Transcript Ten Defenses for Irresponsible Tax Cuts, and Why They are Wrong Jeffrey Frankel John F.

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
When a Republican President Comes In,
the Budget Balance Plummets
Fig. 1 Budget balance as % of GDP, 1977-2003
3
2
1
2003est
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
-1
1977
0
-2
-3
G.W. Bush
W.J. Clinton
G.H.W. Bush
-6
J. Carter
-5
R. Reagan
-4
-7
Source: Office of Management and Budget
Budget Deficits Are Partly Due To Republican Tax Cuts.
But Republican Spending Increases Are Equally Important.
Fig. 2
Spending as % of GDP, 1977-2003
24
23
22
21
G.W. Bush
W.J. Clinton
R. Reagan
J. Carter
19
G.H.W. Bush
20
2003est
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
18
Source: Office of Management and Budget
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.”
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.”
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.
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).
-6.0%
-4.0%
Net Private Saving
Net Government Saving
Source: National Income and Product Accounts, Bureau of Economic Analysis, US Department of Commerce.
G.W. Bush
W.J. Clinton
G.H.W. Bush
1980-I
1980-III
1981-I
1981-III
1982-I
1982-III
1983-I
1983-III
1984-I
1984-III
1985-I
1985-III
1986-I
1986-III
1987-I
1987-III
1988-I
1988-III
1989-I
1989-III
1990-I
1990-III
1991-I
1991-III
1992-I
1992-III
1993-I
1993-III
1994-I
1994-III
1995-I
1995-III
1996-I
1996-III
1997-I
1997-III
1998-I
1998-III
1999-I
1999-III
2000-I
2000-III
2001-I
2001-III
2002-I
2002-III
2003-I
2003-III
-2.0%
R. Regan
Saving Offsets Budget Deficits? No, National Saving Falls
Shares of GDP, 1980-2003
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
-8.0%
Net National Saving
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.
Overly Optimistic Official Forecasts During the Bush
Administration
Fig. 3 Forecasted Annual Budget Balance
400
300
200
US$ bn
100
0
-100
-200
-300
-400
-500
Jan.
2001
Aug.
2001
Jan.
2002
2002
Aug.
2002
Jan.
2003
2003
2004
Aug.
2003
Jan.
2004
Source: Office of Management and Budget
Overly Optimistic Official Forecasts
During 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.
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.
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,
Brookings,
Jan. 13,
2004
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.
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.”
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?
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.
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.
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.
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.
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
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.
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.
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.