The Great Budget Debate

Supply siders and deficit hawks will square off over the best way to rev up the recovery

When Congress returns in January, President George W. Bush is almost certain to propose an economic-stimulus package that includes a heavy dose of tax cuts. Yet already, even without the Bush plan, the nation's budget deficit is expected to soar past $200 billion in current fiscal year 2003.

That collision of big tax cuts and ballooning deficits has set the stage for an acrimonious debate over how large a tax cut the U.S. can afford and whether the positive effects of lower taxes can outweigh the negatives of deeper deficits. Along with the prospect of war with Iraq, tax cuts vs. deficits will be one of the defining political and economic issues of 2003.

Predictably, the fight is breaking down along party lines. Most Republicans, even if they abhor big deficits, will eventually line up behind the Bush plan. Likewise, tax cuts will be attacked by Democrats on the grounds that they create bigger deficits.

Lost in the political dogfight, however, is the critical economic question: What provides a bigger boost for the economy, tax cuts or deficit reduction? The debate has raged among economists since at least 1980, when then-Presidential candidate Ronald Reagan proposed big tax cuts. Supply siders contend that cutting tax rates can unlock forces of long-term growth powerful enough to compensate for bigger deficits. Deficit hawks hold that big federal budget gaps drain vigor from the economy, even with lower tax rates.

Over the past 20 years, economists have learned a lot about the relative impact of tax cuts and budget deficits. But the real advances in knowledge have been obscured by the tendency of partisans on both sides--including economists who should know better--to make exaggerated claims.

The bottom line: At today's levels, income taxes aren't a big burden on long-term economic growth. Similarly, while the budget gap may seem large in absolute terms, it's far below the share of gross domestic product that has historically triggered problems. Once the overheated rhetoric is cleared away, Washington has the flexibility to shape a fiscal-stimulus bill that addresses the needs of the sluggish economy. Here's a primer on the issues that will help sort through the truths, half-truths, and exaggerations in the coming debate.

Let's start with the basics: Have federal income taxes been going up or down over the long term?

Surprisingly, the long-term trend in the income tax has been more or less flat. Over the past 30 years, federal income tax has generally absorbed 8% to 9% of GDP. When it goes much above 9%, as it did in 1981 and 2000, it creates political pressure for tax cuts. When it drops below 8%, as it did in the early 1990s, that opens the door for tax hikes.

Over the past year, with part of Bush's 2001 tax legislation already in effect, federal income taxes have fallen to 8.6% of GDP, right around the 30-year average of 8.4%.

If income taxes are not overly oppressive today, what are the economic arguments for further cuts in tax rates?

In the short term, tax cuts clearly pump up the economy by putting more money in consumers' pockets. It does matter, however, which taxes are cut. Lowering taxes paid by high-income filers is likely to hike savings, which could give an upward jolt to the stock market. In contrast, a cut in the Social Security payroll tax paid by employees would mostly benefit low-income workers, who are more likely to spend it quickly.

The more difficult question, though, is the impact of tax cuts on long-term growth. The core of supply-side theory is that people are discouraged from working harder, investing in themselves, and taking risks if they have to give much of their additional income to the government in the form of taxes.

But after countless economic studies, it's clear that those arguments have been overstated. The positive incentive of lower tax rates on the labor supply is limited. Research shows that it applies mainly to married women, who face high marginal tax rates on their income. Yet this group makes up only 30% of the adult population. As a result, the sort of tax cuts being proposed by Bush "will not have an effect on aggregate economic activity," says Joel B. Slemrod, a tax economist at the University of Michigan.

Moreover, a moderate tax increase appears not to hurt the economy, despite what supply siders claim. In 1993, as President Bill Clinton's tax hike was passed, then-Representative Newt Gingrich (R-Ga.) declared that "the tax increase will kill jobs and lead to a recession." Yet what eventually followed was the longest expansion in U.S. history, a big surplus, and an unemployment rate that fell below 4%.

What about the other effects of lower taxes?

Supply siders make a plausible case that lower tax rates can encourage people to get more education, since they'll retain more of the eventual benefits. And highly skilled workers are more likely to start or join risky new businesses if they expect to keep more of their higher wages. One study, suggests that a lower marginal tax rate boosts the growth rate for small businesses.

But the time lags are much longer than supply siders admit. It may take years--or decades--for lower taxes to have a payoff in a better-educated workforce and new-business formation.

So it's hard to make a strong case in favor of tax cuts. Are there better arguments for holding down budget deficits as a way of boosting growth?

There's just as little hard economic evidence supporting the views of deficit hawks, despite the inherent logic of their argument. Deficit hawks believe that a big budget gap means the government has to borrow more, which drives up interest rates and hampers investment. The theory is that the more the government dips into the nation's savings, the less is available for the private sector. That was the argument made in the early 1990s by Robert E. Rubin, Clinton's top economic adviser who became Treasury Secretary in '95.

Based on this reasoning, various macro-econometric models have estimated that budget deficits will have a big impact on interest rates. On average, these models report that a tax cut that swells the deficit by 1% of GDP will boost long-term interest rates by 60 basis points, reports a new paper by Brookings Institution economists William G. Gale and Peter R. Orszag.

That seems like a pretty straightforward indictment of deficits. So why the continued debate?

The real world doesn't work the way the models predict. In the 1980s, despite giant budget deficits, real interest rates--interest rates minus inflation--fell rather than rose. The real rate on 10-year Treasury bonds stood at 8.7% in 1984, when the budget gap was roughly 5% of GDP. But by 1986, the real rate had fallen to 4.5% because the U.S. attracted enough foreign money to make up for big budget deficits.

The real world didn't behave as expected in the 1990s, either. Even as the budget shifted from a deficit of $290 billion in fiscal 1992 to a surplus of $236 billion in fiscal 2000, real interest rates dropped only slightly, from 4.2% to 4.1%. Nevertheless, investment and productivity growth soared far beyond the hopes of even the most optimistic forecasters.

The deficit-hawk argument failed globally in the 1990s as well. Both Japan and Germany devoted far more of their output to national savings than the U.S. did. So, according to anti-deficit reasoning, their higher national savings should have driven down interest rates and spurred investment. Japan, especially, had a national savings rate well in excess of 30% in the first half of the 1990s--about double that of the U.S. Yet the U.S. economy performed much better.

How could that be?

As global capital markets become increasingly integrated, national economies become less limited by the funds they generate internally. Thus, the U.S. was able to fund 20% of the late 1990s investment boom with foreign capital.

And with capital easily available, what distinguishes an economically strong country from a weak one is how competitive its markets are and how well it fosters innovation. Japan, without much competition or encouragement for innovation, wasted that big pool of national savings on low-productivity projects.

Does that mean there are no links between deficits and interest rates?

No. Brookings' Gale and Orszag argue that interest rates are sensitive to projected budget deficits rather than the current deficit. Econometric studies seem to support the view that a tax change that boosts projected deficits may also raise interest rates.

Unfortunately, over the past 20 years, long-term projections of the budget gap have turned out to be consistently wrong. Long-term deficit forecasts depend on notoriously unreliable projections of growth and productivity. Thus, the claim that interest rates are sensitive to projected budget deficits doesn't tell you much.

What about Social Security? Don't we need to run a budget surplus to fund the retirement of baby boomers?

It's not that simple. The two are issues that need to be considered separately. First is the question of what the U.S. economy can afford as the country grapples with supporting retired Americans. That's a function of future growth.

An economy that grows at 4% a year over the next 30 years will be 33% bigger than one that grows at 3% a year. That's an $8 trillion difference in today's dollars and enough to support retirees if properly distributed.

The other issue is how to fix the funding mechanism for Social Security. Because of the way the system is currently designed, Social Security's financial situation will not improve much even if the country posts faster economic growth. Thus, the Social Security system will have to be changed to ensure its long-term financial viability.

In other words, the U.S. government can run as big a budget deficit as it wants without any consequences?

No. Just as there's a limit to the tax burden Americans are willing to pay, there also appears to be a limit to how big the deficit can get relative to the size of the economy. Historically, when the federal budget gap has approached 5%, as it did in 1983, 1986, and 1992, politicians have felt pressure to do something about it.

We're not approaching that limit yet. The Congressional Budget Office projected that the budget gap would be less than 2% of GDP in fiscal year 2003. Adding the potential costs of an Iraq war would bring the deficit up to 3% of GDP or so. That means there's room to give the economy a fiscal jolt. Either a tax cut of $100 billion a year--1% of GDP--or spending increase of similar size would help boost growth without pushing budget deficits dangerously high.

Ultimately, the U.S. economy is remarkably flexible and resilient. As long as tax cuts and budget deficits don't get too far out of line, American businesses will keep growing and innovating. That's the crucial point to keep in mind as the supply siders and deficit hawks get ready for battle.

By Michael J. Mandel in New York

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