Lessons from the Fiscal Cliff

CAMBRIDGE – One of the many things I learned from Milton Friedman is that the true cost of government is its spending, not its taxes. To put it another way, spending is financed either by current taxes or through borrowing, and borrowing amounts to future taxes, which have almost the same impact on economic performance as current taxes.

We can apply this reasoning to the United States’ unsustainable fiscal deficit. As is well known, closing this deficit requires less spending or more taxes.

The conventional view is that a reasonable, balanced approach entails some of each. But, as Friedman would have argued, the two methods should be considered polar opposites. Less spending means that the government will be smaller. More taxes mean that the government will be larger. Hence, people who favor smaller government (for example, some Republicans) will want the deficit closed entirely by cutting spending, whereas those who favor larger government (for example, President Barack Obama and most Democrats) will want the deficit closed entirely by raising taxes.

As the economist Alberto Alesina has found from studies of fiscal stabilization in OECD countries, eliminating fiscal deficits through spending cuts tends to be much better for the economy than eliminating them through tax increases. A natural interpretation is that spending adjustments work better because they promise smaller government, thereby favoring economic growth.