How Did Surpluses Become Deficits?

by Reihan Salam

Lori Montgomery of the Washington Post asks the question on everyone’s mind:

The biggest culprit, by far, has been an erosion of tax revenue triggered largely by two recessions and multiple rounds of tax cuts. Together, the economy and the tax bills enacted under former president George W. Bush, and to a lesser extent by President Obama, wiped out $6.3 trillion in anticipated revenue. That’s nearly half of the $12.7 trillion swing from projected surpluses to real debt. Federal tax collections now stand at their lowest level as a percentage of the economy in 60 years.

The trouble with this paragraph is that it conflates a number of different phenomena that while difficult to disentangle are nevertheless conceptually distinct. The recession of the early 2000s followed an extraordinary asset price bubble that swelled tax revenues in part because it swelled incomes at the top. So it seems pretty important to ask, “How did we achieve surpluses in the first place?” And I think it’s fair to say that an unexpected revenue surge, which derived from productivity gains that derived from years of investment in IT and the organizational capital needed to effectively deploy IT. We can’t really attribute this to a public policy decision, though we did see some spending restraint in this era. We also saw a revenue surge in 2007, which shrank but did not quite close the budget deficit, thanks in no small part to the extraordinary cost of the wars in Iraq and Afghanistan. 

My Economics 21 colleague Christopher Papagianis wrote an instructive piece that touched on some of these issues last August:

In 2000, federal revenues reached 20.6% of GDP, a level only exceeded at the height of World War II. The tax relief enacted in 2001 reduced the level of tax receipts and also slowed their growth. But tax revenues still grew substantially; leaving total tax receipts 27% higher in 2007 than they were in 2000 in nominal terms. After adjusting for inflation, revenues in 2007 were 5.3% greater than revenues in 2000 – a fact rarely mentioned in the current debates about tax policy.

The chart above uses actual tax receipts from 2000 to 2008 to measure the deficit that would have resulted in each of those years under three spending scenarios:

What actually occurred (blue line); Real government spending remained constant starting in 2000 (red line); and Real government spending remained constant starting in 2002 (green line).

 

Had government spending grown at just the rate of inflation over this period, the federal government would have run a $414 billion surplus in 2007. Allowing government spending to grow at three times the inflation rate from 2000 to 2002 (as actually occurred) and then slowing spending growth to the rate of inflation thereafter would have resulted in a $250 billion surplus in 2007. So what’s the lesson here?

One could argue that growing government spending at just the rate of inflation is simply not realistic, particularly in light of an aging population. Yet there is widespread agreement that we could have achieved considerable efficiencies in Medicare and Medicaid. Moreover, it is not obvious that increased expenditures on defense and domestic security were truly cost-effective. 

Then there is the following:

From 2003 (when the tax cuts were fully phased-in) to 2007, tax revenues grew 18% more on a cumulative basis than GDP. The result was a 2.3% increase in the receipts-to-GDP ratio to 18.5%, or 0.7% above the post-1945 average.

This presumably reflects top-heavy income growth, and it is worth keeping in mind. 

Back to Lori Montgomery:

Big-ticket spending initiated by the Bush administration accounts for 12 percent of the shift. The Iraq and Afghanistan wars have added $1.3 trillion in new borrowing. A new prescription drug benefit for Medicare recipients contributed another $272 billion. The Troubled Assets Relief Program bank bailout, which infuriated voters and led to the defeat of several legislators in 2010, added just $16 billion — and TARP may eventually cost nothing as financial institutions repay the Treasury.

I think we can’t emphasize the role of Iraq and Afghanistan enough. The numbers Montgomery cites address the shift, and there is, of course, a longer term cost of caring for wounded veterans that will be quite high. 

Obama’s 2009 economic stimulus, a favorite target of Republicans who blame Democrats for the mounting debt, has added $719 billion — 6 percent of the total shift, according to the new analysis of CBO data by the nonprofit Pew Fiscal Analysis Initiative. All told, Obama-era choices account for about $1.7 trillion in new debt, according to a separate Washington Post analysis of CBO data over the past decade. Bush-era policies, meanwhile, account for more than $7 trillion and are a major contributor to the trillion-dollar annual budget deficits that are dominating the political debate.

The term Bush-era policies is a bit slippery: is she referring to the $6.3 trillion in losses of anticipated revenue plus everything else? Yet she carefully established that it was “the economy and tax bills” that were to blame for revenue losses.

I agree that Bush-era policies played a role: had President Bush and the Republican Congress taken action on mandatory spending and tax expenditures, and if we hadn’t invaded Iraq and Afghanistan, we’d be in much better shape, even with fairly deep tax cuts. I am hard-pressed to see how the high-income rate reductions were a significant part of this picture, particularly if you accept the CBO’s view that the high-income rate reductions triggered a labor response.

Montgomery includes some interesting comments from Republican lawmakers of the early 2000s:

 

But some key advocates of the tax cuts now say such a large reduction was probably ill-advised.

“Nobody would have thought that all these things would have happened after you cut taxes,” Domenici said. “That you’d have two wars and not pay for them. That you’d have another recession. A huge extravaganza of expenditures” for the military and homeland security after the Sept. 11, 2001, attacks. “You would pause before you did it, if you knew.”

Bill Thomas, the former House Ways and Means Committee chairman who helped shepherd the tax cuts through Congress, defended the 2003 package as “fuel for the economy.” But he said in an interview that the 2001 measure was larded with “stuff that I was not all that wild about,” including bipartisan priorities such as a big increase in the child tax credit and a break for married couples — provisions Thomas believes did little to promote economic growth and amounted to “throwing money out the window.”

“I couldn’t do anything about it,” said Thomas, a California Republican who retired in 2006. “You’re the candy man when you advocate those kinds of tax cuts.”

In the end, Bush cut taxes and spent more money. Good times masked the impact, as surging tax revenues reduced the size of year-to-year deficits during the first three years of his second term. But after the economy collapsed during Bush’s final year in office, deficits — and therefore the debt — began to explode as Obama sought to revive economic activity with more tax cuts and federal spending.

That strikes me as a fair characterization. I am particularly sympathetic to Bill Thomas’s take. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.