Where Have All the Dollars Gone?

How the government robs Peter to pay him back.

On the ground, an overloaded airplane still looks like an airplane. It seems to have all the necessary parts—the wings, the motors, the tail assembly. It looks so much like an airplane that passengers may be easily deceived and embark upon it expecting to travel to faraway places. But to the engineer who reckons such unseen factors as thrust and lift, this machine has no capacity for flight. It is, in its present state, nothing more than a truck, a vehicle that can only motor noisily around the airport grounds.

The modern helping state has become something like this overweight airplane. The politicians have used it to subsidize practically everything that human beings could want, from housing to hospitals, from science to string quartets. The prevailing assumption in welfare-state capitals around the world is that there is always room for one more subsidy.

But a close look into the theory of subsidies shows that this assumption is incorrect. Government cannot successfully subsidize a large number of beneficiaries. This is not a statement of opinion, nor even a declaration of fact. It is a mathematical point. Too many subsidies mean that government cannot help anyone. The passengers climb aboard and the engines make an impressive roar, but the plane goes nowhere.

Although Beltway insiders haven't got it yet, some onlookers are beginning to note the circularity of welfare-state economics. "I love the message coming from both parties," said Ross Perot at the National Press Club during the '92 campaign. "'Can we buy your votes with your money this year?'" Perot may be more sound bite than substance, but even he seems to recognize that there is something absurd about this system.

The Cornucopia Illusion

Our intellectual roots leave us poorly prepared to analyze the limits to subsidies. The modern Western tradition treats government as a cornucopia, an inexhaustible source of everything that people might need. Government has a bulging treasury of hundreds of billions that it showers in subsidies in every direction.

A closer look reveals, of course, that this appearance of wealth is deceptive. Government does not create wealth. It is simply an agency for coercively shifting it about. The helping state is not a complete economic system; it is merely the attractive face of an equal and opposite "hurting state," a government that day by day inflicts privation upon its citizens, taking their money away from them.

Economists have generally been willing to point this out, to reveal to their students that the standard government subsidy merely represents the robbing of Peter to pay Paul. Unfortunately, they fail to extend the inquiry. They do not ask the critically important question: What happens when we feel sorry for Peter and try to subsidize him, too? What are the economic implications of taxing Peter to pay Paul, and then taxing Paul to pay Peter?

One excuse they will give for not having studied this problem is that it would be illogical to tax and subsidize the same person. But the idea that governments are rational is, unfortunately, little more than an academic fiction. Subjects and sufferers of governments, from the days of Nero to the age of Rostenkowski, know that wise government is, if not an outright myth, at least an historical rarity.

It may indeed be silly for government to subsidize the same people it is taxing, but that is certainly what it is doing today—on a vast scale. It is practically impossible to find someone who is the object of a government helping program who does not also pay taxes: retirees, farmers, scientists, elderly people needing medical care, veterans, the unemployed, college students, the disabled, even the very poor. Some groups may escape the income tax, but they pay a hefty employment tax as well as a multitude of federal, state, and local excise taxes. We are now in the age of self-subsidy: To a considerable degree, each of us is paying for his own government benefits.

Perhaps we have overlooked this problem because it has crept up on us cloaked in a subtly shifting "public goods" theory of government spending. In its original meaning, a public good was a socially beneficial thing that individuals could not purchase for themselves: defense, police, and judicial services; protection of patents and copyrights; and public works of great scale where user charges are infeasible.

Over time, the meaning of "public good" quietly evolved to include any socially beneficial expenditure. This shift opened the floodgates to self-subsidy, since practically all personal expenditures have a socially beneficial aspect. If you house yourself, you are preventing homelessness; if you educate yourself you are improving productivity; if you go to the doctor you are improving health. Now it has become full-bore public policy to buy things people can buy for themselves.

The point applies to cultural, charitable, and scientific activities as well. These have benefits that extend to the wider society, but they are not public goods in the strict sense of not being purchasable by individuals. Art, music, literature, scientific research, and charitable projects of all kinds can be—and are—supported privately, both on a profit-making basis and philanthropically. If to fund such activities the government taxes the people who already would support them, then it engages in self-subsidy. The opera-goer who gets a reduced-price ticket because of a subsidy is also a taxpayer who pays for that subsidy.

Consider painter Donald Baechler, who has had 27 solo exhibitions around the world and sells several hundred thousand dollars of art each year. The federal government has decided that he is a valuable contributor to modern culture and wants to make his life and work easier by putting more dollars in his pocket. He was awarded a $15,000 National Endowment for the Arts fellowship in 1989. But at the same time the government makes his life and work harder by taking thousands away from him in taxes. Baechler commented to The Wall Street Journal, "I paid about a quarter of my taxes with my NEA grant."

Farm subsidies illustrate the same pattern. Government spends billions to support farmers and bolster their standard of living. In 1982, for example, the federal budget showed outlays of $13.3 billion for "farm income stabilization" (commodity price supports, crop insurance, agricultural credit, etc.). I choose 1982 because that's when the Department of Agriculture happened to do a survey of disposable farm income. It revealed that farmers paid $4.5 billion in various business taxes, $1.3 billion in Social Security taxes, and $7.6 billion in personal tax payments (such as federal and state income taxes, federal self-employment tax, and property taxes). So by this accounting (which did not include all tax burdens on farmers), government was forcing farm income down by $13.4 billion—almost exactly what it was spending to keep farm income up. Everywhere we look, we find government using its powers of taxation to drain funds away from the same people and functions that government itself has declared worthy, subsidizable social needs.

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.

Yet whenever a subsidy is under consideration, members of Congress, pressure groups, and journalists stress the neediness of the beneficiaries. If the question is medical care, everyone will insist that it is "impossible" for workers to afford it out of their own resources. But these same workers are subject to taxation. If their budget is so tight they can't afford medical care, how are they expected to spare the thousands of dollars they are forced to pay in taxes? To be consistent, policy makers should agree that if people need money, then government shouldn't be taking it away from them.

A Way Out

A simple rule would save us from the waste and futility of the overloaded helping state: Never tax and subsidize the same thing. Before policy makers try to help some group, they need to make sure they are not first hurting them with their tax programs. Before they tax some interest or activity, they should check to see that they are not already subsidizing it.

This precept seems to have been missing from both popular and academic formulations of political economy. The state has been seen as a mystical something-for-nothing machine which could aid all human aspirations. It has been assumed that funds flow into government hands through some harmless process, and that in spending these tax monies, policy makers somehow multiply their value. In this optimistic view, even self-subsidy represents a kind of plus: The cupcake that government buys for you with your tax money somehow represents a better, fairer cupcake than the one you buy for yourself.

Overcoming this fallacy directly may not be easy in a culture still in the grip of the primitive cornucopia illusion. But indirectly, there is a route to sanity. It's the tax-credit approach: Instead of taxing a person and then trying to give the money back as a subsidy, don't collect the tax and let him use the money for the same purpose as the subsidy. A number of these have been enacted in recent years. The tax-sheltered Individual Retirement Account lets people save for their own old-age pensions, instead of running the funds through the tax-and-spend system for the same purpose. The investment tax credit is another example. More such ideas are on the way. Freshmen Reps. Rod Grams (R-Minn.) and Tim Hutchinson (R-Ark.) are now pushing for a $500 child tax credit, on the sensible grounds that letting parents spend their own money on their children is a more worthwhile child-care program than anything government could ever fund.

There are problems with tax credits, of course. They involve a certain amount of red tape, and if members of Congress refuse to rein in spending as they enact them, they widen the deficit. But even with flaws, they make more sense than digging ourselves deeper into the self-subsidy hole. The widespread practice of using people's own tax monies to buy things they would buy for themselves amounts to a national disaster. We urgently need to undo the intellectual and institutional framework that sustains this folly.

James L. Payne is director of Lytton Research and Analysis in Sandpoint, Idaho. His latest book is Costly Returns: The Burdens of the U.S. Tax System, published by ICS Press.