Starving the beast revisited.

• Author: Moghaddam, Masoud
• Position: Tax cuts and government spending - Essay

The determinants of government budget deficits have been studied extensively, especially during the years in which the discrepancy between federal income taxes and expenditures has widened. In that respect, it is of interest to explore the causal relationship between government revenues and expenditures. If the direction of causation is from taxes to spending, then enjoying tax cuts without cutting expenditures necessitates starving the beast, as suggested by Milton Friedman (1978) and confirmed by a number of studies including Gareia and Henin (1999), and Chang, Liu, and Caudill (2002). On the other hand, if a tax cut is perceived by rational agents to be a cut in the cost of public goods, then spending would increase. In that ease, taxes and spending are inversely related. Support for that relationship--the so-called fiscal illusion hypothesis--is provided by Wagner (1976), Niskanen (1978, 2002, 9.006), and more recently by New (2009) and Young (2009). There are also a few studies in which no significant causal relation between tax and spend variables has been reported (e.g., Baghestani and McNown (1994).

In this article, I revisit the evidence in favor of the fiscal illusion hypothesis, as presented in Young (2009) for the period 1959Q3-2007Q4. According to Young, the tax and spend variables are integrated of order one and share a long-term linear common trend (cointegration). He attempts to depict asymmetric behavior by incorporating interaction dummies in the standard expenditure regression model. Subsequently, he correctly states that the employed interaction dummies (eight dummies in a univariate model, four of which appear to be redundant) are incapable of capturing the essence of nonlinear dynamic adjustments. (1) Eventually, following the findings presented by Ewing et al. (2006), Young identities residual thresholds and reestimates the regression model using the TAR (threshold autoregression) and M-TAR (momentum TAR) models. He concludes that while TAR and M-TAR estimate different speed of adjustment, the findings are not favorable to starving the beast. His findings reject the type of tax cuts that are not contingent on spending cuts of the same magnitude.

This article empirically demonstrates that the findings presented by Young are heavily plagued by the lack of an "attractor" (i.e., tendency toward budgetary long-run equilibrium) in the residual of the model he estimated within the utilized asymmetric framework. Indeed, the findings reported in Table 4 of his article do not include any evidence of an attractor--nor do they indicate asymmetry or the lack of residual autocorrelation. Consequently, his findings in Table 4 invalidate the results presented in Table 5 and overturn the main contention of his article. (2)

Anomalies in Young's Expenditure Model

The standard government expenditure model is specified as:

(1) [spe.sub.t] = a + b [rev.sub.t] + [e.sub.t],

where spe and rev are the natural logarithm (ln) of total federal government spending and tax revenue scaled by In GDP, respectively. Furthermore, a is the intercept, b is the regression coefficient, and e is a well-behaved error term (residual). Under asymmetric adjustments, the residual behaves in the following manner:

(2) [DELTA][e.sub.t] = [rho]l [I.sub.t] [[e.sub.t-1 - [tau]] + [rho]2 (1 - [I.sub.t])[[e.sub.t-1] - [rho]] + [e.sub.1t]

where [DELTA] is the first differencing operator, [rho]1 and [rho]2 are the autoregression coefficients depicting...