3. Government Requires Taxation

Government cannot create wealth; it can only transfer it.  For every dollar spent by the government, a dollar is taken from private individuals using force, commonly known as taxation.  Wealth is effectively stolen from taxpayers, and transferred to government bureaucrats and the recipients of government spending.

When analysing effects of government spending, we must always keep in mind both sides of the equation; we must not forget that all spending must ultimately come from the proceeds of taxation.  Whether the government raises tax rates, borrows money, or inflates the money supply, for every dollar the government spends, a dollar must, either immediately or eventually, be taken from taxpayers. 

Let us illustrate this with an example:

First let us consider a useless government project: a $1 million “bridge-to-nowhere” which will be of no value to anyone.  The $1million must come from the proceeds of taxation; it must be stolen from taxpayers.  Suppose there are 10million taxpayers.  On average, each individual is 10c poorer because of the government action.

What would each taxpayer have done with his 10c?  He would either save it, or spend it on consumption.  Either way, what each individual does with their 10c is determined by their own preferences.  The structure of production will adjust to satisfy the extra demand generated by the extra 10c that each individual has.  If all individuals would have spent their 10c on consumption, this would represent a change in time-preferences, in favour of present goods.  If all individuals save their 10c, this would also represent a change in time-preferences, in favour of future goods.

For simplicity, suppose that, with their additional 10c each, each taxpayer would have clubbed together to build themselves a useful bridge across a river between two towns.  (Equivalently, suppose that an entrepreneur who would have embarked upon the building of the useful bridge now will not, because without the 10c in each individual’s pocket, the venture would no longer be profitable.)   

The most obvious effect of this government action is that the useful bridge will now not be built and consumers will be that much worse off.  Even in this case, the utility of the consumers is reduced.  However, there is no distortion to the structure of production here in terms of types of industry; no new jobs in the bridge-building industry have been created, they are simply moved from one location to another. 

If the same bridge-builders that would have built the useful bridge will now be building the useless bridge, they clearly do not benefit at all; they are simply working in a different location.  The only distortion to the structure of production here is geographical; businesses in the area of the useless bridge benefit from the consumption spending of the bridge-builders, at the expense of the businesses in the area of the useful bridge, where the bridge-builders would otherwise have spent their money.  If it will be a different group of bridge-builders building the useless bridge as would have built the useful bridge, then one group of bridge-builders will gain employment while another group of bridge-builders will lose employment, representing a further geographical distortion.

A more realistic scenario is that each individual would have spent his 10c in a different industry, and it would not be another bridge that must be foregone.  Because of the taxation, there will be slightly less demand for thousands of different products.  Each taxpayer is slightly worse off through not being able to satisfy his marginal ends.  Fewer goods will be produced and society as a whole will be that much poorer. 

In this scenario, the structure of production has been distorted from useful industries and into bridge-building.  New jobs in the bridge-building industry have been created, but only at the expense of jobs in other industries, which, by definition, would better satisfy consumers’ needs.  Potential technological progress in the useful industries is foregone, and skills and knowledge in those industries may decline.

After the bridge has been built, demand for bridges returns to being genuine consumer demand.  If the bridge-industry gained by the government spending, it will now lose the same amount back into the structure of production geared to satisfying consumer demand.  The temporary distortion of the structure of production delays technological process, wastes resources, lowers productivity and causes disruptions to employment.  The bridge itself is of no benefit to society, so producing it was a pure loss.  No one has benefited in the long-term from the bridge coming into existence.

Now consider a potentially more useful government project: say, a beautiful water fountain in the middle of a city.  The fountain costs $1million.  All the same temporary disruptions and distortions to the economy take place as with the bridge-to-nowhere.  The same $1 million is taken from taxpayers to pay for the fountain as it was to pay for the bridge.  The same $1 million-worth of useful goods and services will now never come into being.

But this time, something useful has come out of the spending; many individuals enjoy seeing the fountain.  Some would have paid 10c to see the fountain.  But overall, $1million would not have been given up by people to see it, or else it would have built already by an entrepreneur, charging admission.  Even if 900,000 people were prepared to pay 10c to see the fountain, this would still represent a waste of resources.  100,000 people would have had 10c stolen from them and got nothing in return.  As well as being unjust, the decision to support the building of the fountain by the government – even though it would have been supported by a majority – is a waste of resources and worsens the structure of production.  The measure of whether a project is a good use of resources is whether it is profitable or not.  If a business were profitable, it would not need to be done by government.

So even an apparently useful government project like a fountain, by definition, lowers consumers’ satisfaction below what it otherwise would have been.

When analyzing the effects of government spending, we need to consider both the direct and indirect effects of the spending as well as the effects of taxation.  Now we shall consider the effects of spending and taxation separately.