So-called tax breaks don’t shrink governments, they swell deficits

Posted on December 26, 2011 in Governance Policy Context

Source: — Authors: – report-on-business/commentary/barrie-mckenna
Published Sunday, Dec. 25, 2011.    Barrie Mckenna, Ottawa

Starving the beast is the foundation of conservative budget thinking.

According to the theory, tax cuts don’t just spur private investment, they actually starve governments of the food they need to grow. The result is that swelling deficits quickly force governments to tighten their belts and become smaller.

So far so good?

Well, no. Tax cuts may have an intuitive appeal. But the evidence of the last few decades in Canada and the U.S. suggests tax cuts don’t shrink the size of government. They merely curtail government revenues.

A thought-provoking study by Texas A&M economists Joseph Ura and Erica Socker concluded that “starving the beast” does exactly the opposite of the theory. And it’s at the root of the fiscal mess in the U.S.

Tax cuts actually increase demand for government services, in the same way that lowering the price of gas increases consumption. The result is ever-expanding budget deficits, according to Mr. Ura and Ms. Socker. Tax cuts create a “fiscal illusion” – a sense that life is good and a “perception” that government services are better value.

The result is much like price controls, the economists say in their study, “Budget Deficits and Demand for Government: How Starve the Beast Policies Feed the Machine.”

“Reducing the tax burden without constraining spending creates the illusion of lowering the price of the basket of government goods and services, which, in turn, increases demand for government,” they say.

Even controlling for such variables as inflation, unemployment and the level of domestic spending, the study finds a statistical link between larger federal deficits and increased public demand for government. In essence, one follows the other.

The key for policymakers, according to Mr. Ura and Ms. Socker, is to steer clear of “revenue policies that obscure the actual costs of government programs and services.”

There is an important lesson in this for Ottawa, Washington and governments everywhere.

First, dispense with the myth that tax cuts make governments smaller. A good start would be to change the terminology. Call tax breaks what they really are: tax expenditures.

That puts them on par with spending programs.

Shrinking deficits can be achieved either through trimming tax expenditures or cutting programs and services.

And in most cases, the fairest way is to do both.

Ottawa, like many provincial governments, spends billions of dollars on numerous tax expenditures. They’re typically aimed at very specific policy goals. There are credits to encourage people to go to college or university, to defray child-care costs, or to spur research and investment in oil and gas.

Some of these work well. But many do not, and they should be reviewed and pared back, in conjunction with the ongoing “program review” process to curb government spending, which aims to cut departmental budgets by up to 10 per cent.

The Harper government has offered billions of dollars worth of tax breaks since taking power in 2006. It lowered the goods and services tax, cut corporate income taxes, introduced tax breaks for small businesses and manufacturers, and handed out a batch of small, targeted goodies for individuals.

Ottawa has so far made no commitment to review its lengthy list of tax expenditures as it prepares the next budget, expected as early as February.

That’s a lost opportunity. Tax expenditures are essentially government programs delivered via the tax system. The government must demonstrate that they work – that they produce the intended outcomes at a reasonable price – particularly as it moves to slash the size of government.

If, for example, the government is going to slash Industry Canada’s budget, it should also determine whether it’s getting good value for the nearly $4-billion a year spent on research-and-development tax credits for businesses. Similarly, if Natural Resources is taking a haircut, maybe it’s also time to review the resource company flow-through share deductions and mineral exploration tax credits ($335-million a year). The same questions apply to the $200-million a year in film- and video-production credits, which should be weighed against big cuts to Canadian Heritage. Or, as Ottawa ponders cuts to Health Canada, does it know whether five years of the children’s fitness tax credit ($115-million a year) has made children any healthier?

These breaks all help swell the deficit. Ottawa has an obligation to convince Canadians they’re still useful and relevant.

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