Consulting by RPM || Free Advice Blog

There Isn’t a Spending Category Called “Deficit Reduction”

[UPDATE below.]

David R. Henderson over at EconLog praised my recent critique of a David Frum article on carbon taxes, but David had one quibble with me. I’m not sure if David and I have a genuine disagreement, or if it’s just a matter of him not understanding what I was trying to say.

Let me first set the context. Frum was arguing that not only would a carbon tax mitigate human-caused climate change, but it would also boost the conventional economy. I pointed to my recent article on the “tax interaction effect” to point out that according to the actual peer-reviewed literature, even if 100% of the revenues from a new carbon tax were used to reduce pre-existing tax rates on income, the net result would probably mean greater deadweight loss. In other words, a carbon tax is more directly damaging to the economy than the income tax, and so even a purely revenue-neutral tax swap would hurt the economy. On net the move might make sense, taking into account environmental benefits, but my point was that this growing call for a carbon tax swap as a “win-win” (for the environment and the economy) was hard to square with the actual literature.

Now, after establishing that even a revenue-neutral carbon tax swap would likely reduce (conventionally defined) economic growth, I then said: “The damage to the economy would be even greater if, as Frum suggests, some of the new carbon tax is not revenue-neutral but instead is spent (i.e. used to reduce the deficit).”

In response to this, David (Henderson) wrote: “I’m not clear why Bob sees reducing the deficit as spending.”

So let me elaborate here… My point is that Frum is not advocating a revenue-neutral carbon tax swap, rather he is advocating a net tax increase. He wants to impose a new carbon tax that will raise $1.5 trillion over the next decade, but he only wants to devote (say) $750 billion to reducing other taxes. The remaining $750 billion will be used to make the federal debt that much lower than it otherwise would be. (Note, I’m making up the 50/50 split, but the $1.5 trillion comes from Frum, based on another outfit’s estimate.)

Thus, what I was getting at is that Frum won’t use the new carbon tax receipts just to cut other taxes–he will also use them to fund government spending.

The reason I framed it like that, is that there’s no category of spending called “deficit reduction.” If the government spends $4 trillion on programs A, B, C, …, Z, while it only takes in $3 trillion in tax receipts, then it has a $1 trillion deficit. If the government then levies a new surtax on millionaires and raises an extra $10 billion, that money goes into some program, say program D, which is bullets for troops in Afghanistan. The government ends up borrowing $990 billion (instead of $1 trillion), of course, but strictly speaking the new tax revenue goes into spending.

Now in fairness, someone (perhaps David himself?) could object along the following lines: “Bob, that’s misleading. When people complain about new taxes being used to fund ‘spending,’ they mean new spending, i.e. that the government spends more on A, B, C, …, Z than it otherwise would have, because now it has more receipts at its disposal. Frum wasn’t arguing for an increase in total spending, he was merely coming up with a way to reduce the deficit needed to finance what was already baked into the cake. Since deficits are effectively future taxes, whether we use carbon tax revenues to reduce income taxes today, or to reduce the budget deficit, either way they are being used to cut taxes–it’s just in the latter case, we’re using it to cut future taxes.”

If that’s what David had in mind, fair enough. But I would then come back myself and say: In the absence of $1.5 trillion in new carbon tax receipts, I think the pressure will be greater upon the politicians to cut spending, if not in absolute terms, at least relative to what it otherwise would be. Chief among the motivations will be the soaring government debt.

Thus, whether in a simplistic or fully-Ricardian sense, I think David Frum’s suggestion to levy a carbon tax and use some of its revenues to “cut the deficit” will in fact lead to more government spending than would otherwise occur. Since even a 100% revenue-neutral carbon tax will likely reduce economic growth, this alternate proposal will be much worse.

UPDATE: I forgot to mention, the reason I have this particular bee in my bonnet, is that during the first George W. Bush Administration (I think?), there was a proposal to allow taxpayers to check a box on their 1040s earmarking 10% of their taxes to “deficit reduction.” The idea was, you could require the government to set aside 10% of your tax payment to reduce the deficit, rather than to fund spending. That was clearly a gimmick that made no sense at all; 100% of what you send in, is used to make the deficit smaller than it otherwise would be, and 100% of what you send in, is used to fund actual government programs (in this context). The only way this conceivably could have made sense, is if the total government budget growth would be constrained, based on how many people checked their boxes. Clearly there was nothing like this behind the idea; it was just a dumb gimmick.