Magazine: Reason Issue: February 1994 Title: Where Have All the Dollars Gone? Author: Jame

Magazine: Reason
Issue: February 1994
Title: Where Have All the Dollars Gone?
Author: James L. Payne

Where Have All the Dollars Gone? How the government robs Peter to pay 
him back.

By James L. Payne

On the ground, an overloaded airplane still looks like an airplane. 
It seems to have all the necessary parts -- the wings, the motors, 
the tail assembly. It looks so much like an airplane that passengers 
may be easily deceived and embark upon it expecting to travel to 
faraway places. But to the engineer who reckons such unseen factors 
as thrust and lift, this machine has no capacity for flight. It is, 
in its present state, nothing more than a truck, a vehicle that can 
only motor noisily around the airport grounds.

The modern helping state has become something like this overweight 
airplane. The politicians have used it to subsidize practically 
everything that human beings could want, from housing to hospitals, 
from science to string quartets. The prevailing assumption in 
welfare-state capitals around the world is that there is always room 
for one more subsidy.

But a close look into the theory of subsidies shows that this 
assumption is incorrect. Government cannot successfully subsidize a 
large number of beneficiaries. This is not a statement of opinion, 
nor even a declaration of fact. It is a mathematical point. Too many 
subsidies mean that government cannot help anyone. The passengers 
climb aboard and the engines make an impressive roar, but the plane 
goes nowhere.

Although Beltway insiders haven't got it yet, some onlookers are 
beginning to note the circularity of welfare-state economics. "I love 
the message coming from both parties," said Ross Perot at the 
National Press Club during the '92 campaign. "`Can we buy your votes 
with your money this year?'" Perot may be more sound bite than 
substance, but even he seems to recognize that there is something 
absurd about this system.

The Cornucopia Illusion

Our intellectual roots leave us poorly prepared to analyze the limits 
to subsidies. The modern Western tradition treats government as a 
cornucopia, an inexhaustible source of everything that people might 
need. Government has a bulging treasury of hundreds of billions that 
it showers in subsidies in every direction.

A closer look reveals, of course, that this appearance of wealth is 
deceptive. Government does not create wealth. It is simply an agency 
for coercively shifting it about. The helping state is not a complete 
economic system; it is merely the attractive face of an equal and 
opposite "hurting state," a government that day by day inflicts 
privation upon its citizens, taking their money away from them.

Economists have generally been willing to point this out, to reveal 
to their students that the standard government subsidy merely 
represents the robbing of Peter to pay Paul. Unfortunately, they fail 
to extend the inquiry. They do not ask the critically important 
question: What happens when we feel sorry for Peter and try to 
subsidize him, too? What are the economic implications of taxing 
Peter to pay Paul, and then taxing Paul to pay Peter?

One excuse they will give for not having studied this problem is that 
it would be illogical to tax and subsidize the same person. But the 
idea that governments are rational is, unfortunately, little more 
than an academic fiction. Subjects and sufferers of governments, from 
the days of Nero to the age of Rostenkowski, know that wise 
government is, if not an outright myth, at least an historical rarity.

It may indeed be silly for government to subsidize the same people it 
is taxing, but that is certainly what it is doing today -- on a vast 
scale. It is practically impossible to find someone who is the object 
of a government helping program who does not also pay taxes: 
retirees, farmers, scientists, elderly people needing medical care, 
veterans, the unemployed, college students, the disabled, even the 
very poor. Some groups may escape the income tax, but they pay a 
hefty employment tax as well as a multitude of federal, state, and 
local excise taxes. We are now in the age of self-subsidy: To a 
considerable degree, each of us is paying for his own government 
benefits.

Perhaps we have overlooked this problem because it has crept up on us 
cloaked in a subtly shifting "public goods" theory of government 
spending. In its original meaning, a public good was a socially 
beneficial thing that individuals could not purchase for themselves: 
defense, police, and judicial services; protection of patents and 
copyrights; and public works of great scale where user charges are 
infeasible.

Over time, the meaning of "public good" quietly evolved to include 
any socially beneficial expenditure. This shift opened the floodgates 
to self-subsidy, since practically all personal expenditures have a 
socially beneficial aspect. If you house yourself, you are preventing 
homelessness; if you educate yourself you are improving productivity; 
if you go to the doctor you are improving health. Now it has become 
full-bore public policy to buy things people can buy for themselves.

The point applies to cultural, charitable, and scientific activities 
as well. These have benefits that extend to the wider society, but 
they are not public goods in the strict sense of not being 
purchasable by individuals. Art, music, literature, scientific 
research, and charitable projects of all kinds can be -- and are -- 
supported privately, both on a profit-making basis and 
philanthropically. If to fund such activities the government taxes 
the people who already would support them, then it engages in 
self-subsidy. The opera-goer who gets a reduced-price ticket because 
of a subsidy is also a taxpayer who pays for that subsidy.

Consider painter Donald Baechler, who has had 27 solo exhibitions 
around the world and sells several hundred thousand dollars of art 
each year. The federal government has decided that he is a valuable 
contributor to modern culture and wants to make his life and work 
easier by putting more dollars in his pocket. He was awarded a 
$15,000 National Endowment for the Arts fellowship in 1989. But at 
the same time the government makes his life and work harder by taking 
thousands away from him in taxes. Baechler commented to The Wall 
Street Journal, "I paid about a quarter of my taxes with my NEA grant.

Farm subsidies illustrate the same pattern. Government spends 
billions to support farmers and bolster their standard of living. In 
1982, for example, the federal budget showed outlays of $13.3 billion 
for "farm income stabilization" (commodity price supports, crop 
insurance, agricultural credit, etc.). I choose 1982 because that's 
when the Department of Agriculture happened to do a survey of 
disposable farm income. It revealed that farmers paid $4.5 billion in 
various business taxes, $1.3 billion in Social Security taxes, and 
$7.6 billion in personal tax payments (such as federal and state 
income taxes, federal self-employment tax, and property taxes). So by 
this accounting (which did not include all tax burdens on farmers), 
government was forcing farm income down by $13.4 billion -- almost 
exactly what it was spending to keep farm income up. Everywhere we 
look, we find government using its powers of taxation to drain funds 
away from the same people and functions that government itself has 
declared worthy, subsidizable social needs.

The Illusion of the Frictionless State

Taxing the same people and activities that you subsidize may be 
pointless, but is there any real harm in it? This was the view of a 
staff member of the Senate Budget Committee when I tried to interest 
her in the dilemma. Self-subsidy represents no real problem, she 
felt, because "it evens out: Everybody pays for everyone else's goods.

This complacency betrays a second illusion about government spending 
-- namely, the idea that the state can transfer resources without any 
significant cost. If this assumption were true, then self-subsidy 
would indeed be no problem. If we took from a poor person, say, 
$1,000 in various taxes and then returned $2,000 to him in various 
benefits, he would simply be up $1,000. Mathematically, it would be 
the same as not taxing him at all and giving him a $1,000 subsidy.

But the state is not a frictionless machine. Governmental transfers 
of resources entail enormous overhead costs, which appear in both the 
tax system that collects the funds and in the disbursement system 
that allocates the subsidies. On the taxation side, they include the 
following:

Tax compliance costs: record keeping, reporting, filling out forms, 
and learning about tax regulations. A recent Arthur D. Little study 
found that the total time businesses and individuals spent on federal 
tax compliance activities was 5.4 billion hours. This translates into 
2.9 million people -- the entire work force of the state of Indiana 
-- working full-time all year long. The economic cost of this labor 
amounts to 24 percent of federal tax revenue. (The detailed 
calculation of this figure, based in part on cost information from 
the IRS and Arthur O. Andersen, appears in my new book, Costly 
Returns: The Burdens of the U.S. Tax System.)

Tax disincentive costs: the loss of production because of the 
discouraging effect of taxes on investment and labor. In recent 
years, a number of economists have made calculations of this "excess 
burden" for a wide variety of taxes. In a 1985 article in the 
American Economic Review, Michigan State economist Charles Ballard 
and his colleagues estimate that for each additional dollar in taxes 
collected the economy loses 33.2 cents of production.

Costs of tax enforcement: resources expended in responding to the tax 
authority. Each act of tax enforcement -- each audit, each notice, 
each levy -- entails a burden for the citizen subject to it. Since 
these actions run into many millions every year, the time and expense 
for citizens is significant. Tax avoidance -- setting up shelters, 
using loopholes, litigation -- entails further costs. My calculation 
of the enforcement and avoidance costs comes to 8 percent of tax 
revenue.

When the overhead costs are added together, (24 percent compliance 
costs, 33 percent disincentive costs, and 8 percent other costs), 
they total 65 percent of tax revenue. Although future studies may 
come up with slightly different numbers, there is no doubt that the 
overhead costs of taxation are substantial. This means that every act 
of self-subsidy entails a significant waste. When the government 
takes a dollar from Peter to give it back to him later, there is a 
huge loss attached to the transaction.

Unfortunately, the bad news doesn't end there. Peter is never going 
to see this dollar, even if it is destined for him, because of the 
waste in the system for disbursing subsidies. These overhead costs 
include the following:

Administrative costs: the resources expended by government in 
attempting to give the subsidy to the right people in the right 
amounts and to control their proper use of it. For example, in the 
federal food-stamp program, the cost of operating the state and 
federal bureaucracies that administer the program amounts to 16 
percent of total spending. Hence, a recipient who was taxed $1.00 for 
this program would, at best, get 84 cents worth of food back.

Subsidy compliance costs: the resources expended to get the subsidy. 
Government benefits don't drop out of the sky. Would-be beneficiaries 
have to apply for subsidies, which means filling out forms, drafting 
proposals, and standing in lines. Getting food stamps, for example, 
requires many days of "work," supplying officials with some 60 pieces 
of required information.

Misallocation costs: resource loss caused by inefficient purchasing 
practices. Because government is shielded from the disciplines of the 
market, it tends to be wasteful. George Mason University economists 
James T. Bennett and Manuel H. Johnson reviewed a number of 
public-private comparisons in service delivery (including trash 
collection, fire protection, ship repair, airlines, and ambulance 
service). They found that it costs government twice as much to supply 
the same service as a private provider -- a 50-percent waste factor.

Subsidy disincentive costs: the loss of production caused by 
undermining incentives to work, save, invest, or innovate. In trying 
to help people, a subsidy will typically weaken their motivation to 
help themselves, lowering productive effort. Government payments for 
disability or retirement, for example, encourage people not to work. 
So do unemployment payments. Economists Lawrence Katz of Harvard and 
Bruce Meyer of Northwestern have found that each 10-day extension of 
unemployment benefits increases the average unemployment spell by two 
days.

To estimate the average disbursement cost for all government spending 
programs would be a major undertaking. But it is clear that we are 
dealing with a very substantial number. Until a more complete study 
comes along, I am inclined to use the Bennett and Johnson figure -- 
$1.00 of waste for every $1.00 spent. Combined with the overhead 
costs of the tax system, this means that it costs $1.65 to raise 
$1.00 for members of Congress to spend on subsidies and overhead, 
with only 50 cents finally getting to the beneficiary. So Donald 
Baechler's $15,000 NEA subsidy actually cost more than $45,000; to 
put $13 billion in farmers' pockets actually costs the country $39 
billion.

Nationwide, the cost of the tax and self-subsidy system is 
staggering. American governments are extracting around $2 trillion 
from the public and imposing tax-system overhead costs of about 
another trillion on top of that. This loss is akin to every American 
family suffering a $48,000 robbery each year. Surely, this tax bite 
ought to figure as a first explanation of hardship -- of the 
unemployed with no savings, of the working poor who can't make rent 
payments, or of the elderly who can't afford prescriptions.

Yet whenever a subsidy is under consideration, members of Congress, 
pressure groups, and journalists stress the neediness of the 
beneficiaries. If the question is medical care, everyone will insist 
that it is "impossible" for workers to afford it out of their own 
resources. But these same workers are subject to taxation. If their 
budget is so tight they can't afford medical care, how are they 
expected to spare the thousands of dollars they are forced to pay in 
taxes? To be consistent, policy makers should agree that if people 
need money, then government shouldn't be taking it away from them.

A Way Out

A simple rule would save us from the waste and futility of the 
overloaded helping state: Never tax and subsidize the same thing. 
Before policy makers try to help some group, they need to make sure 
they are not first hurting them with their tax programs. Before they 
tax some interest or activity, they should check to see that they are 
not already subsidizing it.

This precept seems to have been missing from both popular and 
academic formulations of political economy. The state has been seen 
as a mystical something-for-nothing machine which could aid all human 
aspirations. It has been assumed that funds flow into government 
hands through some harmless process, and that in spending these tax 
monies, policy makers somehow multiply their value. In this 
optimistic view, even self-subsidy represents a kind of plus: The 
cupcake that government buys for you with your tax money somehow 
represents a better, fairer cupcake than the one you buy for yourself.

Overcoming this fallacy directly may not be easy in a culture still 
in the grip of the primitive cornucopia illusion. But indirectly, 
there is a route to sanity. It's the tax-credit approach: Instead of 
taxing a person and then trying to give the money back as a subsidy, 
don't collect the tax and let him use the money for the same purpose 
as the subsidy. A number of these have been enacted in recent years. 
The tax-sheltered Individual Retirement Account lets people save for 
their own old-age pensions, instead of running the funds through the 
tax-and-spend system for the same purpose. The investment tax credit 
is another example. More such ideas are on the way. Freshmen Reps. 
Rod Grams (R-Minn.) and Tim Hutchinson (R-Ark.) are now pushing for a 
$500 child tax credit, on the sensible grounds that letting parents 
spend their own money on their children is a more worthwhile 
child-care program than anything government could ever fund.

There are problems with tax credits, of course. They involve a 
certain amount of red tape, and if members of Congress refuse to rein 
in spending as they enact them, they widen the deficit. But even with 
flaws, they make more sense than digging ourselves deeper into the 
self-subsidy hole. The widespread practice of using people's own tax 
monies to buy things they would buy for themselves amounts to a 
national disaster. We urgently need to undo the intellectual and 
institutional framework that sustains this folly.

James L. Payne is director of Lytton Research and Analysis in 
Sandpoint, Idaho. His latest book is Costly Returns: The Burdens of 
the U.S. Tax System, published by ICS Press.


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