This column by ACRU General Counsel and Senior Fellow for the Carleson Center for Public Policy (CCPP) Peter Ferrara was published March 29, 2012 on Forbes.com.
The Washington Post proclaimed editorially on March 21, “There is no credible path to deficit reduction without a combination of spending cuts and revenue increases.” They insisted that this “is the fundamental failure of the budget blueprint released Tuesday by House Budget Committee Chairman Paul Ryan.”
But this criticism is factually wrong as a matter of simple mathematics. Under CBO’s score of the Ryan budget, federal revenues virtually double over the next 10 years from $2.444 trillion today to $4.601 trillion by 2022. That is one whopping revenue increase, roughly $2.2 trillion, which is more than the entire GDP of almost every other country in the world.
And we know for certain that the revenue increase will be much more than that. That is because under CBO’s simple minded static scoring no credit is given for the extra revenues resulting from increased economic growth due to the proposed tax rate cuts in Ryan’s budget.
Ryan proposes to reduce the current 6 federal income tax rates to just 2, 10% and 25%. He has previously said the 10% rate would apply to couples earning less than $100,000 a year, and singles earning less than $50,000, with the 25% rate applying to incomes above that. But in the budget he rightly leaves those precise thresholds and the deductions and credits to be eliminated in the tax reform to the House Ways and Means Committee as they determine necessary to leave the whole reform revenue neutral.
Ryan also proposes to reduce the federal corporate income tax rate from 35% to 25%, the same rate as in China. That 25% rate is the international average, and Ryan’s proposed reduction is the minimum necessary to restore international competitiveness to American business.
Such rate reductions would stimulate increased production because the marginal tax rate, the tax rate applied to the last dollar of earnings, controls the incentives for production. It is the tax rate that determines how much the producer is allowed to keep out of what he or she produces. For example, at a 25% tax rate, the producer keeps three-fourths of his production. If that rate is increased to 50%, the producer keeps only half of what he produces, reducing his reward for production and output by one-third. Incentives are consequently slashed for productive activity, such as savings, investment, work, business expansion, business creation, job creation, and entrepreneurship. The result is fewer jobs, lower wages, and slower economic growth, or even economic downturn.
In contrast, if the tax rate is reduced from 50% to 25%, what producers are allowed to keep from their production increases from one-half to three-fourths, increasing the reward for production and output by one-half. That sharply increases incentives for all of the above productive activities, resulting in more of them, and more jobs, higher wages, and faster economic growth.
Under more realistic dynamic scoring taking these effects into account, the rate cuts would not lose as much revenue as the CBO expects, and so the growth in revenues would be even more than it estimates as reported above. Public policy needs to be made based on the most accurate estimate of the effects of the proposed changes. But the failure to take into account these dynamic effects has led to gross errors in estimated effects from rate cuts in the past.
In 1997, when Congress was considering a cut in the capital gains rate from 28% back down to 20%, CBO and the Joint Tax Committee (JTC) estimated that revenues would increase by $7.8 billion from 1997 to 1999, but produce a loss of $28.8 billion over the following 7 years, for a net loss of $21 billion over the 10 year period. The actual numbers after the tax cut was passed showed an increase of $84 billion over the pre-tax cut projections for 1997 to 2000, despite an almost 30% cut in the rate.
Similarly, when Congress considered cutting the capital gains rate again in 2003, from 20% to 15%, CBO and the JTC estimated that this would cause a loss of revenue of $5.4 billion from 2003 to 2006. But after Congress passed the tax cut, capital gains revenues increased by $133 billion during those years, as compared to the pre-tax cut projections.
President Kennedy understood it. He proposed legislation to reduce income tax rates across the board by nearly 30%, explaining,
“It is a paradoxical truth that tax rates are too high today, and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the tax rates….[A]n economy constrained by high tax rates will never produce enough revenue to balance the budget, just as it will never create enough jobs or enough profits.”
Kennedy’s proposed tax rate cuts were adopted in 1964, cutting the top tax rate from 91% to 70%, as well as reducing the lower rates. The next year, economic growth soared by 50%, and income tax revenues increased by 41%! By 1966, unemployment had fallen to its lowest peacetime level in almost 40 years. U.S. News and World Report exclaimed, “The unusual budget spectacle of sharply rising revenues following the biggest tax cut in history is beginning to astonish even those who pushed hardest for tax cuts in the first place.” Arthur Okun, the administration’s chief economic advisor, estimated that the tax cuts expanded the economy in just two years by 10% above where it would have been.
Similarly, while President Reagan cut tax rates by 25% across the board, and reduced the top income tax rate from 70% all the way down to 28%, federal tax revenues doubled during the 1980s.
The Washington Post so badly misled its readers about the effects of Ryan’s proposed budget not because it is stupid, but because it was not being completely honest in criticizing Ryan’s budget for failing to raise revenues. What it really believes and means to say in its editorial is not that the budget cannot be balanced without increasing revenues, but that it cannot be balanced without a combination of spending cuts and increased taxes, meaning increased rates, since Ryan’s budget would produce sharp increases in revenues even under CBO’s troglodyte static scoring.
But history and logic prove the Post quite wrong on that point. The dominant effect on the deficit comes from the economy, not tax policy. If the economy is booming, creating surging revenues, then the deficit declines sharply. If the economy is weak, resulting in lagging revenues, then the deficit grows, even in the face of tax increases.
This was shown by the 1990 budget deal, which is the model for the Washington establishment (always faithfully reflected in the Washington Post), under which President George H.W. Bush agreed to violate the no tax increase pledge on which he was elected (Read my lips, no new taxes), in return for promised spending cuts. But spending actually increased by over 10%, or nearly $130 billion, over the next 2 years, while the agreed tax rate increases are still with us today. Those tax increases pushed the economy into recession, and as a result the deficit actually soared rather than declined over the next two years, from $221 billion in 1990, to $269 billion in 1991, to $290 billion in 1992
In 1993, President Clinton tried the Washington establishment approach again with a Democrat Congress voting through a tax increase in supposed return for spending cuts as part of another budget deal. By 1995, the new Republican Congress, elected to replace the tax increasing Democrat Congress, was greeted with a Clinton budget still projecting continued $200 billion deficits indefinitely into the future,
despite the tax increases.
House Speaker Newt Gingrich led Congress to try a different approach, the one tried and true way to balance the budget, which has worked every time it has been tried. It’s a simple two step process. One, cut tax rates to improve incentives for savings, investment, job creation, business creation, business expansion, entrepreneurship and economic growth, to get the economy booming. You can’t balance the budget by constantly chasing lower than expected revenues. With the economy booming, revenue surges consistently. Step two, cut spending growth, and let revenues surge past it.
The new Republican Congress cut the capital gains tax rate by 40%, and reduced other tax burdens on capital investment, leading to a resurgent economy. Then they sharply restrained federal spending. Indeed, in 6 years from 1994 to 2000, they cut total federal spending relative to GDP by one-seventh, more even than Reagan did, though he was constrained by the need to raise defense spending, which won the Cold War without firing a shot, in Margaret Thatcher’s famous phrase.
As a result, $200 billion annual federal deficits, which had prevailed for over 15 years, were transformed into surpluses by 1998, peaking at $236 billion by 2000. Those surpluses actually continued for 4 years, the first time that has happened since the 1920s, resulting in total surpluses of $559 billion over that period, the biggest reduction in federal debt held by the public in U.S. history.
Ryan’s budget follows this one tried and true way to balance the budget. His budget would cut tax rates to produce a booming economy, leading to robust revenue growth, while restraining federal spending to let revenues grow past the level of spending over time. That is why by in just the fifth year under Ryan’s budget, 2017, even with CBO’s static scoring, the federal deficit is reduced by 86%, from $1,327 billion, or $1.327 trillion, today, to $182 billion. With dynamic scoring, as discussed above, the budget would probably be balanced by then, in the real world.
The bottom line is this. Ryan’s budget, even with all of his proposed rate cuts, restores federal revenues to their long term, historical, postwar average over the last 70 years at 18.3% of GDP. But the problem is that under the budget policies supported by President Obama and the Democrats, federal spending soars to 30% of GDP by 2027, 40% by 2040, 50% by 2060, and 80% by 2080. With state and local taxes over 10% of GDP, that’s actually communism. Ryan’s budget, by sharp contrast, quickly returns federal spending to its long term, historical, postwar average of about 20% of GDP, by 2015.
So this is the issue framed for the American people by Ryan’s budget, on which the 2012 election should be decided. Do we want to restore federal taxes and spending to their long term, historical, postwar average over the last 70 years, under which America prospered to become the richest and mightiest nation in world history? Or do we want to raise taxes to begin to finance exploding federal spending well above that long term, historical, postwar average, with government spending over the long run eventually reaching 100% of GDP?
The one true shortcoming of the Ryan budget is that it proposes nothing about reform of the Fed and monetary policy. While federal budgets never address this, that does not mean that Ryan’s budget proposals cannot.
I raise this because restrained monetary policy providing for a stable, strong dollar without inflation is so central to creating booming economic growth. That can be achieved through legislation requiring the Fed to follow a “price rule” for monetary policy, which means the Fed would conduct its monetary policies to maintain stable market prices for gold and other key commodities.
With a stable dollar investors know that their returns will not be depreciated by a falling dollar, inflation, or the repeated recessionary cycles created by discretionary, “Bernanke standard” style monetary policies. As a result, investment would pour into our economy, from at home and abroad, promoting still further booming economic growth, which would produce still further booming revenues.
Ryan should include such a provision in all future budgets, helping to tutor everyone about the central importance of sound monetary policy to economic growth and prosperity. In the meantime, it would be desirable if he would lead House Republicans to pass such legislation this year, and promote it to the Senate.