The State of the Economy and the Budget

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Mr. Chairman and members of the committee, thank you forinviting me to testify today on the economic and budget situation.The U.S. economy is continuing its solid expansion, and we appearto be in the middle of a long boom, as the nation enjoyed duringthe 1980s and 1990s. I suspect that much of the good economicperformance of recent years has little to do with the actions offederal policymakers. Instead, the activities of America'sentrepreneurs, continued advances in technology, and the dynamismof global markets are the main drivers of U.S. economic growth andjob creation.

However, federal spending, tax levels, and the tax structureplay important roles in aiding or impeding growth. I will discusssome of the relationships between fiscal policy and growth in lightof recent tax and 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

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 taxes needed tosupport federal spending is a complex and economically damagingprocess. As a result, substantially more than one dollar of privateactivities are displaced for every added dollar of spending. Thoseadded costs are called "deadweight losses," which areinefficiencies created by distortions to working, investment, andentrepreneurship. Those distortions reduce the nation's standard ofliving.

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.

Tax Cuts and Deficits

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.5 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 tax cutsare created equal. Tax cuts that reduce the worst distortions inthe tax code will spur economic growth and will not create as largea revenue loss as static calculations suggest. Such high-value taxcuts represent long-term reforms to the federal fiscal system thatshould be implemented regardless of the current budget balance. Bycontrast, further tax reductions that do not simplify the tax codeor make it more efficient should be avoided, or at least notconsidered unless they are matched by equal spending cuts.

Here are some general rules to use in maximizing the pro-growthbenefits of tax cuts:

  • Reduce the highest marginal tax rates because those ratescreate the largest deadweight losses. High marginal tax ratesexacerbate every distortion in the tax code. A flatter taxstructure with lower rates would be much more efficient thantoday's graduated, or "progressive," structure.7
  • Reduce taxes on the most mobile tax bases because that wouldcreate the largest increase in productive activities and thelargest reduction in tax avoidance. Capital, in particular, isbecoming increasingly mobile in today's competitive globaleconomy.
  • Reduce taxes on savings and investment. That would increase thenation's capital stock, boost productivity, and raise worker wages.Simulations by Harvard's Dale Jorgenson and Kun-Young Yun foundthat the potential welfare gains from replacing current incometaxes with consumption-based taxes is "very large" at more than $2trillion.8

Numerous studies have found that tax cuts on capital income areparticularly beneficial to the economy. A 2005 Joint Committee onTaxation study presented the results of a macroeconomic simulationof hypothetical personal and corporate income taxcuts.9 They found that acorporate tax rate cut (matched by spending cuts) boosted U.S.output twice as much in the long run as an individual rate cut ofthe same dollar magnitude.

Tax cuts that reduce tax code inefficiencies and spur growth arecalled "supply-side" tax cuts. Tax cuts that are not aimed atspurring growth can be called "social policy" tax cuts.

Federal tax legislation since 2001 has been a mix of supply-sideand social policy cuts. Figure 1 shows that about 55 percent ofrecent tax cuts have been supply-side tax cuts, including thereductions in individual rates, the dividend and capital gains taxcuts, small business expensing, and the liberalization of savingsaccounts. The other 45 percent of recent tax cuts have been socialpolicy tax cuts, including the new 10 percent income tax bracket,the expansion of the child tax credit, and various education taxbenefits.10

The economic impact of recent social policy tax cuts, ifcombined with higher deficits, is mixed at best because those cutsgenerally do not reduce the deadweight losses of the tax system. Bycontrast, supply-side tax cuts boost long-term economicgrowth.11 The dividend andcapital gains tax cuts of 2003, for example, have helped to reducelong-recognized distortions caused by the double taxation ofcorporate equity. The markets have responded strongly to thedividend and capital gains cuts, indicating that the prior highrates were creating substantial distortions.

The average per-share dividend payout for corporations in theStandard & Poor's 500 has increased 50 percent since the taxcut passed in early 2003.12Meanwhile, the Standard & Poor's 500 stock market index soaredby more than 20 percent in the year following the 2003 cuts. Alsonote that capital gains tax receipts have risen from about $50billion annually in 2003 to more than $80 billion this year,despite the rate cut from 20 to 15 percent.13 Of course, dividend payouts and capital gainsrealizations are partly on the rise due to the economic expansion,but the strong positive effects we have seen makes it tough toargue that these cuts are not contributing to current growth.

Recent supply-side tax changes have also included individualrate cuts. Cutting the top income tax rate from 40 to 35 percentwas particularly good policy because the top end is where thelargest efficiency gains can be achieved.14 Those in the top brackets have the mostflexibility in adjusting their taxable income, and their actionscreate substantial impacts on the economy.15 People with high incomes often have uniquetalents as executives, surgeons, entrepreneurs, and otherhigh-value occupations. About three-quarters of the top 1 percentof federal taxpayers report small business income.16 Numerous studies have found thatmarginal tax rate changes have substantial effects on smallbusiness hiring and investment.17 Note that the bipartisan Tax Reform Act of 1986reduced the top marginal rate to just 28 percent. Thus, recent taxcuts have moved in the right direction, but have not fully reversedthe rate increases passed in 1990 and 1993.

In addition to extending recent supply-side tax cuts on theindividual side, Congress should reduce the excessively high U.S.corporate tax rate. Many countries have cut their corporate taxrates in recent years to attract foreign investment and promotegrowth. The average top corporate tax rate across the 25 countriesof the European Union is 27 percent, which compares to the U.S.federal and average state rate of 40 percent.18 In today's competitive global economy,policymakers need to respond to foreign reforms and cut U.S. incometax rates.

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.19 Thus, recentspending increases are four times more important in explaining thecurrent budget deficit than are recent tax cuts.20

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.21

Looking ahead, Congress should extend the supply-side tax cutsof recent years beyond the current 2010 expiration.22 To allay fears about the effects oftax extensions on the deficit, Congress should set a goal ofeliminating the deficit with spending cuts by 2011. After all,"American citizens are not under-taxed by their government, ratherthe government spends too much," as Senator Judd Gregg (R-NH)recognized in his "Stop Over Spending Act of 2006" (S. 3521).23 The country faces a hugeentitlement crunch in the future, but the government is spendingtoo much right now, as Senator Gregg notes. Cutting unwarrantedspending will free up space for extending supply-side tax cuts anddealing with the entitlement problem.

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.24 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 2040.25 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 by2040.26 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.27

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 I applaud Senator Gregg for his budget reformproposals in the Stop Over Spending Act of 2006 (S. 3521).28 The Act contains newrules to control deficits, restrain entitlement spending, capdiscretionary spending, limit "emergency" spending, and create acommission to eliminate waste in federal programs.

Sadly, imposing such sensible budget reforms has drawnopposition.29 Some peopleargue that new budget restrictions are not needed because Congresshas the power to restrain spending anytime it wants. But politicalscientists have long recognized that the self-interested actions ofindividual policymakers often lead to overall legislative outcomesthat undermine the general welfare. Indeed, frequent statements bymany policymakers make it clear that their top priority is totarget spending to interests in their states, not to legislate inthe national interest. If left to their own devices, many membersbecome activists for narrow causes, while broader concerns such asthe size of the federal debt are ignored.

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.

Senator Gregg's bill, S. 3521, simply proposes to add restraintsto the federal budget that are common in the 50states.30 Virtually all thestates have statutory or constitutional requirements to balancetheir budgets. Governors in 42 states have line-item vetoauthority. Most state constitutions include limitations ongovernment debt. A number of states have commissions similar to the"CARFA" proposed in S. 3521, which would reevaluate spendingprograms at regular intervals.31 More than half the states have some form ofoverall tax and expenditure limitation (TEL).32 Also, the states are fiscally constrainedby the need to prevent their bond ratings from falling.

Capping Total Federal Spending

Senator Gregg's proposals are an excellent 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.33 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.34 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. Thus,as under Senator Gregg's bill, such a spending cap would utilizeregular reconciliation bills to reduce excess growth in entitlementprograms.

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. A broader sequester,as under Senator Gregg's bill, 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 as entitlement costs soar infuture years. To extend the recent tax cuts and ensure continuedstrong economic growth, policymakers need to scour the budget forprograms and agencies to cut.35 The proposed rules in Senator Gregg's bill (S.3521), or a growth cap on total spending, should be part of thesolution to get the budget under control. Clearly, current budgetrules have not worked very well, and we should experiment with newrules to try and get a grip on the overspending problem.

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


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.

7For estimates, see DaleJorgenson and Kun-Young Yun, Lifting the Burden: Tax Reform,the Cost of Capital, and U.S. Economic Growth (Cambridge, MA:MIT Press, 2001).

8Jorgenson and Yun, p.280.

9Joint Committee onTaxation, "Macroeconomic Analysis of Various Proposals to Provide$500 Billion in Tax Relief," JCX-4-05, March 1, 2005.

10Based 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.

11For example, see JointCommittee on Taxation, "Macroeconomic Analysis of Various Proposalsto Provide $500 Billion in Tax Relief," JCX-4-05, March 1,2005.

12Data from Standard andPoor's Investment Services, www.standardandpoors.com/indices.

13CBO, "The Budget andEconomic Outlook, Fiscal Years 2007 to 2016," January 2006, p.92.

14See Emmanuel Saez andJonathan Gruber, "The Elasticity of Taxable Income: Evidence andImplications," National Bureau of Economic Research, Working Paperno. 7512, January 2000. Saez and Gruber found that the elasticityof taxable income for those earning less than $100,000 was only asthird as large as for those earning more than $100,000.

15The magnitude ofeconomic benefits from tax rate cuts can be estimated by looking atthe increase in the size of the tax base. In particular, the changein compensated taxable income determines the magnitude of thechange in deadweight losses. See Martin Feldstein, "The Effect ofTaxes on Efficiency and Growth," Tax Notes, May 8, 2006,p. 679.

16Scott Hodge and ScottMoody, "Wealthy Americans and Business Activity," Special Reportno. 131, Tax Foundation, August 2004.

17See the followingNational Bureau of Economic Research papers by Robert Carroll,Douglas Holtz-Eakin, Mark Rider, and Harvey Rosen: "Entrepreneurs,Income Taxes, and Investment," NBER Working Paper 6374, January1998; "Income Taxes and Entrepreneurs' Use of Labor," NBER WorkingPaper 6578, May 2000; and "Personal Income Taxes and the Growth ofSmall Firms," NBER Working Paper 7980, October 2000.

18Chris Edwards,"Catching Up to Global Tax Reforms," Cato Institute Tax &Budget Bulletin no. 28, November 2005.

19Based 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.

20Note 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.

21Chris Edwards, "SocialPolicy, Supply-Side, and Fundamental Reform: Republican Tax Policy,1994 to 2004," Tax Notes, November 1, 2004, p. 691.

22In addition, Congressshould use the revenue from expiring social policy tax cuts foradditional supply-side tax cuts, such as reducing the corporate taxrate.

23U.S. Senate, Committeeon the Budget, "The Stop Over Spending Act of 2006," Senate Report109-283, July 14, 2006, p. 3.

24GovernmentAccountability Office, "21st Century Challenges: Reexamining theBase of the Federal Government," GAO-05-325SP, February 2005,Figure 2, p. 8.

25The 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.

26Estimate based onMartin Feldstein, "Prefunding Medicare," National Bureau ofEconomic Research, Working Paper no. 6917, January 1999, p. 4.

27Chris Edwards andJagadeesh Gokhale, "Unfunded State and Local Health Costs: $1.4Trillion," Cato Institute Tax & Budget Bulletin, September2006.

28U.S. Senate, Committeeon the Budget, "The Stop Over Spending Act of 2006," Senate Report109-283, July 14, 2006.

29Ibid., p. 61, forcomments by Senator Kent Conrad (D-ND).

30For background onstate budget processes, see National Association of State BudgetOfficers, "Budget Processes in the States," January 2002.

31Chris Edwards,"Sunsetting to Reform and Abolish Federal Agencies," Cato InstituteTax & Budget Bulletin no. 6, May 2002.

32Michael New, "LimitingGovernment through Direct Democracy," Cato Institute PolicyAnalysis no. 420, December 13, 2001.

33For 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.

34The commission wassponsored by the Center for Strategic and InternationalStudies.

35For detaileddiscussion of federal programs that should be cut, see ChrisEdwards, Downsizing the Federal Government (Washington:Cato Institute, 2005), www.downsizinggovernment.com.