Negative Relationship between Federal Spending and Tax Revenues:

I’ve run across a fascinating paper by William Niskanen and Peter Van Doren of the Cato Institute (which Niskanen has kindly allowed me to quote). In a paper that Niskanen published in 2002 and that Niskanen and Van Doren have just updated (and presented to the Public Choice Society), they discuss the “starve the beast” hypothesis — the idea that reductions in federal tax revenues will produce reductions in federal spending. Strikingly, they find that:

The problem with this hypothesis is that it is not consistent with the evidence, at least since 1980. Niskanen’s article published in 2002 presented evidence that the relative level of federal spending over the period from 1981 through 2000 was coincident with the relative level of the federal tax burden in the opposite direction; in other words, there was a strong negative relation between the relative level of federal spending and tax revenues. Controlling for the unemployment rate, federal spending during this period increased by about one-half percent of GDP for each one percentage point decline in the relative level of federal tax revenues.

Their paper presents their data in some detail, and the presentation is pretty convincing.

How to explain this inverse relationship between spending and taxation? Here’s their take:

What is going on? The most direct interpretation of this relation is that it represents a demand curve — that the demand for federal spending by current voters declines with the amount of this spending financed by current taxes. Future voters will bear the burden of any resulting deficit but are apparently not effectively represented by those making the current fiscal choices. One implication of this relation is that a tax increase may be the most effective policy to reduce the relative level of federal spending. On this issue, we would be pleased to be proven wrong.

I can’t think of a better explanation. But, in any event, the data are startling.

By the way, the 2004 paper has not yet been published, but the 2002 version is available in American Economic Policy in the 1990s (MIT Press 2002).