Taxes Are Costly When Money Is Free

A blog about business and economics.
July 13 2012 9:59 AM

Taxes Are Costly When Money Is Free

As a generous welfare stae kind of guy who's unhappy with the extent to which Democrats have surrendered on the view that nobody earning less than $250,000 should pay a penny more in taxes, I really want to agree with Bill Gale about the Bush tax cuts:

Earlier this week, President Barack Obama proposed to extend the Bush-era income tax cuts, which expire at the end of this year, for one year for people with income below $250,000. People with higher income would continue to receive all of the benefits of lower taxes on their first $250,000 of income, but the tax rate they face on income above that amount would rise.

One might wonder why we need more tax cuts, given that the Congressional Budget Office just released a study showing that tax burdens as a share of income for almost all households were the lowest in 2009 that they have been in decades and given that we face a long-term deficit problem that will require more revenues over time.

Unfortunately, I think the facts say otherwise. There are three ways a government can finance current expenditures. One is to conscript resources from the public via taxation. The second is to borrow money on financial markets. The third is to print money. Regardless of one's views about what the appropriate level of expenditure is, it's desirable to finance that expenditure in the way that imposes the least cost on society.

Under normal circumstances, taxation is a relatively low-cost means of financing expenditure. Printing money would generate inflation and possibly generate expectations of accelerating inflation wreaking havoc with citizens' plans, provoking capital flight from the country, and generally making everyone miserable. Borrowing money on a large scale, by contrast, tends to raise interest rates and "crowd out" private investment unless the central bank is willing to engage in inflationary low interest rate policies. But today the real yield on government debt is exceptionally low. As of yesterday, the government could borrow for free on a 20-year time horizon or borrow at a negative rate on a 10-year time horizon.

Combine that with the fact that inflation is low, and that modestly higher inflation would be socially beneficial and suddenly debt financed government looks extremely cheap. That could mean borrowing money to finance new government expenditures, but it could equally mean simply borrowing the money to finance existing government spending commitments. Either way, the point is that to tax people when other people are willing to lend the government money for free is a very costly means of finance. Something like an excise tax on cigarettes or alcohol that's intended in part to discourage consumption might still be OK,  but the federal government is levying large taxes on productive labor and lighter but meaningful ones on productive investment. It's something we do because you "need to pay for things." Except right now we don't.

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.



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