January 16, 2004, 9:23 a.m.
Deficit Mongers & the IMF
It’s time to “crowd out” unsupportable economic analysis.

A favorite pastime of the Democratic presidential candidates is to denounce the big federal budget deficits. They are fond of pointing out that President Clinton left the current administration with a budget surplus and that it vanished in a few short years under George W. Bush.

The culprits, according to most, are the Bush tax-rate cuts and the increase in defense spending. The assertion is that deficits lead to higher interest rates, which "crowd out" private investment and slow down economic activity. Unfortunately, the deficit-monger view of the world is not confined to U.S. politicians — the International Monetary Fund recently echoed almost verbatim the "crowding out" hypothesis.

The following quote from a recent IMF report criticizing the Bush administration's economic policies could not be more precise as to the views of this international body.

With budget projections showing large federal fiscal deficits over the next decade, the recent emphasis on cutting taxes, boosting defense and security outlays, and spurring an economic recovery, may come at the eventual cost of upward pressure on interest rates, a crowding out of private investment, and an erosion of longer-term U.S. productivity growth ...

The logic of the deficit mongers is compelling. There is only one small problem — the data do not support their views. If you compare federal budget surpluses as a percent of gross domestic product with 3-month Treasury-bill yields during the 1980's, both trend downward. So, in this case, the correlation is the opposite of what the deficit mongers forecast. And if there is no real link between higher budget deficits and higher interest rates, the deficit-monger argument falls apart.

There is simply no reason to worry about the possible effects of the deficit on interest rates.

That said, the solute to the budget deficit lies in the economy's growth rate. When the U.S. growth rate picks up, so does the budget surplus (i.e., the budget deficit declines). Equally important is the fact that fluctuations in real GDP growth precede those of the budget surplus. Hence, if one is willing to equate temporal precedence with economic causality, the data suggest that growth causes surpluses.

More, with the advent of the investor class and the booming stock market during the last 25 years, capital gains have become a major source of tax revenue. In fact, a higher real GDP growth rate and an appreciation of the equity markets relative to GDP is all that is needed to eliminate the U.S. budget deficit.

Which brings us back to the IMF.

The IMF report suggests that the Bush tax-rate cuts gave the economy only a modest boost; that the tax measures only modestly shifted the tax burden from income to consumption. A second criticism is that while the tax rates on dividends and capital gains were lowered, they were not eliminated. A third and final criticism is that the Bush tax-rate cuts did little to address the complexity of the U.S. tax code.

The IMF position is hard to understand; they cannot have their cake and eat it too. They complain that the Bush tax-rate cuts cost too much and so they want to reverse them. Simultaneously they complain that the rate cuts did not eliminate the disincentives of double taxation and regulatory burden due to tax-code complexity.

Well, if the Bush administration did nothing more on the tax front, some of the IMF criticisms would be valid. But they are looking at the Bush tax-rate cuts as a fait accompli, instead of what they are: a work in progress that eventually will lead to the elimination of the double taxation of income.

President Bush has pledged to make his tax-rate cuts permanent and to eliminate the double taxation of income. Once the objectives are accomplished the transformation from income to consumption taxation will be complete, and so will the simplification of the tax code.

Ever since the days of Ronald Reagan the world has been noticing the favorable results of the supply-side policy mix and the IMF has been losing influence as a result.

— Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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