Tax hikes are not the first place to look

California faces another budget chasm—one so big rosy scenarios and smoke and mirrors cannot evade.  It has put both budget cuts and substantial tax hike proposals on the table.  But defenders of every spending program insist that theirs is exceptionally deserving and must be spared.   

The resulting focus has been on why every possible funding reduction is unfair and unjustified, backed by the so-called Washington monument strategy of dire threats that the most valuable services (rather than the least valuable ones) would have to be decimated.  The clear implication is taxes must be raised instead.  Unfortunately, however, while it is true that government spending and taxes are not created equal, tax increases are in fact far more costly to society than reining in spending, because a dollar of government spending costs Californians far more than a dollar.

An appreciable part of expenditure programs and the taxes that finance them go to administrative costs, raising the cost of providing a dollar of services to beneficiaries.  Large compliance costs are also imposed on both taxpayers and recipients, but they are not reflected in program budgets.

Ever-changing tax rates and rules also impose substantial risks on every investment decision because they can undermine results after the fact, by reducing, often massively, the returns investors are allowed to keep.

The most important “surcharge” to the burden imposed by government spending, however, is the added social cost of raising the tax revenue to fund it. Taxes introduce a wedge between the value to buyers of the goods and services provided and what sellers receive net of taxes.  And the wedge created by California’s taxes comes on top of the burdens from federal taxes and state and federal regulations (whose costs act like taxes). This eliminates many jointly productive transactions that would otherwise take place, and the wealth they would have created.

Suppose someone faced a 40% combined tax rate on added income, far below the rate for many Californians, given our state tax rate and that multiple taxes are imposed on the same stream of income-creating services and the purchases they finance. That would mean that every arrangement that provided $100 of value to buyers but cost the seller more than the $60 left after the government’s “cut” would no longer be made, and the mutual gains they would have generated disappear with them. Raising taxes further would destroy even more wealth creation.

Including all the costs of taxation implies that the true social cost of even a “well spent” state budget dollar far exceeds a dollar. Therefore, even where it could be demonstrated that a particular spending program generated more in benefits than its budget, which has certainly not been done for all the “indispensable” programs defended, it still would not justify tax increases rather than spending cuts.

Current critics of proposed budget cuts appear most interested in protecting their favorite areas of spending rather than citizens’ well-being.  But that requires forcing the burdens onto state taxpayers.  However, to be justified as good policy, the benefits of any spending project or program have to exceed not just the dollars spent, but all the costs entailed, particularly the very substantial costs from gains wiped out by the greater tax wedges necessary to fund that spending. The list of spending that can meet those higher standards is far smaller than California’s budget.  Since an essential criterion for promoting Californians’ general welfare is for government to do only those things for which the benefits exceed the costs, tax hikes are not the first place to look to solve budget problems.  And that remains true even when program beneficiaries and their patrons loudly proclaim their opposition to losing what other people pay for.

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