March 26, 1984

March 26, 1984 | Backgrounder on Federal Budget

Dangers of the Deficit Reduction Plan

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341 March 26, 1984 DANGERS OF THE DEFICIT REDUCTION PLAN INTRODUCTION Ronald Reagan and Senate Republican leaders are lobbying intensively for a three-year projected 150 billion Deficit Reduc tion Plan that could be brought to the Senate floor early this week. The plan is t o be introduced as an amended and expanded version of S.2062, the Senate Finance Committee's Budget Recon- ciliation 'Bill. Proponents claim it represents a fair compromise because it cuts 40 billion from defense, and $43 billion from non-defense spending , raises 48 billion by hiking taxes and closing tax llloopholes,ll and reduces interest outlays by an e.sti- mated 18 billion.

Despite the backing given to the plan by the President and Senate leaders Robert Dole (R-KS) and Pete Domenici (R-NM a number of Republican senators are balking. Charles Grassley (R-IA and Nancy Kassebaum (R-KS for instance, are pressing for defense cuts below the 5 to 8 percent real growth in FY 1985 al1,owed by the plan. Robert Kasten R-WI) and others hesitate to accept tax hikes and argue, using the President's previous statements, that this would damage the economy A great many conservatives loyal to the President fear that this new plan will only be a replay of 1982's TEFRA flcompromisell disaster--in which the President signed the largest tax increase in history on the promise that he soon would receive 3 in spending cuts for every $1 in tax increases. Congress broke its word and instead of cutting spending, actually increased non-defense outlays 4 cents for every $1 of new tax es.

Deficit hysteria is blinding legislators to the reality of the economic recovery and to the facts of 1982's "deficit reducing package. Congress agonizes that current fiscal policy will push up interest rates and impede economic growth. Congress embrace s a tax increase as a spur to economic growth or reduced deficits yet can cite no historical evidence of any link between deficits. 2 and interest 100 billion doubled less rates. Has Congress forgotten that despite TEFRA's in tax increases in 1982, projec t ed deficits were than a month after the bill was Dassed?' How can Congress be so certain that this time a tax bbost would cut the deficit advisors overlooked the unpleasant fact that just four months after TEFRA was passed interest rates ended what had be e n a rapid decline and have been rising ever since Why have the Senate leadership and the President's The logic that a tax increase somehow increases investment is fundamentally flawed. Though high deficits, say the tax-hikers would stifle business investm ent and halt the economic recovery, gross private domestic investment (GPDI) increased over 35 percent between the fourth quarters of 1982 and 19

83. This far exceeds the average of 26 percent for post-war recoveries, and indicates that this recovery was l ed by investors, not consumers.3 Those now supporting this tax package are baffled by this and say it cannot happen because of l'highlf interest rates purportedly due to the deficit. Yet capital spending plans are projected to increase a thumping 17 perce n t this year.4 Businesses are investing because real rates of return on investment have increased more than the real interest rate for loanable funds--thanks in large part to prospects for economic recovery and the lower cost of investment resulting from 1 9 81 tax reductions. TEFRA and some elements of the proposed tax increase bill erode seriously the after-tax rate of return. Most disturb ing, the new package takes the illogical step of taxing investment, its proponents argue to improve the climate for inv estment.

The proposed deficit plan has been forced on the President by legislators who have an extremely poor track record of economic forecasting since Reagan took office. They ridiculed Reagonomics; they said unemployment would not drop sharply (it has t hey said the recovery would be weak (it hasn't been and they warned that the recovery would sputter out (it isn't). At the least, respon sible members of Congress, no matter what their views of the deficit issue, should demand that the out ironclad provis ions ensuring that taxes are raised. The last thing the TEFRA package must not pass with spending will be cut if nation needs is a rerun of See Paul Craig Roberts Taxes and Deficits Wall Street Journal, Janu ary -14, 1984.

John Palffy The Hatch-Gramm Balanced Budget Spending Freeze Proposal ,I Heritage Foundation Issue Bulletin No. 91 ,-May 5, 1983.

See Norman Ture The Anatomv of This Recoverv: No Case for Tax Hikes,"

Institute for Research on thi Economics of Taiation, March 2, 1984.

Business Week, Marc h 12, 1984, p. 12. 3 DEFICITS AND INTEREST RATES Most members of Congress are not really worried about defi cits as such high interest rates and reduced business investment due to an alleged crowding out" of private borrowers by the government.

They mistakenly see a tax hike as a means of avoiding this. But this reasoning is based on the myth that deficits lead to high interest rates. It ignores the economic reality that federal spending, not deficit size, is the real drain on the economy.

Discu ssions of taxes and deficits distract attention from the fundamental truth--all government expense must be financed by the nation's wage earners either through higher taxes, higher infla tion, or higher interest rates or a combination of them. Each damage s the economy and destroys Jobs.5 Tax increase proponents overstate the correlation between government deficits and interest rates. In fact, most empirical analysis and historical evidence confirms that, if anything there is a slight negative relationship b etween interest rates and deficits. Deficits skyrocketed in 1982, for instance, while interest rates plummeted. Other countries, such as Japan, have managed for years to run much larger deficits than the United States as a percentage of gross national pro d uct, while maintaining low interest rates. And the Wall Street Journal recently noted that despite an unexpected 12 percent decrease in the federal deficit in January, due to the strength of the su ply-side recovery Treasury bills and the prime rate both i ncreased.8 A recent survey of the data and studies on the matter by Treasury Department ex perts also confirmed that there is no conclusive theory available linking large deficits to high interest rates What actually concerns them are the prospects of The case that tax increases reduce deficits or increase eco nomic growth is equally unproven. Weeks after TEFRA was enacted on the promise that a tax increase would reduce federal budget deficits, the Congressional Budget office (CBO) raised its projec tions o f future deficits. On the other hand, the Kennedy tax cut of the early 1960s demonstrates that tax reductions can bring down deficits by encouraging growth. Tax receipts rose $10 billion in 1964 and 1965, and GNP increased by $25 billion despite the $12 b illion tax cut When taxes are raised, deficits are rarely cut because the new revenues remove the pressure for making deep spending cuts.

Legislators.soon begin edging away from their politically unpleas ant agreements to reduce outlays. Notes Nobel Laurea te economist Milton Friedman See Thomas Humbert Understanding the Federal Deficit, Part 3: The Un proven Impact Heritage Foundation Backgrounder No. 330, January 27, 1984 and John Palffy, op. cit The Prime Movement Wall Street Journal, March 21, 1984.

See Paul Craig Roberts, The Supply-side Revolution: An Insider's Account to Policy Making in Washington (Cambridge, Massachusetts: Harvard University Press, 1984 pp. 76-81 6 4 You cannot reduce the deficit by raising taxes. In creasing taxes only results in more spending. Poli tical Rule No. 1 is: Government spends what government receives plus as much as it can get away with.

The record of TEFRA proves Friedman's dictum. Congress raised spending to more than offset the projected tax increase Not only do tax increases lead to more spending, they rarely yield the revenue promised, just as tax cuts rarely cut revenues as much as opponents fear. Most tax increases hit productive economic activity, such as work, saving and investment. This damages the economy and thus cuts future tax revenues. Even closing non-productive tax "loopholes1' invariably fails to raise the promised amount of revenue because a portion of the money merely finds its way into other loopholes. Taxpayers will seek loopholes so long as it is l e ss costly to pay.accountants than to pay taxes on normal investments. The way to eliminate loopholes as the Japanese have found is to reduce or eliminate taxes on savings and risk-taking-thus making productive investment attrac tive to taxpayers. When a l o ophole is closed, thus making that particular investment inefficient or unavailable, the creative taxpayer merely moves to the next most efficient loophole or deduction HOW THE TAX BILL WILL HURT INVESTMENT The folly of trying to cut deficits and improve i nvestment by raising taxes should be evident to Congress. But even those legislators who honestly believe that higher taxes will lead to lower deficits and a better business climate should note that several provisions in the package, carried over from the Senate Finance Reconciliation Bill S.2062 would reduce savings and economic growth directly--and thus undermine the deficit reduc tion plan.

The most damaging are a) Repeal of the 15 percent net interest exclusion This provision is projected to raise 7 billion in revenue.

But it could reduce the return on savings by as much as 18 percent thus reducing the incentive to save. The effect of this smaller pool of private savings would offset the advantages from the anti- cipated reduction in government borrowi ng. Extensive tax exemp tions have encouraged Japanese taxpa ers to save at rates more than three times those of Americans.x This large pool of savings allows the Japanese government to finance significantly higher deficits with lower interest rates than d oes Washington. Rather Calculated by Evans Economics, Inc., Washington, D.C. 5 than reducing interest deductions, Congress should learn from Japan and increase interest deductions to foster risk-taking and saving b) Delaying the expensing of business pers onal property for four years Noted business economist Peter Drucker recently explained that in the past decade the American economy has created 20 mil- lion new jobs--mostly by small businesses financed on a shoestring.

This "entrepreneurial revolution" is the foundation of the next generation of U.S. companies.g Delaying expensing would increase the cost of investment to small businesses, directly offsetting any such advantages from possible reductions in interest rates.

The provision is projected to raise 1.4 billion c) Delaying the reduction in the windfall profits tax the future cost of oil, and thus add a further boost to general business costs.

This provision would discourage new oil exploration, increase d) Lengthening depreciation on structures fro m 15 to 20 years ing--well above the average for post-war recoveries. While this capital surge has powered the recovery, business investment has been characterized so far by spending on new equipment, not new fact0ries.l' Only now are expenditures on new p lants beginning to match the pace of other spending A recent survey indicates that firms plan to boost plant spending by 17 percent this year.ll Lengthening the depreciation schedule for structures could nip this acceleration in the bud. And hardest hit w o uld be those industries that most need to replace obsolete factories--such as steel and textiles. This provision, which would raise an esti mated 1.3 billion, could dampen seriously a key stage of the recovery This recovery has been led by an explosion in capital spend e) Raising corporate taxes dends and profits are taxed. They also distort investment deci sions and reduce corporate profits. Economist Kenneth T. Mayland of First Pennsylvania Bank, has noted that existing depreciation write-offs, generatin g corporate retained earnings should al1,ow private companies to generate $350 billion in internal funds in Corporate income taxes hit investors twice, since both divi 9 Report, March 26, 1984, p. 68 How New Entrepreneurs Are Changing U.S. Business U.S. Ne ws and World Norman Ture, op. cit. l1 "A Hot Economy Starts Smoking--Capital Spending Surges ,I1 Business Week March.12, 1984, p. 19. 6 19

84. These retained earnings, he says, will be more than enough to self-finance projected capital expenditures.12 taxe s, however, will mean less retained earnings. This, in turn means that corporations would be forced to borrow more in the credit markets to finance planned investment So pressure on the credit markets, which the tax hikes are intended to reduce, would be i ncreased directly by this provision in both the House of Representatives and the Senate threaten to add 20 billion more in tax increases Higher corporate If these tax provisions were not damaging enough, Democrats Among their possible targets are a) Repea l of the third year of the tax cut New gasoline and Social Security taxes, and inflation, have all but wiped out the original Reagan tax cuts. Raising marginal tax rates now would only destroy and reverse the recovery that got underway only when the full i m pact of the three-year tax plan was felt b) Repeal or delay of the indexinq of income tax brackets This provision, advocated in the recently unveiled Senate Democratic plan, could raise revenues, but it would hurt the poor and middle income classes most-- h ardly a welcome side-effect of a reduction in the deficit.13 c) Imposinq a surcharge on high incomes According to the Grace Commission, even if the government were to tax away all the income of those earning over $60,000 the government would only collect an additional $33 billion. The budget thus cannot be balanced just by over-taxing the wealthy. Moreover, much of this money would come straight from savings thus raising interest rates) since high income households save most earnings over 50,0

00. It would also make remaining tax shelters even more attractive.

In fact, recent IRS data confirm the supply-side hypothesis that lowering marginal rates on the rich results in increased revenue collections from the wealthy. Despite reductions in the top marginal rate from 70 to 50 percent, tax receipts from indi viduals earning over 100,000 in 1982 increased over 13 percent compared with 1981 l2 L3 l4 Statistics of Income S.O.I. Bulletin, IRS vol. 3, no. 3, Winter The 'Crowding Out' Scenario Looks Less Likely Thi s Yea'r Business Week January 30, 1984, p. 12.

Thomas Humbert Tax Indexing Heritage Backgrounder No. 225, March 22, 1983 1983-1984 At Last a Break for the Little Guy," 7 ANOTHER TEFRA FIASCO IN THE MAKING The present tax package threatens to repeat the sorry history of TEFRA. This would be the heavies t tax bill in history--1,000 pages long and hardly a simplification of the tax code. Moreover while it is a tax bill intended to reduce deficits and encourage investment, it could actually have the opposite effect, as did its 1982 predecessor. As former As sistant Secretary of the Treasury Paul Craig Roberts has noted TEFRA was supposed to help investment by raising revenues thereby lowering budget deficits and interest rates.

Instead it reduced the cash flow of the business sector by the amount of the tax hike, thereby making business more dependent on borrowing to finance investment.

Since firms have lower credit ratings than the U.S Treasury, the substitution of business borrowing for Treasury borrowing has the effect of raising the interest rate. In addi tion, TEFRA directly reduced the return on investment by raising the after-tax cost of plant and equipment. The only way TEFRA could have contri buted to lower interest rates is by reducing private investment and thereby lower demand for credit.15.

The current deficit reduction plan could repeat the same Mistakes.

Some Republicans share Roberts' concerns, but reluctantly see tax increases as the painful price they must pay for obtaining spending cuts. But is it a good deal? Again the TEFRA experience sugg ests they are being conned. The First Concurrent Resolution on the Budget for FY 1983 (S. Con. Res. 92 passed in April of 1982, recommended $100 billion in tax increases and $280 billion in budget cuts. President Reagan cited the Resolution's budget cuts as the condition for his support of TEFRA. Indeed, on August 9, 1982, he noted that the budget resolution passed this year (1982 if Congress sticks to its targets, will decrease the red ink in the budget by almost 400 billion through 1985.

The tax bill's new revenues are only one-quarter of that total. The remaining three-fourths--$280 billion in deficit reductions--is to come from lower outlays.

We worked with Congress on this resolution and that was the price of my support--$3 saved in outlays for every 1 in increased revenues.

The critical passage in the President's statement was Ifif Congress sticks to its targets In truth the nation was bur dened with 4 cents in non-defense spending increases for every Roberts, op. cit, pp. 301-302. a dollar of TEFRA taxes. As such, Congress still owes the President over 150 billion of non-defense spending cuts from their last deal.

MAKING THE DEAL STICK The Problem Nobody is now demanding that Congress make good on its past promises. Yet the President and his congres sional allies at least should learn from their past mistakes. Senate and White House backers of the new package, however, are taking some precautions to make sure that they are not bamboozled again. Unfortunately, the tax increases are all specified and c a n be passed in one timely bill. Many of the specific spending cuts, on the other hand, still have to be agreed upon and passed through several appropriations bills much later this year. In order for the spending and defense cuts and tax increases to be in c luded in S.2062--the Senate Finance Recon- ciliation bill--the Senate would have muster a majority to waive its germaneness rule As planned, the bill would state that the spending cuts must be made in particular budget functions not guarantee that the spe nding cuts actually will be delivered.

Some House and Senate authorizing committees already have begun writing budget-busting authorizations. As these authorizations filter through the appropriations process and onto the floor they easily could violate the ceilings mandated in the bill.

Even if a senator or congressman raised a point of order against the appropriation, a majority of 51 senators or 218 representatives could pass the bill--thus reneging on the spending side of the deficit package to sign.int o law spending that violates the budget compromise, or veto entire appropriations bills That may be too much to expect in Washington.

But such a statement does The President would then be forced The Options 1) Conservatives could try to hold tax increases hostage to spending cuts by voting down the Reconciliation Bill--that is the entire deficit reduction plan--on the floor of the Senate.

They could opt to link specific tax increases to specific spending cuts when they are voted on by the appropriations committees.

Unfortunately, including tax legislation with appropriations bills in this way would take some highly creative procedural footwork. It is unlikely that Congress would go along with this--it would require unprecedented cooperation between the Finance commi t tees and the Appropriations committees, and between the House and Senate 2) Legislators would be better advised to call the bluff of those who solemnly promise spending cuts by attaching an amend ment to the Reconciliation bill, allowing the President to " line item veto" any spending that violates the prescribed limits in 9 the next three years thirds of Congress for an override--effectively guaranteeing that the cuts would be made This restricted veto would require two This second option is the only plaus ible method of ensuring that Congress keeps both sides of its bargain with the White House.

ARE THERE REALLY ANY SPENDING CUTS IN THE PROGRAM No sooner had the Deficit Reduction Plan been made public than critics began to cast doubt on its numbers. A CBO s tatement on March 19 claimed that the plan reduced outlays only $52 bil lion--not the 101 billion the Administration claimed. Moreover, rumors abounded that some entitlement cuts were already being stricken from the agreement. And who could forget the dis appear ing act of TEFRA's spending cuts?

Depending on the base figures used for the purposes of calcu lation, the package either reduces defense spending 40 billion or increases it 4 billion. The $40 billion cut in defense spend ing constitutes a cut from the President's proposed FY 1985 increase of 13 percent, leaving a real increase of approximately 8 percent over FY 1984 The Senate also assumes that $18 billion will be saved from reduced interest expenditures, but the Congressional Budget Office claims t he saving will be only $12 billion. Moreover, if the tax increases do not yield the anticipated revenues, or if some of the spending cuts are not made or are cancelled out by other in creases, these spurious interest reductions will never materialize at a ll.

Some members contend that since some of the Finance Committee's entitlement cuts already have been approved they hardly can be considered as part of the compromise. posed spending cuts would result from a broad freeze on non-defense discretionary spend ing. Specific cuts have not yet been agreed to, however. These would be determined in the appropriations cycle this summer. Under election year pressures Congress could ignore limits placed on it in the proposed reconciliation bill Moreover, many of the p r o CONCLUSION The Republican Deficit Reduction Plan is the most attractive option currently under serious consideration. Yet it contains potentially fatal pitfalls. The investment tax provisions of the deficit reduction plan should be resisted strongly. On l y as a last resort should they be viewed as a distasteful, possibly dangerous cost of obtaining spending cuts. Closing non-productive loopholes will do little to reduce the deficit. Closing other loopholes will increase the cost of saving and investment. I t is a curious logic which argues that the deficit must be bridged with taxes on investment in order to raise savings and investment. 10 The Deficit Reduction Plan is supposed to cut $52 billion from CBO basline spending over the next three years can achi e ve this modest goal without counterproductive taxes on savings and investment it would constitute a small step in the right direction cut in federal spending. It needs the scope of cuts proposed in the Grace Commission report and detailed in a proposed bu d get by the House Republican Study Committee.lG Congress should take the opportunity it now has to demand such cuts be part of any com- promise As many of these spending cuts as possible should be specified in the bill rather than left to the vagaries of t he appropriations process.

In addition, if the Senate leadership is to obtain the budget cuts it wants, it should amend the bill to grant the President a line item veto to enforce the proposed spending reductions over the next three years If the plan Howev er, the economy needs more than a 2 percent Only if the President receives assurance that all the pro posed spending cuts will be enforced and that Congress will return to the tables for more cuts should the President sign any bill that includes even 1 of tax increases The booming economic recovery refutes the dire predictions of those in and out of Congress who claimed first that a recovery could not take place because of the deficit; then that it would fizzle out in 1983 because of high interest rates; t h en that con- sumers, not investment, would power the upturn. Now the doomsayers are saying that billions of dollars of new taxes on business are necessary to provide the incentive for continued investment. Not only do those pulling for such tax increases s ystematically ignore all the evidence before them but they use arguments that defy logic. Congress would do much better if it were to devote more time to devising a method of ensuring that spending cuts would stick, and less time inventing new ways of tax ing the recovery to death.

John Palffy Policy Analyst The Grace Commission Budget Alternative, Republican Study Committee February 28, 1984.

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