The Democratic presidential primaries have fueled a debate over President Bush’s 2005 budget and the budget deficit, with voices from all sides claiming to know what policy response would best lessen the currently high deficit projections.
But the one disturbing feature about the 2004 deficit figures is an attribution of $90 billion to a weaker-than-projected economy and $287 billion to the legislated Bush tax cuts. The legislated tax-cut figure does not seem to include many of the substitution effects that occur in an economy when a tax-cut goes into effect. Neither do the base-line projections of the Congressional Budget Office. In a recent Wall Street Journal article, Martin Feldstein touches on this:
The CBO report provides the building block for realistic projections. These estimates imply that even if all the personal tax cuts are extended, a major reform of the Alternative Minimum Tax is enacted to remove most middle-income taxpayers from the AMT, and discretionary spending keeps pace with inflation, the fiscal deficit will decline from 4.2% of GDP in 2004 to 2.7% in 2009 and 2.6% in 2014.
A few paragraphs down Feldstein makes a very revealing point.
Looking ahead, one reason why actual budget deficits may be smaller than those implied by the CBO analysis is that the CBO bases its calculations on a projected GDP growth rate of only 2.8%. The improved productivity after 1995 has caused average GDP growth of 3.4% since then despite the recession. Continued growth at that rate for the next decade would reduce the fiscal deficit in 2014 from the projected 2.6% of GDP to just 0.9% of GDP.
Feldstein shows what growth will do to the deficit. But even his analysis underestimates the true power of a prosperous economy. If things go well, the stock market will rise, so will capital-gains and other tax revenues. Historically, budget surpluses in the U.S. have positively correlated with the growth of real GDP. The historic stock market/GDP ratio also provides a much better explanation of the ups and downs of the budget surplus.
So, if lower tax rates do not produce a higher stock market and higher real GDP growth, aggregate substitution effects (or behavioral changes such as working more, saving more, and investing more) simply do not occur in the real world and there will be no harm to the economy and the markets if tax rates are raised. However, if lower tax rates do in fact produce substitution effects in the real world that lead to a higher level of GDP growth and a rising stock market, then the deficit projections of our government agencies, which ignore these substitution effects, are underestimating the impact of lower tax rates on real GDP growth, the stock market level, and future tax-revenue collections.
With this in mind, let’s consider the possible policy actions of the two likely presidential candidates:
President Bush is to some extent a known commodity. He has already said that he would like to make his tax-rate cuts permanent. Looking back over his first term, he is a man to be taken at his word. Undoubtedly, making the tax rate cuts permanent will be a good thing.
It’s worrisome, however, that the official budget projections now in use underestimate the real GDP growth figure as well as the revenue effect of a strong economy and stock market. Under the rubric that the country cannot afford to do so, the current deficit projections will more than likely stifle any new tax-rate initiatives of a second Bush term. At risk are the lessening or removal of the inheritance tax and the complete elimination of the double taxation of income. Even if tax revenues come in better than expected, the data show that the methodology used by the Treasury and the Congressional Budget Office are biased; they underestimate the substitution effects that occur in the real world and will overestimate the revenue losses of any future tax action.
Sen. Kerry, meanwhile, has pledged to eliminate the Bush tax break on the “rich” and keep the middle-class tax cuts in place. If he buys into the Rubinomics argument (a.k.a. the thinking of former Clinton Treasury man Bob Rubin), he will say that the budget deficit imposes a burden on future generations by “crowding out” private investment. If true, the argument goes, this “crowding out” will lead to higher interest rates and lower private investment, the end result being slower growth and lower income levels in the future — obviously undesirable outcomes.
The counter to the Rubinomics argument is both theoretical and empirical. First, theoretically, if people do in fact worry about their children’s futures, they will collectively increase their bequest motive, savings will increase by the amount of the deficit, and there will be no “crowding out” — and thus no long-term effect on the economy as a result.
On the empirical side, Rubinomics predicts a positive relationship between the budget deficit and interest rates. (So, a negative relationship between the budget surplus and interest rates is an alternative way of saying the same thing.) A casual look at the data suggests that in the U.S. there is no evidence of any “crowding out” effect. Contrary to the expectations of Rubinomics, an improvement in the budgetary conditions appears to be associated with higher not lower interest rates. Another way of stating this relationship is that a higher budget deficit appears to coincide with lower not higher interest rates.
In spite of the empirical evidence, many people in Senator Kerry’s camp hold the Rubinomics view of the world. If they hold sway, it is possible that a newly elected President Kerry may want to implement some new spending programs and improve the budget deficit by raising taxes, in which case the definition of who is rich may include what most people call the middle class.
This is not a far-fetched argument. In 1992 a centrist Democratic candidate promised a middle-class tax cut, but Rubinomics prevented him from delivering on that pledge. While it is true that President Clinton deserves credit for the prosperity achieved during his presidency, it is important to remind people that during the first two years of his presidency the stock market didn’t do very much. (The market feared the First Lady’s health-care reforms.) It was not until the Republican takeover of Congress produced legislative gridlock that the markets began their spectacular ascent. Gridlock was good for the economy and the market. If history is any guide, that may very well be the markets best option in a Kerry presidency.
But let’s be a little more optimistic. Better-than-expected real GDP growth and lower deficit figures will come to pass if we stay the economic course set out by President George W. Bush.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.