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Deficits and High Spending Can Frustrate Tax Cuts
Liberal arguments against tax cuts never take into account the possibility of actually - oh dear no! - cutting spending.
As right-wing as Eric Alterman and Al Gore seem to think the media is becoming, there doesn’t seem to be much press enthusiasm for the Bush administration’s economic policies. Many reports are on balance skeptical of tax cuts, but the coverage does highlight some potential pitfalls of the administration’s present course.
U.S. News and World Report recently described President Bush’s budget proposal as a “curious mix of austerity and profligacy.” It contains both domestic spending cuts and new “compassionate conservative” expenditures; it includes both tax cuts and increases in defense spending, as well as spending on that new item we once thought our defense spending was purchasing, homeland security.
Unsurprisingly, the tax cuts are treated as the real source of the profligacy. This particular article, for example, says that the “tax plan comes with a hefty price tag” that will be followed by “deficits as far as the eye can see.” The report similarly implies that tax cuts are responsible for the shift from a projected $5.6 trillion surplus to a projected $1.5 trillion deficit (never once pausing to consider that the latter projection may turn out to be as illusory as the former).
Nowhere is there any suggestion that perhaps the federal government ought to divest itself of certain functions it has assumed. Proposals to devolve activities to the states are presented as an attempt slough off expenses on cash-strapped states (which they may legitimately be under present circumstances, although this would not have to be the case if the federal government seriously sought to restore the Tenth Amendment and state governments themselves seriously sought to restrain their spending). Only war with Iraq is presented as an activity of government that is both highly costly and not inevitable. Entitlement spending commitments are treated as immutable, perhaps understandably given that under current political conditions they are.
The thrust of this article and so many like it is that the most important choice is between cutting taxes and tolerate deficit spending or balance the budget by keeping taxes at least as high as under present rates, if not higher. No allowance is made for a third option – shrinking government and focusing it on its constitutionally legitimate, to say nothing of newly pertinent, function of securing the American people. This is because many of Bush’s critics believe that human progress can only continue as long as the dizzying ascent of the federal budget is uninterrupted, while many of his supporters simply assume that deficits are the price to be paid for tax cuts.
Both sides fail to correctly learn from the record of Ronald Reagan. Matthew Benjamin’s February 17 U.S. News article almost dismissively reports that the Bush administration relies on economic growth as “the magic potion that will cure all.” But it is unmistakably the case that lower marginal tax rates did not drain the federal treasury in the 1980s. The top marginal income tax rate was reduced from 70 percent (50 percent on “earned income”) all the way down to 28 percent. Yet in seven out of eight years of Reagan’s presidency, the federal government received more revenue than it did the previous year. In each of those eight years, the federal government collected a greater amount of revenue than it did in any single year of any previous administration. Overall, tax collections doubled between 1981 and 1989. Even with the deficits of the 1980s, the “cost” of the Reagan tax cut was far less than static estimates projected.
This was partly due to the acceleration of economic growth after lower marginal tax rates improved the incentives for work, innovation and production. The economy roared back to life after a decade of stagflation, growing 6.8 percent in 1984 and averaging 4 percent annual growth between 1983 and 1989. With incentives to shield or underreport income reduced, revenues grew even faster than the economy – over the same period, personal income tax receipts increased 5 percent per annum.
But this result has led many conservatives – including, at times, this writer – to become to cavalier about deficits, which eventually led to a laxer attitude about spending generally. Yes, there are times – such as, perhaps, the height of the Cold War, the war on terrorism or possibly a war with Iraq – where running a deficit is acceptable. Certainly, it is better to run a deficit than to create or enhance disincentives for productive economic behavior and thus damage the economy in a counterproductive pursuit of arbitrary balance-sheet goals. Yet this does not mean that shifting from tax-and-spend economics to borrow-and-spend is wise either from the perspective of limiting government or maximizing economic growth.
The Reagan economic program may have been even more successful if it had not coincided with deficits. In addition the reduction in government borrowing to go along with the lower taxes, the political conditions would not have shaped up in such a way as to result in deficit-reduction tax increases throughout the 1980s, culminating in major tax-rate increases in 1990 and 1993. Instead, taxes might have gone even lower than they did. If the Bush does not show more boldness on government spending, his tax cuts will not be as lasting as they should be.
Much of the current economic debate revolves around two competing fallacies. Some conservatives have borrowed from the Keynesians the idea that deficits are stimulative, while some liberals have jettisoned their old economic faith to embrace Robert Rubin’s idea that avoiding deficits, even at the price of higher taxes, is stimulative because it keeps interest rates down. Deficits, like taxes, on balance extract money from the private economy and thus do not contribute to its growth. But the effect of any given year’s deficit on the amount of available private capital is very small compared to other factors. This means that contrary to Rubinomics, a deficit’s negative effects may be more than offset by other factors while the benefits of keeping federal borrowing in check can be more than offset by anti-growth tax policies.
All of this is fundamentally an issue of our exorbitantly high level of federal spending. A $2.23 trillion budget in the context of today’s economy is an extremely large amount for a government to spend in a free society. The root problem behind the dilemma of whether to lower taxes or balance the budget, to the extent that it is a real dilemma and not just a product of politics and static scoring, is that federal spending has grown beyond our capacity to pay for it through an economically rational tax policy.
The best solution to this problem would be to return to the Founders’ system of enumerated powers and to cut all government spending not authorized by the Constitution. This would still allow for meaningful homeland security, although perhaps not all spending politicians try to sneak through labeled as such. But perhaps even a more modest level of spending restraint, such as limiting the growth of the federal budget to the rate of inflation or introducing the first actual spending cuts in years, would be beneficial.
Sure, tax cuts might prevent some additional government spending. But the Bush economic team shouldn’t rely on this as a primary source of budgetary discipline. In the long term, those who try to cut taxes while letting spending continue to rise are eventually disappointed.