Ten Defenses for Irresponsible Tax Cuts, and Why They are Wrong

1. Ten Defenses for Irresponsible Tax Cuts, and Why They are Wrong Jeffrey Frankel John F. Kennedy School of Government Harvard University panel on The Budget Deficit and the American Economy: How Much Does the Deficit Matter? What Should Be Done? with Richard Darman, Glenn Hubbard, and Alice Rivlin; moderated by David Ellwood April 30, 2004

2. When a Republican President Comes In,the Budget Balance Plummets Fig. 1 Budget balance as % of GDP, 1977-2003 Source: Office of Management and Budget

3. Budget Deficits Are Partly Due To Republican Tax Cuts.But Republican Spending Increases Are Equally Important. Fig. 2 Spending as % of GDP, 1977-2003 Source: Office of Management and Budget

4. Ten attempted defenses for fiscally irresponsible tax cuts 10. The Laffer Hypothesis: “A cut in tax rates raises tax revenue.” 9.Ricardian neutrality: “A budget deficit will cause people to save, enough that national saving does not fall.” 8. Optimistic forecasts: “Deficits will go away in the future.” 7. “Starve the Beast”: “Sharp tax cuts that create large deficits will later generate more political support to cut wasteful government spending than would have been possible under a strategy of fiscal discipline that was consistently balanced from the start.” 6. anti-Rubinomics: “Robert Rubin asserted that steps to reduce budget deficits are expansionary, counter to economic wisdom.” 5. Demographics swamp: “The long term deficits in Social Security and, especially, Medicare are so huge that there is no point worrying about an extra few $ trillion of debt in the current decade.”

5. Ten attempted defenses for fiscally irresponsible tax cuts, cont. 4. Hubbard claim for public audience: “Interest rates do not move in lockstep with deficits.” 3. Hubbard claim for audience of economists: “The effects of budget deficits on interest rates are small.” 2. Pro-saving: “Cutting taxes on dividends, capital gains, and estates, will lower the corporate cost of capital and thereby provide a stimulus to investment that is greater than opposing “crowding out” effects that come from the resulting budget deficits via higher interest rates.” 1. We can get away with it. “Reagan proved deficits don’t matter.”

6. 10. The Laffer Hypothesis:“Tax cuts stimulate economic activity so much that revenue goes up rather than down.” • Proponents: Supply siders, e.g., in the 1st Reagan Administratn. • Status among Ph.D. economists: rejected, including by a heavy majority of Republican economists • Bush Administration:“The best way to get more revenues in the Treasury is not raise taxes, slowing down the economy, it's cut taxes to create more economic growth. That's how you get more money into the U.S. Treasury.” -- G.W.Bush, July 24, 2003. • Also Majority Leader T. DeLay: “We, as a matter of philosophy, understand that when you cut taxes the economy grows, and revenues to the government grow.”NYT, 3/31/04. • Glenn Hubbard rejects Laffer Hypothesis. 1/ • Greg Mankiw too: “charlatans.” 1/ ERP, 2003, p.58.

7. 9. Ricardian neutrality:“Budget deficits cause people to save more, enough that total national saving is unchanged. The reason they save is so that their great grandchildren will have enough money to pay the future taxes necessary to service the debt. • Proponents: An academic school of thought founded by Prof. Robert Barro, Harvard University. Has never really caught on in Washington. • Status among economists: Divided. Ricardian neutrality is rejected as a practical proposition by many (seems implausible, and counter to experience of Reagan and Bush deficits).

8. Saving Offsets Budget Deficits? No, National Saving Falls Shares of GDP, 1980-2003 Source: National Income and Product Accounts, Bureau of Economic Analysis, US Department of Commerce.

9. 8. Optimistic forecasts: “Deficits will go away in the future.” • Bush Administration: Asserts this in every bi-annual budget forecast. • Status: Wrong every time. Predictably so.

10. Overly Optimistic Official Forecasts During the Bush Administration Fig. 3 Forecasted Annual Budget Balance Source: Office of Management and Budget

11. Overly Optimistic Official ForecastsDuring the Bush Administration Systematic sources of forecast error by OMB and CBO • The original budget forecasts in Jan. 2001 had: • Overly optimistic economic assumptions • Grossly unrealistic spending assumptions • Pretense of sunsetting tax cuts • Greenspan was so overly optimistic in Jan. 2001, his tax-cut defense was fear of paying down the national debt too low ! • The current official budget forecasts are still optimistic (though they now admit $2 trill. cumulated BD over 10 years): • The Administration is still proposing more tax cuts • No proposal in the budget to deal with the AMT • Total cost of those tax measures: approx. another $2 tr. over 2005-14, beyond CBO 2003.

12. Overly Optimistic Official Forecasts During the Bush Administration (cont.) • Continued unrealistic assumptions about domestic spending: • Official forecast claims to cut real discretionary spending outside defense/int.affairs/homeland security by 15% over next 5 years • Again allows zero for military spending in Iraq & Afg. after Sept.1 • Cost of new Medicare drug benefit now in, but underestimated. • If spending rises with GDP, then outlook $1.6 trillion worse than CBO • If spending rises at the rate of last 5 years, it is $3.3 trillion worse. • Be “conservative”: assume real spending increases only with pop.; add in Medicare legislation cost; & the tax corrections. • Then, rather than returning to surplus in 2012, budget reaches $600 billion deficit. Cumulating over 10 years, outlook is at least $4 trillion worse than CBO said last year, for an unbiased estimate of $6 trillion additional debt.[Rivlin-Sawhill study, or Goldman Sachs]. • Even at today’s unnaturally low real interest rates, debt/GDP ratio is rising.

13. Restoring Fiscal Sanity: How to Balance the Budget Fig. 4 Baseline and Adjusted Outcomes as Percentage of GDP, 2003-2014 Source: Alice Rivlin & Isabel Sawhill, Brook-ings, Jan. 13, 2004

14. 7. “Starve the Beast”:Sharp tax cuts that create large deficits will generate more political support to cut wasteful government spending than would have been possible under a strategy of fiscal discipline that was consistently balanced from the start. • Proponents: E.g, WSJ op-eds, by Milton Friedman; G.Becker, E.Lazear & K.Murphy. • Bush Administration: Following the path trodden by Reaganites 20 years earlier, some tax-cut defenders have switched from the initial strategy of denying that deficits would rise, to the convenient “Starve the Beast” rationale, after record deficits did in fact arise. • Status among economists: Divided. Niskanen rejects it statistically. 2/ 2/ pp. 184-188, in American Economic Policy in the 1990s, edited by J. Frankel and Peter Orszag (MIT Press, Cambridge MA), 2002.

15. Policy steps over the 1990s that achieved record surpluses: • 1990 Budget Enforcement Act: spending caps and PAYGO • 1993 Clinton budget: renewed caps and PAYGO and set paths for T & G • 1998 “Save Social Security first”: • SoTU => bipartisan consensus to save SS surplus (in effect until 2001) • These successful mechanisms have in common the logic of shared sacrifice, and budget neutrality as a criterion for future changes relative to baseline. • “I will forego my tax cut if you forego your spending increase.” • Not “If I screw you on taxes, you will forego your spending.”

16. 6. Demographics swamp:“The long term deficits in Social Security and, especially, Medicare are so huge that there is no point worrying about an extra few $ trillion of debt in the current decade.” • Bush Administration: This does seem to be their approach. • Status: If you are worried that the journey ahead is too long, do you start by walking in the opposite direction?

17. 5. anti-Rubinomics:“Robert Rubin asserted that steps to reduce budget deficits are expansionary, and this is counter to economic wisdom.” • Bush Administration: Hubbard coined phrase “Rubinomics.” But he meant to reject it on Keynesian grounds: fiscal contraction today is contractionary today, which is true. • Status: Rubin’s view and Clinton’s record are best interpreted as follows: a credible future path of fiscal discipline helps reduce long-term interest rates and raise confidence and is thus expansionary. Announcements of future rectitude are more credible when accompanied by specific actions and by proven success at reducing deficits over time (Clinton), and are not credible otherwise (Bush).3/ 3/ Robert Rubin, pp. 130-135, in ibid.

18. 4. Hubbard line crafted for political audiences: “Interest rates do not move in lockstep with changes in the budget deficit.” • Bush Administration: This line -- e.g., Cheney, Jan. 10, 2003 -- superficially seems to support the White House position. • Status: True, but empty of content. Of course not just deficits, but other factors as well, such as monetary policy, often move interest rates.

19. 3. Hubbard claim for audience of economists:“The effects of budget deficits on interest rates are small.” • Bush Administration: This was the defense in Hubbard’s speeches and 2003 ERP. • Status among economists: Divided.Some good arguments on both sides. But the Hubbard theory concedes that deficits will crowd out national investment, so it doesn’t really matter whether this is achieved through a big increase in interest rates, small increase in interest rates, fall in the stock market, or other mechanism.

20. 2 . Pro-saving logic:Cutting taxes on dividends, capital gains, and estates, will lower the corporate cost of capital and thereby provide a stimulus to investment that is greater than opposing “crowding out” effects from the resulting budget deficits via higher interest rates. • Status: So far, neither private saving rates, on the one hand, nor securities markets on the other, have really begun to react to the prospects of widening deficits. We will have to see. My prediction: The saving response will not be enough to outweigh the rising budget deficit. Interest rates will rise for the rest of the decade; and securities prices will fall.

21. 1. We can get away with it. “Reagan proved deficits don’t matter.” • Bush Administration: It is Cheney’s view, according to O’Neill book. • Status: The 1st Bush paid the price, in economics and politics, for the debts he inherited from Reagan. (Ask Dick Darman.) Who will pay the price for the debts incurred by the 2nd Bush

22. In 1981 Ronald Reagan Complained Of Inheriting $1 Trillion National Debt… • Each of Reagan’s terms & the 1st Bush added that amount of debt again, reaching $4 trillion by end-1992. • The 2nd Bush, if he gets another term, will add roughly as much debt as his father, Reagan, and the preceding 39 presidents combined. • Those statistics don’t even take into account the last two omissions: • Usurping Social security & Medicare surplus. Over 10 years, $2.5 trillion. • Bush proposal to expand tax-favored saving accounts loses money outside 5-year budget window that OMB now reports.

23. Adverse Consequences of Growing Deficits • Interest rates: • Will rise, crowding out private spending, and slowing growth. • Balance of payments crisis? • Eventually Asian central banks will tire of funding the US deficit. • Next recession • Will be more severe than the last, because we will no longer have the option to respond with expansionary fiscal policy. • Retirement of baby boom generation: • Cuts in social security and Medicare are now inevitable; the question is whether they will have to be drastic or medium.

24. What Do They Think They Are Doing? • What exactly is Bush Admin.fiscal policy trying to accomplish? • (1) Stimulate economic demand (“Jobs and Growth Act”)? No; Composition of tax cuts is wrong. • (2) Reform the tax system to promote investment? No. Boost to budget deficits is too big. • (3) Political strategy to “starve the beast”? No. The political economy of the 1990s regime was a more effective way to limit spending. • (4) Get re-elected? Maybe. But just in 2004? What about after? • (5) I don’t know what they are doing. My fear: neither do they.