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About Starving Beasts and Supply Side Tax Cuts

07 Apr 2008
Posted by Pete Davis

I've spent a lot of time in the middle of the "Starve the Beast" and "Supply Side Tax Cut" debates.  I formulated the Roth-Kemp tax cut in early 1977 and, after working to scale it back, helped pass it in 1981 as the Republican tax economist on the Senate Budget Committee.  I formulated the Earned Income Tax Credit in 1975 and have worked for Democrats too.  I hold myself out as a non-partisan Washington economist.  My main goal all along has been to improve tax and budget policy.  I won't claim much success, but I would offer some observations.

On "Starve the Beast," I vividly recall sitting in the OMB conference room in early 1981 looking at a summary of the budget President Reagan was about to unveil.  His tax cuts were no surprise, but the jump in defense spending was so large, we thought it was a typo.  Spending cuts were proposed, but they came nowhere near balancing the tax cut.  That's where Rosy Scenario came in.  Its projection of sharp personal income and business profit increases yielded lots of revenue and a balanced budget a few years out.  The tax cuts became law; so did most of the defense increase; but Rosy Scenario didn't pan out.  With the exception of the repeal of general revenue sharing with the states, few spending cuts were enacted. Deficits went up sharply.  Throughout his administration, President Reagan predicted declining deficits, but they kept rising.

President Reagan and Congress reacted to higher deficits in several ways.  First, we raised taxes in 1982 by about one-third of the 1981 tax cuts, mostly by going after business loopholes.  Then, in 1983, we "saved" Social Security from going bust with a big payroll tax increase.  Benefits were curtailed far in the future, mostly by extending the retirement age.  So, today, nearly half of all Americans pay more in Social Security and Medicare taxes than they do in federal income taxes.  Third, we enacted Gramm-Rudman-Hollings in 1985 and Gramm-Rudman-Hollings II in 1987 to cap spending growth.  That was like padlocking the refrigerator to enforce a diet, but keeping the combination nearby.  Spending growth finally leveled off as Mr. Reagan neared the end of this second term, but that happened as much from public outcry over the deficits as it did from any budget enforcement policies.

Presidents Bush 41 and Clinton deserve much credit for making the tough and politically perilous decisions to balance the budget.  Old fashioned spending cuts and tax increases enacted in 1990 and in 1993 brought the deficit under control and produced surpluses in FY98, FY99, FY00, and FY01.  The historical appendix of the President's Budget shows the numbers.

On "Supply Side Tax Cuts," I agree completely that marginal tax rate cuts and cuts in the taxation of dividends and capital gains stimulate economic growth that generates offsetting revenue.  The size of that offset was estimated by the Congressional Budget Office in late 2005 to range from +1% to +22% in the first five years and from -5% to +32% over the next five years.  That sounds about right to me.  A lot depends upon the ultimate impact of those tax cuts.  The same is true of spending.  A broad marginal rate cut, or a cut in the double taxation of dividends, has big revenue "feedback," but a special net operating loss carryback for business, as the Senate is about to pass, is just "instant cash," which has little if any "feedback."  Also, tax cuts on top of tax cuts have diminishing "feedback" just as tax increases on top of tax increase yield diminishing incremental revenue.

Finally, I haven't found any silver bullets, when it comes to balancing the budget.  It takes a lot of hard work and difficult political calculus to get the budget under control.  Then it takes a few years for the surpluses to show up, so you don't get much political credit, or worse, like President Bush 41, you get bounced out of office.  Short-run political thinking usually dominates in Washington, and that's why surpluses are so rare. 

Pete, Re: “That's where

Pete, Re: “That's where Rosy Scenario came in. Its projection of sharp personal income and business profit increases yielded lots of revenue and a balanced budget a few years out.” Did the Reagan Administration assume that revenues would be HIGHER due to the tax cuts, ceteris paribus, or just that there would be some (less than 100%) revenue feedback? Bruce Bartlett has claimed the latter. Re: “Presidents Bush 41 and Clinton deserve much credit for making the tough and politically perilous decisions to balance the budget. Old fashioned spending cuts and tax increases enacted in 1990 and in 1993 brought the deficit under control and produced surpluses in FY98, FY99, FY00, and FY01.” Were there really spending cuts during that period, or was that improvement in budget balance due to just a combination of tax increases and strong GDP growth? Spending in real terms increased throughout the 1990s, albeit at a slower rate than before and since. Are you just saying spending declined as a % of GDP? Or perhaps just discretionary spending or per capita spending (which I haven't checked)? Re: “Finally, I haven't found any silver bullets, when it comes to balancing the budget. It takes a lot of hard work and difficult political calculus to get the budget under control. Then it takes a few years for the surpluses to show up, so you don't get much political credit, or worse, like President Bush 41, you get bounced out of office. Short-run political thinking usually dominates in Washington, and that's why surpluses are so rare.” As I pointed out here, I think we need to provide political cover for fiscal responsibility via a bi-partisan or non-partisan commission to develop alternative fiscally-responsible plans, with different sets of trade-offs, coupled with either political pressure or mandate that Congress choose from among the alternatives. Do you agree, or do you see other ways in which the political calculus can change sufficiently for politicians to see fiscal responsibility as less politically costly than continued irresponsibility? (I cynically, but I think realistically, assume that the politicians won’t act fiscally responsibly if it will threaten their re-election or other political future, making changing their calculus key). Thanks.

Pete, I just checked a bit

Pete, I just checked a bit more: In the 1990s Non-Defense discretionary spending went up substantially in real terms. Defense spending declined in real terms, although I assume that had more to do with the end of the Cold War than with any zeal for spending cuts. http://www.heritage.org/research/features/BudgetChartBook/fed-rev-spend-... This chart shows that spending per household was flat during the 1990 in real terms, in contrast to the growth before and since. But average household size decreased 1.5% from 1990 to 2000 (from 2.63 to 2.59), so spending per capita increased, albeit only slightly for a period of a decade. So I'm wondering if all you meant was that total spending in the 1990s declined as a percent of GDP, which seems attributable to strong GDP growth (the denominator) rather than spending cuts, unless I'm missing something.

Starving the Beast and Supply Side Tax Cuts

Brooks:

Re Rosy Scenario, there was no explicit assumption about feedback. It was implicit in the economic forecast. It was nowhere near 100%, but it was large.

Re getting to budget balance post-Reagan, take a look at Table 8.2 in the President's Budget Historical Appendix. You'll see that defense discretionary spending in 2000 dollars declined substantially, and the non-defense discretionary in 2000 dollars was flat. So defense was cut in real terms, and non-defense was cut just enough to keep real spending flat. There were substantial tax increases as well. As I recall, the underlying principle of the Andrews Air Force Base deal was to have a dollar of spending cut for each dollar of revenue increase.

Going forward, I don't have much faith in a deficit reduction commission. The only political cover that works is if a president has enough public support and enough courage to get Congress to sit down with him or her to do the heavy lifting.

Pete




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