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The Amount of Government Spending Is Not Independent of the Means of Financing

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Here’s a letter to my friend Richard McKenzie:

Richard:

In your latest, excellent post at EconLog [2] you quote Milton Friedman’s insistence that “the true tax” is “how much government is spending.” You quote Friedman further: “If you’re not paying for it in the form of explicit taxes, you’re paying for it indirectly in the form of inflation or in the form of borrowing.”

Friedman’s point is both correct and important, and you’re right to remind readers of it. It’s a reality that too many people – including too many economists – ignore.

But I disagree with you on one small matter – specifically, with your claim that:

How the added government outlays are financed—through taxes, newly printed dollars and inflation, or debt—is of secondary importance, perhaps only marginally affecting people’s incentives.

If the amount that government spends were independent of the means of financing, then I’d agree with you. But the amount that government spends surely is not independent of the means of financing.

Spending financed with newly created money gives, at least for a time, citizens-taxpayers the false impression that government-supplied goods and services are less costly than they really are. Therefore, resort to spending financed with newly created money, by lowering the perceived prices of government programs, increases the quantity of such programs that the public demands beyond what it would be were these prices more accurately perceived.

Resort to deficit spending works similarly. By allowing today’s government spending to be paid for by tomorrow’s citizens-taxpayers, deficit financing allows today’s citizens-taxpayers to free ride on future generations. The inevitable result is that today’s citizens-taxpayers will demand more government spending today than they would demand were deficit financing unavailable. Indeed, because, unlike money creation, deficit financing doesn’t itself fuel inflation, deficit financing plausibly fuels an even greater and longer-lasting excess of government spending than does money creation.

In short, while Friedman correctly insisted that the real cost of government is the amount that it spends, it’s a mistake to suppose that this reality implies that the means of financing government are of little importance. Because financing with money creation or debt causes government spending to be higher than it would otherwise be, the means of financing are of paramount importance.

Sincerely,
Don