Government Spending Is the Real Tax; Deficits Are a Sideshow

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by Frank Shostak via Mises

Many economists believe that during an economic slump government should run large budget deficits in order to keep the economy going with increases in government outlays, with the consequent budget deficit giving individuals more disposable money. This, in turn, will result in an increase in consumer spending that will lift the economy’s gross domestic product (GDP) by a multiple of the increase in consumer expenditure.

For example, we assume that out of an additional dollar received individuals spend ninety cents and save a dime. Also, let us assume that consumers have increased their expenditure by $100 million. Because of this, retailers’ revenue rises by $100 million. Retailers, in response to the increase in their income, consume 90 percent of the $100 million, so they raise expenditure on goods and services by $90 million. The recipients of these $90 million in turn spend 90 percent of the $90 million, or $81 million. Then the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million, and so on.

Note that the key to this scenario is that expenditures by one person becomes the income of another. At each stage in the spending chain, people spend 90 percent of the additional income they receive, and the process eventually ends with total output higher by $1 billion (10*$100 million) than it was before consumers had increased their initial expenditure by $100 million.

Observe that the greater the percentage spent of each dollar, the greater the multiplier and, therefore, the greater the impact of the initial spending on overall output. For instance, if individuals change their habits and spend 95 percent from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80 percent and save 20 percent, then the multiplier only will be 5. In other words, the less that is saved, the larger is the impact on overall output.

Within the multiplier framework, overall demand in the economy weakens because of lesser consumer outlays. Therefore, the government must step in and boost its spending in order to prevent overall demand from declining. According to these economists, increasing the budget deficit in response to larger government outlays can boost the economy.

Economists that oppose this view believe that enlarging the budget deficit leads to monetizing it and subsequently increasing inflation. This perspective holds that government must avoid widening the budget deficit, instead emphasizing a balanced budget.

The goal of emphasizing the deficit, whether to increase it or eliminate it altogether, is the wrong policy. What matters for the economy is not the size of the budget deficit but the size of government outlays—the resources that government diverts to its own activities.

The More Government Spends, the More Resources It Takes from Wealth Generators

Government does not generate wealth. Instead, the more it spends the more resources it must take from wealth generators. This, in turn, undermines the economy’s wealth generating process, which means that the effective level of tax is the amount of government spending. For instance, if the government plans to spend $3 trillion and funds these outlays by means of $2 trillion in taxes there is going to be a shortfall, labeled as a deficit, of $1 trillion.

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Since government outlays must be funded, government secures other means of funding such as borrowing, printing money, or increasing taxes. The government will employ numerous means to obtain resources from wealth generators to support its spending. Hence, what matters is that government outlays are $3 trillion, not the deficit of $1 trillion. For instance, if the government lifted taxes to $3 trillion and as a result would have a balanced budget, would this alter the fact that it still takes $3 trillion of resources from wealth generators?

We hold that an increase in government outlays sets in motion an increase in the diversion of wealth from wealth generating activities to non-wealth-generating activities, leading to economic impoverishment. Thus, an increase in government outlays to boost overall demand should be regarded as bad news for both the wealth generating process and the economy.

Government Taxes Stifle Market Processes

Taxes force producers to part with their wealth in exchange for unwanted government projects, implying that producers are forced to exchange more for less, which obviously impairs their well-being. The more projects government undertakes, the more wealth is taken away from wealth producers. We can thus infer that the level of wealth taken from the private sector is determined by the size of government activities.

By being a wealth consumer and not a wealth producer, government cannot contribute to the pool of savings. Moreover, if government activities could have generated wealth, then they would have been self-funded and would not have required any support from other wealth generators. If this, indeed, were the case, taxes would not be an issue.

In the money economy the government will tax (take money from wealth generators) and pay out the received money to various individuals that are employed directly or indirectly by the government, and the money gives these individuals access to final consumer goods. Government-employed individuals are now able to exchange the taxed money for various consumer goods that maintain and improve their lives.

The Meaning of a Budget Surplus in a Money Economy

What then is the meaning of a budget surplus in a money economy? It means that government’s inflow of money exceeds its expenditure of money. The budget surplus here is just a monetary surplus. The emergence of a surplus produces the same effect as tight monetary policy.

A budget surplus does not automatically make room for lower taxes. Only if government outlays are curtailed—i.e., only when the government cuts the number of pyramids it plans to build will an effective lowering of taxes emerge.

Lower government outlays imply that wealth generators will now have a larger portion of the pool of wealth at their disposal. If, however, government outlays continue to increase, no effective tax reduction is possible; on the contrary, the share of the pool of wealth at the disposal of wealth producers will diminish.

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Critics of smaller governments will argue that the private sector cannot be trusted to build and enhance the nation’s infrastructure. However, can Americans afford the improvement of the infrastructure? The referee here should be the free market where individuals, by buying or abstaining from buying, decide on the type of infrastructure that is going to emerge given the available resources.

If the size of the pool of savings is not adequate to afford better infrastructure, then time is needed to accumulate savings to be able to secure something better. The buildup of the pool of savings cannot be made faster by raising government outlays, and an increase in government spending will only weaken the savings pool.

Why Government Cannot Be a Genuine Borrower

One of the ways the government employs in securing the necessary funds is by means of borrowing. But how can this be? A borrower must be a wealth generator in order to be able to repay the principal loan plus interest. This is, however, not the case as far as the government is concerned, for government is not a wealth generator—it only consumes wealth. So how then can the government as a borrower, producing no wealth, ever repay its debt? The only way it can do this is by borrowing again from the same lender—the wealth-generating private sector. It amounts to a process whereby government borrows from you in order to repay to you.

Summary and Conclusion

Government is not a wealth generator; it relies, instead, upon private enterprise for its funding sources. This, in turn, means that the more government spends, the less savings will be available for the wealth-generating private sector. Obviously, this impedes the creation of wealth and impoverishes the economy as a whole. The effective level of tax then is dictated by government outlays—the more government plans to spend the more savings it will divert from the wealth-generating private sector.

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Contact Frank Shostak

Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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