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A Conservative Fix for Future Debt Crises

Europe is on the doorstep of its second debt crisis in a decade.

As it happens, I warned about it back in June. I also pointed out that when the new debt crisis hits, the European Central Bank—a.k.a., the knight in shining armor that saved Europe last time—will have no resources to do it again

Others are beginning to notice the dark debt cloud on the horizon. On June 28th, a senior official with the World Bank called for new laws that allow governments to more easily “restructure” their debt. This is technocratic code-speak for “make it easier for governments to default” on their debt. 

It is also a hint that analysts at the World Bank believe a new sovereign-debt crisis is unavoidable. 

Yet more analysts are chiming in, in large part agreeing with my analysis. However, there is no time for hand wringing as the new debt crisis unfolds. It is high time for everyone involved, in particular government officials, to start finding answers to two questions:

a) Why is Europe on the cusp of another debt crisis, a mere decade after the last one?

b) Instead of feeble stopgap measures to alleviate the fallout of the crisis, perhaps this time we should look a bit deeper and try to prevent future debt crises, period?

You would think that the answer to the first question, which implies the answer to the second question, is heavily technical and accessible only to economists. That is not the case: the cause of Europe’s recurring debt crises, and the factor that drives America at highway speed toward her first, has nothing to do with economics. 

The key to our answer lies in a compelling essay for the Institute of Family Studies. In a discussion of the dire state of the traditional family in America, Kay Hymowitz reports a serious decline in the number of children living in the same household as both their parents.

A similar trend is underway in most of Europe, led by a decline in marriages and child rearing. According to data from Eurostat, from 2009 to 2019, the total number of households in the European Union increased by 7.3%, but the number of households with children declined by 1.5%. 

There are exceptions, with Hungary as the herald of conservative family policy. Just to take one example: household data from Eurostat shows that over the past ten years the number of children per household in Hungary has slowly increased. This trend is contrary to the rest of Europe. 

But what does this have to do with Europe’s recurring debt crises? 

Here is the connection. The disintegration of the traditional family is in large part the work of the socialist welfare state. It is not the fact that government provides support for struggling families—on the contrary, it is perfectly reasonable that government provides a basic safety net for people who, for no fault of their own, lose their ability to provide for themselves. But this conservative type of welfare state is a rare find in today’s world: the standard welfare state in Europe is concentrated on giving benefits to families with working parents.

As Hymowitz explains, the trend is similar in America. Statistics out of Canada speak the same grim language: the total number of live births increased by 13.5% from 2000 to 2019, but the number of children born to unmarried mothers increased by more than 22%.

The modern welfare state, which engages in economic redistribution instead of poverty relief, is a reward system for single parenthood. It encourages parents to abandon traditional marriage and instead enter matrimony with government. 

There comes a point where the erosion of the traditional family starts taking an economic toll on a country. It is also one of the strongest contributing factors to perennial deficits in the government budget. Put simply, the modern socialist welfare state comes with a built-in mechanism that drives up its own cost: it rewards parents who favor benefits over gainful employment, and encourages them to stay in low-paying jobs over developing their careers.

A similar incentives structure applies to working couples as well, albeit less forcefully. As the influence of economic redistribution reaches a critical mass, workforce participation and labor productivity stagnate to where they can no longer provide enough tax revenue to fund an increasingly expensive welfare state. 

Figure 1 illustrates this point. The growth rate of the welfare state is represented by “g” and the growth rate of the tax base by “t”. When the two are equal, the cost of the welfare state stays unchanged over time (the dashed line); when the cost of the welfare state outpaces the tax base, the welfare state gradually claims a growing share of the economy:

Figure 1

The solid line is the path to perennial budget deficits and recurring debt crises. 

Every socialist, economically redistributive welfare state ends up on the solid line. Once there, if we wish to maintain the welfare state in spite of perennial fiscal problems, we have only two options: raise taxes or cut benefits. 

While Europe has gone for higher taxes and nobody has cut benefits, America has tried to find a third option: perennial budget deficits. They have done so based on so-called supply side economics: cut taxes and stimulate economic growth, and tax revenue will grow enough to pay for the welfare state. 

Back in the 1980s, President Reagan was wrestling with steady budget deficits, a relative novelty in America at the time. In comes economist Art Laffer. While having lunch with a couple of officials from the Reagan administration, he drew his famous Laffer Curve on the back of a napkin and convinced them that tax cuts would generate a surge in tax revenue. This surge would close the budget deficit forever. 

This sounded like magic to Reagan and his advisors. They could suddenly go to Congress and promise them that they would not have to raise taxes or cut welfare-state benefits. Since both options were equally detested in Congress—the former by Republicans and the latter by Democrats—Laffer’s “all you need is love and tax cuts” lyrics won bipartisan support. 

There was just one problem. Laffer’s tax-cut mechanics didn’t work. As it turned out, you can’t fund a welfare state with tax cuts, no matter how much you cut them. 

In his book The Great Deformation, David Stockman, director of the Office of Management and Budget under President Reagan, explains (p. 99) that once the Laffer tax cuts had been enacted, “the prospect of a 6 percent of GDP structural deficit during peacetime was truly frightening.” However, credible warnings of government indebtedness fell on deaf ears in Congress. As deficits prevailed, Stockman says, the “massive outpouring of red ink” was a price that Congress thought worth paying; after all, they did not have to cut spending or raise taxes. 

Two other presidents, Bush Jr. and Trump, have also tried tax cuts to increase welfare-state funding. The result has been deeply entrenched budget deficits and a rapidly approaching debt crisis. 

But would it have been better to raise taxes, as they did in Europe? Before we get to this question, let us note why Art Laffer’s tax cuts failed to balance the U.S. government’s budget. It is important to see why, because it helps explain how there can only be one permanent remedy for the welfare state’s debt crisis. 

In The Triumph of Politics, Stockman explains further why the Laffer approach failed. From his position first as a Congressman, then as director of the Office of Management and Budget, Stockman was trying to convince President Reagan that when faced with high inflation and budget deficits, the president only had one package of politics to choose from: a strict monetary policy and spending cuts combined with responsible tax cuts. 

This Gold Standard approach, as he calls it, stood in stark contrast to the Laffer camp’s singular solution to all macroeconomic and fiscal problems: tax cuts. In reality, Stockman explains, Laffer’s tax cuts could only work if inflation remained high. That was the only way he could guarantee that tax revenue would be rising steadily (Triumph, p. 69):

If you implemented the Gold Standard Napkin and stopped inflation, Professor Laffer’s Tax Cut Napkin didn’t work. You would get more real economic growth but no gain in federal revenues. Consequently, only sweeping domestic spending cuts could balance the budget—an action that I believed was desirable but which the other supply siders had denied would be necessary.

Stockman was proven right by the fact that the federal government has run a deficit every year since 1969 (except for four years in the late 1990s). He has also been proven right over the past 15 years when the Federal Reserve has made the deficits “affordable” by printing money on overtime.

Should America have chosen the European model instead and raised taxes? Alas, no: thanks in part to its overall higher tax rates, Europe has experienced economic stagnation for much longer than America has. Part of the reason for this is the restructuring that Europe’s tax systems underwent as the welfare state was put to work. 

The period from 1965 to 2005 is a good framework for studying how the efforts to fund the welfare state changed the tax landscape in Europe. According to tax revenue data from the Organization of Economic Cooperation and Development, OECD, the average tax burden in 1965 for 17 European countries (for which OECD data is available) was 26.4% of GDP. By 2005, that average had risen to 37.6%.

To get this extra revenue, the welfare states had to reach out to new parts of the economy: in 1965 the average European country got 38.4% of their revenue from consumption taxes, i.e., the VAT and other taxes on goods and services we buy on a regular basis. In 2005 that share had fallen to 29.6%.

While taxes on consumption did not exactly decline, the main target for raising new revenue was personal income. Adding up regular income taxes and payroll taxes (which include social-insurance contributions), their share of government revenue went from 54.9% in 1965 to 64.4% in 2005. 

This is a stunning shift, which helps explain why wages and salaries have been largely stagnant in Europe for at least 20 years now. Your paycheck is by far the most important source of revenue for government. 

In some countries, government’s reliance on income-based taxes—again including payroll taxes—has grown dramatically. In Greece, these taxes paid for 42% of all government revenue in 1965; by 2005 the share exceeded 60%. In Norway, the share increased from 55% to 70%.

Even in Switzerland, otherwise known for tax-policy moderation, personal income has become an essential source of revenue. In 1965 income taxes and payroll taxes funded 56% of government; in 2005 that share was 68.5%.

Since 2005, the government burden on Europe’s taxpayers has only grown heavier.

But if tax hikes and budget deficits aren’t the way to go, then how do we fund the socialist, economically redistributive welfare state?

In short: we don’t. The socialist welfare state is inherently unaffordable. It destroys its own tax base and leads to economic stagnation. The only alternative is to reform the welfare state in such a way that it loses its socialist profile. By rewriting government’s social duties in the image of conservatism, we can guarantee that the welfare state will be fiscally affordable. 

We will also kill many of the forces that destroy the traditional family. Budget deficits notwithstanding, that is a goal worthy of pursuing in itself. 

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.