Radical tax simplification: The impossible dream?

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Radical tax simplification: The impossible dream?
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Bush’s Tax-Cut Plan Slashes Growth

Peter R. Orszag and
Peter R. Orszag Vice Chairman of Investment Banking, Managing Director, and Global Co-Head of Healthcare - Lazard
William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

May 9, 2003

Over the past two years, our country has experienced a dramatic deterioration in the federal budget outlook. In January 2001, when President George W. Bush took office, the Congressional Budget Office projected budget surpluses of $5.6 trillion from 2002 to 2011. Now, it projects hundreds of billions of dollars in deficits over the same period.

Having pushed big tax cuts in 2001 and 2002, and another one now in 2003, the Bush administration has adopted a series of mantras in response to the fiscal debacle: It’s not our fault; even if it is our fault, it is not a big problem; and even if it is a big problem, the solution is more tax cuts. These claims have become increasingly outlandish as time marches on.

The first mantra contains a shred of truth. Much of the decline in this year’s deficit is due to a slowing economy and the aftermath of Sept. 11. Even so, the tax cuts enacted and proposed for 2003 and 2004 would be more than three times the cost of the war, according to a study by the Center on Budget and Policy Priorities. And over the next 10 years, the administration’s tax cuts are a larger and larger part of the deficit problem.

The second mantra—that deficits don’t really matter—goes against economic theory, evidence and common sense. Along with many other economists, we believe that there is compelling evidence that projected future budget deficits raise interest rates. Those who share this belief include Federal Reserve Board Chairman Alan Greenspan and Harvard professor Greg Mankiw, whom Bush nominated to be head of the Council of Economic Advisors.

Indeed, the council recently reported that a sustained deficit of 1 percent of gross domestic product would raise rates by a third of a percentage point. One implication is that the Bush tax cuts will eventually raise rates by more than half a percentage point—increasing payments by about $700 a year on a $150,000 mortgage. Another implication is that the 2001 tax cut raised interest rates enough to reduce investment and hurt long-term growth.

But even if deficits don’t affect interest rates at all, there is a real cost to long-term deficits. To see why, think of a family that borrows lots of money to take a vacation. It may run up its credit card balances so much that lenders charge higher interest rates on additional borrowing. But even without a higher rate, the family has a debt to repay. The borrowing effectively places a mortgage on the family’s future income and thereby reduces its future living standards.

The same thing is true for the country as a whole. Budget deficits reduce the country’s national saving, which reduces the assets owned by Americans and so reduces our future national income. The reduction in future national income is effectively a “debt tax,” which is the main reason why Greenspan and other economists are concerned about budget deficits.

“If you get significant increases in deficits that produce a rise in interest rates, you will be significantly undercutting the benefits derived from the tax cuts,” Greenspan said recently.

What about the third mantra? If tax cuts cause deficits, and deficits hurt the economy in the long term, can tax cuts be the best way out of the current mess? Despite the administration’s own estimates that show its tax cuts would dig substantial fiscal holes well into the future, the president and other administration officials argue that tax cuts will actually help restore the budget surplus. Their claim is that cutting taxes would cause the economy to grow so rapidly that we would more than make up for the revenue lost from the tax cut in the first place.

There are two problems with this claim. Most importantly, no credible economist believes it. Even President Bush’s own Council of Economic Advisers has written that the tax cuts would make the budget deficit worse. And, ironically, two years ago, when there were big surpluses, the president himself argued that we needed tax cuts because they reduce revenue, not raise it. Tax cuts, of course, can raise economic growth by encouraging people to work harder and save more. But those effects are not big enough in the president’s proposals to more than offset the effect of the debt tax that would also be created—let alone by enough to have the tax cut pay for itself.

The president’s reckless approach to tax cuts is a huge fiscal gamble. It benefits the wealthy, but would impose new and increasing burdens on low-income households and future generations, and it is unlikely to succeed in restoring broad-based economic growth and financial discipline. The sooner fiscal sanity is restored, the better.