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The Deficit Dance
Sub-par economic growth is the culprit, not tax cuts.


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Larry Kudlow

Whether you’re New York City Republican Mayor Michael Bloomberg, or California Democratic Governor Gray Davis, or OMB director Mitch Daniels, or President George W. Bush, there is one immutable fact when it comes to budgets: Economic growth solves the problem of deficits.

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It follows then that the pursuit of maximum economic growth should always be the number one fiscal priority for our leaders. And yet it’s not.

The federal budget deficit was $158 billion for fiscal year 2002. Democratic politicians blame this shortfall on the Bush tax cut of 2001. But how can they? The bulk of the reduction in personal tax rates designated in that cut do not occur until the 2004 to 2006 period. Thus far, only about 10% of the tax cut has even taken place.

The real blame for the deficit can be placed on sub-par economic growth over the past two years, including the three-quarter-long recession in 2001 that was carried over from the Clinton-Gore administration. Since then, the economy has recovered at 3% — but 3% is a sub-par rate of growth.

Since 1947, the average yearly growth rate of the inflation-adjusted U.S. economy is 3.5%. Since 1982, a twenty-year period covering the disinflationary, tax-cutting, deregulated, information-economy revolution launched by President Reagan, annual real economic growth averaged 3.6%. This pace overcame the dismal 1970′s stagflation period and brought the economy back to its full potential to grow.

In recent years, however, the economy has been buffeted by recession, terrorist bombing attacks, war plans, a plunging stock market, and unprecedented corporate corruption and accounting fraud. Since the end of 2000, our real growth has slowed to 1.4% annually.

As a result, actual economic performance has fallen below the long-term 3.5% historical trend line, which reflects the economy’s indisputable potential to grow. If that trend line were extended through 2002, as though no slowdown had occurred, then the potential third-quarter gross domestic product would have been $9.829 trillion. Instead, actual GDP fell $364 billion short of the mark. Cumulatively, over the past two years, the loss of potential GDP comes to $1.95 trillion — a considerable amount.

All this would be academic were it not for the fact that total output in the GDP account (as compiled by the Commerce Department) equates with the taxable income base of the nation’s economy. So a smaller output pie means a shrinking tax base. If you apply the 18% economy-wide tax rate of recent years to the nearly $2 trillion loss of potential output, you get a $351 billion shortfall in tax revenues — which we’d be counting now if the economy had been running at full steam.

Even if you add in the early stages of the Bush tax cut and the sizable increases in federal spending for military and homeland-defense, the U.S. budget would have registered a $193 billion surplus instead of the official $158 billion deficit — if the economy had grown at its normal pace.

Of course, this lost revenue cannot be recaptured. But there’s plenty we can do to promote a better economic future, one that will have us quickly climbing out of deficit and back into surplus.

A return to a 3.5% long-run growth path with a 5% yearly growth rate over the next three years will get us there comfortably. This may sound like a tall order next to what the pessimists say, but it can be achieved. Normal rebounds after past recessions tended to run near 5%. Output-per-hour productivity is presently running over 5%. With a normal 1% expansion of the labor force, a 5% productivity rate translates to a 6% growth rate. And that, of course, would bring us all the way back to our long-run potential to grow. It would also bring us back to surpluses.

As the president and his team outline their new economic policy for the State of the Union message in late January, they should consider a 5% economic growth target that would bring the federal budget into balance. They should also take great care not to permit any tax-and-spending policies that would create barriers to a 5% growth rate.

Traditionally, when you combine tax incentives that encourage private investment with restraints on federal spending, you get a policy mix that nurtures growth and allows our remarkable productivity to leverage the economy to its potential. It is this thinking that should dominate the upcoming policy debate. For deficit-suffering state and city officials, the exact same logic should prevail. Tax hikes and spending increases are the wrong medicine.

Obsessing over deficits is merely a distraction. Growth is the name of the game.



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