Monday, March 27, 2017

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3. Loss of the Old-Time Fiscal Religion

Map of New Jersey

Before the rise of Keynesianism in the 1940s, the “classical” principles of public finance prevailed. In sum, governments should adopt the same set of financial principles as private households.[23] One should not spend more than one earns. Debt is limited to financing extraordinary items and events—such as war and natural disasters.[24] Prudent fiscal conduct on the part of government means that taxes are kept to a minimum necessary to finance some public goods (e.g., justice, public safety, and the enforcement of property rights and contracts).

These principles were the basis of fiscal conduct until mid-20th century, enshrined in the notion of tax finance, i.e., that taxes (not debt) are the only source of public revenue. Until World War II, the federal government repaid debts incurred for wars. The public treasury was usually balanced or in surplus.[25] Government deficit spending or debt finance was considered profligate and immoral, since it imposes a burden of payment on future generations. Fiscal discipline was based on the principle that current generations should pay for current spending, since only individuals who must foot the bill can fully evaluate public-spending proposals.[26]

These classical principles of prudent fiscal management encouraged an efficient size of government and thus supported long-term sustainable prosperity. Keynes overturned this order, claiming government could manage the economy using public debt as leverage. In the case of public debt, however, the public does not fully observe the source of government revenue and perceives spending as less costly than it actually is. Thus, public demand for spending tends to increase over time, and as taxpayers do not give up anything in the present when the government raises money through bonds, they have less incentive to monitor how the government spends revenues raised by bonds. Unlike private debt, with public debt there is no claim against private assets. The liability for debt is not tied to public officials or to individual members of the community.  Moreover, bondholders do not necessarily care how the government spends the money raised by bonds. They buy debentures because they anticipate a positive return.

The last 40 years of Keynesian economics demonstrate that high levels of public debt and spending create inflation and low growth.[27] In the present era, governments realize that if they present policy proposals with a price tag attached to them, they will find few takers, but if they do not reveal the full bill, voters are more likely to accept such policies. This is the core of fiscal illusion.

By contrast, prudent fiscal management minimizes the amount of resources in the hands of government and promotes robustness and resilience in economies, enabling them to better navigate crisis and recover from shocks. Robustness and resilience depend on the degree to which individuals, especially entrepreneurs, can adapt to changing circumstances. When the government’s share of resources is small, it permits for a more decentralized, and thus, faster, response to economic shocks.[28] Private citizens can amass savings to use for financing private equity and entrepreneurship.

[23] See James Buchanan and Richard E. Wagner, Democracy in Deficit, The Political Legacy of Lord Keynes (Indianapolis: Liberty Fund, 2000). See also Barry Poulson, “Abandoning the Old-Time Fiscal Religion,” available at Vote on Taxes Committee; Bryce Wilkinson, “Restraining Leviathan: A Review of the Fiscal Responsibility Act 1994” (Wellington: New Zealand Business Roundtable, 2004); Barry Poulson, “Tax and Expenditure Limits: A Road to Fiscal Discipline,” available at

[24] Even infrastructure was not always within the purview of the state. Assets such as bridges and roads were often privately financed and built in 19th-century America. The New Jersey Turnpike is an example.

[25] Buchanan and Wagner, Democracy in Deficit,15. As Buchanan and Wagner explain, “Until 1946…the story of our fiscal practice was largely a consistent one, with budget surpluses being the normal rule, and with deficits emerging primarily during periods of war and severe depression. The history of fiscal practice coincided with a theory of debt finance that held that resort to debt issue provided a means of reducing present burdens for the obligation to take on greater burdens in the future. It was only during some such extraordinary event…that debt finance seems to be justified.”

[26] Knut Wicksell, “A New Principle of Just Taxation,” in Classics in the Theory of Public Finance, R. A. Musgrave and A. T. Peacock, eds. (London: Macmillan, 1958), 72-118.

[27] See for instance, Gwartney et al., “The Scope of Government and the Wealth of Nations.”

[28] For a discussion of robustness, see Peter T. Leeson and J. Robert Subrick, “Robust Political Economy,” Review of Austrian Economics 19 (2006): 107-111.