During the Bush Administration's first four years, the White House pursued a market-oriented tax reduction strategy-with much of the effort, especially in 2003, focused on marginal rate reductions to boost economic growth and increase international competitiveness.
In his proposed budget for fiscal year 2006, the President focuses his efforts on slowing the growth of government. This is the correct decision, both because less government will boost economic growth by leaving more of the nation's resources in the productive sector of the economy and because less government will facilitate pro-growth policies, such as:
Making the 2001 and 2003 tax cuts permanent;
Creating personal retirement accounts to improve Social Security; and
Reforming the tax code to move closer to a simple and fair flat tax.
The Administration's budget, while not perfect, is a good first step for fiscal discipline. It eliminates or reduces some 150 federal programs, slows discretionary spending, and actually reduces non-defense discretionary spending. It also begins to address problems in entitlement programs, such as Social Security and Medicaid. There is more that could be done, to be sure, such as reducing or eliminating more programs rather than giving them additional money. Still, the discipline displayed in this budget should be applauded.
The Goal is Less Government, Not a Balanced Budget
Government spending should be significantly reduced. It has grown far too quickly in recent years, and most of the new spending is for purposes other than homeland security and national defense. Combined with rising entitlement costs associated with the looming retirement of the baby boom generation, America is heading in the wrong direction. To avoid becoming an uncompetitive European-style welfare state like France or Germany the United States must adopt a responsible fiscal policy based on smaller government.
Budgetary restraint should be viewed as an opportunity to make an economic virtue out of fiscal necessity. Simply stated, most government spending has a negative economic impact. Every dollar that the government spends necessarily means that there is one less dollar in the productive sector of the economy. This dampens growth because economic forces guide the allocation of resources in the private sector, whereas political forces dominate when politicians and bureaucrats decide how money is spent. Moreover, portions of the federal budget are used to finance activities that directly undermine productive economic activity. Many regulatory agencies have comparatively small budgets, for instance, but they impose large costs on the economy's productive sector. Another problem is that government programs reduce economic growth and diminish national output because they promote misallocation or underutilization of resources-either by subsidizing bad behavior, such as unemployment, or penalizing good behavior, such as work and saving.
Unfortunately, too many policymakers want to treat the symptom-deficits-rather than the problem-excessive spending. The budget deficit is not the critical variable. The key is the size of government, not how it is financed. Taxes and deficits are both harmful, but the real problem is that government is taking money from the private sector and spending it in ways that often are counterproductive. The need to reduce spending would still exist-and be just as compelling-if the federal budget were in surplus. Fiscal policy should focus on reducing the level of government spending, with particular emphasis on those programs that yield the lowest benefits and impose the highest costs.
There is very little evidence that budget deficits have an impact on the economy, but there are dozens of academic studies showing that economic growth slows when government gets bigger. In any event, policymakers who claim to be worried about budget deficits can take comfort in the fact that even a modicum of fiscal discipline-holding spending increases to 4 percent annually-will cut the deficit by more than 50 percent in just five years.
Controlling federal spending is particularly important because of globalization. It is increasingly easy today for jobs and capital to migrate from one nation to another. This means that the reward for good policy is greater then it has ever been.
The Bush Budget: Much-Needed Spending Discipline
The President's budget is a step in the right direction. Most importantly, the White House is proposing to slow the growth of government. As the budget states, the proper goal is "Restraining Federal spending so that more of our resources remain in the hands of the private sector." This is achieved in the budget by:
Reducing the burden of federal government spending from 20.3 percent of GDP in 2005 to 19.0 percent of GDP in 2010. Government would still be bigger, as a share of the economy, than it was in 2001, but the trend would be in the right direction.
Reducing non-defense discretionary spending from 3.8 percent of GDP to 3.0 percent of GDP, the lowest level since data was first collected in 1962.
Holding in check so-called mandatory spending, which would climb to 11.0 percent of GDP from 10.9 percent of GDP. This would be an all-time high, but the upward trajectory would be significantly slowed.
Slowing the growth of government spending, a key long-term economic threat.
The Bush Budget: Pro-growth tax policy
From its inception, the Administration has fought to reduce the federal tax burden. At the Administration's behest, Congress passed significant tax reductions in 2001 and 2003, helping to lower the aggregate tax burden. More importantly, the tax cuts lowered marginal tax rates on productive economic behavior. Lower income tax rates and reductions in the double-taxation of dividends and capital gains are important steps in the direction of a pro-growth tax system.
The good news is that these "supply-side" tax cuts have boosted economic growth and international competitiveness. The bad news is that these tax cuts are scheduled to expire-some at the end of 2008 and others at the end of 2010. This would mean a big future tax increase. The fiscal year 2006 budget seeks to protect the economy from this fate. Specifically, the President proposes to:
Make the existing tax cuts permanent, especially the lower income tax rates and the reductions in the double-taxation of dividends and capital gains.
Reform the tax system to bring America closer to a simple and fair flat tax.
The Administration's budget documents also prove-albeit not deliberately-that not all tax cuts are created equal. The President's 2001 tax cut had many good features, but the "supply-side" components, such as lower marginal tax rates and death tax repeal, were postponed until 2004, 2006, and 2010. Income tax rates were reduced in the short term by one percentage point, but the bulk of the tax relief was in the form of economically ineffective tax rebates and tax credits. The 2003 tax cut, by contrast, was much more effective since it resulted in immediate reductions in the double-taxation of dividends and capital gains and the immediate implementation of the income tax rate reductions that were scheduled to take effect in 2004 and 2006. Because the 2003 tax cut was better designed, it had better effects:
The economy grew much faster after 2003 tax cut, expanding roughly twice as fast as it did after the 2001 tax cut.
The faster growth following the 2003 tax cut has had a "revenue-feedback" effect. Because of a stronger economy, federal tax revenues in 2004 jumped by more than $90 billion, compared to 2003, and they are expected to rise by more than $160 billion this year (an estimate shared by the Congressional Budget Office).
The Next Step
The federal government is too big and it costs too much. The President's budget takes a necessary step in the right direction by asking Congress to control the growth of federal spending. But good proposals will not lead to a better economy unless they are matched by strong action. The President must use his veto pen to ensure that spending does not rise by one penny above what he has proposed.
Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.