February 28, 1986

February 28, 1986 | Backgrounder on Federal Budget

A Tax Hike Is No Cure for the Deficit

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491 March 3, 1986 A TAX HIKE IS NO CURE FOR THE, DEFICIT Bruce Bartlett John M. Olin Fellow INTRODUCTION Pressure to reduce federal budget deficits remains high, despite a District Court ruling invalidating a key section of the Gramm-Rudman-Hollings deficit reduction law deal with such deficits by raising taxes, rather than cutting spending. In particular, a n oil import fee appears to be gaining support as the price of oil slides downward Also high is pressure to Raising taxes will not cure,the deficit, for the deficit is not caused by insufficient taxes, but by excessive spending. In the past ten years, in f act, federal tax revenues have almost tripled, despite the reduction in tax rates. The trouble is that federal spending has grown even faster than revenues An oil import tax, however, would be a mistake: it would hamper America's international competitive ness strike hard at the already depressed refining and petrochemical industries, further weaken the repayment capacity of several debtor nations, and raise U.S. unemployment.

Rather than giving consideration to tax gimmicks as a means of reducing the deficit, Congress should be pressing ahead with the only solution to the red ink--cutting federal spending.

WHY A TAX HIKE IS NOT THE ANSWER Those who .advocate tax increases to solve the.deficit problem base their argument on a series of myths.about the state of the economy h 1: The defici t derives fro m Americans beincr I'undertaxed. I Many tax increase' proponents claim that the deficit was caused by Ronald Reagan's tax '8cuts of 19

81. But the fact is that revenues have remained relatively constant as a s hare of gross national product despite the 1981tax cut. Spending, however, has exploded. Figure 1 and Table 1 show this. Deficit reduction efforts, moreover, thus far have concentrated disproportionately on raising taxes rather than cutting spending. Tabl e 2 siumnarizes the revenue effects of five major tax increases already enacted during the Reagan Administration and it indicates that over the next five years such increases will take over $469 billion out of the pockets of American taxpayers.

Table 3 shows that these tax increases will take back over 39 parcent of the tax reduction under the Economic Recovery Act of 1981, which is so often blamed for the deficits.

Those who advocate tax increases to deai with deficits tend to assume that the economy can benefit from lower deficits without suffering from the tax hike itself. They assume that 'it is possible to have it both ways: higher growth and lower unemployment r esulting from previous tax cuts, along with the alleged benefits from lower deficits, such as lower interest rates, resulting from a new tax increase A related error is to assume that taxes will be increased with the least possible economic damage. Yet, g i ven the political makeup of Congress, it is more likely that new taxes would take the form of increased taxes on capital-hitting saving and investment rather than consumption much or more than the amount of the tax. The result: rising 'interest rates, eve n as deficits fell If taxes on capital were raised, saving could fall by as Mvth 3: Concrress will use the new revenues to cut the deficit not spend them i I I It is wishful thinking to assume that new revenues, however raised, will be applied to deficit r e duction, rather than fueling additional spending. More likely, any deficit reduction due to increased revenues simply will alleviate the pressure to control spending. If the deficit is ever brought under control by raising taxes, spending is almost certai n to take off again-unless checked by a balanced budget/spending limitation amendment to the Constitution i 2 a Table 1 Receipts, Expenditures, and Deficits percent of GNP Year ReCeiDtS Emenditures Def kits 1988* 19.0 20.9 -1.9 1987 1986 1985 1984 1983 198 2 1981 1980 1979 1978 1977 1976 1975 1970 1965 1960 Estimate Source: Office 18.7 18.5 18.6 18.0 18.1 19.7 20.1 19.4 18.9 18.4 18.4 17.5 18.3 19.5 17.3 18.2 of Management and Budget 21.9 -3.2 23.4 -4.8 24.0 -5.4 23.1 -5.0 24.3 -6.3 23.7 4.1 22.7 -2.6 22.2 - 2 .8 20.5 -1.6 21.1 -2.7 J 21.1 21.9 21.8 19.8 17.6 18.2 2.8 -4.3 -3.5 -0.3 -0.2 om1 3Figure 1 25 24 23 22 21 20 19 18 17 16 15 Federal Receipts and Expenditures 60 70 76 78 80 82 84 86 88 65 75 77 79 81 83 85 a7 Year LEGEND I Receipts Expenditures Source: O MB Table 2 Effect of Major Tax Increases billions of dollars Leaislation 1985 1986 1987 1988 1989 1985-89 Tax Equity and Fiscal Responsibility Act of 1982 39.2 49.2 59.2 61.6 61.7 270.8 Highway Revenue Act of 1982 4.2 4.5 4.7 4.8 5.0 23.2 Social Security Amendments of 1983 8.7 8.0 9.2 20.0 24.9 70.9 Railroad Retirement Revenue Act of 1983 0.7 1.1 1.1 I'm1 1.1 5.1 Deficit Reduction Act of 1984 9.3 16.0 21.8 24.9 27.2 99.2.

Total 62.1 78.8 96.0 112.4 119.9 469.2 Table 3 Tax Increases Compared to 1981'Tax Cut billions of dollars 1985 1986 1987 1988 1989 1985-89 1981 Tax Cut 170 3 2017 5 244.8 274 0 303.7 1,200-3 Tax Increases 62.1 78.8 96.0 112 4 119 9 469.2 Increases as a of 1981 Cut 36.5 38.0 39.2 41.0 39.5 39.1 Source: Office of Management and Budget IS DE FICIT REDUCTION WORTH A TAX HIKE? Because the U.S. economy is extremely complex, actions dealing with one problem may create others. irritant, but have declined sharply despite large budget deficits.

Interest rates on three-month Treasury bills, for exampl e, have fallen by half since 1981, from 14 percent to a current level of about 7 percent. How much further do advocates of tax increases think rates High interest rates are still an 5-would fall if the budget were balanced? In 1969, the last year the U.S. had a balanced budget, Treasury bill rates averaged 6.7 pekcent--only slightly lower than they are today down further, what benefits can be expected deficit raises the exchange value of the dollar and thereby penalizes exports. But if interest rates are n o w about what they were when the budget was balanced-and lower than in many competing countries-what continues to draw foreign funds into dollar-dominated assets foreign investment in dollar assets is a problem, and it almost surely is not, balancing the b u dget is not going to solve it If it is unlikely that lower deficits will push interest rates Some argue that the If It has also been argued that the federal deficit causes inflation four years, in fact, inflation has subsided as the deficit has mounted Bu t this is an argument with little evidence. In the past It is even questionable whether any action is needed to curb the They appear to be coming under control under current deficits policies. If the Administration estimates are correct, the budget deficit will fall to 1.9 percent of gross national product by fiscal 1988; this would be the lowest level slnce 19

79. Independent projections reach similar conclusions. The Congressional Budget Office's (CBO) most recent forecast, for example, shows the the deficit falling by 20 billion a year without congressional action.

The case for tax increases to balance the budget thus is extremely weak proposed is an oil import fee.

It becomes weaker still when the specific tax OIL IMPORT FEE In recent months there has been considerable discussion of an oil import fee as a revenue-raising device, either for deficit reduction or for financing tax rate reductions as part of tax reform. Such a fee would be a particularly bad way of raising revenue for economic and politica l reasons alike.

American consumers, some of the nation's most important allies, and many of its heaviest debtors on imported oil. Since oil prices are falling, it is said, this would It would hurt American industry A frequently discussed option is imposin g a $5 per barrel tariff a 1. William G. Dewald CBO and OMB Projections, Adjusted for Inflation, Show Federal Budget Deficit Under Control," Federal Reserve Bank of Richmond Economic Review November/December 1985, pp. 15-22 6be a painless tax hike, barely noticed by the consumer study of this idea concluded.that a tariff would reduce real economic growth by 0.5 percent the first year 100,000 in the unemployed and a 0.4 percent hike in the consumer price index may be surprisingly limited. In calculating the revenues raised by the fee, it is misleading simply to multiply U.S. oil imports by 5 per barrel. The relative increase in the cost of oil caused by the fee would reduce demand for oil, slow economic growth, and spur higher federal expenditures for mounti n g unemployment and for indexed entitlements boosted by higher inflation. Thus while an oil import fee would yield new revenues, it also would trigger higher federal outlays. corporate income taxes and windfall profits taxes, assuming that domestic oil pri c es rose by the amount of the tariff, it is noted by the CBO that there would be lower revenues due to offsetting fffects elsewhere in the economy resulting from higher energy prices Yet a CBO The result of this: a jump of The CBO also noted that the fee's impact on the federal deficit And although Washington might take in more revenue from The amount of revenue might also be affected by.pressures to make Imposing a tariff on Mexican oil exemptions in the tariff's coverage. For example, the U.S. imports a s u bstantial amount of oil from some of its closest allies and from nations with serious debt problems for example, could exacerbate that country's serious foreign debt problems oil imports and Canada is also America's largest trading partner undoubtedly wou l d be strong political pressure to exempt these two countries from an import tariff. Mexico, Venezuela, Ecuador, Nigeria and Indonesia, meanwhile, are heavily in debt and owe large sums to U.S. banks. Again, there would likely be heavy political pressure t o exempt such nations from an import tariff imports just $3.8 billion in oil per year from Saudi Arabia and just 678 million per year from the United Arab Emirates, which together account for just 12 percent of total U.S. oil imports The seven countries 'i n Table 4 provide over 66 percent of U.S.

The U.K and Canada are two of America's closest allies, There By contrast, the U.S 2. The study is reprinted in the Conpressional Record, April 26, 1982, pp. S 3982-91 daily edition 7- Table 4 UaSa Oil Imports from Selected Countries, 1984 Country Imports* Percent of Total Imports Mexico 6.8 Canada 3.5 United Kingdom 4.1 Venezuela 3.7 Ecuador 1.0 Nigeria 2.4 Indonesia 3.7 9.2 10.8 9.8 2.6 6.3 9.8 Billions of dollars Source: Department of Commerce If certain nations were exempted from the tariff, its revenue yield would be sharply reduced enforcement problems, as it would be difficult to prevent an exempted nation from obtaining oil from a nonexempted nation and transshipping it to avoid the tariff determine whether a given barrel of oil came from a nation that was covered by the tariff or from one that was not There also would be serious It would be practically impossible to Another problem with an oil import fee involves the treatment of such petroleum products as g asoline, heating oil, and petrochemicals.

If the tariff applied only to crude oil, an obvious way to evade it would be to refine the oil or manufacture the petrochemicals outs.ide the,U.S. and then ship in the products free of tariff. This would penalize t he UaSa refineries, which are already operating at historically low capacity rates, and the petrochemical industry, which is suffering from slow growth.

Rising imports are already a serious problem in both industries.

Petrochemical imports, for example, doubled from $3.3 billion in 1981 to $6.5 billion in 19

85. Imports of gasoline rose 38 percent in 1985 8while the number of operating refineries fell to 199 from 315 in 1981 and capagity utilization remained at the very low level of 76 percent industries for which the price of oil is an important factor. Such industries would be at an international disadvantage compared with their competitors in nations that paid no oil import fee. Says Du Pont chairman Edward Jefferson: While appealing at first glance, a tax on imported oil would seriously impair the worldwide cost competitiveness of many domestic industries by forcing them to use energy and petroleum-based raw materials at prices above world levels The result could be an increase in the U.S. trade defic it even as oil imports declined.

American firms using imported oil an equivalent amount, as would oil substitutes, such as natural gas As the Washinaton Post puts it The price of the imports sets the price for the domestic product a third of its oil. It me ans that for every dollar collected by the federal government in the tax 2 will go to the domestic oil industry in higher prices. Iv6 Negative effects also can be expected in the other U.S The economic effects of' an oil import fee would extend beyond the The price of all oil would rise by Currently this country imports about It is unfair, in short, to establish a tariff, which is advertised as benefiting all Americans through lower deficits, yet will primarily benefit domestic oil companies-especially whe n no similar import relief has been granted to other industries, such as textiles or shoes. Protectionism is a bad idea.

It also makes little sense to favor oil companies emphasizing domestic production at the expense of those dependent on imported oil to create a new entitlements system, similar to that which existed prior to full oil decontrol in 19

81. Such a system woul d be complex and expensive to administer. It would require domestic producers, in effect, to subsidize imports imports If Washington tried to address these inequities, it would have And it would tend to increase oil 3. See 1986 U.S. Industrial Outlook (Wa shington, D.C U.S. Department of Commerce International Trade Administration, 1986 4. Quoted in John M. Berry, "Impact of Oil Import Fee Disputed," The Was hinaton Posk July 26, 1985, p. B

2. See also Charles Kadlec and Arthur Laffer Oil Levies Were a Bad Idea, Anyway," The Wall Street Journal, July 30, 1985 5. "Taxing 'Oil," editorial, The Washineton Post December 29, 1985 9- Congress alread has considered an oil import fee and wisely rejected it. Just last November, the Senate voted decisively 78 to 18 a gainst an amendment by Senator Gary Hart, the golorado Democrat, to impose a 10 per barrel tariff on imported oil. There is little reason to believe that the political conditions have changed much between then and now opposition to an oil import fee.

And P resident Reagan remains adamant in his CONCLUSION The oil import fee idea is unlikely to go away as long as there are those who believe that with oil prices falling such a fee would be a kind of "free 1unch.I recently, claiming an oil import fee would mer e ly "have the effect of paying ourselves what we have been paying tc 'foreign oil producers I7 This argureent makes no sense. Its advocates apparently ignore or dismiss the overall economic impact of such a fee. An oil import fee would be a bad idea The pe w York Times joined this chorus Equally senselsss, and for most of the same reasons, would be any other kind of tax hike ilrposed to reduce the federal budget deficit 6. Congressional Record, November 14, 1985, pp. S 15599-15606 7 In the Name of Sanity, Ta x Oil," editorial, The New York Times, December 24, 1985 10

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