Tax-spend or fiscal illusion?

• Author: Young, Andrew T.
• Position: Report

[My opponent] tells us that first we've got to reduce spending before we can reduce taxes. Well, if you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker.

--Ronald Reagan (1980)

The attractiveness of financing spending by debt issue to the elected politicians should be obvious. Borrowing allows spending to be made that will yield immediate political payoffs without the incurring of any immediate political cost.

--James Buchanan (1984)

What is the intertemporal relationship between U.S. federal government expenditures and revenues? Do variations in revenues cause variations in expenditures (tax-spend) or is causation the other way round (spend-tax)? Alternatively, is causation bidirectional or nonexistent? Understanding the "revenue-expenditure nexus" has important implications for the political economy of fiscal policies.

For example, if causation is in the tax-spend direction, then there are at least two interpretations. First, there is the conventional tax-spend hypothesis associated with Milton Friedman (1978): Government wants to and will spend whatever is made available. If tax revenues are increased, spending will increase; if tax revenues are lowered, the beast is starved. Revenues have a positive causal relationship to expenditures. This view has led various proponents of limited government to encourage tax cuts that are not conditional on offsetting spending cuts. The ultimate goal is for eventual spending cuts as a result of "starving the beast." (1)

On the other hand, a negative causal relationship from revenues to expenditures may exist due to fiscal illusion (Wagner 1976, Buchanan and Wagner 1977). Niskanen (1978, 2002, 2006) finds a negative correlation between federal expenditures and tax receipts. He states, "The most direct interpretation [is] a demand curve [where] federal spending is a negative function of the tax price" (Niskanen 2002: 184). A tax increase may make taxpayers hostile toward government spending as they are forced to directly reckon with its costs. (2) Likewise, tax decreases may lessen the perceived cost of government spending, increasing the quantity demanded.

For proponents of limited government, understanding which of these relationships best explains reality is critical in terms of policy. Believers in conventional tax-spend or "'starve the beast" may applaud the type of tax cuts associated with Ronald Reagan and George W. Bush because, despite the lack of simultaneous spending cuts, lower taxes are expected to constrain future spending. Alternatively, believers in fiscal illusion may view such tax cuts as counterproductive because they perversely encourage even greater spending by decreasing its perceived (by the electorate) price. Fiscal illusionists may instead encourage tax increases (especially during times of budget deficits) because they force the public to confront the costs of excessive spending, hopefully decreasing their tolerance for it.

Ultimately, which relationship best describes the revenue-expenditure nexus is an empirical question and several recent studies using U.S. federal time series data provide evidence for the conventional (Friedman-type) tax-spend hypothesis. Examples include Bohn (1991), Mounts and Sowell (1997), Koren and Stiassny (1998), Garcia and Henin (1999), and Chang, Liu, and Candill (2002). However, Baghestani and McNown (1994) find that there is no relationship between revenues and expenditures, and Ross and Payne (1998) provide evidence favoring the spend-tax hypothesis. Payne (2003) provides an excellent survey of the literature for the United States and other nations. All of the recent studies follow the example set early on by Miller and Russek (1989) in estimating error-correction models that allow for long-run fiscal synchronization (cointegration).

Recent U.S. evidence for the fiscal-illusion hypothesis is scant. One exception is a recent paper by Romer and Romer (2007a). They use a measure of "tax changes taken for long-run purposes" based on narrative evidence from government sources (developed in Romer and Romer 200719). Regressing changes in federal spending on contemporaneous and lagged values of this measure, they find that tax cuts are positively associated with significant increases in expenditures. This sort of perverse effect is precisely the type a fiscal illusionist may fear is associated with tax cuts unaccompanied by spending cuts. However, Romer and Romer do not consider an intertemporal budget constraint for the government and control for budgetary disequilibria in an error-correction framework. Doing so is standard in the literature. This criticism is also applicable to the early findings by Niskanen (1978). Darrat (1998, 9,002) finds evidence of the fiscal illusion hypothesis in the context of the revenue-expenditure nexus for Turkey, Lebanon, and Tunisia.

The existing literature uniformly imposes symmetry on revenue effects in expenditure equations. This constraint may bias results toward the conventional tax-spend hypothesis because it is based on simple adherence to a budget constraint. In contrast, the fiscal illusion hypothesis--based on the public's subjective perceptions of the cost of government spending--is more plausibly associated with asymmetric responses. For example, individuals may be more sensitive to tax increases, seeking to assign blame for those shocks, while tax decreases are more passively accommodated. This may be due to irrationality, but not necessarily. Tax decreases (relative to spending) create future tax liabilities that may or may not be paid during the individual's lifetime. Tax increases, on the other hand, are realized with certainty. Also, an insensitivity to tax decreases relative to increases is consistent with the loss-aversion hypothesis put forth in the prospect theory of Kahneman and Tversky (1979, 1991).

In this article, I evaluate the conventional tax-spend hypothesis versus the fiscal illusion hypothesis by analyzing quarterly data from 1959:3 to 2007:4 on U.S. federal revenues and expenditures within an error-correction framework. The findings suggest that (a) decreases in taxes do not Granger-cause changes in federal expenditures while (b) increases in taxes significantly and negatively affect expenditures. Following Ewing et al. (2006), I also allow for asymmetric responses to long-run budgetary disequilibria. The findings, (a) and (b) from above, are robust...