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Economic Perspective

January 15, 1996
Progressivity And Government Downsizing.
by Gene Steuerle

Summary by Tax Analysts®

Economic Perspective columnist Gene Steuerle looks at how issues of progressivity and regressivity affect the debate on government downsizing.

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Gene Steuerle is a senior fellow at the Urban Institute and an economic consultant to Tax Notes.

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[1] The scarce resources available to government should be devoted to those areas where they are needed most. If government operates in such an efficient fashion, it will almost assuredly be progressive at the same time. After all, the greatest needs in society often tend to be more heavily concentrated among those with less income and wealth, while the greatest ability to pay is among those with higher incomes. Nonetheless, it is incorrect to try to apply a rule of progressivity to every enactment of Congress. Not only does this stricter application of the principle tend to prevent other useful action, but it can create a bias toward ever-larger government.

[2] Let us deal with a simplified version of government to prove our case. Assume a government that devotes the same amount of every expenditure to each of its citizens. At the same time, let us suppose that its tax system levies a flat tax rate. To make the example even simpler, our hypothetical society will have only two individuals whom we will label rich (R) and poor (P). Now suppose that R has $100,000 in income and P only $10,000 and that a tax rate of 30 percent is assessed against each of them. Table 1 demonstrates this society:

                               Table 1
             Government Redistribution in Initial Stage
---------------------------------------------------------------------
     Income and Taxes              R              P
---------------------------------------------------------------------

Income Before Taxes             $100,000       $10,000

Taxes at 30 Percent               30,000        3,000

Income After Taxes                70,000        7,000

Government Expenditures           16,500       16,500

Income After Taxes &
  Expenditures                    86,500       23,500
=====================================================================

[3] As can be seen, this system involves a substantial, progressive, redistribution from rich to poor. Interestingly, when debates over progressivity proceed item by item, this type of expenditure system is often considered by many to fail a progressivity test because the rich receive as much as the poor. Similarly, the tax system by itself is defined as proportionate, not progressive, because the poor pay the same tax rate as the rich.

[4] As can be seen by the example, however, there clearly is substantial redistribution from rich to poor. What, then, is going on? The confusion is caused by an inconsistent set of standards. In the expenditure measure of progressivity, dollars are usually compared, whereas in the tax measure, rates are compared. In the United States, we have a tax system that overall is close to being proportionate, even though the income tax by itself has a fairly progressive structure. The expenditure system, on the other hand, probably provides more in dollar terms to the rich than the poor. For example, consider the largest sources of expenditure. The rich generally will receive more educational benefits for their children because the children are more likely to go to college. They will receive more social security because benefits rise with income, and they will receive more Medicare because they tend to live longer. Nonetheless, even the U.S. system is moderately progressive in that the rich pay in far more than they receive, while the reverse is true for the poor.

[5] Suppose now in our simplified society that taxes and expenditures are decreased, say, to a 25 percent rate (Table 2). Then R will pay $5,000 less in taxes and receive $2,750 less in expenditures for a net gain of $2,250, while P will pay $500 less in taxes and receive $2,750 less in expenditures, for a net loss of $2,250. Smaller government, even in this simplified society, implies a less progressive overall expenditure and tax structure.

                               Table 2
             Government Redistribution After Downsizing
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     Income and Taxes              R              P
---------------------------------------------------------------------

Income Before Taxes             $100,000       $10,000

Taxes at 25 Percent               25,000         2,500

Income After Taxes                75,000         7,500

Government Expenditures           13,750        13,750

Income After Taxes &
  Expenditures                    88,750        21,250

Change From Initial Stage         +2,250        -2,250
=====================================================================

[6] Perhaps government has come to be viewed as too large. Perhaps it has become more inefficient, at least with respect to the last dollars it has received. Or perhaps times have simply changed, and during a given period demand for government services has fallen. That is, assume that there is some reasonable argument for downsizing government at some point. If our government keeps this basic general tax and expenditure structure, any cut will initially shift resources from poor to rich, and likely create a hue and a cry about the regressive nature of the change.

[7] Such is one of the major dilemmas, I believe, that is putting too much emphasis on distributional tables and analyses of progressivity for every action of government. If in this imaginary economy, the legislature insisted that every change had to be progressive, then the only direction it could possibly head would be toward larger government. Eventually, in the extreme, 100 percent of income would be taxed and all would be redistributed evenly, a mathematical representation of the expression, "From each according to means; to each according to needs."

[8] Almost no one, whether liberal or conservative, today believes that democratic government should move toward this level of socialism or communism. The extraordinary disincentives of such a system simply involve too many efficiency costs, distortions, and losses of output, as well as corruption. If former communist governments were to be driven, as our imaginary society, by a rule requiring that all legislative changes be progressive, then it would have been impossible for them to achieve some downsizing. Indeed, many of those who oppose the "liberalization" of their former communist societies justify their opposition on the basis of exactly these types of redistributional consequences, in defiance of the requirement to restore appropriate incentives to these societies.

[9] In our simplified society, any requirement to be always as progressive as the current system means that existing levels of taxes and expenditures would set a minimum bound on size of government. No cycles could be allowed, regardless of relative shifts in demand for private and public goods, or relative shifts in the supply capabilities of the public and private sectors.

[10] This example reveals much about the current debate over government in the United States. Almost any downsizing is likely to be somewhat regressive in a static redistributional sense. Once those engaged in the downsizing lose the progressivity debate in the public forum, some become tempted to tilt changes even further by trying to garner the favor of those richer constituencies who are favored. After all, on an interest group basis, they are not going to get much credit on the other end. We end up, unfortunately, with many on both sides debating the issues in a logically inconsistent and incorrect manner: one side arguing that all changes must always be progressive, and the other that progressivity does not matter at all. In fact, government by its very nature should be progressive, but it cannot always be expected to grow, even if downsizing at times will create a less progressive overall system.

[11] Interestingly, by the way, the tendency in the U.S. to spend more in many programs on those with higher incomes gives it the possibility of downsizing simply by evening out some of those expenditure patterns, yet without reducing progressivity. No effort has ever been comprehensively organized along this pattern.

Tax Analysts Information

Jurisdiction:  United States
Subject Area:  Legislative and Policy Issues
Index Term:  tax policy, progressivity
Author:  Steuerle, Gene
Institutional Author:  Tax Analysts
Tax Analysts Document Number: Doc 96-1681 (3 pages)
Tax Analysts Electronic Citation: 96 TNT 11-45