Libertarianism and Shrinking the Size of Big Government

It is a commonly accepted fact that our government is a bloated beast that, left to its own devices, will consume us all. It is also commonly accepted that it is essential to shrink the size of Big Government, and the way to do that is to "starve the beast" by cutting taxes.

But what if there is evidence to the contrary? What happens when commonly accepted "facts" are shown to not be facts at all? Will the public still believe in those statements? Unfortunately, most of the time they will.

As author Thom Hartmann recently pointed out in his book "Rebooting the American Dream", William A. Niskanen, a key architect of Reaganomics "figured something out that would make Reagan's head explode." There is a strong inverse correlation over the 24 year period from 1981 to 2005 between tax rates and the overall size of government. That is to say, when tax rates go up, government shrinks. When tax rates go down, the size of government gets bigger.

But how can this be? Not only is this counter intuitive, but it flies in the face of what the public accepts as common fact. The reason for the inverse correlation between tax rates and the size of government is actually quite simple, and is within the intellectual grasp of anyone who possesses even the most basic knowledge of the laws of supply and demand.

When taxes go down, you would expect the size of government to shrink. But in the short term, the government's size stays the same, namely because there are essential services that cannot be immediately cut. This is called "tax cuts that are not paid for." The government proceeds as it did before the tax cuts (without making spending cuts), and then borrows or prints money to make up the shortfall.

What happens next is where the supply and demand curve comes into play. Because the public gets the same services but pays less in taxes for them, the cost of these government services is effectively reduced. Tax cuts without spending cuts have the overall effect of reducing the tax payer's cost of government, and therefore encouraging its growth. According to Niskanen, "You make government look cheaper than it would otherwise be."

So what happens when you reduce the price of something, but continue to sustain the supply? The answer is obvious. The demand for that commodity or service goes up. In this case, cheaper government services (because the government subsidizes the shortfall from the tax breaks with borrowed or printed money) leads to an increased demand for government. The supply then increases to meet the demand. This in turn grows the size of government.

On the other hand, in the cases where tax rates were increased, government became "expensive." Once again - the supply and demand curve is in play, as it always is. The price of the commodity or service was increased, while the supply was uninterrupted. This decreases the demand for government services, and in turn, caused the size of government to shrink, i.e. the supply is reduced to meet the lower demand. The tipping point in terms of how tax rates affect spending seems to be right around 19 percent of the GDP. Tax rates above that level tend to decrease spending, and thus reduces the size of government. Tax rates below that level increases spending (and borrowing) and ultimately results in a bigger government.

This seems to contradict the accepted notion that the more money we send to Washington, the more government will increase in size. The flawed idea being, no matter how much money we send to Washington, it will all get spent. They will always grow the government accordingly to a larger and larger size. The historical data shows the opposite. The extra revenue from higher taxes leads to smaller government, and the surplus can be used to balance the budget, and eventually reduce the national debt.

This is an amazing irony, yet it also makes so much sense. Historically, we are in a period of relatively low tax rates (revenues have been well below 19 percent since 2002), and the size of government is large. But yet the answer from the right and from libertarians (and, increasingly so from average middle class Americans) is to cut taxes in order to reduce the size of government. It is in fact these tax cuts that were not paid for during the Bush II administration that grew the size of government to the size that it is today.