Today those all seem like distant memories. Or are they?
With the budget balanced for the first time in 30 years, the unemployment rate at its lowest level since 1970 and inflation virtually nonexistent, it would seem that we are in a policy regime that is entirely benign. The most likely outcome over the next two years on Capitol Hill — gridlock — might not be all bad. We could do a lot worse than have two years of policy paralysis in Washington — we usually do.
But there remain two signs of potential danger that could finally bring this 16-year high-employment, bull market to an end. The first is fiscal drag and the second is regulatory drag. Both are like termites in the basement, relentlessly and silently gnawing away at the structural soundness of the home.
The accompanying figure shows that over the past five years the tax burden has being creeping up by half a percentage point of gross domestic product per year — from 18.5 percent in 1994 to a projected 21 percent in 1999. Over the course of the past 30 years a tax-to-GDP ratio of more than 20 percent has typically sounded a Code Blue warning of recession. In 1969 taxes hit 20 percent of GDP and the next year the economy screeched to a halt. From 1978 to 1981 the tax burden ratcheted up from 18 to 20 percent of GDP, thanks mostly to inflationary bracket creep. The economy collapsed. Yes, in both cases bad monetary policy accentuated the fiscal policy mistakes. And, yes, Alan Greenspan is not likely to repeat those blunders.
But the fact remains that federal tax burden is higher today than it was in the stagflationary Carter years.
Why are tax burdens rising? Republicans have not raised taxes recently. But in a period of growth, taxes rise at a faster pace than GDP, thanks to the graduated income tax structure. Hence, by not cutting taxes aggressively, congressional Republicans have, through their inaction, allowed the tax burden to swell.
Supply-side skeptics exalt that taxes aren’t an important economic factor and point to the fact that the American economy performed so well after the Clinton tax rate hike of 1993, when tax rates rose from 31 to 40 percent. They should look more closely at the evidence. By my calculations, the higher tax rates knocked a half to one full percentage point off GDP growth in 1993 (the taxes were retroactive) and another half percentage point off growth in 1994. Once the new taxes were finally absorbed, the economy soared at a 3.5 percent real annual rate.
The fiscal drag from the rise in tax rates legislated by Clinton was not as severe as expected because the tax hikes were partially offset in the mid-1990s by falling inflation. Between 1990 and 1998 inflation fell from 4 percent to less than 1 percent (correctly measured). Falling inflation reduces the real capital gains tax rate (capital gains are not indexed for inflation) and allows firms to write off capital investments more rapidly.
But as the Fed now closes in on its zero inflation target (some might say we’re already there), there is not much more adrenaline that Alan Greenspan can pump into the economy. To keep the economy growing, tax cuts may soon be necessary.
The second Code Blue warning comes from tight regulatory policy. After a fairly quiet first Clinton term in the rulemaking area, of late the Clinton administration has been on a regulatory rampage, increasingly relying on executive orders and independent agency rulemaking procedures to impose new nonlegislated costs on the economy. Republicans are such nervous Nellies on issues like the environment and product safety that they have simply given the White House carte blanche to promulgate new rules and edicts. Between April 1996 and April 1998 the Clinton regulation factory sent Congress 7,600 new rules to review. Not even one was disapproved, according to a Heritage Foundation analysis.
According to the most recent data compiled by Thomas Hopkins of the Rochester Institute of Technology, in 1998 the total economic cost of federal red tape rose to a record $700 billion. The last two times regulatory costs were rising this rapidly, in 1970 and in 1980, the economy slipped into recession. The regulatory tax wedge costs the private sector almost three times as much as the corporate income tax and almost as much as the personal income tax.
Time and again the economy has proven itself awe-inspiringly resilient despite periodic wrong turns by policymakers here and catastrophic wrong turns by politicians abroad. But taxes and regulations are starting to reach historically dangerous levels. With Brazil and other nations to the south of us teetering on the verge of collapse, the American economy could use some recession antibiotics right about now. Fed easing isn’t the answer. You can’t inflate and tax your way to prosperity. Loose monetary policy is never the answer to excessive taxation.
No, the stimulus must come from fiscal and, to a lesser extent, from regulatory policy. Both are currently contractionary. A 10 percent income and payroll tax cut, paid for out of projected budget surpluses, could be enacted without unbalancing the budget. On the regulatory side, Congress need not roll back existing rules; it simply needs to declare a regulatory moratorium until the Latin American flu subsides and we’re safely out of the woods.
It’s time for Congress to purchase some anti-recession insurance.