paid in most of the 1970s, 1980s, and 1990s. So once the economy recovers, we can expect to see total tax collections rise back towards that 31 percent figure.

Unfortunately, federal, state, and local politicians have promised to spend far more than 31 percent of income on government programs. It is highly unlikely that trying to push the tax burden to 35 percent or beyond will generate greater benefits (in valuable services) than costs (in lower economic output).

So, yes, the real problem is on the spending side.

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Hood is president of the John Locke Foundation.