Government Budget Basics

This page provides a basic analysis of the dynamics between growing government spending and the tax burden on the private sector. The analysis is meant to conceptually explain the interaction between spending - it does not provide any definitive empirical explanation of any particular government budget. However, an understanding of the conceptual dynamic of a government budget is greatly helpful in the understanding of why governments run into deficit problems, especially persistent ones that last over several years. 

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We have two variables at work here: government spending and the tax burden. Government spending, G, determines the size of government; the standard legislative procedure is that government decides what it wants to give people, then they tries its best to collect the taxes needed to pay for its desired spending.

The function, or curve, called G in Figure 1 below illustrates how government spending evolves when government grows. The bigger government is - measured as any given point on the Government Spending axis - the faster it will tend to grow from there on. The reason for this is in the nature of government spending:

a) the more entitlements government gives to people, the more "growth variables" are built into the budget in the form of cost adjustment for all the goodies government provides;
b) the more employees government has, the more people will expect annual raises and advancement of their benefits.

A small government tends to grow slowly; a large government tends to grow rapidly.

The tax burden, T, is not explicitly tax revenue, but the share of its earnings that the private sector can give up in the form of taxes at any given tax burden. 

The function, or curve, called T in Figure 1 below illustrates what size of government (measured along the vertical line) that any given tax burden can pay for. Up to a certain point, the private sector can accommodate higher taxes, and government can spend more money. However, the ability of the private sector to pay for more government weakens as the tax burden grows; at a certain point, the function T turns downward again, meaning that the tax burden has now grown so heavy that tax revenue begins to shrink. The government that the private sector can pay for actually shrinks. 

This is, plain and simple, the Laffer curve at work.

When we put the two functions together, something quite interesting happens:

Figure 1

So long as we have a small or moderately sized government, spending tends to fall below the maximum government that taxpayers can afford at any given tax burden. This creates a "green" margin between actual government spending and the maximized size of government that taxpayers can afford. 

Think of the green margin as a "buffer zone" between the impact that taxes actually have on people's lives, and the tax collections that would start to bother businesses and families in their daily lives.

This moderately sized government is long gone. So long as government was small enough to fall within the thick of the green margin, legislators in the world's welfare states discovered that they could expand government spending - along the G function - and increase the tax burden, without long-term detrimental effects on private-sector activity. Slowly, however, the green margin shrunk, until it was all gone and the tax burden was so big that taxes became a regular annoyance in business operations and family finances. 

Yet government has continued to grow, primarily because, over time, more and more of government spending consists of entitlements. Soon enough, government spending accelerated above what taxpayers could tolerate; taxes began negatively affecting private-sector activity. 

We are now in the red-margin part of Figure 1. Even a modest expansion of government will have drastically negative effects on the private sector.

Figure 2 explains the policy implications of the green and red margins. If we are in the green margin, then theoretically government could continue to expand; once we are in the red margin, government must shrink:
Figure 2

The problem with government spending as it is in modern government budgets, is that the majority of expenses are for entitlements. We cannot simply shut down entitlements overnight, or we will throw dependent citizens out in the cold - often literally. They have been convinced by generous-with-taxpayers-money legislators that government both can and will provide them with a roster of goodies. When government spending, as a result of those generous promises, grows deep into the red margin, it is the responsibility of our elected officials to roll back the size of government into the green margin - and do it in such a way that those who were lured, like Homer by the Sirenes, into the treacherous waters of government dependency, will come out of the process as stronger, prouder and more independent citizens. 

A prudent path to smaller government consists of two steps: short term and long term. 

Long-term reforms take time to design, legislate and implement. Some take more time than others, but a window of 2-5 years will allow practically all long-term reforms to go from idea to actual policy. 

Given where Wyoming is today, we do not have that much time - we simply cannot rely solely on the long-term reforms to close our runaway budget deficit. We need "breathing room", and the best way to get that is through a process that enhances the efficiency of our current government. Improving the efficiency of government operations is a permanent solution (if done right) that will make current government programs less unaffordable to taxpayers - in terms of our technical analysis, this pushes the government-spending curve out to the right:

Figure 3

The new function Ge (for efficiency) expands the green margin and reduces the red one. In practical terms, this means that we can now make modest but badly needed reductions in the tax burden while we await the effects of the long-term spending reforms. 

Please note that an efficiency improvement of government does not change the slope of government spending. Most of our tax dollars still go toward funding entitlements, and the efficiency reform will leave the entitlement growth parameters largely intact.

That said, if we use wisely the breathing room provided by the efficiency reform, we can launch long-term spending reforms so that their positive effect on the economy gradually add on to the gains from the efficiency reform.

Permanent spending reforms aim to permanently change the trajectory of government spending. Their purpose is to target the growth parameters of all government-spending programs, thus forcing government spending to fall in line with what taxpayers can afford under any given tax burden. The theoretical point is explained in Figure 4, where the black arrow represents the growth trajectory of a government when its spending is long-term compliant with basic principles of fiscal conservatism:

Figure 4

Fiscal conservatism means:
  • as much as possible keeping government away from economic redistribution;
  • concentrating government resources on protection if life, liberty and property; and
  • at all times confining government to a tax burden that will not negatively affect the private sector.
In other words, all the permanent-spending reforms needed to individual entitlement programs will be accompanied by one, over-arching reform that confines total government spending to the private sector's ability to pay for government without negative impact on the continuous operations and long-term growth and prosperity of businesses or the finances of individual citizens and families.

For examples of actual reforms to spending programs, please see my previously published examples of K-12 education and Medicaid reforms, as well as my proposal for privatizing the University of Wyoming.

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