In my most recent post, I discussed whether tax cuts can help grow an economy, even if there are no cuts in government spending.  I concluded that although cutting spending would be the key driver of increased economic growth, it is possible for tax cuts to help with growth without spending cuts if taxes are really high and acting as a severe disincentive to work.

If we are on the left side of the peak of the Laffer Curve, then the cutting of taxes will ultimately lead to less tax collections by the government.  If spending remains the same (or increases), then the deficits are going to increase.  While this is seemingly bad, there is a long-run case to be made for this, as opposed to not cutting taxes at all.

To be sure, cutting taxes can have an initial stimulative effect, just as creating money out of thin air has an initial stimulative effect.  But government spending and monetary inflation both ultimately misallocate resources and hurt wealth generation that is in accordance with consumer demand.

In addition, cutting taxes can give some of us a better chance in terms of saving extra money in the short run and investing in assets that benefit from the inflation.  But cutting taxes and not cutting spending will, on net, typically not be beneficial for society as a whole and for economic growth.

However, the case to be made for tax cuts is that it will perhaps put stricter limits on spending in the future.  To examine this closer, let’s take an extreme example.

Let’s say that the deficits keep getting bigger and bigger.  Let’s say that interest rates also go up as the debt goes up.  The interest payments from the Treasury get larger and larger.  The interest payments consume a greater and greater portion of the federal budget.

If the federal budget remains the same overall, then a bigger and bigger percentage has to go towards paying the debt.  This means that spending will be cut elsewhere, whether it is on military spending or domestic welfare.

Let’s say we hit a scenario where the federal government is still spending $4 trillion per year in total, but payments on the national debt now equal $2 trillion annually.

In round numbers, the government currently spends about $4 trillion, with about $300 billion (a little less) going towards interest payments.  Essentially, the government is spending around $3.7 trillion on everything else.  In the above scenario, the government would now only be able to spend $2 trillion on these same things if the total budget remains the same.

This would mean massive cuts.  Some would say it would mean cuts to “services”.  But for libertarians, it would mostly be positive.  It would mean major cuts to the military and a likely scale back on interfering in other countries.  It would likely mean reduced entitlement spending.  It would mean massive cuts, or perhaps eliminations, to whole departments such as education, energy, commerce, and transportation.  Maybe it would mean major cuts in drug enforcement, the spying agencies, and the intelligence agencies.

Instead, this $2 trillion would be going to the holders of U.S. government debt in the form of interest payments.  This would likely include substantial amounts to the central banks of China and Japan.  It would also mean substantial amounts going to investors.

In any case, it would likely be a better allocation of resources.  At least the private investors would likely put the capital to productive use.

But more importantly, we would see a continued rise in interest rates.  Maybe we would see a default on the debt at some point.  We would likely see the U.S. dollar lose its status as the world’s reserve currency.  And even though the Fed can create money at will, there are limits here.  The limit is that they don’t want to see runaway price inflation.

And once the Fed has to stop (or at least severely slow down) its creation of money, then it will be up to private investors and foreign central banks to buy the debt.  But the government won’t be able to afford to issue a lot more debt at this point, especially at high interest rates.  Ultimately, the politicians in DC will be limited to what they can collect in taxes.

Unfortunately, even though this will all be painful when it inevitably happens, it is likely going to be necessary in order to downsize the federal government.  Unless we have a quite dramatic turn in public opinion towards libertarianism, this is our likely path for downsizing Washington DC.

If overall spending by the federal government could fall to $3 trillion annually, or even $2 trillion, we will be so much better off.  There will be winners and losers in the short run.  However, in the longer run, it will be mostly those with the political power who lose.  The average American will be a beneficiary in the long run, even if there is some short-run pain.

If tax cuts with higher deficits can speed up this process, we will actually be better off.  I would rather see the government have to downsize extensively in the next five years than have to wait another couple of decades.  The quicker that this downsizing can happen, the quicker we will return to greater prosperity.