fiscal cliff and taxes as percentage of income

The discussions associated with the fiscal cliff have brought to light issues that individuals with like political, educational, and/or socio-economic backgrounds passionately disagree.  When it comes to elected officials, the fiscal cliff decisions come down to vote maximization and/or personal beliefs about the benefits of reducing the costs associated with government (i.e. reducing government spending) and the risks associated with increasing the costs associated with government spending (i.e. increasing the tax burden).  To economists, who supposedly are more level headed with less personal attachment to the politics of the issue, the matter comes down to evaluating the numbers and the effects of various policy decisions.


Not surprisingly, professionals with comparable empirical evidence come to completely different conclusions about the effects of the tax increase/cost reductions associated with the fiscal cliff.  The Obama Administration and the Congressional Research Service, for example, have been arguing for some time that increasing the cost of government has little effect on overall economic activity.  On the other hand, many professional analysts and Republican lawmakers with access to the same information come to completely different conclusions.

So, who’s right?  Well, the answer is – it depends.

What appears to be missing from the discussion are the signals associated with the fiscal cliff discussion.  In theoretical and empirical economics and contract theory, signalling refers to information one party to a contract conveys to the other party (see, for instance, Michael Spence’s foundational work on signalling in the labor market).

In the current issue of the fiscal cliff, the matter is the signal the government as a whole is sending to the other party to the contract – the public (in this case the “government” includes Republicans, Democrats, Independents, and so forth; the “public” includes anyone from the lowly moochers to the deserving unemployed to the rich covering the costs of the programs).

What’s the signal the government is sending?  The signal the government is sending, even though Republicans avidly disagree, is that the era of tax liability reduction may be over for the foreseeable future, and that’s a very bad signal to be sending.

It’s one thing to send the signal that tax liability may need to increase on a one-time basis, such as California’s recent one-time tax increases approved narrowly by voters in the 2012 General election.  It’s a completely different thing to indicate ongoing tax liability increases are needed because of the desire among the majority of elected officials to continue to allow costs to rise, rather than employ cost control techniques.

Take a look at the the chart at the top of this article.

The chart simply indicates that the United States as a whole has been committed to the strategy of reducing the cost of government (the tax liability side of government costs) for the past decade and a half.

What concerns most business professionals and other individuals aware of the dangers of the populist “tax the rich” idea is not necessarily that it is being used now, but rather that the United States is sending the signal to investors and international businessmen that the ongoing future of the United States tax structure is on the way up, which is a reversal of strategy since the late 1990s.

And, no doubt, the signal is likely to have a detrimental effect on the longer term outlook of the United States’ economy.

Essentially, because of mostly Democratic signal mismanagement, investment and consumption expectations, and other non-material expectations – in a very real sense – are likely to have downward effects on such things as material construction, material spending, and material profit.  It’s real, and, although difficult to extract in terms of economic measurement, will show up, with most of the effects materializing for our children in terms of slower overall economic growth.

Overall, elected officials should spend some time managing expectations (perhaps spend some time with private equity and other high level investment professionals, who are the masters of expectations management).  It means that individuals with some ability to influence public policy should signal that the tax burden does not need to be permanent and that long term cost management is also part of the U.S.’s federal government’s budget solution.  The U.S.’s hard fought reputation as a place where tax liability is on its way down is a terrible thing to waste.