Raising taxes can hurt the war effort

One of the best US television clips from the 1950s comes from an episode of Jackie Gleason's Honeymooners.

In the show titled The Income Tax*, Ralph the bus driver thinks aloud about his tax bill. At first he feels resentful. He has been saving his cash for a new bowling ball, not Uncle Sam. But then Ralph considers the state of the world. The show aired as US soldiers were finishing their third bitter winter in Korea. Refugees in Europe were still short of coffee and potatoes. And he changes his mind, breaking into patriotic tears and telling his wife Alice: "Gee, we ought to give all our money to the government."

Wars, more than almost anything, give rise to a willingness to pay taxes. We have the sense that we are ingrates, poor citizens - traitors, in a small way - if we do not accept higher rates in a time of crisis.

This is not necessarily a logical view, as economist David Henderson points out in a wonderful new book put out by this newspaper's sister publishing house, FT/Prentice Hall. In The Joy of Freedom*, Mr Henderson makes the case that less government is almost always better. It even fosters peace, or at least a stronger community.

Mr Henderson's chapter on taxation has particular relevance for this new wartime moment. Higher tax rates, he argues, are not efficient and should not necessarily be supported by those of us who want our nations to be able to afford the strongest possible defence.

This may sound counterintuitive. But here's the Henderson explanation: when a government raises taxes, it also does damage to the general economy. That's because taxes generate what economists call a "deadweight loss". The tax system distorts behavior, forcing people to waste time and money on tax avoidance. Instead of devising a new widget, they commit valuable hours to estate planning, or other activities that are a gain to no one, except perhaps tax attorneys.

What's more, Mr Henderson notes, "the deadweight loss from a tax is proportional to the square of the rate". Thus, he argues, doubling a petrol tax to 20 cents from 10 - the sort of thing Western governments start to contemplate during a war in the Middle East - does more than double the deadweight loss. It quadruples the deadweight loss. Raising the marginal rate on an already progressive rate schedule, another war era move beloved of politicians, also generates deadweight exponentially.

The exponential theory of deadweight loss is not new. It dates back to the 1920s, when it was posited by the economist Frank Ramsey. But it has yet to be absorbed by most lawmakers.

The Clinton administration, for example, billed its early 1990s tax increase as small. Yet in work for the National Bureau of Economic Research, Martin Feldstein and Daniel Feenberg reckon the rise deprived the US economy of two dollars of growth for every dollar the Internal Revenue Service got from it.

The implications of the deadweight loss argument for the war are obvious. Nowadays, waging successful wars requires a robust private sector. Boeing and Raytheon need less deadweight, not more, if they are to do the work of building jet fighters and defence systems. Scientists who develop designer antibiotics to combat the next biowar challenge need a lighter burden as well.

When taxes are already at a historic high as a share of gross domestic product, as they are now in the US, the deadweight loss from incremental rate increases are enormous.

Mr Henderson makes his argument from a libertarian point of view. But that does not mean his point does not apply for those who would like to see an increase in defence budgets. In the Henderson scenario, aka supply side economics, a government is most likely to get revenues it desires by lowering tax rates. Lower tax rates will generate higher tax revenues because people will be more willing to work.

Finally, as Mr Henderson points out, undoing "temporary" wartime tax rises is harder than it seems. During the seond world war, the modern income tax was levied broadly in the US for the first time as a contingency step.

But after VE and VJ days, the tax was cut only slightly. That cut was then reversed, with the Korean War, when a nation of loyal Ralphs allowed their lawmakers to raise America's top rate to a confiscatory 91 per cent. And there it stayed, for a number of very long years, until President John F. Kennedy pushed for a law to hack rates back.

At this writing, House and Senate are still haggling over tax cuts. But with the US surplus fast disappearing, and Washington's promise of a long war, a call for some sort of tax increase looks inevitable. Lawmakers in Washington might like to pick up a copy of Mr Henderson's book. In it, they'll find a perfect case that cutting rates is the most patriotic step they could take.

*The Honeymooners: Lost Episodes, MPI Home Video.

*The Joy of Freedom: An Economist's Odyssey, David R Henderson, FT/Prentice Hall, 2001.

© Copyright 2001 Financial Times

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