Tuesday, June 19, 2007


Investor's Business Daily has noted that the real problem in public finance is not budget deficit but the size of government spending. Whether it is financed by taxes and borrowing, high goverment spending causes the distorsions in dynamic economic behavior. If tax rates are high and widespread, market agents tend to absorb the money and hide it away from the taxation base. Inevitably, high tax rates, as Laffer Curve correctly explains, cause the loss of tax revenue which becomes the heaviest weapon in the hands of economic policymakers as well as the worsening of economic conditions in doing business and creating wealth emerging from productive behavior such as risk-taking, entrepreneurship, saving and work.

The most obvious agony of public spending is an empirical fact, that an obscure size of spending correlates with intensive inefficiency of public sector. Robert J. Barro, for instance, showed that growth and saving rates fall with an increase in utility-type expenditures; the two rates rise initially with productive government expenditures, but subsequently decline. With an income tax, the decentralized choices of growth and saving are too low, but if the production function is Cobb-Douglas, the optimizing government still satisfies a natural condition for productive efficiency (link). The explanation is simple: higher the spending rate, greater the inefficiency of government spending in a sample economy with endogenous growth.

In the long run, of course, high budget deficits are unsustainable as the size of the deficit is possibly fueled by raising public debt and tax rates as it is expected that individuals pursue adaptive expectations statically so that increasing tax rate on labor and capital will return higher tax revenue, but Nobel-winning economist Edward Prescott has shown that labor supply as a market agent is highly sensitive to taxes, as compliance costs per unit of output increase as a single taxation unit adds relative burden to agent's income earned in the market. As the tax rate rises, GDP per capita falls. For example, compliance costs is when you hire lawyers and accountants to help you overcome the burden of annual tax returns such as finding the right exemption for capital gains, income earned abroad etc... in a heavily complicated tax system marred by loopholes, exemptions and deductions pushing compliance costs ever upward.

Nowdays, it is silly to listen how deficits soared and how facts on high rate of public spending are left ignored.

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