• The Heritage Network
    • Resize:
    • A
    • A
    • A
  • Donate
  • Are Spending Cuts as Harmful as Tax Increases?

    Wednesday’s warning by the Congressional Budget Office (CBO) that the fiscal cliff is likely to push the economy back into recession should bring things sharply into focus for lawmakers. The CBO is correct that the fiscal cliff will lead to a recession, but its report contains faulty economic reasoning.

    The analysis contained in the CBO report treats tax increases and federal spending cuts as equally harmful to the economy. That contradicts a foundational principle of economics: People respond to incentives.

    Professor John Cochrane of the University of Chicago’s Booth School of Business points out that the CBO report misses badly on unemployment insurance, a topic exhaustively studied by economists, including The Heritage Foundation’s James Sherk. Cochrane writes:

    What will the effect on output and employment be of ending 99 weeks of unemployment insurance? That’s part of the fiscal cliff, and the CBO’s analysis says that reducing unemployment insurance will lower GDP. Really? A standard economic analysis comes to exactly the opposite conclusion. Generous unemployment and disability means that some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move. So long as you stay unemployed, you get a check from the government. Subsidizing anything produces more of it. So, a standard analysis says that cutting back unemployment insurance lowers unemployment, and raises output and this part of the fiscal cliff analysis should go the other way.

    Before you go all nuts on how heartless I am, keep the question in mind. I didn’t say what’s good or bad, I said what raises or lowers GDP and unemployment. The standard analysis of unemployment insurance says, yes, it raises unemployment and lowers GDP, but it provides important insurance for the truly needy and unfortunate. It’s something we do out of compassion even though it hurts us.

    What’s obviously true about unemployment insurance is usually true of other government spending. When the government taxes one person and provides for another, it reduces the incentives for both of them to work or to invest in education, a new business, or career mobility.

    For instance, if government provides health care to all citizens by taxing citizens who work, that twice reduces everyone’s incentive to work: earning an income is harder with higher taxes and is less important when someone else is paying for one’s health care. This does not mean that all transfer payments should be eliminated, but it does mean that they reduce GDP and employment.

    Government spending is good when it pays for valuable public goods. We tax ourselves to provide a fair justice system, education for all, and protection from violence—not to stimulate the economy. As Congress and the President consider how to address the fiscal cliff, they should understand that reducing the size of government through lower taxes and spending systematically raises private GDP, but increasing spending does not.

    Posted in Economics [slideshow_deploy]

    13 Responses to Are Spending Cuts as Harmful as Tax Increases?

    1. CharlesD says:

      Insightful article. Thank you. A thought on Professor Cochrane's analysis: Anyone receiving an unemployment check will likely spend most of it. This money will end up as a private sector revenue.
      and an increase in GDP. Since the business sector incurred no additional costs, it will also become a business profit (assuming it was deficit financed). I don't think this observation changes any overall conclusions but I do think it is worth noting that for those who lose their benefits and can not find work, the effect will be lower GDP and lower profits. Comments welcome. Thanks.

      • Txn says:

        You are simple minded. Debt financed cannot be equated with zero cost. First, who's buying the bonds? If it's the fed, buying with freshly minted currency, then M3 is increased and the value of all of our savings and incomes is diminished. The cost of raw materials for that same business owner goes up. It's the silent tax. M3 has gone up by a factor of 3 in the last 5 years. If debt financing of spending projects was a panacea, why is the recovery slow? We've done 5 trillion worth in the last 4 years. For all those not bought by the fed…. do you not think that this capital might have been deployed more efficiently?… spent more wisely?… perhaps invested in private enterprise?

        In summary, there is no such thing as a free lunch. You can hide or obscure the cost. You can get useful idiots to post oversimplified explanations on why deficit spending is a good thing. But you can't escape the facts… there is always a cost and consequences.

      • Robert says:

        But First they steel the money from the GDP to pay for it. So at best you have a wash, but more likely you have a net loss, because the money could have been generating income thereby raising revenue to the government instead of lowering it. If the government wasn't running deficits, then yes it could help, but when you borrow from china to pay paul while sticking it to peter, it is just bad all around.
        If obama wasn't dead set on killing the churches that help, they could go to the soup kitchen to eat without downgrading the economy.

    2. CharlesD says:

      Insightful article. Thank you. One observation: As Professor. Cochrane said – some (not all) choose to collect benefits instead of attempting to find work. For those who genuinely can not find work, the loss of their benefit will reduce their spending – negatively impacting GDP, corporate revenues and corporate profits.
      Thus, the overall impact on GDP would seem to depend on the proportion of current benefit recipients who would instead find work versus those that can not find work. I don't know that proportion.

      • BLonghorn says:

        In the article Prof. Cochrane states "some people choose to stay unemployed rather than take lower-paying jobs, or jobs that require them to move" To say someone cannot find work is false. You may not find the same type of job, but there is work out there. The point of the article is that by giving incentives to not take the lower paying job or relocating the negative effect on the economy is greater than what their spending would be.

    3. BPF says:

      I love this post, it really captures how the a government mandate can screw up the incentive system. I love capitalism.

    4. MichMike says:

      As with all policy, using evidence and data seems to always lead to a different conclusion than that promoted by the left. All history shows that dependency results in very bad outcomes. So wouldn't discussions about needs based assistance always start with attempting to avoid dependency? Not when dependency is your goal, ala the left.

    5. Alexey says:

      What everybody seems to misunderstand is that government has no money of its own. If it cuts spending to reduce the deficit, it follows that the financial market will receive a boost in form of new investment resources unleashed which can be spent in ways that are better than ones directed by government. Therefore production and investment will be much better aligned on a time scale.

      • jadedserf says:

        What about our foreign aide spending? Or foreign occupations and military spending?

        Consider this illustration:
        What would we think of a supposedly 'good' and trusted parent who abandons his own son, without food, shelter, medicine or safety? What decent person sends his friend, family, neighbor to parish, strips away and steals all provisions so the person is left naked and alone. Despite the years of school, the hopeless economy presents an insurmountable obstacle to employment and self sufficiency. The employment choices, if any at all, fail to provide any decent or realistic chance for meaningful work? The only local job listings include pyramid schemes, bait and switch scams, telemarketer ads, door to door magazine sales and casting calls limited to 18-22 year olds for work in the adult film industry. What sort of person, knowing these things, pushes the son out into the cold? What sort of person diverts the dollars set aside and intended for his fellow countryman so he can support some armed contract hit-man who swears he needs our unlimited money so he can go abroad and fight some unknown, unproven enemy?
        The only enemy we have is our own gullibility, lack of critical thinking skills and arrogance that keep us in this mess year after year!

    6. Robert says:

      Spending cuts would not be harmful at all if the government wouldn't punish you for earning a living.
      The entire military industrial complex can make it on their own if you allow them to sell what they make.
      Instead they only let them sell to the government so they are harmed when the government cuts back.

    7. David M says:

      Why do animal rights activists preach, "Do not feed the animals". Because it promotes dependence. Same goes for the human animal.

    8. jdmeth says:

      The fact that unemployment is over 8% has nothing to do with people taking unemployment checks until the run out? Has anyone studied how many people who's unemployment has ran out find a job paying at least 85% of their previous pay? How many of you can take unpaid time off or shut down you business because the next hundred thousand dollars you earn will be taxed at 33%?

    9. lwg says:

      Two major problems with the CBO. One, the CBO treats the economy as static. Thus, a tax increase equals a porportionate increase in Gov. revenue, while a tax cut equals a proportionate reduction Gov. revenue. However, tax cuts encourage efficient use of labor and capital, which result in increased Gov. revenue. Tax increases encourage people to seek inefficient tax safe investments, which result in decreased Gov. revenue. As a resutl, CBO predictions are always wrong.

      Second, the media treat the CBO reports as though they were inspired by God. This divine treatment of CBO reports makes it impossible for an honest debate to occur.

    Comments are subject to approval and moderation. We remind everyone that The Heritage Foundation promotes a civil society where ideas and debate flourish. Please be respectful of each other and the subjects of any criticism. While we may not always agree on policy, we should all agree that being appropriately informed is everyone's intention visiting this site. Profanity, lewdness, personal attacks, and other forms of incivility will not be tolerated. Please keep your thoughts brief and avoid ALL CAPS. While we respect your first amendment rights, we are obligated to our readers to maintain these standards. Thanks for joining the conversation.

    Big Government Is NOT the Answer

    Your tax dollars are being spent on programs that we really don't need.

    I Agree I Disagree ×

    Get Heritage In Your Inbox — FREE!

    Heritage Foundation e-mails keep you updated on the ongoing policy battles in Washington and around the country.