Regarding America’s Public Debt: How Do We Keep It From Rising?

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Mr. Chairman and members of the committee, thank you forinviting me to testify today on the topic of controlling growth inthe federal public debt. Federal debt continues to rise as spendinggrowth keeps running ahead of the increased tax revenues thegovernment is enjoying as a result of the strong economy. I willdiscuss some of the relationships between federal debt, spending,and taxation in light of recent budget developments.

Background: The Cost of Federal Spending

To support its large budget, the federal government will extract$2.4 trillion in taxes and about $300 billion in borrowed fundsfrom families, businesses, and investors in fiscal 2006. Thatextraction transfers resources from the more productive privatesector to the generally less productive government sector of theeconomy. Many studies have shown that, all else equal, the largerthe government's share of the economy, the slower economic growthwill be.1 That is trueregardless of whether higher spending is financed by increasedtaxes or higher deficits, which can be considered deferred taxes onfuture generations.

It is clear that a larger federal budget results in slowergrowth when you consider that a big share of spending is aimed at"social" goals, not at spurring growth. Indeed, 50 percent of thefederal budget goes to transfers, which are typically justified on"fairness" grounds, not economic grounds.2 For example, the largest federal program, SocialSecurity, has a negative impact on growth the way it is currentlystructured. People may support the current Social Security systemfor non-economic reasons, but economists believe that itspay-as-you-go structure reduces national savings and economicgrowth.

An additional problem is that extracting the current and futuretaxes needed to support federal spending is a complex andeconomically damaging process. As a result, substantially more thanone dollar of private activities are displaced for every addeddollar of spending. Those added costs are called "deadweightlosses," which are inefficiencies created by distortions toworking, investment, and entrepreneurship. Those distortions reducethe nation's standard of living

The Congressional Budget Office found that "typical estimates ofthe economic [deadweight] cost of a dollar of tax revenue rangefrom 20 cents to 60 cents over and above the revenueraised."3 Studies byHarvard's Martin Feldstein have found that deadweight losses areeven larger. He noted that "the deadweight burden caused byincremental taxation ... may exceed one dollar per dollar ofrevenue raised, making the cost of incremental governmentalspending more than two dollars for each dollar of governmentspending."4

What this means is that the large increases in federal spendingof recent years will create a substantial toll on the economybecause current or future taxes will be higher than otherwise tofund the expansion. There is no free lunch on the spending side ofthe federal budget, but we can minimize the damage of raisingfederal funds by continuing to reform the most distortionaryaspects of the income tax system.

Deficits and Tax Cuts

Policymakers opposed to recent tax cuts have argued that taxcuts that are "financed by deficits" don't do much good for theeconomy. It is true that recent tax cuts have not benefited theeconomy as much as they would have if they had been matched byspending cuts.6 To the extentthat recent tax cuts have added to federal deficits, a burden isimposed on future taxpayers (assuming that federal spending is notaffected).6

However, there is a crucial point to consider with regard to thedebate over recent tax cuts and budget deficits-not all taxcuts are created equal. "Supply-side" tax cuts that reducedistortions in the tax code will spur economic growth and will notcreate as large a revenue loss as static calculations suggest. Anyadded debt from such tax cuts can be compared against the largergross domestic product that will be generated. Supply-side tax cutsthat represent long-term reforms of the federal fiscal systemshould be implemented regardless of the current budget balance. Bycontrast, further "social policy" tax cuts that do not simplify thetax code or make it more efficient should be avoided, or at leastnot considered unless they are matched by equal spending cuts.

Numerous studies have found that supply-side tax cuts on capitalincome are particularly beneficial to the economy. A 2005 JointCommittee on Taxation study presented the results of amacroeconomic simulation of hypothetical personal and corporateincome tax cuts.7 They foundthat a corporate tax rate cut (matched by spending cuts) boostedU.S. output twice as much in the long run as an individual rate cutof the same dollar magnitude. The JCT also found that there aremuch larger positive growth effects when tax cuts are offset byspending cuts to prevent the deficit from increasing.

Federal tax legislation since 2001 has been a mix of supply-sideand social policy cuts. About 55 percent of recent tax cuts havebeen supply-side tax cuts, including the reductions in individualrates, the dividend and capital gains tax cuts, small businessexpensing, and the liberalization of savings accounts.8 The other 45 percent of recent tax cutshave been social policy tax cuts, including the new 10 percentincome tax bracket, the expansion of the child tax credit, andvarious education tax benefits.

The economic impact of social policy tax cuts, if combined withhigher deficits, is mixed at best because those cuts generally donot reduce the deadweight losses of the tax system. By contrast,supply-side tax cuts boost long-term economic growth.9 The dividend and capital gains tax cutsof 2003, for example, have helped to reduce long-recognizeddistortions caused by the double taxation of corporate equity. Themarkets have responded strongly to the dividend and capital gainscuts, indicating that the prior high rates were creatingsubstantial distortions.

Spending Increases, Not Tax Cuts, Are theProblem

Have tax cuts or spending increases caused today's large budgetdeficits? Federal outlays have increased from $1.9 trillion infiscal 2001 to $2.7 trillion by fiscal 2006, an increase of $800billion. By contrast, the tax cuts enacted in 2001 and 2003 havereduced federal revenues by roughly $200 billion thisyear.10 Thus, recentspending increases are four times more important in explaining thecurrent budget deficit than are recent tax cuts.11

Another way to think about recent tax cuts is that they havehelped reverse the large tax increases of 1990 and 1993. CBO datashows that those tax increases increased federal revenues by acombined 1.1 percent of GDP over the first five years after eachwas enacted. The 2001 and 2003 tax cuts reduced revenues by asimilar magnitude of 1.2 percent of GDP over the first five yearsafter each was enacted.12

Regardless of whether or not one supports recent tax cuts, it isclear that there are gigantic long-term fiscal problems on thespending side of the budget. The Government Accountability Officehas projected a long-range business-as-usual scenario for thebudget.13 The projectionsassume that entitlement programs are not reformed, and that otherprograms and taxes stay at the same size as today relative to GDP.Under that scenario, federal spending would grow from 20 percent ofGDP today to a staggering 45 percent of GDP by 2040. Such aEuropean-sized government would bring with it slow growth, lowerwages, a lack of opportunities, and many other pathologies.

Unfortunately, the long-term fiscal situation could be evenworse than that. The GAO's "static" estimates ignore the economicdeath spiral that would occur if taxes were raised in an attempt tofund higher spending. Higher taxes would result in greater taxavoidance, slower growth, less reported income, and thus less thanexpected tax revenue, perhaps prompting policymakers to jack up taxrates even higher.

Consider Social Security and Medicare Part A, which are fundedby the federal payroll tax. On a static basis, the cost of thesetwo programs as a share of taxable wages is projected to rise from14 percent in 2005 to 25 percent in 2040.14 But as tax rates rise, the tax base will shrink.To get the money it would need to pay for rising benefits, andtaking into account this dynamic effect, the government would haveto hike the payroll tax rate to about 30 percent by2040.15 That would be acrushing blow to working Americans, who would have to pay this taxin addition to all the other federal and state taxes they pay.

Note that on top of these federal costs, state and localgovernments are also imposing large and unfunded obligations onfuture generations. State and local governments have rapidly risinglevels of bond debt, and they have unfunded costs for theirworkers' pension and health plans that could total more than $2trillion.16

Reform Options

These figures suggest a bleak fiscal future awaiting youngAmericans and taxpayers without major reforms. There are manyactions that should be taken right away to reduce deficits andunfunded obligations.

  • Social Security should be cut by indexing future initialbenefits to the growth in prices rather than wages.
  • Medicare deductibles and premiums should be increased. Thosechanges could be phased-in over time, but it is important to getthe needed cuts signed into law to reduce the exposure oftaxpayers.
  • Medicaid should be block-granted and the federal contributionto the program restrained or cut. This was the successful strategybehind the 1996 welfare reform.
  • Federalism should be revived and federal aid to the states cutsharply. Aid to the states does not make any economic sense. It hasbeen a bastion of "pork" spending, and it has created massivebureaucracies at all three levels of government. With the comingentitlement crunch, the federal government simply cannot afford tobe Santa Claus to the states any longer.

Of course, such cuts are politically difficult for Congress tomake. That is why new budgeting structures are needed to get ahandle on rising spending and deficits. Considering that federaloutlays have increased 45 percent in the last five years and thegovernment has run deficits in 33 of the last 37 years, it isobvious that current budget rules are not working very well.

That is why budget reform proposals, such Senator Gregg's "StopOver Spending Act of 2006" (S. 3521) are important.17 The Act contains new rules to controldeficits, restrain entitlement spending, cap discretionaryspending, limit "emergency" spending, and create a commission toeliminate waste in federal programs.

Some people argue that such new budget restrictions are notneeded because Congress has the power to restrain spending anytimeit wants. But political scientists have long recognized that theself-interested actions of individual policymakers often lead tooverall legislative outcomes that undermine the general welfare.Indeed, frequent statements by many policymakers make it clear thattheir top priority is to target spending to interests in theirstates, not to legislate in the national interest. If left to theirown devices, many members become activists for narrow causes, whilebroader concerns such as the size of the federal debt areignored.

New and improved federal budget rules are needed to channel theenergies of members into reforms that are in the interests ofaverage citizens and taxpayers. Without tight budget rules, CapitolHill descends into an "every man for himself" spending stampede-abudget anarchy that creates unsustainable budget expansion andsoaring deficits. That is why there have been numerous, and oftenbipartisan, efforts to create new budget procedures, such the 1974Budget Act, the 1985 Gramm-Rudman-Hollings Act, and the 1990 BudgetEnforcement Act.

Consider also that the 50 states generally have much tighterbudget rules than does the federal government.18 Virtually all the states have statutory orconstitutional requirements to balance their budgets. Governors in42 states have line-item veto authority. Most state constitutionsinclude limitations on government debt. More than half the stateshave some form of overall tax and expenditure limitation(TEL).19 Also, the statesare fiscally constrained by the need to prevent their bond ratingsfrom falling.

Capping Total Federal Spending

Senator Gregg's proposals are a good starting point fordiscussing budget reforms, but Congress should also consider a morecomprehensive budget control idea. That is to impose a statutorycap on the annual growth in total federal outlays, includingdiscretionary and entitlement spending.20 Deficits are a byproduct of the overspendingproblem, and such a cap would target that core problem directly.The basic principle of a budget growth cap is that the governmentshould live within constraints, as average families do, and notconsume an increasing share of the nation's output.

Prior budget control efforts have imposed caps on discretionaryspending, but not entitlement spending. Yet the rapid growth inentitlement spending may cause a major budget crisis, and thusshould be included under any cap. There has been interest incapping entitlements in the past. In 1992, the bipartisanStrengthening of America Commission, headed by Sens. Sam Nunn(D-GA) and Pete Domenici (R-NM), proposed capping all non-SocialSecurity entitlement spending at the growth rate of inflation plusthe number of beneficiaries in programs.21 The Entitlement Control Act of 1994 (H.R. 4593)introduced by Rep. Charles Stenholm (D-TX) would have capped thegrowth in all entitlement programs to inflation plus one percentplus the number of beneficiaries. Both of those proposals includedprocedures for sequestering entitlement spending with broad cuts ifthe caps were breached.

A simple way to structure a cap is to limit annual spendinggrowth to the growth in an economic indicator such as personalincome. Another possible cap is the sum of population growth plusinflation. In that case, if population grew at 1 percent andinflation was 3 percent, then federal spending could grow at mostby 4 percent. That is the limit used in Colorado's successful"TABOR" budget law. Whichever indicator is used should be smoothedby averaging it over about five years.

An interesting alternative would be to simply cap total federalspending growth at a fixed percentage, such as four percent. Thatwould make it easy for Congress to plan ahead in budgeting, andwould prevent efforts to change caps by fudging estimates ofeconomic indicators. Another interesting advantage of a fixedpercentage cap is that it would provide an incentive for Congressto support a low inflation policy by the Federal Reserve Board.

With a spending cap in place, Congress would pass annual budgetresolutions making sure that discretionary and entitlement spendingwas projected to fit under the cap for upcoming years.Reconciliation instructions could be included to reduce entitlementspending to fit under the cap for the current budget year and toreduce out-year spending to fit under projected future caps.

The Office of Management and Budget would provide regularupdates regarding whether spending is likely to breach the annualcap, and Congress could take corrective actions as needed. If asession ended and the OMB determined that outlays were still abovethe cap, the president would be required to cut, or sequester,spending across the board by the amount needed. The GRH and the BEAincluded sequester mechanisms that covered only portions of thedefense, nondefense, and entitlement budgets, but a sequester onthe overall budget would be a better approach.

A shortcoming of a statutory spending cap and other budget rulesis that Congress would always have the option of rewriting the lawif it didn't want to comply. But a cap on overall spending would bea very simple and high-profile symbol of restraint for supportersin Congress and the public to rally around and defend. An overallcap on spending growth of, say, four percent is easy to understand,and watchdog groups would keep the public informed about anycheating by policymakers. Over time, public awareness and budgetarytradition would aid in the enforcement of a cap.

Conclusion

Federal policymakers need a change in mindset and tougher budgetrules to ward off large tax hikes and rising debt as entitlementcosts soar in future years. Policymakers need to scour the budgetfor programs and agencies to cut.22 A cap on total federal spending should be partof the solution to get the budget under control. Clearly, currentbudget rules have not worked very well, and we should experimentwith new rules to try and get a grip on the overspendingproblem.

Thank you for holding these important hearings. I look forwardto working with the committee on its agenda for federal budgetreform.

Chris Edwards
Director of Tax Policy Studies
Cato Institute
cedwards@cato.org
www.cato.org/people/edwards.html


1See James Gwartney andRobert Lawson, "Economic Freedom of the World: 2004 Annual Report,"Fraser Institute, 2004, and see James Gwartney and Robert Lawson,"Economic Freedom of the World: 2005 Annual Report," FraserInstitute, 2005. For a summary of academic studies, see Daniel J.Mitchell, "The Impact of Government Spending on Economic Growth,"Heritage Foundation, March 15, 2005. To state this relationshipmore precisely, if the government increases its share of theeconomy beyond a certain modest level of about 15 percent, thengrowth begins to suffer.

2Transfers are 50 percentof total program outlays (outlays excluding interest). See ChrisEdwards "How to Spend $2.8 Trillion," Cato Institute Tax &Budget Bulletin no. 39, August 2006.

3Congressional BudgetOffice, "Budget Options," February 2001, p. 381. For a generaldiscussion, see Chris Edwards, "Economic Benefits of PersonalIncome Tax Rate Reductions," U.S. Congress, Joint EconomicCommittee, April 2001. See also William Niskanen, "The EconomicBurden of Taxation," presented at a conference at the FederalReserve Bank of Dallas, Texas, October 22-23, 2003.

4Martin Feldstein, "HowBig Should Government Be?" National Tax Journal, Volume50, no. 2, June 1997, pp. 197-213.

5Tax cuts matched byspending cuts produce much stronger growth effects in the long run.See the various simulations in Joint Committee on Taxation,"Macroeconomic Analysis of Various Proposals to Provide $500Billion in Tax Relief," JCX-4-05, March 1, 2005.

6If higher deficits createa "starve the beast" effect resulting in lower spending, then taxcuts now will not lead to equally large tax increases later.

7Joint Committee onTaxation, "Macroeconomic Analysis of Various Proposals to Provide$500 Billion in Tax Relief," JCX-4-05, March 1, 2005.

8Based on the dollarvalues of extending the cuts between 2012 and 2016. See Office ofManagement and Budget, Midsession Review Fiscal Year 2007,July 11, 2006, Table S-6. The estate tax is not included.9For example, see JointCommittee on Taxation, "Macroeconomic Analysis of Various Proposalsto Provide $500 Billion in Tax Relief," JCX-4-05, March 1,2005.

10Based on CBO'sestimate of the revenue loss from EGTRRA and JGTRRA in fiscal 2012as a share of GDP, then applied to GDP in fiscal 2006. I have notincluded the alternative minimum tax.

11Note that thisestimate of federal revenue losses is on a static basis. The actualloss is likely to be smaller because of the positive economiceffects of the cuts.

12Chris Edwards, "SocialPolicy, Supply-Side, and Fundamental Reform: Republican Tax Policy,1994 to 2004," Tax Notes, November 1, 2004, p. 691.

13GovernmentAccountability Office, "21st Century Challenges: Reexamining theBase of the Federal Government," GAO-05-325SP, February 2005,Figure 2, p. 8.

14The 2005 AnnualReport of the Board of Trustees of the Federal Old-Age andSurvivors Insurance and the Federal Disability Insurance TrustFunds (Washington: Government Printing Office, April 5, 2005),p. 166. These are the intermediate assumptions.

15Estimate based onMartin Feldstein, "Prefunding Medicare," National Bureau ofEconomic Research, Working Paper no. 6917, January 1999, p. 4.

16Chris Edwards andJagadeesh Gokhale, "Unfunded State and Local Health Costs: $1.4Trillion," Cato Institute Tax & Budget Bulletin, September2006.

17U.S. Senate, Committeeon the Budget, "The Stop Over Spending Act of 2006," Senate Report109-283, July 14, 2006.

18For background onstate budget processes, see National Association of State BudgetOfficers, "Budget Processes in the States," January 2002.

19Michael New, "LimitingGovernment through Direct Democracy," Cato Institute PolicyAnalysis no. 420, December 13, 2001.

20For background, seeChris Edwards, "Capping Federal Spending," Cato Institute Tax &Budget Bulletin no. 32, March 2006. Also see Brian Riedl, "RestrainRunaway Spending with a Federal Taxpayers' Bill of Rights,"Heritage Foundation, August 27, 2004.

21The commission wassponsored by the Center for Strategic and InternationalStudies.

22For detaileddiscussion of federal programs that should be cut, see ChrisEdwards, Downsizing the Federal Government (Washington:Cato Institute, 2005), www.downsizinggovernment.com.

Chris Edwards

Subcommittee on Long-Term Growth and Debt Reduction

Committee on Finance
United States Senate