How High Should Taxes Be?

Steven Landsburg correctly observes that taxes should 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. It was almost surely a mistake to run up this much debt in the first place, but now that we’ve got it, the best thing to do is to keep it forever….

The right policy, then, is to estimate future outlays including interest on the existing debt but not including any principal payments on that debt, and to set tax rates so that revenues match those outlays in a typical year. Insofar as Mr. Obama asks for more than that, he’s either a) planning higher future spending than he’s admitting to or b) embarking on a reckless policy of debt reduction.

The following discussion is for the benefit of readers who may remain unenlightened by Landsburg’s explanation.

I begin with the parties to the spending-lending-taxing triangle:

A — beneficiaries of government programs who provide no products or services in return (i.e., recipients of “entitlement” spending, the largest and fastest growing aspect of U.S. government spending)

B — lenders who are willing to underwrite that spending in return for interest payments of 3 percent on the amounts lent (the principal)

C — taxpayers who are “responsible” for the payment of the interest on the loan and who would also bear the cost of repaying the principal if government decided to retire the debt.

Take it as given, for the purpose of this example, that there is little overlap between A, B, and C. A‘s tax payments are either zero or de minimis — because A (mainly) represents the non-taxpaying 47 percent invoked by Mitt Romney during the recent presidential race. B represents a mix of foreign lenders and a relatively small contingent of American entities. C stands for the millions of taxpayers who bear the burden of U.S. government spending — the other 53 percent — especially those in the upper reaches of the income distribution.

Now suppose that in year 1 the government gives A $100 and finances the expenditure by borrowing the sum from B. If the loan is for 10 years at 3 percent, the transaction could be structured in one of two ways:

  1. annual interest payments of 3 percent ($3), with a “balloon” of $100, which can be paid off by finding a new lender (a debt roll-over); or
  2. annual payments of $12.84, which would reduce the debt to zero after 10 years, while giving the lender a return of 3 percent on the unpaid balance.

Option 1 burdens C with annual payments of $3. Option 2 raises the annual burden by $9.84. That is a deadweight loss to C — a burden that is imposed on C without a compensating benefit.

But what about the benefit that C will reap in the future, when C becomes A and takes his turn at the public trough? Well, because the taxes imposed on C force him to forgo remunerative investments, C would be made whole only if his future benefits are somewhat larger than A‘s current benefits, and only then to the extent that his valuation of those benefits matches their nominal valuation. (A healthy C, for example, would place little value on Medicare.) Further, there is reasonable doubt that the A of the future will be as well-fed as the A of today.

No matter how you slice it, A‘s “free lunch” is a bad deal for C. A deadweight loss, to be sure.

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