by Robert Kleine, M.B.A., Vice President and Senior Economist

This Advisor presents the reasons why the proposed federal tax cuts may be ill-advised.

The rush is on in Washington to reduce taxes regardless of the consequences for the economy and despite polls that show that most Americans prefer a reduction in the federal budget deficit to a tax cut. It seems that little was learned from the experience of the 1980s. The claims of some tax cut supporters that cuts will pay for themselves by stimulating economic activity is ludicrous for two reasons.

  • First, to slow down the economy, the Federal Reserve Board (the Fed) is raising interest rates. A tax cut will mean that fiscal and monetary policy will be working at cross purposes. The result will be higher interest rates, which will offset the stimulative effect of the tax cuts and cause an explosion in the budget deficit, which will push interest rates even higher.
  • Second, to avoid increasing the deficit and pushing up interest rates, there appears to be general agreement that the tax cuts should be offset by spending reductions. As a result, the stimulative effect of the tax cuts largely will be offset by the expenditure reductions.

In my view, when the economy is strong and the budget deficit is over $160 billion and expected to increase after the current fiscal year, there is no justification for cutting taxes.

The Budget Deficit

As shown in Exhibit 1, considerable progress has been made in reducing the budget deficit in recent years, due to the deficit reduction acts of 1990 and 1993 and the strong economic recovery—which is in part due to the progress made in reducing the deficit.

The deficit peaked in FY 1991 at $290 billion and is expected to be “only” $162 billion in the current fiscal year before beginning to rise again in FY 1996, due mainly to expected increases in the cost of entitlement programs (e.g., Medicare, Medicaid, Social Security). As a share of the economy (as measured by gross domestic product, or GDP), the deficit peaked in FY 1983 at 6.1 percent, was 5.2 percent in FY 1991, and is expected to be 2.3 percent in FY 1995. However, the Congressional Budget Office forecasts that it will rise to 2.7 percent of GDP in 1999 and 3.6 percent in 2004, assuming no tax cuts and the expiration in FY 1999 of the dollar caps on discretionary outlays. The deficit problem is even worse than it appears, however, because now there is a large surplus in the Social Security Trust Fund ($71 billion in FY 1995), but this will quickly disappear and the fund will incur a deficit after the “baby boomers” begin to retire, in about 2010. Excluding Social Security, the deficit for FY 1995 is estimated at $233 billion, jumping to $325 billion in FY 1999.

There is little disagreement that federal spending should be reduced or at least slowed. It is, however, the explosion in debt (largely since 1981), not runaway spending, that has increased the deficit. Current revenues exceed current expenditures (minus interest on the debt) by $57 billion. At the end of FY 1981 the federal debt held by the public was $785 billion (the current interest on this alone is $51 billion annually), and since then it has increased by another $2,648 billion. The interest on this latter portion will be $174 billion in FY 1995, exceeding by $12 billion the expected annual deficit of $162 billion. (See Exhibit 2.) In other words, if the federal debt had remained at the 1981 level, the budget would be in surplus.

Expenditure Reductions

The new Republican majority in the U.S. Congress has pledged its support for a balanced budget amendment to the Constitution. Balancing the budget is easy to talk about but much harder to deliver.

The growth in the budget is in entitlement programs, which are expected to increase 7.6 percent annually (adjusted for inflation) from FY 1994 to FY 1998. Expenditures for defense and nondefense discretionary spending actually are expected to decline over the next few years. It is clear that the budget cannot be reduced without slowing the growth in entitlements, which means cutting benefits, because much of the growth is being driven by cost increases and not by higher real benefits or more claimants.

Can this be done? The Kerrey-Danforth Entitlement Commission was not even able to reach consensus on a set of recommendations, and everyone has taken Social Security, which is 22 percent of the budget, off the table. When you add expensive tax cuts—those proposed in the House GOP “Contract with America” are estimated by some as costing $200 billion over five years and $700 billion over ten years—the problem becomes unmanageable.

Exhibit 3 sets out the magnitude of the spending reductions that will be required to balance the budget in FY 1995 and FY 2000 without tax cuts. For example, in FY 1995, if only discretionary spending (this excludes entitlements and interest on the debt) is reduced, the required reductions will be about 30 percent. (See Exhibit 4 for a summary list of discretionary programs.) If we wait until FY 2000, the required reductions will be 44 percent.

If one assumes that some entitlements will be cut and only defense, Social Security, and interest on the debt are off limits, the required cuts in FY 1995 will be 23 percent, rising to 27 percent in FY 2000. Even the modest tax cut proposed by the president, estimated to cost $60 billion over five years, will increase the required cuts in FY 2000 to 33.5 percent; the ten-year cost is projected at $175 billion.

Cuts of this magnitude will be very painful, and state and local governments, which receive hundreds of billions of dollars from the federal government, will feel the most pain. The drying up of federal funds could force up state and local taxes and also force cuts in state programs that are closer to citizens and more popular than are many federal programs.

The federal government also could pass programs on to the states, without funding, or require states to pay all the costs of new programs. This will encourage state officials to push hard for an amendment to the Constitution that will prohibit unfunded mandates from being imposed on lower levels of government. (Michigan has such a provision in the state constitution, to protect local governments from the state’s telling them that they must implement a program and pay for it themselves.)

Some good could come out of all this, however: The American public may be about to learn a lesson in the reality of what benefits they really receive from government.

As serious as the deficit problem is in the near term, it becomes much more so over the longer term. The baby boomers will begin to retire in about 2010, which will cause an explosion in Social Security and health (Medicare and other) costs. In a 1993 report the federal General Accounting Office estimated that by 2030 the federal budget deficit could exceed 40 percent of GDP. This can be prevented by taking relatively modest actions now, such as reducing Social Security benefits to those who have high incomes, raising the retirement age, capping cost-of-living increases, or raising taxes slightly. However, if we wait too long, draconian actions will be required, such as doubling the Social Security tax or reducing benefits sharply. Cutting taxes now will only add to the long-term problem.

Economic Growth

The economy appears to be on the right track—there is solid, real economic growth and low inflation, and the Fed is committed to fostering continuation of this trend by attempting to keep economic growth at a moderate rate. To accomplish this, the Fed has raised the federal funds rate (the rate at which banks borrow from one another and the principal rate it controls) six times in the past year, from 3 to 5.5 percent, and it is likely to raise it again.

I believe that the Fed has overreacted to the threat of inflation and is dangerously close to pushing the economy into a recession. Exhibit 5 shows the historical reaction of the economy to increases in the federal funds rate. As shown, an increase of more than 3 percentage points has resulted in a decline in GDP 12 months later. Another 0.5 percent jump in the current rate will push the overall increase to 3 percent.

The Fed’s record in fine-tuning the economy is not very good, in part because its actions generally aren’t felt for six months to a year. In several instances its actions have pushed the economy into recession. As discussed above, a tax cut will complicate the problem for the Fed and possibly increase the chance of a policy misjudgment.

My view is that the best thing for the economy is low interest rates—as demonstrated by the economic reaction to the decline in rates in 1993—and any action that could push up rates, including tax cuts, should be avoided. Even if the Fed were not to react to tax cuts, the bond markets likely will panic about the likelihood of the federal budget deficit’s ballooning and sharply push up interest rates.

The U.S. economy is in its best shape in nearly 30 years, and with export markets opening worldwide and the United States becoming more competitive, the long-term outlook is bright—but only if we pursue responsible fiscal and monetary policies.

What we need are measures to encourage savings and investment, improve our education system, raise the standard of living of lower-paid workers (by expanding the earned-income credit for example), improve our job training system, control health care costs, and allow us to continue to chip away at the budget deficit.

A tax credit for families with children is not going to achieve any of these purposes. Changes in the tax system that could move us toward these goals are replacing the corporate profits tax and the employer share of Social Security taxes with a value-added tax, eliminating certain tax preferences and lowering marginal tax rates, indexing capital gains for inflation, and possibly enacting the president’s proposal to allow education expenses to be deducted for federal tax purposes as well as the Republican proposal to expand individual retirement accounts. However, to avoid increasing the budget deficit, all such changes should be revenue neutral or offset by expenditure cuts.

Conclusion

Major changes have been promised in Washington, but it looks like politics as usual. There appear to be too many politicians willing to throw away the painful gains of the last few years in order to gain votes by cutting taxes. They give lip service to fiscal responsibility but won’t or can’t say what specific budget reductions will be made to pay for the tax cuts.

I do not believe this is the time to cut taxes, but if it is to be done, we should learn from the lesson of the 1980s and enact spending cuts before the tax cuts. I believe that the voters are looking for responsible leaders and are more interested in an efficient, fiscally responsible government than they are in tax reductions. Increased efficiency and fiscal responsibility will result, in a few years, in the opportunity to reduce taxes without damaging the economy and creating an unmanageable long-term deficit problem.


Copyright © 1995

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