Deficits, Interest Rates, and Taxes: Myths and Realities

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The federal government's swing from budgetsurpluses to budget deficits has raised concernsabout possible negative economic effects. Someeconomists have argued that deficits will raiseinterest rates, reduce economic growth, increasetrade deficits, and possibly create a financial crisis.

This paper examines those claims and findsthat they are not supported by the evidence. Inparticular, the arguments of a recent study by formerTreasury secretary Robert Rubin, BrookingsInstitution scholar Peter Orszag, and economistAllen Sinai are examined in detail. That studyproposed four hypotheses about the effects ofsustained budget deficits: First, projected futuredeficits affect current interest rates. Second,smaller budget deficits produce more domesticprivate investment. Third, budget deficits causetrade deficits. Fourth, budget deficits cause fiscaldisarray and require tax increases to maintainconfidence.

Empirical evidence--U.S. time series data andinternational comparisons--do not supportthese hypotheses. Also, several of the hypothesesare inconsistent with each other. In reality, neitheractual nor projected budget deficits raisereal or nominal interest rates, steepen the yieldcurve, reduce national savings, cause tradedeficits, or make the dollar go down or up. Thelogic behind such speculations is flawed and theevidence is missing.

These issues are important because numerouspundits and policymakers are arguing thattaxes should be raised to reduce deficits. Indeed,a theme of Rubin, Orszag, and Sinai is that highertax rates can improve economic growth, butthat runs directly counter to serious research onthe causes of economic growth. Research on economicgrowth assigns importance to the taxstructure, marginal tax rates, and the level andcomposition of government spending, but not towhether spending is financed by taxes or deficits.Deficits are a sign that federal spending is toohigh, but deficits do not cause many of the economicharms that some analysts are claiming.

Alan Reynolds

Alan Reynolds is a senior fellow at the Cato Institute.