Monday, August 27, 2018

Shielding Government from Recessions

There is an interesting issue rising in the Wyoming gubernatorial race, an issue that has national interest. Democrat candidate Mary Throne has stated repeatedly that she wants to take the Wyoming economy out of its boom-and-bust cycle. In reality, she wants to shield government from the business cycle that is inherent to the private sector.


This idea of a government that is immune to recessions is far bigger than Wyoming. It is, in fact, a wet dream of every statist legislator around the country: recessions reduce tax revenue; with reduced tax revenue come deficits; with deficits come demands for spending cuts. Statists live by the aphorism "Cutting spending, like eating children, is wrong", which makes it imperative for them to find a way to protect government from the business cycle.

It is, of course, impossible to keep any corner of the economy out of the business cycle. All the resources that government spends originate with the private sector. Government does not originate any economic value, it only redistributes what the private sector has already provided. The reason for this is simple: the private sector operates on the open market, where every transaction is voluntary and subject to more or less intense competition.

Under the conditions of the free market, people who engage in gainful trade add value to the economy. Since transactions are voluntary, they meet the needs and wants of buyers with a precision that no other form of trade can match. The selection process involved in free-market trade is a guarantee for value added.

Since government does not engage in voluntary trade, but forces people to contribute, there is no value created in the process.

The distinction between the value added by gainful exchange on a free market, and the value redistribution of government, is important in the context of efforts to shield government from the business cycle. To see why, let us work through a regular business cycle scenario.

In Figure 1, g is the growth rate in percent in annual government spending. It is assumed to be constant over time. Private-sector activity grows cyclically, with a peak of p1 in the growth period (green) and a trough of p2 in the recession (red):

Figure 1

The theory behind shielding government from the business cycle suggests that government shore up tax revenue in the growth period and use it to fund a shortfall in the recession. Unfortunately, this theory does not work in reality, and there are primarily three reasons for this. 

First, the business cycle does not look like this nice theory suggests. Just to take one example, the latest recession we had, which has gone down in history as the Great Recession (alluding to the Great Depression of the 1930s), was deeper and more protracted than other, recent recessions. The balance between the preceding growth period and this recession could be described like this:

Figure 2

In a situation like this, any surplus accumulated during the growth period will be sorely ineffective in the following recession. There is nothing that says we will not experience similar discrepancies in the future, nor is there anything in either macroeconomic theory or macroeconomic experience that says we will have extended growth periods in the future. 

In other words: the theory behind the idea to elevate government above the business cycle relies on the false notion that business cycles are symmetrical. They are not.

On a related note, it is worth point out - as I do in my book The Rise of Big Government - that there is a long-term decline in economic growth throughout the Western world. The U.S. economy has not escaped this trend, only experienced a milder version of it. Nevertheless, this means that tax revenue grows more slowly over time; if we do not adjust government spending to this lower growth rate, we build in a structural deficit into government finances. 

Figure 3 expresses this point in historic data for the federal government budget:

Figure 3
Source: Office of Management and Budget

It is worth noting that while tax revenue is increasingly cyclical, government spending is on an almost uninterrupted growth trajectory. In fact, if we remove temporary stimulus spending in the wake of the Great Recession, federal spending follows a smooth path of growth throughout the period covered by Figure 3.

The data in Figure 3 are relevant for the second reason why the theory of a business-cycle shield around government does not work in the real world. Advocates of this shield idea, especially at the state level, tend to suggest that by means of "economic development", a.k.a., corporate welfare, we can diversify a state's economy and thereby the tax base. A broader tax base means expanding taxation to economic activities that have not yet been taxed. 

There is just one problem with this. The economy moves in business cycles together. When there is a recession, 

-Personal income declines, depressing tax revenue from the individual income tax;
-Consumption declines, depressing tax revenue from sales, excise and value-added taxes;
-Corporate sales decline, depressing tax revenue from the corporate income tax;
-Property values decline, depressing tax revenue from the property tax.

In other words, a more diverse tax base is no protection against the detriments of a recession.

In some states that do not yet have an income tax, there are whispers about introducing an income tax precisely to diversify the tax base. Connecticut did this in the 1990s and there is a not-insignificant risk that Wyoming will do the same in the next couple of years. 

The Cowboy State would be making a big mistake. If the Connecticut example is not deterring enough - although it should be - perhaps Figure 4 can explain the dangers of creating a state income tax. It compares the volatility in employee compensation and tax revenue at the federal level: 

Figure 4
Sources of raw data
Bureau of Economic Analysis (Compensation of Employees); 
Office of Management and Budget (Tax Revenue)

The federal personal income tax fluctuates more than the employee compensation that constitutes its tax base. An income tax could, in other words, destabilize tax revenue, quite the opposite of what proponents tend to suggest. The only remedy is a flat-rate tax with no deduction for low-income families, hardly an appealing idea to statists.

There is a third reason to dismiss calls for a business-cycle shield around government: it would incentivize unrelenting growth in government spending. When government is impervious to the strife and struggle among its taxpayers, it will have no incentives at all to moderate its spending demands. 

Rather than shielding government from the ups and downs of the economy, perhaps it is time to shield taxpayers from the ups and ups of government spending. 

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