From Stimulus to Austerity – What Role for Taxes?


In arguably the greatest book ever written on public finance[1], Richard Musgrave pointed out that there are three primary government functions: allocation, stabilization, and income re-distribution.

  • Allocation – if market prices do not reflect all costs and benefits, government can step in to make appropriate adjustments, e.g., cigarette taxes;
  • Stabilization – government should adjust its surplus/deficit to achieve full employment;
  • Income re-distribution – if market forces generate a distribution of income that is not satisfactory to society, government should take corrective action.

But perhaps Musgrave’s most important contribution was to point out that government policies designed for any one of these functions will impact the others. And that makes good government policy more of an art form than a scientific endeavor. Nevertheless, focusing on these three primary government functions is helpful, and I use them to examine possible roles for tax policy when the US government moves from stimulus to austerity.

Allocation – Democrats and Republicans

The ideological divide between Democrats and Republicans is really an argument over allocation. The Republicans believe government should do less and have far less say over how the country’s resources are allocated. The Democrats have an opposing view, believing there are many market imperfections that require more government involvement.


I have recently argued that while politicians are now focusing on austerity, it is yet not time for the US to move from stimulus to austerity. My rule of thumb: wait until the private sector has generated 200,000 new jobs monthly for at least four straight months. However, at some point the focus should switch from stimulus to a more neutral policy that will entail smaller government deficits. What are we looking for?

Congressman Ryan’s proposals, if accurate, would reduce the deficit from 9.72% to 1.6% of GDP over the next 12 years. Over the same period, Obama’s deficit reduction proposals, if accurate, would reduce the deficit to 4.8% of GDP. Table 1 gives you a sense of the deficit reductions, if completed in 2011.

Table 1. – Ryan and Obama’s Deficit Reduction Proposal (in bil. US$) 

Federal % Budget Proposed
Budget GDP Deficit Reduction
2011 9.72% 1,480 (annualized)
Ryan 1.60% 244 1,236
Obama 4.90% 746 734

Source: Congressional Budget Office

Ryan’s proposals would reduce today’s deficit by $1.2 trillion, while Obama’s budget reductions would be $734 billion. With these figures in mind, I turn to possible revenue raising options.

Revenue Raising Options

1. End the Exclusion of Employer Contributions for Workers’ Health Care

If your employer pays for your health insurance, he deducts the payment as cost from his tax base, and you get free health care. This treatment is unfair to the person who pays for his own insurance. From a distributional perspective, it hurts poor people more because they are less likely to have an employer who pays their health insurance. To rectify this, the company’s health payment should be added to the recipient’s income, and the recipient should be allowed to deduct this expense from their tax base. Stabilization Effect: This reform would generate $165 billion annually for the Federal government.

2. Increase the Gas Tax by $1

Per capita, the US consumes almost four times as much gas as other OECD countries. Why? Because US energy policy has been to keep gas prices as low as possible. In contrast, European and Japanese gas prices have been in the $6-$7 range for at least a decade. So the US drives more in bigger cars. The US now imports 67% of its crude oil, and this percentage is growing. Allocation effects of the proposal: It would discourage driving and encourage the use of more fuel-efficient cars. Income distribution effects: its burden would fall more on low-income people who must use their cars to get to work. Stabilization: Increasing the Federal gas tax by $1 per gallon would generate an additional $138 billion annually.

3. End the Mortgage Interest Deduction

Is there any reason why the tax code should give people who purchase their home a break relative to people who rent? I don’t see it, especially after the home buying excesses of the last decade. Allocation effects: it would eliminate the subsidy for home ownership. Distribution effect: this tax break goes primarily to upper income people who often get bigger deductions, and often for more than one home. Eliminating this tax break would have to be done gradually. Stabilization effect: its elimination would generate $121 billion in additional tax revenues.

4. End the Tax Break for Dividends and Long-Term Capital Gains

Dividends and long term capital gains are taxed at lower rates than wages. The argument has been that these tax breaks stimulate investment. While the argument sounds plausible on its face, it does not hold up under scrutiny. The overwhelming majority of stock purchases do not increase the liquidity of the companies whose equities are purchased. Liquidity is added via stock purchases only when for new issues. Most purchases are made of equities already being traded and not new issues. Allocation effects: very little. Distribution: This tax break is of tremendous benefit to the wealthy. Stabilization: Eliminating this tax break would increase tax revenues $101 billion annually.

5. End the Exclusion of Capital Gains Taxation at Death

For some reason, the capital gains tax that would be due if assets were sold during one’s lifetime is forgiven at death. The result: the beneficiary gets the assets tax free. Allocation effect: this exclusion freezes stock purchases that would otherwise be sold to take advantage of the death benefit. Distribution: This benefit goes to people with considerable wealth. Stabilization: Ending this exclusion would increase revenues by $49 billion annually.


As Table 2 indicates, the tax changes discussed above would result in new Federal revenues of $573 billion annually. It would cover 78% of the deficit reduction proposed by Obama and 46% of the deficit reductions proposed by Ryan.

Table 2. – Tax Revenue Raising Possibilities, (in bil. US$)

Item Revenues
Exclusion of Employer Health Care Contributions 165
$1 Gas Tax 138
Mortgage Interest Deduction 121
Dividends/Long Term Capital Gains 101
Capital Gains at Death 49
Total 573

Source: US Congress, Joint Committee on Taxation, “Background Information

on Tax Expenditure Analysis and Historical Survey of Tax Expenditure

Estimates”, February 28, 2011; Gas tax estimates by author

The next article in this series will cover the pros and cons for higher taxes on the wealthy.

[1] Richard A. Musgrave, The Theory of Public Finance, McGraw –Hill, 1959.

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