HOW BIG SHOULD GOVERNMENT BE?

Abstract

The appropriate size and role of government depends on the deadweight burden caused by incremental transfers of funds from the private sector. The magnitude of that burden depends on the increases in tax rates required to raise incremental revenue and on the deadweight loss that results from higher tax rates. Both components depend on the full range of behavioral responses of taxpayers to increases in tax rates. The first part of this paper explains why the official method of revenue estimation used by the Treasury and the Congress underestimates the tax rate increases required to raise additional revenue. This is closely related to the on-going debate about the use of `dynamic' revenue estimation. The second part of the paper emphasizes that the deadweight burden caused by a tax rate increase depends not just on the response of labor force participation and average working hours but also on other dimensions of labor supply, on the forms in which compensation is paid, on the individuals' spending on tax favored (deductible or excludable) forms of consumption, and on the intertemporal allocation of consumption. Recent econometric work implies that the deadweight burden caused by incremental taxation (the marginal excess burden) may exceed one dollar per dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending.