A Fiscal Curb To Tame the State?

In this environment, a serious attempt to end deficits by the force of law is truly sensational and deserves more attention than it has received. The two houses of the German federal legislature have enacted a constitutional amendment that limits the combined deficits of the federal and state governments from 2016 onward to an average of 0.35 per cent of national income.

“Average,” in this context, means “over the whole of the economic cycle.” In other words, the German government does not violate its constitution if it runs a deficit of 2, 3 or even 5 per cent of GDP in the down phase of the cycle provided that it runs a surplus of 2, 3 or 5 per cent in the up phase. This presents an awkward problem of identifying the phases of the cycle while they are happening rather than after they have happened. (Mr. Greenspan found the same problem with “bubbles”. It is easy enough to say that the Federal Reserve should have pierced the 1929 stock market bubble, the 2001 dot.com bubble or the 2007 house price bubble before they went too far, but one does not necessarily see that a bubble is a bubble before it has gone too far). Future German governments will always be under pressure to relax the 0.35 per cent rule face to meet the threat of a possible recession and to move to a sizeable deficit, but will also come under pressure not to run a surplus for fear of aborting the recovery. Will future German governments ride roughshod over the rule or circumvent it either overtly or by accounting subterfuges and definitional fudge?

A constitutional rule that bars a monarch, a representative government or the majority will of a society from doing what it very much wants to do is a logical curiosity. It is not unlike this conundrum: “The king decreed that the king must not do X and that he does not do X, the king must undo it and punish the king for disobeying the king”. (For “king”, you may read “the administration” or “the sovereign people” without getting any nearer to resolving the logical problem.) Thomas Schelling, one of the acutest minds of our age, said it all when he called the constitution a vow. It is like a promise to oneself and one’s near and dear to stop smoking or taking drugs; the difference is that it is rather more solemn and more awkward openly to break than an ordinary promise. In any case, however, keeping or breaking it is up to him who has made the vow. The separation-of-powers argument disguises this simple truth. It is functions, not powers, which are divided between the legislative, the executive and the judiciary branches of government. Its power is undivided.

Let us, however, give Germany the benefit of the doubt. If there is a people that genuinely wishes such a constitutional rule to work, and would accept a modicum of austerity to allow it to work, it is the German. Let us suppose, admittedly against the odds, that a constitutional rule limiting the budget deficit to an annual average of next to nothing does really work as an effective curb in Germany or somewhere else. What would be the likely consequences?

The democratic pressure on the government to do good, to help this or that activity and to make the welfare state ever more caring and ever more complete, would continue unabated. The basic reason, of course, is that the hopeful beneficiaries of each and every such measure would expect to bear only a fraction of its cost, the rest being borne by everyone else. Many of the beneficiaries would indeed expect to bear none of the cost, or better still, would simply assume that the cost would be met by some bottomless cornucopia of the state. The government could yield to the electorally most vital of these pressures and spend the necessary sums, but only by increasing total taxation by the same amount, since borrowing from the future would be banned by the constitutional curb.

The politically most feasible targets for levying more revenue would be corporation taxes and personal income and estate taxes on the top slice of income-receivers. However, both these sources are quickly exhausted. Corporations are mobile and cannot very well be stopped from removing themselves or their profits to fiscally less hostile places. Individuals are less mobile, but at high marginal rates of tax are apt to shift their efforts from the making of money to rescuing it from the taxman. Experience proves that even when the distribution of income is very unequal, the real scope for capturing the top slice turns out to be disappointingly small. For really large increases in tax revenues, the government must turn to excise, sales or value added taxes. These are politically less easy targets. They are regressive, hitting the poor and the middle strata more than proportionally. If each round of higher government expenditure is regularly accompanied by a round of higher consumption taxes, even the more obtuse kind of voters will soon get wise to the fact that they are paying the price of every “gift” the government hands them.

The upshot, it seems, is that the share of GDP the state can pre-empt for its expenditures hits a ceiling. The ceiling may be high or low depending on a society’s culture, and may change over the long run. But in any case, there is a ceiling. Putting it in other words, if government is really prevented from mortgaging the future, it becomes genuinely limited, though it may not be small.

Classical liberal thought has always held that government must be limited, but has never given plausible reasons why it should choose to limit itself, nor why society would choose to limit it. Friedrich von Hayek was and is still admired for his constitutional theory which tacitly assumes that sweet reasonableness will make everyone opt for liberty and prosperity. It would be wonderful if a piece of legislation, such as the German 0.35 per cent fiscal curb inspired by a dread of abysmal deficits, proved to be a step towards bringing such a wishful ideal closer to reality.