Can’t Cut Spending? Look Around the Globe

By TYLER COWEN
Published: April 16, 2010
Source: The New York Times.

AMERICA’S long-run fiscal outlook is bleak, mostly because of an aging population and rising health care costs. To close the gap between expenditures and revenue, we’ll likely see a combination of revenue increases and spending cuts. And we’ll need to focus especially on reducing spending, largely because that taxes on the wealthy can be raised only so high.

Consider the tax burden on high earners once the Bush administration’s tax cuts expire next year. Add up the federal, state, city and sales taxes for a lawyer in New York City who earns $300,000 a year. Depending on the circumstances, this individual could be facing marginal tax rates in the range of 60 percent. Higher income tax rates would discourage hard work and encourage tax avoidance, thereby defeating the purpose of the tax increases.

The most potent way to add revenue is to impose a value-added tax. As its name indicates, a V.A.T. takes some percentage of the value added at each stage of production. V.A.T.’s raise money so readily and so invisibly that they often climb to a range of 15 to 20 percent; politicians like the revenue, and voters don’t always notice the burden.

A move toward a V.A.T., however, also brings price inflation, a big increase in the tax-collecting bureaucracy and the emergence of favored sectors with exemptions or lower rates. Though we may well end up with a V.A.T., it isn’t obviously the best option.

Burdening citizens with much higher taxes would fundamentally change what this country is about. Our founders envisioned a government that would provide public goods but not guarantee everyone’s well-being against every possible obstacle. Immigrants would be offered a franchise to come here and make good if they could — while bearing considerable risk themselves. To this day, this openness has elevated many millions in health, prosperity and liberty — and enabled many newcomers to innovate and offer new goods and services, or scientific ideas, to the world.

Higher levels of government spending and taxation would also soak up resources that might otherwise foster innovation and new businesses. And sentiment would most likely turn ever stronger against those immigrants who consume public services and make the deficit higher in the short run. Current residents might feel more secure in a larger welfare state, but over time the loss of commerce and innovation takes a toll.

The macroeconomic evidence also suggests the wisdom of emphasizing spending cuts. In a recent paper, Alberto Alesina and Silvia Ardagna, economics professors at Harvard, found that in developed countries, spending cuts were the key to successful fiscal adjustments — and were generally better for the economy than tax increases. Their conclusion was based on data since 1970 from the Organization for Economic Cooperation and Development.

The received wisdom in the United States is that deep spending cuts are politically impossible. But a number of economically advanced countries, including Sweden, Finland, Canada and, most recently, Ireland, have cut their government budgets when needed.

Most relevant, perhaps, is Canada, which cut federal government spending by about 20 percent from 1992 to 1997. The Liberal Party, headed by Jean Chrétien as prime minister and Paul Martin as finance minister, led most of this shift. Prompted by the financial debacle in Mexico, Canadian leaders had the courage and the foresight to make those spending cuts before a fiscal crisis was upon them. In his book “In the Long Run We’re All Dead: The Canadian Turn to Fiscal Restraint,” Timothy Lewis describes Canada’s move from fiscal irresponsibility to a balanced budget — a history that helps explain why the country has managed the current global recession relatively well.

To be sure, the spending cuts meant fewer government services, most of all for health care, and big cuts in agricultural subsidies. But Canada remained a highly humane society, and American liberals continue to cite it as a beacon of progressive values.

Counterintuitively, the relatively strong Canadian trust in government may have paved the way for government spending cuts, a pattern that also appears in Scandinavia. Citizens were told by their government leadership that such cuts were necessary and, to some extent, they trusted the messenger.

IT’S less obvious that the United States can head down the same path, partly because many Americans are so cynical about policy makers. In many ways, this cynicism may be justified, but it is not always helpful, as it lowers trust and impedes useful social bargains.

Forces like the Tea Party movement argue for fiscal conservatism, though it isn’t obvious that they are creating the conditions for success. Over the last year, we have been treated to the spectacle of conservatives defending Medicare against proposed cuts, in large part to curry favor with voters and mobilize sentiment against the Democratic health care plan.

Right now there is plenty of concern about debt and deficits, but little consensus on which expenditures should be cut or reined in. Sooner or later, we’ll have to reconsider virtually every segment of the federal budget.

The issue of fiscal responsibility isn’t going away. So the question is now this: How deeply will we dig ourselves in before we create a more mature and more forward-looking political culture?

Tyler Cowen is a professor of economics at George Mason University.