The True Costs of Government Spending
By Michael J. Boskin
While every president makes foolish statements, this must be the most economically illiterate presidential utterance since Jimmy Carter’s demand that the Federal Reserve lower interest rates in the midst of surging double-digit inflation.
In Carter’s case, the result was a dollar crisis. What will come of the Biden administration’s foray into nonsense?
Biden, along with other Democratic leaders such as Speaker of the House Nancy Pelosi, claims that the plan will be “fully paid for” with tax hikes. Apparently, the administration thinks that only budget deficits impose costs (which runs contrary to the “deficits are costless” argument offered by other “progressives”). Yet it has long been clear that the bill would leave a $1.5-$3 trillion hole to be filled with debt even after the tax hikes.
In any case, Americans aren’t buying it. Polls show that roughly half want less government and lower taxes and that three-quarters of Americans doubt that the $3.5 trillion bill would make them “better off.” Perhaps not surprisingly, a majority now disapproves of the Biden administration.
Students in introductory economics learn that the social cost of something is the value of the goods and services that could have been produced with the same resources (labor, capital, land, energy, materials). Usually, this “opportunity cost” can be measured by market prices – though sometimes these must be adjusted to account for other factors, such as pollution or monopolies.
From a basic economics standpoint, there are three fundamental errors in Biden’s “zero-cost” argument. First, there is the suggestion that the proper measure of cost is the impact on the federal fiscal position. The notion that a country’s wealth lies in the value of the sovereign’s Treasury was destroyed by Adam Smith 245 years ago. He showed that wealth comes from the country’s ability to produce goods and services that people need and want. For any country, the cost of government spending is the value of the foregone opportunities from shifting resources from the private sector to the government. Less private consumption and less private investment leads to less housing and fewer factories.
Second, taxes are far from costless, because they, too, divert resources from the private sector and thus impose an opportunity cost. Just as sales taxes primarily affect consumption, corporate income taxes affect investment. The cost is the value of the displaced private consumption and/or investment.
The third fundamental flaw in Biden’s approach is the notion that the cost can be measured just by the dollar amounts involved. In reality,these are far higher than stated. Not only are there administrative and compliance costs, but there is also the economic damage that taxes cause by distorting incentives. For example, income taxes reduce incentives to work and to save (though this is partially offset by tax-deferred savings accounts); corporate taxes reduce incentives to invest; and progressive tax rates decrease incentives to invest in one’s skills.
Every introductory economics class teaches that the harm these distortions cause rises with the square of the tax rate and the responsiveness of the taxed activities. Doubling the rate quadruples the inefficiency cost (what economists call deadweight loss) of the tax. The effective tax rate takes into account all taxes on the activity, for example, state, local, and federal income taxes.
This is not a doctrinal issue; it is simply a description of what is happening in the areas under the supply and demand curves on a graph. Spending $5 trillion will cost the economy about $6.5 trillion, because the marginal cost of federal dollars is estimated to fall in the $1.30 range. For a government spending program to be considered sensible, it must provide benefits of at least $1.30 per dollar of spending.
Especially damaging to the economy would be the proposed tax hikes on capital income, as this introduces a tax distortion that compounds over time as horizons lengthen. That would both harm economic growth and create bigger obstacles to more people getting ahead financially – building their own wealth, reducing their dependence on government, and, yes, becoming rich.
The promises of universal pre-school, free community college and other entitlements are deeply misleading. Taxpayers, after all, will pay for the salaries, the facilities, the computers and the electricity needed for these ongoing services. It would be more truthful for Biden to say: “I know these costs are huge, even larger than the estimated budgetary impact. Here is my rationale and evidence, program by program, that the efficiency or distributional benefits so outweigh these costs as to justify taking the resources from families and firms, now or in the future.”
Exactly when exaggeration crosses a line into deliberate deception is debatable. President Barack Obama either knew, or should have known, that he was issuing a blatant falsehood when he said, “If you like your doctor, you can keep your doctor, period. If you like your health-care plan, you can keep your health-care plan, period.” (To his credit, he later reversed his claim that the 2009 stimulus bill would soon create lots of construction jobs, admitting in 2010 that “there’s no such thing as shovel-ready projects.”) And, of course, President Donald Trump made a habit of excessive claims.
Political hyperbole is par for the course. But like so much else, it seems to have gotten worse, and with fewer consequences. We would all be better off if more elected officials followed the example of Fiorello La Guardia, the mayor of New York City from 1934 to 1945, who, in admitting error, boasted, “When I make a mistake, it’s a beauty.”
Michael J. Boskin, a professor of economics at Stanford University and senior fellow at the Hoover Institution, was chairman of George H.W. Bush’s Council of Economic Advisers from 1989 to 1993. This was first published by Project Syndicate — “The True Costs of Government Spending“.