Government Spending and Taxation: What Causes What?

In the past few years, as federal deficits have risen to high nominal levels, economists have argued about the effect that raising taxes, ostensibly to reduce deficits, might have on government spending. Some economists, including Milton Friedman, have argued that raising taxes will simply lead to more spending. Others, including James Buchanan and Richard Wagner, have said that the high deficits themselves have been responsible for the growth of federal spending and that if that spending had to be financed completely by direct taxes, people would demand that the federal government spend less. A third group, led by Robert Barro, says that increased taxes and borrowing are results of increased government spending. In section II we briefly review various hypotheses about the relationship between federal government spending and revenues. Section III describes the testing procedure used to discriminate between these hypotheses. The results of four tests are presented in section IV. Section V contains a summary and major conclusions. To foreshadow what follows, we find no evidence that higher real federal taxes today lead to either higher or lower federal spending tomorrow. On the other hand, we find strong evidence that higher spending now will lead to higher taxes later. Our results support a view of the world in which the political system somehow determines how much to spend and then looks for revenue sources to finance that level of spending, including direct taxation, borrowing, and money creation. We also find evidence that real federal revenues are positively affected by real Gross National Product (GNP). Real federal spending also rises with real GNP, but it appears to be independent of the rate of inflation.