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The Budget Problem: Lower Government Spending or Higher Taxes; Which is it?

By Edited Nov 13, 2013 0 0

How to deal with record government debt levels is on the minds of millions of people worldwide; probably more so than at anytime in history.  The answer to this question will apply in almost any economy on earth, and with so many of them in desperate trouble, it warrants looking at carefully.

In the United States, the debate on whether we should cut or increase government spending and taxes continues.  Both sides are adamant that their method is the proper way to lower the US budget deficit.  Republicans claim that raising taxes will cause a weak recovery to collapse; Democrats claim that raising taxes (primarily on the wealthy) will go a long way toward reducing government debt.

A chart from the Office of Management and Budget[4095] shows that while national revenue has dipped in recent years due to the recession, spending has continued to increase unabated.  Only during World War II did we have a higher debt level then we do now.  However, even it will pale in comparison to the debt levels facing us based on current spending and tax policies.

Since the solutions from each side are so tied to political ideology, it would be a good idea to step back and take a broader perspective at the situation; to look at real data that spans periods when each party controlled congress.

 In business, we expect businesses to adjust their expenses when revenues decrease.  That is in part why we feel the effects of a recession so severely.  Businesses lay off employees (the single largest business cost) and trim other costs until profitability returns.  If it doesn’t, the business will close or go bankrupt.  Businesses carry out measures to improve productivity and lower costs.  The result is a more efficient business that can survive until a return of consumer demand allows the return of corporate profitability. 

But, we don’t see the same level of budgetary constraint with national, state, or local governments.  The chart included here from US Bureau of Economic Analysis data shows government income and expenses over the last eighty years.  You can see that since the 1950’s government revenue has remained between 15 – 20% of GDP.  Expense, on the other hand has consistently stayed higher, running between about 17% and 25% of GDP.

Political philosophy aside, eighty years of spending more than the country brings in each year is not sustainable.  We have gotten used to all the programs the government funds each year, and for the most part, they are all worthy programs that do much good for society.  However, if we had implemented the practice that no program be funded without the revenue set aside for it, many of them would not exist in the first place.

So, do we raise taxes or cut government spending?   Heritage.Org in a study of Office of Budget and Management data, demonstrated that raising tax rates does lead to increased tax revenue.   On the other hand, economist Paul Krugman argues that tax cuts don't raise tax revenue.

During the decade from 1980 to 1990 when Ronald Regan was president, he lowered the top tax rates from 70% to 28%, the famous "Regan Tax Cuts".  Tax revenue during 1979 to 1990 rose nearly 80% and is often cited as the evidence that lowering taxes will actually raise tax income. Krugman argues, that when corrected for inflation and population growth, the increase was only about 19% per capita over the decade, or 1.9% per year.  This is nowhere near the 3.2% per year  for the decade after that.

But let's think about this.  If they cut the  tax rates by more than 50%, and we still grew the tax revenue by 1.9% per year, that means that cutting taxes did not hurt the county's revenue.  So, where did the income materialize from?  And if tax rates remained low for the following decade, how did revenue continue to grow by another 68% (1.9% to 3.2% per year).

Part of the answer comes from IRS data.   The IRS in a “Trends in Business” report demonstrated that from 1980 – 1990 the number of business (of all types) increased by over 45%, with corresponding increases in total business revenue and net profit. It is from this larger capital base that the government was able to keep up its revenue in the face of lower tax rates. 

In the graph shown earlier, you can see that the level of government income since about 1960 has remained in the range of 10% of GDP.  The US Gross Domestic Product (GDP), itself, has continually grown throughout the last hundred years, except for a few years during the Great Depression of the 1930's and in the first years of the 2008 depression.   Put the two of these together and we can see that government income has continued to grow in the face of drastic income tax cuts.

Since the 1980's, the United States has gone through a process of replacing income tax revenue with revenue derived from a growing business sector.  This business sector growth brought jobs, which brought income to the individual households, far more than any tax rebate might have.  Business tax revenue grew, and business profits grew;  both taxed.  Business owners or shareholders received more income and dividends, providing income to the government. 

The point is that allowing business to grow, will give much more stimulus to the struggling economy than any program the government can start.  In addition, growing businesses are self-sustaining; they don't need more stimulus to keep them running.  Government programs on the other hand are finite in time, limited in scope and are non-revenue generating.  They cannot be maintained without renewing the budget item that funds them.  We need to keep the current tax rate.  It has been effective over the last thirty years . Helping business grow will give the economy the spending it needs in  to bring the county back into financial health.

The 2012 Long-Term Budget Outlook(102412)
Credit: Congressional Budget Office
US Government Income and Expense 1930- 2011
Credit: US Bureau of Economic Analysis


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  1. United States Office of Management and Budget "The 2012 Long-Term Budget Outlook." The 2012 Long-Term Budget Outlook. 5/06/2012. 13/06/2012 <Web >

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