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At some point, the U.S. government will have to deal with its exploding debt
load. Typically, we hear that the solution involves “some combination
of reduced spending and higher taxes.” Proponents often claim that this
solution is “mathematically inevitable.”
Oh really? There are two great examples in history of
governments that got out of huge debt commitments without either defaulting
or devaluing the currency, which is essentially another form of default. One
was Britain after the Napoleonic Wars, ending in 1815; the other was the
United States, after World War II. This was quite unusual. Most governments,
when faced with excessive debts, have defaulted either legally or via currency
devaluation.
After World War II, the U.S. government had a debt/GDP ratio of about 125%. In
1970, this had fallen to 25%. During this entire period, the dollar was
pegged to gold at $35/oz. under the Bretton Woods system.
Did spending go down during this period? It did immediately after the war,
dropping from $93 billion in 1945 to $30 billion in 1948. Then, it went up,
reaching $195 billion in 1970.
Did taxes go up? No, they did not. Immediately after the war’s end,
wartime tax rates were reduced slightly. The Revenue Act of 1945 repealed an
excess profits tax, and reduced income and corporate tax rates. Tax rates
were reduced further in the Revenue Act of 1948, although they went up
slightly in the early 1950s. A fairly large tax rate reduction took place in
1964. The overall trend was a modest decrease in tax rates.
Was the debt paid off? Nope. In 1948, the federal Government had gross debt
outstanding of $252 billion. In 1970, it was $381 billion.
Apparently, when “mathematically inevitable” meets reality,
reality wins.
So, what happened? Mostly, GDP increased, so that the debt/GDP ratio declined
as a result of the expanding denominator. GDP was $233 billion in 1947 and
$1,103 billion in 1970.
How do you get GDP to expand? You use the Magic Formula: Low Taxes, Stable
Money. Stable Money was provided through the Bretton Woods gold standard
system. Tax rates weren’t as low as we would like in that period, but
they were, in many ways, lower than today. Top income tax rates were very
high, but they applied to very high incomes and were riddled with loopholes,
which is inevitable whenever you see high tax rates. Sales taxes and payroll taxes
were much lower. The general trend was for tax rates to decline during this
period. There was no “austerity” involving big tax increases, as
we have been seeing in Europe recently.
When GDP expands, tax revenues go up, which allowed the federal government to
spend more and more money. However, the government was fairly disciplined, in
those days, about not spending more than it took in. From 1950 to 1970, the
government, on average, had an annual deficit of 0.6% of GDP.
Because GDP was rising, and the total debt wasn’t growing much, people
could see that the debt/GDP ratio was falling. The situation was getting
better and better. Thus, they weren’t particularly worried that the
government would not be able to pay back its debts.
From this example, I conclude that the solution today for the U.S., or other
governments with similar issues, is: Lower Spending, Lower Taxes, and Stable
Money.
The Lower Spending is to get expenditures in line with revenues. Stop the
bleeding. However, in the longer term, as GDP expands and revenue expands,
spending can increase by a large amount. In a surprisingly short time, the
government might be spending more than it was during the days of big
deficits. In 1945, the federal government spent $92.7 billion and ran a deficit
of 21.5% of GDP. In 1960, the federal government spent $92.2 billion and had
a surplus of 0.1% of GDP.
Lower Taxes, in the first instance, means a plan to raise the same amount of
revenue, as a percentage of GDP, with a much more efficient and business-friendly
tax system. This basically means much lower tax rates, like the Flat Tax
programs that have been popular throughout eastern Europe. In
ten recent examples, Flat Tax implementation did not lead to a meaningful
decline in revenues in either nominal terms or as a percentage of GDP. The
increase in GDP, however, was impressive.
Later, we can have a discussion about even lower taxes, with the goal of
lowering the amount of tax revenue the government collects as a percentage of
GDP. Places like Singapore (14.2%) and Hong Kong (13.0%) provide all the
government services we are familiar with in the United States (26.9%) —
plus universal healthcare! But first, let’s aim for the first goal, of
collecting the same percentage in a more efficient manner.
Stable Money, ideally, means a gold standard system. (For smaller countries,
it can mean a link to a reliable international currency.) Although it is
possible to devalue the debt away, unfortunately you also devalue your
economy away at the same time. If you are going to default – countries
like Greece and Spain are probably too far gone at this point — then
just default plain and simple, but keep the Low Taxes and Stable Money so
that the private sector can continue to thrive.
Today, U.S. economic thinking alternates between “stimulus,” with
big deficits, and “austerity,” with higher taxes. Both will lead to eventual
disaster. Usually, spending doesn’t even decline much
with “austerity,” because, as the economy crumbles, the demands
on the government to provide some kind of support intensify. This has been
true of Greece recently, and
was true in the U.S. in 1932.
The most sophisticated thinkers will see that major tax reform is actually a
path toward spending reduction. As the private sector thrives, demands on the
government dwindle and spending reduction becomes politically easier.
Margaret Thatcher cut back the British socialist state, but first she reduced
tax rates to get the private economy to flourish.
As the “fiscal cliff” approaches, Congress needs to think about
its economic strategy going forward. Remember the Magic Formula: Low Taxes
and Stable Money. Reduce spending to bring it in line with revenues.
(This item originally appeared at Forbes.com on
October 21, 2012.)
http://www.forbes.com/sites/nathanlewis/2012/10/21/raise-taxes-and-cut-government-spending-to-reduce-debt-not-really/
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