Voodoo Economics and the Myth about Tax Cuts

Cutting taxes to shrink government doesn’t work—and that spells trouble for the conservative movement by Jonathan Rauch

The Atlantic | June 2006

PRESIDENT CARTER ducked the presidential debate of September 21, 1980, but Ronald Reagan and John Anderson, the independent candidate, were on hand for a revealing exchange. The question was whether Reagan’s proposed tax cuts, if not balanced by spending reductions, would fuel inflation. Anderson thought so: “I have been very careful in saying that what I’m going to do is to bring federal spending under control first.”

Reagan scoffed. “John tells us that first we’ve got to reduce spending before we can reduce taxes,” he said. “Well, if you’ve got a kid that’s extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker.” With that statement, Reagan performed one of the last century’s great feats of political prestidigitation.

Until then, the conservative movement had been at odds with itself. Libertarians in the Goldwater tradition wanted to reduce spending in order to shrink Big Government. Supply-siders derided that idea as a political loser, “root-canal economics.” Instead, they demanded large tax cuts that would grow the economy. Traditional business conservatives, however, believed in balanced budgets, and they held tax cuts hostage to spending cuts that never happened. The movement was gridlocked.

Reagan and his supply-side vanguard saw a way to break the jam—or, more precisely, two ways. First, some argued that tax cuts would so energize the economy as to pay for themselves. That claim was widely controversial, even among Republicans (Reagan’s then-rival George H. W. Bush called it “voodoo economics”), and it proved mostly wrong. Less controversial, but in the end more important, was the claim Reagan lobbed at Anderson. Often called the Starve the Beast hypothesis, it held that tax cuts shrink the federal Leviathan by starving it of funds. Tax cuts need not await spending cuts because they would cause spending cuts.

For modern conservatism and the country, the importance of Starve the Beast is impossible to overstate. Suddenly Republicans could offer both lower taxes and smaller government without any need for fiscal dentistry. Suddenly it was the Democrats who were trapped. From then to now, tax cutting has been the lodestar of conservatism, rising to its apogee under the current President Bush. But there have always been dissenting voices, of which perhaps the most prominent speaks from within the conservative movement.

WHEN Diogenes searches Washington, D.C., for an honest man, he could do worse than carry his lantern to the office of William A. Niskanen, the chairman of the libertarian Cato Institute. Niskanen’s wall displays portraits of Isaac Newton, Adam Smith, and Charles Darwin, each captioned ORDER WITHOUT DIRECTION. Apart from the floor and a writing desk, every horizontal surface, including the window sill, is stacked a foot high with files and reports. At six feet four inches and of military bearing, with a thatch of white hair and an austerely professorial manner, the seventy-three-year-old Niskanen seems to glide above political Washington.

Trained at the University of Chicago, Niskanen spent his formative years crunching numbers at the RAND Corporation and then in the Pentagon (he was one of Defense Secretary Robert S. McNamara’s “whiz kids”) and in the Nixon administration’s Office of Management and Budget. He is a data guy, the sort of economist who responds to a visitor’s question by saying, “I’ve got a chart on that that I made up yesterday.” In the Reagan administration, he served as acting chairman of the Council of Economic Advisers. Blunt-spoken and seemingly impervious to partisanship, he was passed over for the permanent chairmanship after telling senior politicos, in Reagan’s presence, that one of their pet tax proposals would have made Walter Mondale proud.

Even during the Reagan years, Niskanen was suspicious of Starve the Beast. He thought it more likely that tax cuts, when unmatched with spending cuts, would reduce the apparent cost of government, thus stimulating rather than stunting Washington’s growth. “You make government look cheaper than it would otherwise be,” he said recently.

Suppose the federal budget is balanced at $1 trillion. Now suppose Congress reduces taxes by $200 billion without reducing spending. One result is a $200 billion deficit. Another result is that voters pay for only 80 percent of what government actually costs. Think of this as a 20 percent discount on government. As everyone knows, when you put something on sale, people buy more of it. Logically, then, tax cuts might increase the demand for government instead of reducing the supply of it. Or they might do some of each.

Which is it? To the naked eye, Starve the Beast looks suspiciously counterproductive. After all, spending (as a share of the gross domestic product, the standard way to measure it) went up, not down, after Reagan cut taxes in the early 1980s; it went down, not up, after the first President Bush and President Clinton raised taxes in the early 1990s; and it went up, not down, following the Bush tax cuts early in this decade.

Niskanen recently analyzed data from 1981 to 2005 and found his hunch strongly confirmed. When he performed a statistical regression that controlled for unemployment (which independently influences spending and taxes), he found, he says, “no sign that deficits have ever acted as a constraint on spending.” To the contrary: judging by the last twenty-five years (plenty of time for a fair test), a tax cut of 1 percent of the GDP increases the rate of spending growth by about 0.15 percent of the GDP a year. A comparable tax hike reduces spending growth by the same amount.

Again looking at 1981 to 2005, Niskanen then asked at what level taxes neither increase nor decrease spending. The answer: about 19 percent of the GDP. In other words, taxation above that level shrinks government, and taxation below it makes government grow. Thanks to the Bush tax cuts, revenues have been well below 19 percent since 2002 (17.8 percent last year). Perhaps not surprisingly, government spending has risen under Bush.

“I WOULD like to be proven wrong,” says Niskanen. No wonder: for the modern conservative coalition, the implications of his findings are discomfiting, and in a sense tragic.

First, the root-canal economics of pre-Reagan conservatism was right all along: the way to limit the growth of government is to force politicians, and therefore voters, to pay for all the government they use—not to give them a discount.

Second, conservatives who are serious about halting or reversing the dizzying Bush-era expansion of government—if there are any such conservatives, something of an open question these days—should stop defending Bush’s tax cuts. Instead, they should be talking about raising taxes to at least 19 percent of the GDP. Voters will not shrink Big Government until they feel the pinch of its true cost.

Third, the most effective constraint of all is to raise taxes and cut spending: exactly the sort of anti-deficit package that anti-tax conservatives pummeled the first President Bush and President Clinton for approving, and exactly the sort of package that the current President Bush and his anti-tax allies are sworn to block.

The conservative movement is in no position to accept or even acknowledge those implications, now that tax cutting has become the long pole in the Republican tent. Therein lies the element of tragedy. By turning a limited-government movement into an anti-tax movement, conservatism has effectively gone into business with the Big Government that it claims to oppose. It is not starving the beast. It is fueling the beast’s appetite. And the beast has a credit card.

This is an article from the upcoming June edition of Atlantic Monthly.