Starve the Beast or Explode the Deficit? the Effects of Tax Cuts on Government Spending

The hypothesis that reductions in taxes reduce future government spending is often cited as a reason for cutting taxes. Despite its prominence in debates over fiscal policy, however, this view has been subject to little investigation. Because taxes change for many reasons, both legislated and unlegislated, examinations of the relationship between overall measures of taxation and subsequent spending are plagued by problems of reverse causation and omitted variable bias. This paper therefore focuses on the behavior of spending following legislated changes in taxes not motivated by current or planned changes in spending, a desire to reduce a persistent budget deficit, or short-run macroeconomic considerations. The results provide no support for the hypothesis that tax cuts restrain government spending. The results suggest, however, that tax cuts may cause a shift in the composition of expenditures toward defense spending. They also indicate that the main effect of legislated tax changes on the overall government budget is to induce subsequent tax changes in the opposite direction. Examination of four episodes of major tax cuts reinforces these conclusions. Christina D. Romer David H. Romer Department of Economics Department of Economics University of California, Berkeley University of California, Berkeley Berkeley, CA 94720-3880 Berkeley, CA 94720-3880 [email protected] [email protected] In a speech urging passage of the 1981 tax cuts, Ronald Reagan made the following argument: Over the past decades we’ve talked of curtailing government spending so that we can then lower the tax burden. Sometimes we’ve even taken a run at doing that. But there were always those who told us that taxes couldn’t be cut until spending was reduced. Well, you know, we can lecture our children about extravagance until we run out of voice and breath. Or we can cure their extravagance by simply reducing their allowance (Address to the Nation on the Economy, 2/5/81, p. 2). This idea that cutting taxes will lead to a reduction in government spending has become a staple of conservative economic orthodoxy. Distinguished economists from Milton Friedman to Robert Barro have argued that the most effective way to shrink the size of government is to “starve the beast” by reducing tax revenues (see, for example, Friedman, 1967; Barro, 2003; and Becker, Lazear, and Murphy, 2003). Of course, this is not the only view of the effects of tax cuts. In the 1996 presidential campaign, Bill Clinton repeatedly argued that large tax cuts would “explode the deficit” (for example, Address by the President to the Democratic National Convention, 8/29/96, p. 5). Clinton’s view was that expenditures would not drop along with revenues, so the deficit would rise, perhaps uncontrollably. Some observers even argue that tax cuts may lead to increases in expenditures through “shared fiscal irresponsibility.” If some policymakers are acting without concern for the deficit, this may cause others to behave similarly, so their supporters get a piece of the pie before the inevitable fiscal reform or crisis. The question of how tax cuts affect future government spending would seem to be one that should be investigated empirically, not answered as a tenet of political faith. And, indeed, there have been attempts to look at the aggregate relationship between revenues and spending. However, such examinations of correlations are of limited value in determining the effect of revenues on spending. Revenues change for a variety of reasons. Many changes are legislated, but many others occur automatically in response to changes in the economy. And legislated tax changes themselves are motivated by numerous factors. Some, such as many increases in payroll taxes, are driven by increases in 1 Citations to presidential speeches are from the database of presidential documents available from John Woolley and Gerhard Peters, The American Presidency Project (www.presidency.ucsb.edu).