Tag: taxation

The 1993 Clinton Tax Increase Did Not Lead to the Budget Surpluses of the Late 1990s

Proponents of higher taxes are fond of claiming that Bill Clinton’s 1993 tax increase was a big success because of budget surpluses that began in 1998.

That’s certainly a plausible hypothesis, and I’m already on record arguing that Clinton’s economic record was much better than Bush’s performance.

But this specific assertion it is not supported by the data. In February of 1995, 18 months after the tax increase was signed into law, President Clinton’s Office of Management and Budget issued projections of deficits for the next five years if existing policy was maintained (a “baseline” forecast). As the chart illustrates, OMB estimated that future deficits would be about $200 billion and would slightly increase over the five-year period.

In other words, even the Clinton Administration, which presumably had a big incentive to claim that the tax increase would be successful, admitted 18 months after the law was approved that there was no expectation of a budget surplus. For what it’s worth, the Congressional Budget Office forecast, issued about the same time, showed very similar numbers.

Since the Clinton Administration’s own numbers reveal that the 1993 tax increase was a failure, we have to find a different reason to explain why the budget shifted to surplus in the late 1990s.

Fortunately, there’s no need for an exhaustive investigation. The Historical Tables on OMB’s website reveal that good budget numbers were the result of genuine fiscal restraint. Total government spending increased by an average of just 2.9 percent over a four-year period in the mid-1990s. This is the reason why projections of $200 billion-plus deficits turned into the reality of big budget surpluses.

Republicans say the credit belongs to the GOP Congress that took charge in early 1995. Democrats say it was because of Bill Clinton. But all that really matters is that the burden of federal spending grew very slowly. Not only was there spending restraint, but Congress and the White House agreed on a fairly substantial tax cut in 1997.

To sum things up, it turns out that spending restraint and lower taxes are a recipe for good fiscal policy. This second chart modifies the first chart, showing actual deficits under this small-government approach compared to the OMB and CBO forecasts of what would have happened under Clinton’s tax-and-spend baseline.

Four Reasons Why Big Government Is Bad Government

A new video from the Center for Freedom and Prosperity gives four reasons why big government is bad fiscal policy.

I particularly like the explanation of how government spending undermines growth by diverting labor and capital from the productive sector of the economy.

Some cynics, though, say that it is futile to make arguments for good policy. They claim that politicians make bad fiscal decisions because of short-term considerations such as vote buying and raising campaign cash and that they don’t care about the consequences. There’s a lot of truth to this “public choice” analysis, but I don’t think it explains everything. Maybe I’m an optimist, but I think we would have better fiscal policy if more lawmakers, journalists, academics, and others grasped the common-sense arguments presented in this video.

And even if the cynics are right, we are more likely to have good policy if the American people more fully understand the damaging impact of excessive government. This is because politicians almost always will do what is necessary to stay in office. So if they think the American people are upset about wasteful spending and paying close attention, the politicians will be less likely to upset voters by funneling money to special interests.

For those who want additional information on the economics of government spending, this video looks at the theoretical case for small government and this video examines the empirical evidence against big government. And this video explains that America’s fiscal problem is too much spending rather than too much debt (in other words, deficits are merely a symptom of an underlying problem of excessive spending).

Last but not least, this video reviews the theory and evidence for the “Rahn Curve,” which is the notion that there is a growth-maximizing level of government outlays.

Spending Restraint and Red Ink

I’m not a big fan of central banks, and I definitely don’t like multilateral bureaucracies, so I almost feel guilty about publicizing two recent studies published by the European Central Bank. But when such an institution puts out research that unambiguously makes the case for smaller government, it’s time to sit up and take notice. And since these studies largely echo the findings of recent research by the International Monetary Fund, we may have reached a point where even the establishment finally understands that government is too big.

The first study looks at real-world examples of debt reduction in 15 European nations and investigates the fiscal policies that worked and didn’t work. Entitled “Major Public Debt Reductions: Lessons From The Past, Lessons For The Future,” the report unambiguously concludes that spending restraint is the right way to reduce deficits and debt. Tax increases, by contrast, are not successful. The study doesn’t highlight this result, but the data clearly show that “revenue increases do not seem to have induced debt reductions, whereas cuts in primary expenditure seem to have contributed significantly in the case of major debt reductions.”

Here’s a key excerpt:

[T]his paper estimates several specifications of a logistic probability model to assess which factors determine the probability of a major debt reduction in the EU-15 during the period 1985-2009. Our results are three-fold. First, major debt reductions are mainly driven by decisive and lasting (rather than timid and short-lived) fiscal consolidation efforts focused on reducing government expenditure, in particular, cuts in social benefits and public wages. Revenue-based consolidations seem to have a tendency to be less successful. Second, robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to “grow their way out” of indebtedness. Here, the literature also points to a positive feedback effect with decisive expenditure-based fiscal consolidation because this type of consolidation appears to foster growth, in particular in times of severe fiscal imbalances.

The last part of this passage is especially worth highlighting. The authors found that reducing spending promotes faster economic growth. In other words, Obama did exactly the wrong thing with his so-called stimulus. The U.S. economy would have enjoyed much better performance if the burden of spending had been reduced rather than increased. One can only hope the statists at the Congressional Budget Office learn from this research.

Equally interesting, the report notes that reducing social welfare spending and reducing the burden of the bureaucracy are the two most effective ways of lowering red ink:

The estimation results indicate that expenditure-based consolidation which mainly concentrates on cuts in social benefits and government wages is more likely to lead to a major debt reduction. A significant decline in social benefits or public wages vis-a-vis the overall decline in the primary expenditure will increase the probability of a major debt reduction by 31 and 26 percent, respectively.

The other study takes a different approach, looking at the poor fiscal position of European nations and showing what would have happened if governments had imposed some sort of cap on government spending. Entitled “Towards Expenditure Rules And Fiscal Sanity In The Euro Area,” this report finds that restraining spending (what the study refers to as a “neutral expenditure policy”) would have generated much better results. 

Here are the main findings:

[T]he study assesses the impact of the fiscal stance on primary expenditure ratios and public debt ratios and, thus, provides a measure of prudence or imprudence of past expenditure policies. The study finds that on the basis of real time rules, expenditure and debt ratios in 2009 for the euro area aggregate would not have been much different with neutral expenditure policies than actually experienced.

…Primary expenditure ratios would have been 2-3½ pp [percentage points] of GDP lower for the euro area aggregate, 3-5pp of GDP for the euro area without Germany and up to over 10 pp of GDP lower in certain countries if expenditure policies had been neutral.

There’s a bit of academic jargon in that passage, but the authors are basically saying that some sort of annual limit on the growth of government spending is a smart fiscal strategy. And such rules, depending on the country, would have reduced the burden of government spending by as much as 10 percentage points of GDP. To put that figure in context, reducing the burden of government spending by that much in the United States would balance the budget overnight.

There are several ways of achieving such a goal. The report suggests a spending limit rule based on the growth of the overall economy, which is similar to a proposal being developed in the United States by Senator Corker of Tennessee. But it also could mean something akin to the old Gramm-Rudman-Hollings law, but intelligently revised to focus on annual spending rather than annual deficits. Some sort of limit on annual spending, perhaps based on population plus inflation like the old Taxpayer Bill of Rights (TABOR) in Colorado, also could be successful.

There are a couple of ways of skinning this cat. What’s important is that there needs to be a formula that limits how much spending can grow, and this formula should be designed so that the private sector grows faster than the public sector. And to make sure the formula is successful, it should be enforced by automatic spending cuts, similar to the old Gramm-Rudman-Hollings sequester provision.

The IRS Run Amok

I’m not a big fan of the Internal Revenue Service, but I try not to demonize the bureaucrats because politicians actually deserve most of the blame for America’s complex, unfair, and corrupt tax system. The IRS generally is in the unenviable position of simply trying to enforce very bad laws.

But sometimes the IRS runs amok and the agency deserves to be held in contempt by the American people

Let’s look at a grotesque example of IRS misbehavior. It deals with a seemingly arcane issue, but it has big implications for the US economy, the rule of law, and human rights.

On January 7, the tax-collection bureaucracy proposed a regulation that, if implemented, would force American financial institutions to put foreign tax law above US tax law. Banks would be required to report to the IRS any interest they pay to foreigners, but not so the US government can collect tax, but in order to let foreign governments tax this US-source income.

This isn’t the first time the IRS has tried to pull this stunt. At the very end of the Clinton years, the agency proposed a rule to do the same thing. But the bureaucrats were thwarted because of overwhelming opposition from Capitol Hill, the financial services industry, and public policy experts. There was near-unanimous agreement that it would be crazy to drive job-creating capital out of the US economy and there was also near-unanimous agreement that the IRS had no authority to impose a regulation that was completely inconsistent with the laws enacted by Congress.

But like a zombie, this IRS regulation has risen from the grave.

I’m not sure what is most upsetting about this proposed rule, but there are five serious flaws in the IRS’s back-door scheme to turn American banks into deputy tax collectors for foreign governments.

1. The IRS is flouting the law, using regulatory dictates to overturn laws enacted through the democratic process.

Ever since 1921, and most recently reconfirmed by legislation in 1976 and 1986, Congress specifically has chosen not to tax interest paid to non-resident foreigners. Lawmakers wanted to attract money to the U.S. economy.

Yet rogue IRS bureaucrats want to impose a regulation to overturn the outcome of the democratic process. Heck, if they really think they have that sort of power, why don’t they do us a favor and unilaterally junk the entire internal revenue code and give us a flat tax?

2. The IRS has failed to perform a cost-benefit analysis, as required by executive order 12866.

Issued by the Clinton Administration, this executive order requires that regulations be accompanied by “An assessment of the potential costs and benefits of the regulatory action” for any regulation that will, “Have an annual effect on the economy of $100 million or more or adversely affect in a material way the economy, a sector of the economy, productivity, competition, jobs, the environment, public health or safety, or State, local, or tribal governments or communities.”

Yet the IRS blithely asserts that this interest-reporting proposal is “not a significant regulatory action.” Amazing, we have trillions of dollars of foreign capital invested in our economy, perhaps $1 trillion of which is deposited in banks, and we know some of which definitely will be withdrawn if this regulation is implemented, but the bureaucrats unilaterally decided the regulation doesn’t require a cost-benefit analysis.

During a previous incarnation of this regulation, the IRS’s failure to comply with the rules led the Office of Advocacy at the Small Business Administration to denounce the tax-collection bureaucracy, stating that “…there is ample evidence that the impact of the regulation is significant and that a substantial number of small businesses will be impacted.”

3. The IRS is imposing a regulation that puts America’s economy at risk.

According to the Commerce Department, foreigners have invested more than $10 trillion in the U.S. economy.

And according to the Treasury Department, foreigners have more than $4 trillion in American banks and brokerage accounts.

We don’t know how much money will leave America if this regulation is implemented, but there are many financial centers – such as London, Hong Kong, Cayman, Singapore, Tokyo, Zurch, Luxembourg, Bermuda, and Panama – that would gladly welcome the additional investment if the IRS makes the American financial services sector less attractive.

4. The IRS is destabilizing America’s already shaky financial system.

Five years ago, when the banking industry was strong, the IRS regulation would have been bad news. Now, with many banks still weakened by the financial crisis, the regulation could be a death knell. Not only would it drive capital to banks in other nations, it also would impose a heavy regulatory burden.

How bad would it be? Commenting on an earlier version of the regulation, which only would have applied to deposits from 15 countries, the Chairman of the Federal Deposit Insurance Corporation warned that, “[a] shift of even a modest portion of these [nonresident alien] funds out of the U.S. banking system would certainly be termed a significant economic impact.” He also noted that potentially $1 trillion of deposits might be involved. And a study from the Mercatus Center at George Mason University estimated that $87 billion would leave the American economy. And remember, that estimate was based on a regulation that would have applied to just 15 nations, not the entire world.

So what happens if more banks fail? I guess the bureaucrats at the IRS would probably just shrug their shoulders and suggest another bailout.

5. The IRS is endangering the lives of foreigners who deposit funds in America because of persecution, discrimination, abuse, crime, and instability in their home countries.

If you’re from Mexico you don’t want to put money in local banks or declare it to the tax authorities. Corruption is rampant and that information might be sold to criminal gangs who then kidnap one of your children. If you’re from Venezuela, you have the same desire to have your money in the United States, but perhaps you’re more worried about persecution or expropriation by a brutal dictatorship.

There are people all over the world who have good reasons to protect their private financial information. Yet this regulation would put them and their families at risk. The only silver lining is that these people presumably will move their money to other nations. Good for them, bad for America.

Let’s wrap this up. Under current law, America is a safe haven for international investors. This is good news for foreigners, and good news for the American economy. That’s why it is so outrageous that the IRS, unilaterally and without legal justification, is trying to reverse 90 years of law for no other reason than to help foreign governments.

By the way, you can add your two cents by clicking on this link which will take you to the public comment page for this regulation. Don’t be bashful.

One last point. The Obama Administration says this regulation is part of a global effort to improve tax compliance. But unless Congress changes the law, the IRS is not responsible for helping foreign tax collectors squeeze more money out foreign taxpayers. Moreover, the White House has been grossly misleading about U.S. compliance issues (as this video illustrates), so their assertions lack credibility.