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Backgrounder #823 on Taxes

April 15, 1991

The Four Percent Solution to Runaway Federal Spending


(Archived document, may contain errors)

Y 823 April 15,1991 THE FOUR PERCENT SOLUTION To RUNAWAY FEDERAL SPmING INTRODUCTION For most American taxpayers, April 15 usually is painful enough as they rush to file their taxes.This year it is doubly painful as Americans will be reminded of last years record five-year $165.5 billion tax increase. What few Americans real ize is that t here is to be no gain for their pain.The tax hike was prescribed for Americans by the Bush White House as bitter but needed medicine to reduce the federal budget deficit. It has not. Instead, the tax hike has spurred a huge spend ing spree on domestic pro g rams that is driving up the deficit from the $230 billion promised for fiscal 1991 to more than $318 billion. For every new dollar that tax payers turn over to the federal treasury as a result of last years budget deal, Con gress and the Bush Administrati on will spend an additional $1.83 on domestic programs, making this the largest build-up in domestic spending in three decades.

This year, Washington will collect 19.4 percent of gross national product (GNP in tax revenues, the highest level in ten years. In only four other years since 1945 have taxes taken a greater share of the economy. What is worse, the spending in creases in last years budget agreement give the federal government over 25 per cent of GNP, the highest level since 1946 and up from 22.3 p ercent in fiscal 1989.

From this it is clear as it has been for years: The cause of the towering federal budget deficit is profligate federal spending, not a shortfall of tax revenues.

Hiding the Spending Binge. The Bush Administration apparently does not yet understand what its budgets are doing to the deficit. The White House claims to hold the growth of federal spending in the budget it proposes for fiscal 1992 to 2.6 percent, well below the rate of inflation.The real rate of total federal spending gro w th is double this figure, and domestic spending growth is more than three times this figure. What permits the perhaps inadvertent deception about the true increase in spending is how the White House handles the costs of the Savings and Loan (S&L) bailout. It uses what are the one-time costs and later the revenues of the bailout to hide the spending binge and allow claims of fiscal responsibility.

When the effects of the SBtL bailout are removed from the current budget figures, aggregate spending rises at a 5.4 percent rate, 1.1 percentage points (or 20 percent) above inflation This follows on the heels of an 8 percent increase in total spending in fiscal 1991, nearly 3 percentage points above inflation What is more telling, Bush proposes to boost domestic spending by nearly $64 billion in fiscal 19% an increase of 82 percent, or 3.9 points above inflation.

When this hike is combined with last year's increase of $82 billion, or 12 percent the two-year total jump in domestic spending is $146 billion, a stagge ring 20 per cent.This is over $12 billion more than the combined increase in tax revenues during the two-year period.Taxpayers should not be surprised that the deficit con tinues to rise Unrealistic Limits. Bush Administration officials claim that the wor s t is now be hind them and that future expenditures are limited by ca s that last year's budget agreement imposes rigorously on discretionary spending. To be sure, such limits are good in theory.They never have worked in practice. For one thing, the caps h a ve been set so high for the first years of the five-year budget agreement that spending is assured of soaring. For another thing, current entitlement programs generally are exempt from spending limits! The current spending binge is the result. And to make matters worse, nothing prevents Congress from removing or revising the caps in the future, just as it in effect abolished the limits imposed by the once-famous Gramm-Rudman-Hollings deficit reduction measure when they begin to pinch.

Bush's 1992 budget pr oposal continues to heap a partidarlycrippling burden on American taxpayers with families. Compared to the average family tax burden of four decades ago, the average American family today has lost $8,200 in take home pay due to a steadily increasing tax b u rden5 To control spending, reduce the budget deficit, and make taxArelief possible for all Americans, the Administration and Congress could adopt a policy that balan ces the budget by fiscal 1995, and would do so with no new taxes. Beginning in fis s Exce p t where noted, spending rates reported here for fiscal 1992 through fiscal 1995 are the baseline growth rates.The Administration has recommended reducing the growth of entitlements by some $35 billion over the four-year period. IfcongreSS enacts these cha nges in fiscal 1992, the growth rate of aggregate federal spending will be lowered to 4.9 percent and the growth rate of domestic spending will be lowered to 7.4 percent.

Domestic spending here and below denotes all non-defense spending excludiog net interest on the natiod debt and the costs of the SBrL bailout.

Disactionaryprogramsgcnerallyaredefincdasprogram~whosefundsmustbcappnwedbyCongress through the annual appmpriationsprocxss.

Entitlement programs are programs created in such a manner that the gove rnment is obligated to make payments to quali6ed individuals or groups. Here, entitlement spending, also known as "mandatory" or direct" spending, does not include net interest on the federal debt or the costs and receipts of the SCL bailout.

See Robert R ector, "Reducing the Tax Burden on the Embattled American Family Heritage Foundation Backpun forthcoming 2 call992, the annual growth rate of all domestic spending should be limited under a unified cap to four percent, the approximate level of inflation. S uch a Four Per cent Solution, enforced by automatic spending cuts if Congress exceeded the spending targets still would provide an additional, and predictable 32 billion for domestic programs each year above the previous years level. More important the Fo ur Percent Solution would save taxpayers $255 billion through 19

95. This quarter-trillion dollars in savings could be used in three ways: exclusively for deficit reduction, exclusively for tax relief (which is a deficit neutral option or a combination of deficit reduction and tax relief.

Using the savings exclusively for deficit reduction, would produce a $36 billion surplus in fiscal 1995.

Using the savings exclusively for deficit-neutral tax relief could Fund a Family Tax Freedom Plan, which would provide by 1996 a tax credit of $1,800 for each child under age five 1,200 for each child aged six to eighteen, and an expanded Earned PomeTax Credit EITC) for low income working families Reduce substantially the tax codes bias against business in vestment. For example: Allow businesses, after a phase-in period, to subtrac t from their gross revenues the money they spend on new machinery, factories, and other investments just as they do the money spent on salaries, office supplies and advertising. The business taxable profits thus would be determined by subtracting all expen ses from revenues.

Known as full expensing, this would promote vastly in creased investment an would lower the cost of capital for American companies 4 Using the savings for both deficit reduction and tax relief could Fund a FamilyTax Freedom Plan Balance the budget by fiscal 1996 NEW TAXES AND PORK BARREL SPENDING Last year budget summiteers toiled for six months to find ways to head off an expected over-$150 billion budget deficit.They need not have done so because there was an automatic way to deal with the problem. Congress and the Ad ministration could have allowed budget cuts mandated by the Gramm-Rudman Hollings Deficit Reduction Act of 1985 automatically to bring the deficit to $64 6 7 For a full description of the FamilyTax Freedom Plan see ibid.

D an Mitchell, A Proven Formula to Restore Economic Growth, Heritage Foundation Exlecurive Memorcmhm No. 295, February 13,1991 3 billion. But claiming that federal spending already had been reduced to bare bones, and that the Gramm-Rudman-Hollings cuts thus would gut essential ser vices, the White House and Congress chose to solve the deficit crisis by raising taxes. So doing they ignored hundreds of pork barrel projects which bloat what is claimed to be a bare bones 1991 budget.These projects include 400,00 0 for sweet potato research 200,000 for locoweed research 1.7 million for a bee laboratory inTexas 3.8 million for the Arkansas Poultry Center of Excellence 2.2 million for the Tailored Clothing Technology Corporation in Am- Iowa 2.7 million for a fish far m in Stuttgart, Arkansas 3.3 million for zebra mussel research 2 million for the National Writing Project SO,OOO for a recreational boating census 1 million for the National Bicycling and Walking Study 64 million for the Washington, D.C subway system 14.5 m illion for railroad-highway crossing demonstration 3.4 million for improvements on FiftWSixth streets in Water 28 million for the Veterans Administrations parking garage 995,000 for a performing arts center in North Miami, Florida These and scores of simi l ar expenditures funded by the fiscal 1991 budget sug gest that policy makers left most of the fat in the budget and made little attempt to trim programs of lesser value to fund those of high priority projects loo, Iowa revolving fund HIGHER SPENDING AND H I GHER DEFICITS In the two years since Ronald Reagans final fiscal year budget, 1989, the deficit has soared from $131.4 billion to $198.6 billion, excluding the S&L bailout costs and the costs of Operations Desert Shield and Desert StomThis dramatic 51 per cent increase is not due to falling tax revenues, but to a huge growth in spending especially for domestic programs.

The deficit declined steadily during Reagan% second term because the annual growth in new revenues exceeded the annual growth in new spend ing by slightly over $20 billion per year. This trend was reversed in Bushs first two budgets those for fiscal 1990 and 19

91. New tax revenues grew by $40.6 billion in 1990 and 4 $60.1 billion in 1991, an average of about 5 percent per year, just over th e inflation rate. Total federal spending, however, grew on average bv 7.2 Dercent during those 1990 and 1991, the deficit would Table I Alternative Federal Spending Scenarios 137.4 $1 62.5 625.1 1990 Y I two years, exceeding revenues each year by almost $ 34 billion.

Had the growth of total federal 1989 1990 1991 1992 1 31.4 I 1 28.3 $162.5 $34.2 1 17.8 $1 98.6 $80.8 80.6 $1 95.0 $1 15.0 HUGE DOMESTIC SPENDING INCREASES 1993 lgg4 Domestic spending growth is the principal cause of the rapid deficit growth. D omestic spending is rising at a far faster rate than the growth rate of total federal spending.

Domestic spending jumped $142 billion between 1989 and 1991, and accouIlts for 85 percent of the over all growth in spending. And through 1995, domestic spendi ng will grow 7.6 percent annually, an average of 3.4 points above the in flation rate. This domestic spending growth is masked in part by the 24.7 $1 66.4 $141.7 S60-8 $106.1 $1 66.9 surplus 1988 131.4 I I lgg5 I surplus 31*2 I $54.3 I $85.4 I All deficit figures exclude Savings and Loan bailout costs and the eventual profib from S8L asset sales. Source: Budget ol the United States Government la Table 2 Alternative Domestic Spending Scenarios B11110~ of cumnl Dolkn I 1995 I I $54.3 I $187.6 I All deficit f igures exclude Savings 8 Loan bailout costs and the eventual profits from S8L asset sales.

Source: Budget ol the United States Government 1992 5 reduction, in nominal terms, of defense spending by roughly 3 percent per year through 19

95. These reductions are enough to slow the growth rate of aggregate spending This creates an appearance of fiscal restraint and hides what in fact is fiscal profligacy.

Had this explosion in domestic spending been checked in the fiscal 1990 budget, the budget deficit pictur e today would be very different.The deficit would be $118 billion 80 billion less than the current figure, if beginning in 1990 domestic spending growth had been simply held to the inflation rate. Were this restraint continued through 1995, the budget wou l d show a surplus of $133 billion that year rather than a projected deficit of $54 billion As Table 2 shows, the cumulative six-year deficit impact of this domestic spend ing spree is almost $726 billion.This amounts to an extra $4.40 in deficit spending f o r every dollar of taxes raised by last years budget deal FEW LIMITS ON DOMESTIC SPENDING GROWTH White House and congressional supporters of last years budget agreement claim that they have established tough new budget procedures to prevent spend ing from g etting out of control. They point to separate spending caps that have been placed on domestic, international, and defense spending. The agencies within each of these categories, say the budget accord champions, are restrained in the efforts to fund new pr ograms because they must compete with other agen cies for resources.

Another tough procedure pointed to by budget accord boosters is the pay-as you-go (Pay-Go) provisions on entitlement spending. While entitlements still can 50w at the rate dictated by cur rent law, so-called Pay-Go provisions require that Table 3 Domestic Discretionary Spending Note: fhe Budget Summit set spending caps for the Domestic Discretionary category only for fiscal yeam 1991 to 19

93. Fiscal year8 1994 and 1995 have been estimated by OMB Source: Budget of the United States Government 1992.

Based upon the Composite Deftatof 6 Chart 1 Average Annual Domestic Discretionary Spending any cost hikes brought on by changes in entitlement l aws must be deficit neutral Thus, if Congress adds new expenditures to current programs or in creases spending by creating new programs, these costs must be paid for by a tax increase or a spending reduction in other entitlement programs In theory, of cou r se, placing caps on the various categories of discretionary spending is a good way to get control of the budget process.The problem is that the spending levels for domestic discretionary programs permitted by last years budget accord are extremely high. I n practice, therefore, they check spending powth no more than a rigorously enforced 100 mph speed limit would check fast driving. The budget agreements huge spending increases in the first years of the agreement are padding most programs with enough fat to carry them through any spending moderation in future years. Example the spending caps that have been placed on domestic discretionary spending were set at 9.5 percent growth in fiscal 1991; 6.1 percent above that in 1992; and an additional 5.3 percent in fiscal 1993 See Table 3 higher than Bushs first budget in 1990, and 33 percent, or $54 billion, larger than Reagans last budget in 19

89. This massive boost will send domestic discretionary spending to its highest annual constant dollar level since Jimmy C arters last budget, after adjusting for inflation. Over the past three decades, in fact, only the Domestic discretionary spending in 1993 will be 22 percent, or $40 billion 7 Carter Administration consistently spent as much in real terms on domestic dis c r etionary programs as is now being spent by Bush. Chart 1 compares the average four-year inflation-adjusted spending levels of the past five presidents Misleading Caps. The high levels of the budget summits caps make a mockery of instituting caps at all. T h ese high ceilings will require little reordering of pro gram priorities and little trade-off of funding. The Bush Administration, for in stance, tries to boast that its proposed fiscal 1992 budget would terminate 3,591 projects within 238 domestic discret ionary programs and would trim spending for an additional 261 projects within 109 programs. These cuts ostensibly will save the taxpayer about $2 billion in fiscal 1992 and about $13 billion in future spending commitments.

This sounds good. The trouble is that it is at best misleading and possibly even deceptive. Because the 1992 spending cap is set at 6.1 percent above the 1991 cap the Administration can boost spending for 250 other major programs by nearly 11 billion, and raise the budget authority for t hose programs by $17.8 billion.

Thus, taxpayers end up the losers in this trade-off because the high cap levels force no real cuts or force no genuine evaluation of the relative merits of these programs TESTING ENTITLEMENT SPENDING CURBS The rules from las t years budget agreement governing spending for entitle ment programs, like Medicare, food stamps and aid for women with dependent children, have yet to be fully tested. Under the rules, any entitlement cost in creases that result from changes in legislat i on must be deficit neutral. Thus en Table 4 Entitlement Spending Nota Totals exclude net interest on the national debt and S&L bailout costs Source: Budget of the United States Government 1992 Based upon the Composit Deflat0r.t 8 titlements are allowed to grow according to the rates Congress has already estab lished in current law, but any spending increases Congress adds through new laws must be paid for by a tax increase or an equal spending reduction in other entit lement programs.

As with other parts o f the budget accords, the rules governing entitlement ap pear good in theory but are sure to stumble in practice.The zero-sum enforce ment procedures, for example, are in many respects moot because spending on entitlement programs under current law is now projected to grow by over 85 per cent per year through 19

95. She last years summit, the costs of entitlements have been revised and reestimated to reflect changing economic conditions, such as higher inflation and greater demands placed on such programs owing to rising unemployment and other effects of the recession. The resulting new figures now exceed the levels agreed to by the summiteers by a cumulative $183 billion by fis cal 1995.This spending jump is nearly $20 billion higher than the five-year in crease in new taxes.

The Bush Administration acknowledged this trend in entitlement spending in its 1992 budget and recommended trimming roughly $35 billion from this growth by 19

95. If these changes are adopted by Congress, they will slow entitlement g rowth only modestly from the 8.5 percent average to an 82 percent average per year A FOUR PERCENT SOLUTION Since the caps on discretionary expenditures and the Pay-Go rules for entitle ments have allowed spending to increase to record levels, the most eff e ctive method for controlling spending is a unified cap on total domestic spending, ex cluding net interest on the federal debt and the S&L costs.This unified cap should be fixed at four percent above the previous years level, roughly the rate of inflation . Such a Four Percent Solution initiated in fiscal 1992, and enforced by automatic spending cuts if Congress exceeded the established spending limits would save taxpayers $255 billion by 1995.

This quarter-trillion dollars in savings could be used for deficit reduction, tax relief, or both. If the entire savings is used exclusively to reduce the budget deficit, the budget would be running a happy $36 billion surplus in 19

95. If the en tire amount is used exclusively to reward Americans with tax relief, a plan which does not lower or increase the deficit, around $1,400 per child in tax relief could be given to every family each year, and the tax bias against business investment could be reduced substantially, if not eliminated. American families in particu l ar have been the biggest losers during Washingtons latest spending binge. A third 9 option would apply roughly tyo-thirds of the savings toward family tax relief and the remaining savings toward deficit reduction, in which case the deficit would be balanc e by 1996.8 Long-Term Contract. The Four Percent Solution is much like a long-term union contract on which the worker can count for a specific percentage pay in crease every year of the contract. In this way the worker can plan how his or her family will a llocate the new money within the family budget.

Beginning in fiscal 1992, the Four Percent Solution would provide policy makers each year with an additional 32 billion above the previous years base level for new spending within the pool of domestic program s his new money can be allocated throughout domestic programs as policy makers see fit. If this new money is not enough to fund all of the priorities set by the White House and Con gress, then other less valuable programs must be reduced or eliminated to make up the additional needs.

Last years budget accord has ruled out a Four Percent Solution.The budget summit erects firewalls between three categories of discretionary spending domestic, international, and defense -and another firewall between these cate gories and entitlement programs. The firewall between domestic discretion ary spending and defense spending wisely prevents Congress from cutting defense spending to increase domestic spending. Unwise, however, is the firewall between domestic entitlement programs and discretionary programs. Just as all of the programs that comprise the nations defense needs should compete equally for the funds dedicated to that purpose, so too should all of the programs that com prise the nations domestic interests compet e equally for the available domestic resources Erroneous Perception. The enforcement mechanisms also have made tax relief very difficult.The rules governing tax cuts, such as those imposed on entitlement increases, require any changes to be deficit neutral . Therefore, tax cuts must be paid for by raising other taxes or cutting entitlement programs just as increases in entitlement spending must be paid for by tax increases or equal entitlement cuts elsewhere.The unhappy result of these rules, however, is tha t they create the erroneous perception that reducing the tax burden for American workers can only be achieved by reducing entitlement benefits for the poor tion policy. Reducing benefits for the poor should not have to be a trade-off for cutting taxes for all workers. The rule requiring a hike in taxes to cover an in crease in spending also would be eliminated under the Four Percent Solution.

Congress repeatedly has lured taxpayers into tax increases to pay for new entitle ment programs even when new programs duplicate or contradict existing programs In time the cost of these programs mushrooms and so too does the bill to the taxpayer.The budg e t rules thus should force Congress to reevaluate old This aspect of the Pay-Go rules would be eliminated under a Four Percent Solu 8 See Rector, op. cit 10 CONCLU programs before it initiates any new ones. This means keeping the Pay-Go re quirement that a ny spending increase be met by a spending reduction elsewhere in the budget would be an effective method of preventing the eqansion of entitlement programs.

Eliminating the firewall between domestic discretionary spending and entitle ments also would benef it the taxpayer. The firewall has insured that tax cuts can not be traded for cuts in pork barrel programs or other unnecessary discretionary programs. Creating a unified cap on domestic spending and allowing the ex change of tax cuts for spending cuts in any domestic spending area would add a new dynamic to budgeting. With such a change, programs not only would have to compete with other programs for available resources, but they would also have to compete with taxpayers demands for tax relief.

Keeping the Mini-Sequester. Lastly, a Four Percent Solution budget plan would keep the mini-sequester rule now in place for discretionary spending.

The mini-sequester requires across-the-board spending cuts within the discre tionary category if Congress breaches th e spending caps at any time during the fis cal year. A unified Four Percent Solution cap would simply distribute the pain of a mini-sequester across a larger number of programs. In effect, this is the same sequester format used in the original Gram-Rudman -Hollings 1aw.The new for mat, however, applies the rule on an on-going basis rather than at the end of the fiscal year, as was the case under the old Gram-Rudman law.

Members of Congress may be uncomfortable with the limitations imposed by the Four Percen t Solution.They may say that a four percent, or $32 billion, in crease in domestic spending above last years base is not sufficient to meet the ur gent needs of the country. What they are really saying is that $32 billion in new spending every year plus t h e $1.3 trillion in base spending are not enough to maintain essential programs and to fund pork barrel and special interest programs. Yet, the Four Percent Solution offers even these lawmakers something that they should value: the ability to cut their con s tituents taxes SION As taxpayers dutifully send in their tax returns to meet the April 15 deadline they are justified if they feel betrayed by how Washington has handled the federal budget in the past two years. Policies that for eight years had slowed th e growth of spending and, in turn, slowly reduced the deficit, were abruptly shelved by the Bush White House and Congress and replaced by record tax hikes, soaring domes tic spending, and, consequently, towering deficits 9 Some lawmakers, who may otherwise support the basic concept of the Four Percent Solution, might want to allow a higher growth rate of domestic spending. A Five Percent Solution, for instance, would save taxpayers $170 billion by 19

95. Were these savings applied directly toward deficit re dudion, the budget would be balanced by 1995.The appendix displays a comparison of five alternative spending cap plans 11 Washington now taxes nearly 20 cents of every dollar produced by the American economy and now consumes 25 cents of every dollar, when taxes are combined with the borrowing to finance the national debt and the S&L crisis Both of these levels are at historic proportions and show no signs of falling soon.

Washingtons big spenders -in the White House and on Capitol Hill -have betrayed taxpa yers by attempting to hide their record spending spree with a series of budget gimmicks, such as using the fluctuating one-time costs of the S&L bailout to mask huge increases in permanent domestic programs trol the federal budget. It would avoid the need for future tax hikes and even allow for substantial tax relief. The only pain inflicted by this policy is on the big spenders in Washington and the special interest groups who repeatedly win back ing for their special and costly programs. By limiting the growth of total domestic spending to just four percent per year, the average American family each year could receive $1,400 in tax relief for every dependent child.

The Washington establishment has abused the sound concept of spending caps to fool taxpayer s into the notion that spending growth has been slowed. Like a bear that fattens itself before a winters hibernation, the big spenders have stuffed the budget full of higher spending that most programs will live off if the spending growth rate slows down. Come spring, the cycle will begin again and the big spenders will be hungry for more new spending. A unified four percent spending cap will curb their hunger Honest Attempt. The Four Percent Solution would be an honest attempt to con Scott A. Hodge Grover M. Hermann Fellow in Federal Budgetary Affairs 12 APPENDIX The roposed policy calls for limiting the growth of domestic discretionary and domestic manfatory s ending under a single unified spending cap. The figures below show the effects of a unified cap Liting the growth of total domestic spending at various rates. All fi ures exclude S&L bailout costs and revenues and net interest in the federal debt which wouldgbe exempt fram the growth cap 1992 1993 1994 1995 28.74 48.21 m.14 72.96 13

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