Where Have All the Dollars Gone?

How the government robs Peter to pay him back.

James L. Payne from the February 1994 issue

(Page 2 of 3)

The Illusion of the Frictionless State

Taxing the same people and activities that you subsidize may be pointless, but is there any real harm in it? This was the view of a staff member of the Senate Budget Committee when I tried to interest her in the dilemma. Self-subsidy represents no real problem, she felt, because "it evens out: Everybody pays for everyone else's goods."

This complacency betrays a second illusion about government spending--namely, the idea that the state can transfer resources without any significant cost. If this assumption were true, then self-subsidy would indeed be no problem. If we took from a poor person, say, $1,000 in various taxes and then returned $2,000 to him in various benefits, he would simply be up $1,000. Mathematically, it would be the same as not taxing him at all and giving him a $1,000 subsidy.

But the state is not a frictionless machine. Governmental transfers of resources entail enormous overhead costs, which appear in both the tax system that collects the funds and in the disbursement system that allocates the subsidies. On the taxation side, they include the following:

Tax compliance costs: record keeping, reporting, filling out forms, and learning about tax regulations. A recent Arthur D. Little study found that the total time businesses and individuals spent on federal tax compliance activities was 5.4 billion hours. This translates into 2.9 million people--the entire work force of the state of Indiana--working full-time all year long. The economic cost of this labor amounts to 24 percent of federal tax revenue. (The detailed calculation of this figure, based in part on cost information from the IRS and Arthur O. Andersen, appears in my new book, Costly Returns: The Burdens of the U.S. Tax System.)

Tax disincentive costs: the loss of production because of the discouraging effect of taxes on investment and labor. In recent years, a number of economists have made calculations of this "excess burden" for a wide variety of taxes. In a 1985 article in the American Economic Review, Michigan State economist Charles Ballard and his colleagues estimate that for each additional dollar in taxes collected the economy loses 33.2 cents of production.

Costs of tax enforcement: resources expended in responding to the tax authority. Each act of tax enforcement--each audit, each notice, each levy--entails a burden for the citizen subject to it. Since these actions run into many millions every year, the time and expense for citizens is significant. Tax avoidance-- setting up shelters, using loopholes, litigation--entails further costs. My calculation of the enforcement and avoidance costs comes to 8 percent of tax revenue.

When the overhead costs are added together, (24 percent compliance costs, 33 percent disincentive costs, and 8 percent other costs), they total 65 percent of tax revenue. Although future studies may come up with slightly different numbers, there is no doubt that the overhead costs of taxation are substantial. This means that every act of self-subsidy entails a significant waste. When the government takes a dollar from Peter to give it back to him later, there is a huge loss attached to the transaction.

Unfortunately, the bad news doesn't end there. Peter is never going to see this dollar, even if it is destined for him, because of the waste in the system for disbursing subsidies. These overhead costs include the following:

Administrative costs: the resources expended by government in attempting to give the subsidy to the right people in the right amounts and to control their proper use of it. For example, in the federal food- stamp program, the cost of operating the state and federal bureaucracies that administer the program amounts to 16 percent of total spending. Hence, a recipient who was taxed $1.00 for this program would, at best, get 84 cents worth of food back.

Subsidy compliance costs: the resources expended to get the subsidy. Government benefits don't drop out of the sky. Would-be beneficiaries have to apply for subsidies, which means filling out forms, drafting proposals, and standing in lines. Getting food stamps, for example, requires many days of "work," supplying officials with some 60 pieces of required information.

Misallocation costs: resource loss caused by inefficient purchasing practices. Because government is shielded from the disciplines of the market, it tends to be wasteful. George Mason University economists James T. Bennett and Manuel H. Johnson reviewed a number of public-private comparisons in service delivery (including trash collection, fire protection, ship repair, airlines, and ambulance service). They found that it costs government twice as much to supply the same service as a private provider--a 50-percent waste factor.

Subsidy disincentive costs: the loss of production caused by undermining incentives to work, save, invest, or innovate. In trying to help people, a subsidy will typically weaken their motivation to help themselves, lowering productive effort. Government payments for disability or retirement, for example, encourage people not to work. So do unemployment payments. Economists Lawrence Katz of Harvard and Bruce Meyer of Northwestern have found that each 10-day extension of unemployment benefits increases the average unemployment spell by two days.

To estimate the average disbursement cost for all government spending programs would be a major undertaking. But it is clear that we are dealing with a very substantial number. Until a more complete study comes along, I am inclined to use the Bennett and Johnson figure--$1.00 of waste for every $1.00 spent. Combined with the overhead costs of the tax system, this means that it costs $1.65 to raise $1.00 for members of Congress to spend on subsidies and overhead, with only 50 cents finally getting to the beneficiary. So Donald Baechler's $15,000 NEA subsidy actually cost more than $45,000; to put $13 billion in farmers' pockets actually costs the country $39 billion.

Nationwide, the cost of the tax and self-subsidy system is staggering. American governments are extracting around $2 trillion from the public and imposing tax-system overhead costs of about another trillion on top of that. This loss is akin to every American family suffering a $48,000 robbery each year. Surely, this tax bite ought to figure as a first explanation of hardship--of the unemployed with no savings, of the working poor who can't make rent payments, or of the elderly who can't afford prescriptions.