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Backgrounder #927 on Taxes

February 16, 1993

Putting Families First: A Defict Reduction and Tax Relief strategy

By


(Archived document, may contain errors)

927 I February 16,1993 PWIING FAMILIES FIRSTt A DEF'ICIT REDUCTION AND TAX RELIEF STRATEGY INTRODUCTION Just thne weeks into the new admin istration merican taxpayers my have mson to be ded about the emerghg shape of White House economic policy-making. hsi dent Bill Clinton, who promised "to focus on the economy like a laser beam appears to be struggling to craft a budget and economic ~tegy t hat achieves the five cconomic policy promises he made during the campaign 1) Cut the dMIt In half 2) Provide middleclass tax rellef 3) Enact measures to spur investment and economic growth 4) RR po~icies In place that assure the deiicit wlii continue to M; and 5) Accomplish all of the flnt four goals in a manner that is 'yak."

The new Resident already has ntrcated from his first two promises, telling Americans to =ad the fine print of campaign statements. Citing rising deficit fancasts, Clinton's economic advisors now argue that the govenrment needs new tax revenues just to prevent the deficit picnae from getting even warsc.This is in spite of the fact that Americans now pay $157 billion man in taxes to the federal government than they did four years ago, and the fact that tax nvenues are expected to grow under current tax rates some $376 billion over the next five years 1 Bill Clinton, Putting People First: A Notional Economic Suategy forAwica,l992 President Clinton is due to release his economic plan on February

17. If early press reports are any guide, American taxpayers should hold on to their wallets, because they should ponder the striking similarities between the budget agreement that ruined George are in for a repeat of the disastrous 1990 budget a greement. And Resident Clinton Bushs credibility and the ideas now being floated by Clintons own advisors Example: The-1990 agreement raised the gasoline tax by five cents per gallon. The Clinton tee is talking about raising taxes on energyorfuel even hig h er Example: The 1990 agreement raised excise taxes on alcohol, tobacco, and shipping in ad dition to creating a new national sales tax on luxury items. The Clinton team is talking I about instituting a new national consumption tax Example: The 1990 agreem e nt raised the income threshold on Medicare payroll taxes and raised the top income tax rate to 31 percent. The Clinton team is talking about ex panding the amount of Social Security benefits eligible for taxation and raising the top income tax rate to 36 p ercent. 1 Example: Despite much fanfare about cutting spending, the 1990 budget deal ushered in the largest increase in domestic spending in American history. After adjusting for infla tion, domestic spending grew eight times faster in Bushs single term t h an it did during two terns under Ronald Reagan. The Clinton team promises to increase domestic spending by some $30 billion per year above the current growth rate What should be of particular concern to President Clinton is that the 1990 budget deal Georg e Bush negotiated with Congress was supposed to cut the projected deficits be tween fiscal years 1991 and 1995 by some $500 billion. But recent forecasts now project that deficits during that period will be mm than $700 billion higher than projected before the agreement-a Merence of $1.2 trillion.

Root Cause of Record Deficits. Most troubling to ordinary Americans should be that the Clinton team, like the Bush team before it, does not seem to understand that rampant federal spending, not a lack of tax reven ues, is the root cause of Washingtons record deficits. Total federal spending now eats up nearly 24 percent of gross domestic pduct or two percentage points more than when Ronald Reagan left office. And rather than fall annual federal spending is expected to climb by a cumulative total of some $370 billion ova the next five years, resulting in $300 billion-plus deficits through the end of the decade.

American taxpayers are being told-yet again-that if only they will agree to more taxes, Congress will cut s pending and the deficit will fall. But in the past ten years there have been five budget summits in which Americans were told that mm taxes would mean lower deficits. Each summit led to higher taxes, higher spending, and higher deficits.

What American tax payers need is an economic plan that actually delivers real spend ing cuts, not spending increases; real tax cuts for American families, not tax hikes; and a real economic growth package, not pork barrel jobs programs. Heritage Foundation 1 scholars have d eveloped such ti comprehensive plan, Putting Families First: A Deficit 2 Reduction and Tax Relief Strategy. This plan would deliver real deficit reduction family tax relief, and economic growth by attacking theme problem, rampant government spend ing. In s hort, the plan would achieve the principal economic goals that Bill Clin ton promised the American pple Putting Families First would cap the annual growth of domestic spending which is projected to grow by some five percent per year Putting Families First : A Deficit Reduction and Tax Relief Strategy Family Tax Relief 1 36 Billion n Investment Tax Relief 27 Billion Net Deficit Reduction 405 Bllllon Total Package 568 Bllllon Over Five Years through fiscal 1998, at a more reasonable rate of two percent per ye ar. This saves enough to cut the deficit in half by fiscal 1998; finance a $500 per child tax cut to American families; and finance pinvestment tax cuts for American businesses and entrepreneurs.

The Pum'ng Families First plan has six policy components 1) Place a two percent cap on annual domestic spending growth. Combined domestic discretionary and mandatory spending (excluding net interest and the savings and loan bailout cos is projected to grow by roughly five percent per year on average through fiscal 19

98. The plan caps this annual growth rate at two percent. This produces $509 billion in total program savings ;below the projected baseline growth rate and $59 billion in interest savings, for a total savings of nearly $570 billion 2) Give families a t ax credit of $500 for each child. The plan uses $136 billion of these savings to provide a $500 per child tax credit for every American family. This credit could be raised to $750 per child if the $53 billion in additional defense cuts planned by Clinton w ere channelled into family tax relief 3) Spur investment and real wage growth through tax cuts. The plan uses roughly $27 billion of these savings to fund tax cuts that will generate the private investment needed to increase the productivity of American w o rkers, and thus real wages.These tax measms include indexing the capital gains tax and lowering the maximum rate to 15 3 2 Hereafter, the use in this BacRgrounder of the term "total domestic spending" means'the sum of domestic discretionary spending and d o mestic mandatmy spending, but excludes net interest on the federal debt and the costs and revenues of the Savings and Loan (Sa) bailout 3 percent for both individuals and corporations (producing a net five-year loss to the Treasury of roughly 53 billion); enacting a neutral costncovery plan for capital invest ments (generating a five-year net gain to the Treasury of over $22 billion and expand ing individual retirement accounts IRAs generating a five-year net gain to the Treasury of $3.5 billion 4) Cut the deficit in half by flSA 19

98. The plan uses the remaining $405 billion of savings to cut the deficit in half in five years. This means the fiscal 1998 deficit will fall from $320 billion, the current projection, to roughly $160 billion generate over $500 billion in savings, the plan involves a two-step process of spending cuts 5) Enact a package of spending cuts. To keep spending within the two percent cap, and Step #1: Enactment by Congress of 100 spending cut options already endorsed by Of fice of Mana gement and Budget (OMB) Director Leon Panetta and Deputy OMB Director Alice Rivlin. These recommendations, listed in the appendix to this paper would save $275 billion over five years-over half the savings needed for this plan.

Step #2: Creation of a bi-pa rtisan commission to identify the remaining necessary savings, modeled on the Base Closing Commission. Under the law creating the commission, Congress would have to vote on the entire package of recommended cuts 6) Ensure lonpterm deficit reduction. The s p ending caps, enforced by a sequester, will provide the long-term discipline needed to prevent future deficit spending and keep the budget on track toward balance. These caps also will ensure that any new tax revenues pumped into the Treasury automatically go toward reducing the deficit, not to fund higher spending.

Putting Families First thus fulfills the five major economic promises made by can dida~ Clinton, but achieves these goals without repeating the fiscal mistakes of the Bush Administration. Moreov er, unlike other deficit reduction plans, Putting Families First will work politically because it includes the carrot of tax relief for families to build public support for the stick of reducing spending THE PROBLEM: THE SIZE OF GOVERNMENT The Clinton Whi t e House is falling into the same Washington trap that brought grid lock to the Bush Administration. The reason: Clinton apparently views the deficit as a dis ease that must be cud, rather than understanding that the deficit is the symptom of a deeper dise a se-Washingtons own profligate spending habits borrows huge sums to fund the deficit, private borrowing is crowded out of the credit market. The competition between government and private borrowing drives up inmst rates which, in turn, leads to reduced pri v ate investment. Cutting the deficit, these law makers say, will lower interest rates and thus spur private investment and economic Those lawmakers who see the deficit as the problem believe that when the government growth 4 It is certainly true that every dollar the government borrows from private credit markets is a dollar that is unavailable far other purposes, such as car loans, home loans and new business start-ups. But research indicates that the budget deficit itself has a surprisingly small impact o n interest ra s. Interest rates fell throughout the early 1980s while the deficit soared to record levels. Mortgage rates are now at their lowest levels for many years, while the deficit has been hitting all-time highs. In addition to the very weak link be t ween deficits and interest rates, investment decisions are not driven solely byintemstrates:More important in investment decisions is the after-tax rate of return on capital! 1nterest.ratesm merely one determinant of how much that post-tax rate of rehlm W i ll be Confucating Money from the Private Sector. The fatal flaw in the deficit fmt view is that it puts equal value on reducing the deficit through spending cuts or tax in creases. This is why the typical view in Washington is that any credible deficit re d uction plan must contain some new taxes. One reason this view is wrong is because it fails to un derstand that there is a big economic difference between raising taxes and curbing spend ing. Raising taxes simply confiscates money from the private sector r ather than bomw ing it. The money is still removed from private use. Moreover, taxation is a political act.

Taxes a.te levied on those groups that can be overcome politically, not in ways that are economically most efficient. By contrast, the economy actually adjusts more efficiently to government borrowing, because no one sector carries the full cost.

Eve n more important, the deficit first view fails to understand that whether govern ment takes or borrows is secondary to how much the government removes from the economy. When the government takes money out of the private economy to pay for spending, privat e capital is crowded out regardless of whether the money is borrowed from invest- or extracted from them through higher taxes. In either case, a rise in spending means money that cannot be used by the private sector to invest in new plant and equipment, st a rt a new business, or add new employees. A rise or fall in the deficit merely indicates a change in the way government raises funds. Unfortunately, this draws attention away from the far more important issue of the level of government spending As a result of the missed diagnosis produced by faulty economic analysis, there are early signs that Clintons economic agenda will look largely like Bushs: higher taxes and unchecked spending, l&.ig to slow economic growth and higher, not lower deficits. If the Admin i stration is seriousabout producing a healthy economy it must focus its attention on three things 9 It must reduce the governments total demand on the private economy by con trolling federal spending. Political and other factors mean that a dollar spent by the public sector is almost always spent less efficiently than the same dol lar in the private sector. So a rising share of national income going to govern 3 4 Michael Schuyler, What Deficits Dont Do, Institute for Research on the Economics of Taxation, P olicy Bullerin No. 46, July 6,19

90. For a detailed explanation, see Gary Robbins and Aldona Robbins, Capital,Taxes and Growth (National Center for Policy Analysis: Dallas,Texas, January 1992 5ment means an economy that is less efficient. Tackling spending , moreover pennits both tax and borrowing needs to be reduced d The Administration also must provide middle class tax relief, but for economic rather than political reasons Explains Heritage Foundation scholar Robert Rector, during the past four decades, t he federal income tax burden on a family of four has increased by over 300 percent as a share of family in- mme..-And while government has been taking a larger share of family in comes in taxes, their real:wages have stagnated.Between 1970 and 1990, real p re-tax incomes of single-earner families grew by only 8 percent. However even this small gain in real family income was mostly taxed away by Uncle Sam. The erosion of living standards among the middle class is directly re lated to tax policy d It must spu r private investment to generate the economic resourns to raise the living standards of Americans and to fund those programs that are necessary THE SOLUTION: PUTTING FAMILIES FIRST To be sue, any attempt to rein in government spending will be fought by a l e gion of Washington special interests who will argue instead for higher taxes on American families. Over the past thirty years, the powerful lobbies have won this debate to the detriment of ordinary Americans; Washington has raised taxes 56 times since 196 0 , yet balanced the budget only once, in 1969.6 The reason for this abysmal record over the past four decades is that for every $1 Congress raised in new taxes it inneased spending by $1.59.7 As a result, the federal government now consumes 5.6 percent mor e of the U.S. economy than it did in 19

60. This cycle of tax-and-spend policy-making has taken a tremendous toll on American families.

Spending will continue to soar out of control, and government will continue to demand a greater share of family income, as long as the costs of government are dispersed among all taxpayers and the benefits this is that each narrow interest has a large financial incentive to campaign aggressively to preserve or expand a particular program, while the small cost to each taxp ayer of any particular program is not usually sufficient to trigger significant opposition.

But Clinton can reverse the politics of spending by employing strategies that put federal spending in human, or family, terms. One such strategy is to demonstrate h ow the savings from reduced government spending can be used to improve the finances and real wages of American families. Building an economic strategy around the notion of put concentrated among narrow interests. The reason for 5 Robert Rector, How to Str e ngthen Americas Crumbling Families, Heritage Foundation Backgrounder No. 894 April 28,1992 6 Senator Robert W. Kasten, Jr A Balanced Budget Amendment that Wont Tax America, Herifage Lecture No 386, June 2,1992 7 Richard Veddex, Lowell Galloway, and Christ o pher F~em, Taxes and Deficits: New Evidence, Joint Economic Committee, October 30,199 1 6 ting families first could turn the tide against the powerful spending coalitions and build popular support for the spending cuts needed to reduce the deficit. This r equires a plan that links spending control to a significant tax benefit for ordinary Americans.

The Heritage Foundation economic plan, Putting Families First: A Deficit Reduction and Tux Relief Strategy, is designed to build the grass roots support needed for Congress to curb its spending habits. Putting Families First places tight controls, called spending caps, on the knual.growth of domestic spending.Tota1 domestic spending is now rising by some five percent annually, but constraining this growth rate t o a more reasonable pace of two percent annually could save a total of $570 billion over five years time direct tangible benefits to families, Putting Families First applies nearly one-third of these savings to funding tax cuts that put cash in the pockets of families and spurs the private investment needed to increase worker productivity and real wage growth But rather than direct all of these savings to deficit reduction, which will provide few PUlTlNG FAMILIES FIRST la I Investment lax incentive ~ct2 -5. 9 -12.1 -11.6 -2.2 9.7 I -22.1 I Plus Deficit Reduction Schedule 6.1 42.3 75.4 121.5 160.0 I 405.3 Savings from Two Percent Spending Cap 22.1 61.3 101.2 160.0 224.0 568.6 flncludlns Interest Note: Revenue gaining measures are shown as negative figures beca use they reduce the deficit.

Revenue losing measures increase the deficit so they are shown as positive figures sources 1. Joint Tax Committee, U.S. Congress 2. House of Representatives, Republican Study Committee, based on Joint Tax Committee models 3. Jo int Tax Committee, U.S. Congress 4. HeritaQe Foundation Tax Model 7 There m six elements to Putting Families First Element #1: Cap Domestic Spending Growth at Two Percent Per Year Taming the federal deficit will require firm measures to control the true s ource of the problem-domestic spending. Over the past four years, an explosion in domestic spend ing (both disptionary and mandatory spending combined) has driven the deficit to reCord-levels.

Infuture years, thedeficit will look smaller because the government will sell off assets acquired during the bailout.

The profits from these asset sales will be recorded on the budget not as new revenues but as offsets to the level of spending-what is called negative outlays. Excluding these profits from spending to tals gives a more accurate and honest picture of the governments spending trends.

Since Ronald Reagans last fis cal year, 1989, total domestic spending has jumped $306 bil lion, from about $633 billion to some $939 billion, a 48 per cent increase. Increas es in domestic discretionary spending, which is spending appropriated annually by Con gress, accounted for $61 bil Capping Domedic Spending Growth at 2 Saves Some $568 Billion over Five Years Trllllons of Dollars 1.2 1.1 1 .o 9 1994 lW4 1998 Norw Figures do not include 569 billion in interest savings. which are deduned seperately from annual interest payments.

SOIIIW: Calculations based on BurQethefm HistorkalDeta andAttmrivarp Ibr the Fuhue. Oflice of Management and Budget January 19

93. HetWageDataChad lion of this overall growth. Inmases in mandatory spending, which is spending driven by prior law accounted for the remaining $245 billion increase.

Domestic spending growth will continue to keep the deficit at record levels for the next five years. Domes tic spending is projected to grow on average by about five percent per year through fiscal 1998, a total increase of $292 billion. Thus the key to controlling deficit spending during the next five years is to hold the yearly growth rate of total domestic s pending to below five percent 8 As stated earlier, the tenn total domestic spending in this Buckgrounder excludes net interest payments and both the costs and future revmues of the Savings and Loan bailout. In only two fmal years, 1989 and 1990, did the a nnual increase in cost of SLL bailout have any si

icant impact on the deficit. Deposit insurance costs me from roughly 10 billion in fiscal 1988 to just over $20 billion in 1989 to nearly $52 billion in fiscal 19

90. However, in fiscal 1992, deposit insurance costs fell to $2 billion from the $56 billion level in 1991.This $54 billion decrease had a dampening effect on the deficit 8 Moderating Effect on Deficit. But many in Congress and in the Clinton White House s ay that deeper defense cuts will be needed to bring the deficit down. While it is true that further defense cuts could lower the deficit somewhat, the argument ignores the fact that defense spending was cut in red terms by some $57 billion during the Bush Administra tion and will continue to fall an additional $40 billion in real terms by fiscal 19

98. These are deep cuts, and raise serious concerns about U.S. military capabilities in a very un stable world.-From a strictly budget point of view, these real reductions in defense al ready:have had a moderating effect on deficit spending and will continue to do so. But even if Clinton follows through with his campaign pledge to cut $53 billion more from defense by fiscal 1997, the deficit that year will only fall from $305 billion, as currently projected, to roughly $285 billion-still $130 billion short of achieving Clintons pledge to cut the deficit in half.

Thus, no economic or deficit reduction plan is credible unless it limits the growth of domestic spendi ng. The simplest but most effective method of doing this is by capping the annual rate of domestic spending growth to a fixed percentage set well below the cur rent pace. Such a spending cap need not fix the growth rate of every program. Some programs may grow faster than the fured rate and others much slower. The goal must be to hold the combined growth rate of all programs below the cap.

The idea of spending caps is not new. Indeed, the 1990 budget agreement placed in dividual spending caps on three categories of discretionary spending-domestic defense, and international-for fiscal years 1991 to 19

93. These three categories are then to be merged into one for fiscal years 1994 and 19

95. Thus far, the defense and interna tional caps have successfully co ntrolled spending (defense had substantial cuts built into its cap levels) but the domestic cap has not. The reason for the failure to control domestic spending is that the 1990 budget summit actually set the domestic spending cap levels some $27 billion above the pre-budget agreement discretionary spending projections hardly a device to control spending.

Capping Mandatory Spending. Some in Congress have proposed placing spending caps on mandatory, or entitlement, spending. Mandatory spending is the fastes t growing component of domestic spending; in some areas it is growing at three to four times the in flation rate. Last year, in fact, a plan proposed by Senator Pete Domenici, the New Mexico Republican, and former Republican Senator Warren Rudman of New H a mpshixe would have capped total mandatory spending growth at-a rate determined by inflation and the population expansion of the program cretionary and mandatory programs (but excluding net interest and deposit insurance costs). While there is merit to ind ividual caps targeted at domestic discretionary programs and mandatory programs, then3 are two principal reasons for enacting a unified cap for all of domestic spending.

Fitst, because of the increases built into the 1990 budget agreement, domestic discre tionary spending has now returned to the high levels of the Carter Administration, after adjusting for inflation. And when all three discretionary categories become subject to one spending cap in fiscal 1994, it is quite likely that significant cuts in de f ense spending will merely be channeled into higher domestic discretionary spending. This will allow domes tic discretionary spending to rise far above the levels of the Carter era. A real peace The spending cap proposed in the Heritage plan is a unified c a p, covering both dis 9 CAP DOMESTIC SPENDING GROWTH AT TWO PERCENT Plus Interest Savings 0.0 0.6 3.2 8.6 17.3 29.9 59.6 Source: Calculations based on Budget 6ase/ims1 Historim/ Datal and Alternatives for the Fururn oftice of Management and Budaet, Januarv 1993 dividend" should not be used for increased spending, it should be returned to taxpayers or used for deficit reduction. That is why a unified domestic cap is so important Second, creating a single domestic spending cap will force a healthy competition for funds between all of 'those programs labeled as domestic. Congress should engage in serious debate over domestic priorities, funding high priority items and dropping low priority programs from the budget. A healthy competition for limited resources be t ween AMTRAK, Belgian Endive research, and Medicare, for instance, would probably make sure that funds were directed to the most important programs Based on the spending foxzasts released last January by the Office of Management and Budget, capping the gro w th of domestic spending at two percent per year, three per centage points below the current average growth rate, will save enough money (with in terest 9) to cut the deficit in half by fiscal 1997, as Clinton pledged to do during the campaign. While it wo u ld be a good beginning to halve the deficit within the timetable established by candidate Clinton, there would be insufficient savings also to fund the family tax relief and investment incentives needed to produce a more healthy economy 9 OMB estimates, r a ther than Congressional Budget Office fgures, are used in this report because OMB is the government's official budget "scorekeepea OMB's Janlyw estimates may be subject to change when the Clinton budget is complete sometime in March. While these official f orecasts may change, the basic concept of using spending caps to lower the deficit is still valid.Thus, the two percent spending cap propod here may have to be adjusted slightly to produce exactly the same results 10 If the goal of cutting the deficit in h alf were pushed back one year, however, to fiscal 1998, the two percent spending cap would save enough money to cut the deficit by half and to fund family tax relief and investment incentives. As shown in the above table, the two percent annual spending c ap saves some $509 billion below the current growth rate through Fiscal 1998 and some $60 billion in interest savings, for a five-year total of near ly $570 billion.

It is reasonable to delay the goal of halving the deficit by one year if other important e conomic objectives can be achieved. As President Clinton has stated, it is important to strengthen the economy before the tough deficit reduction measures begin. Thus he would do well to dedicate most of the roughly $22 billion in fmt-year savings achieve d by the two percent spending cap to initiating the tax cuts outlined in Elements #2 and #3 below. This will have the dual effect of bringing immediate relief to families and busi nesses as well as building the public support needed to win long-term defici t xeduction I Element #2: Cut Taxes on Families With ChlldrenJo Federal taxation of families with children has increased dramatically during the past four decades. In 1948, a family of four at the median family income level paid just two percent of its inc ome to the federal government in taxes. In 1989, the equivalent family paid nearly 24 percent of its income to the federal government. When state and local taxes are included, the tax burden on that family exceeds one-third of its annual income.

Thm are two pMcipal reasons for this rising tax burden on families with children: the eroding value of the personal exemption for children, and massive increases in Social Security taxes, technically known as "payroll taxes."

The personal exemption for chilhn was i ntended to offset part of the annual cost of raising a child by allowing families to deduct an amount of money from their taxable in come. In 1948, the $600 per child personal exemption, plus other deductions, shielded nearly all the income of a family of four from federal income taxes. The value of this ex emption, now set at $2,000, has eroded over the past forty years. For the personal exemp tion to have the same value relative to family income that it did in 1948, it would have to be about $8,000 today and some $9,000 in 1996.

Besides rising income taxes, the other blow to families has been increases in Social Security taxes. In 1948, workers paid a two percent Social Security tax on annual wages up to $3,000: one percent was paid directly by the employ ee and one percent paid direct ly by the employer through the so-called employer share. By 1989, combined Social Security taxes had risen to 15 percent of wages on incomes up to $48,0

00. The effect of this tax on lower-income workers is particularly severe; a family with an income of 25,000 per year, for instance, pays $3,750 in Social Security taxes.

The forty-year combined effect of these two tax trends has been an eleven-fold in cr ease in the share of family income consumed by federal taxes. For the median income family today, the loss of income because of the increase in federal taxes as a share of family income, due to the falling value of the personal exemption and the rise in S ocial 10 This section draws heavily from Rector, op. cif 11 Security taxes since the late 1940s, is over $8,2

00. This is more than the yearly mdrtgage payments on a median price single family home This gradual loss of family income due to a rising tax bur den explains much of the frustration exhibited by middle-class families today, and the fear that they will be unable to live as comfortably as their parents did at the same age. This too explains why so many mothers have entered the work force to make end s meet But the averageemployed mother; jugglirrgher job andfamily demands, knows only too well that despite her efforts the:paycheck she brings home does not seem to be rais ing her familys living standards very much. The reason: only about one-third of he r eam ings are taken home for the familys budget. The mmaining two-thirds of todays mothers earnings pay the higher federal taxes on family income levied since World war II A practical way to give reasonable tax relief to families with children, especially low and moderate-income families, is through a 400 to $500 non-refundable child credit.

Parents would use such a credit to directly reduce both their income tax and the employer and employee Social Security tax liability; though, the maximum value of the proposed credits would not exceed a familys total tax liability.

Under the plan, the value of the child credit would be increased incrementally. The credit would be worth $400 per child during the first four years of the plan. In the fifth year, the credi t would be raised to $500 for each child aged five to eighteen, and $750 for each child under the age of five. The higher credit for pre-school children would be provided to help offset the greater financial pressures faced by families with young children ; these families must either pay greater day caxe costs or sacrifice the income of one parent who remains at home to care for the familys children.

Added Defense Savings. This Family Tax Relief plan assumes there are no further cuts in the defense budget b elow the levels planned by the Bush Administration. During the campaign, Clinton proposed cutting more than $50 billion from the defense spending levels already authorized by the Bush Administration. If the Clinton White House goes ahead with these deeper cuts, it should apply these savings to raising the value of the family tax credit to $750 per child aged five to eighteen and $1 ,OOO for each child under age five rather than funnel them into higher domestic spending.

Element a: Cut Taxes on Investment a nd Job Creation The $500 per child tax credit outlined above would be a good first step toward alleviat ing the growing tax burden on American families. But American families face another financial problem which requhs a more indirect and long-term soluti on. That problem is the slowdown in wage and salary growth due to distressingly slow productivity improve ments in the U.S. economy. The heavy tax burden on savings and investment is the prin cipal cause of this slow growth.

After adjusting for inflation, median family income grew less rapidly in the 1970s and 1980s than in prior decades. Worse still, most of the increase in family income in the 1970s and 1980s did not come from higher worker productivity, but from wives entering the labor farce. In earlie r decades a husbands salary alone normally could provide a steady increase in real family income, but after 1970 it became increasingly necessary in 12 many families for both spouses to enter the labor force just to achieve a modest inckease in the familys standard of living.

The chart below shows the inflation-adjusted ywth of income inmarried couple families in which only the husband is employed. Between 1950 and 1970, the real in come of husbands nearly doubled. Between 1970 and 1990, however, real pre-t ax incom P es grew by only eight per cent.12 what is worse, grow ing federal taxation swal lowed up what little income gain there was; post-tax in come for these single earner families has not increased at all over the past twenty years income of working h us bands played a large role in inducing large numbers of wives to enter the labor force in the 1970s and 1980s. While this extra labor did raise family incomes somewhat, at least half of the family income added in this manner was swallowed by rapidly esc a lating federal This stagnation in post-tax The :Federal Tax Bite: It Keeps Growing and Growing and Growing 1960 1970 1980 1990 Not.: Fgures era for e din income manied couple with wile Sour#: Heritage Tax Wet income data from U.S not in the labof force Bu r eau 01 the Census. Haltaae- taxes.Todays families thus are being crushed by the dual problem of high taxation and slow wage growth This means that lawmakers who wish to relieve the financial pressures on the modem family must do more than reduce taxes on f amilies. They must also design policies that will restore wage growth to the rates experienced in the 1950s and 1960s. Candidate Clin ton promised to raise the level of investment in America in a way that would create more jobs at higher wages Transferrin g Resources. The policies proposed by Clinton, however, mean more government spending, targeted to infrastructure projects and select industties. But such government spending does not create new jobs, and it certainly does not improve productivity. It mere l y transfers resources from one sector of the economy to another and generally ftom productive sectors to less productive ones. These new government funded jobs also are created at a very high cost to taxpayers. Indeed, the General Ac counting Office found that the new jobs created by the 1983 Emergency Jobs Act, for 11 These data provide a reasonable proxy for the salary growth of husbands in general since World War II 12 For a more thmugh discussion of the deterioration of family income growth, see Rector , op. cir 13 instance, cost 128,000 per job; effectively destroying four private sector jobs for eveiy one it created.

But government can stimulate genuine job &eation and higher real wages by institut ing tax reforms that lead to investment that will incr ease the output of workers. If workers can produce more, then businesses not only will want to hire mm employees they will also be willing to pay them more. The ability of workers to produce is deter mined.principally by their education .and .skills, and by the quantity and quality of the capital stock with which they work. Employees who work with modem equipment, tech nology, machines, and production processes can produce more and earn more.

Among the necessary pro-investm nt tax reforms that would be imp lemented in the first year of Putting Families First 3 1 d Cut the capital gains tax rate to 15 percent and index this tax rate to the rate of inflation Cutting capital gains taxes should be a central crease wages and worker productivity. Investment is dr i ven primarily by the after-tax rate of return on capital. When taxes on capital are reduced, more money will be invested, wages will increase, and living standads will rise. Capi tal gains taxes are a direct tax on job creating investment. If not eliminat e d, the tax should be cut dramatical ly and indexed for infla tion so investors are not paying taxes on purely nominal gains part of any plan to in Capital Gains Tax: US. Rate is Among Highest in Industrial World I Source: American Council for Capital Form ation, 19

89. I 13 See Daniel J. Mitchell, "An Action Plan to Create Jobs Heritage Foundation Memo to: President Elect Clinton No. 1, December 14,19

92. Also Anti-Recessionary Job Creation: Lessons From the Emergency Jobs Act of 1983,"

Testimony of Lawrence H.Thompsan, General Accounting Ofice, GAOR-HRD-92-13, February 6,1992 14 For a complete discussion of measures needed to boost savings and investment in the US. ewnomy, see Daniel J.

Mitchell A Tax Reduction Strategy to Spur Economic Growth in Scott A. Hodge. ed., A Prosperity Ph for Americu-Fiscal2993 (Washington, D.C he Heritage Foundation, 1992 14panies face high taxes on the nominal value of gains they make in the value of their investments In the U.S. the top rate of capital gai n s is 28 percent. By con trast, the top mte in Japan is 5 percent and in Germany there is no such tax on as sets held for longer than six months. The heavy tax on U.S. capital gains dis courages Americans fiom making the investments in industry necessary t o im prove productivity, and thus the income of American workers.

The Congressional Budget OMice estimates that this recommendation will lose nearly 54 billion in federal revenue over five years. But the CBO uses a static model to estimate the impact of ta x changes. More realistic dynamic models have been more accurate than CBO in predicting the revenue effects of tax changes. These suggest that cutting the capital gains tax will mean that greater private inv stment will generate more economic growth and m oTe federal tax revenues.

Still, to comply with the forecasting model used by the government in its budget scoring, Putting Families First uses the CBO estimate In contrast with Americas leading industrial competitors, investors in U.S. corn 13 Extend and expand Individual Retirement Accounts (IRAs Like capital gains, the eamings Americans receive on their savings is more heavily taxed than most other industrialized countries. This high taxation en courages Americans to consume their income rather than to save it. This in turn duces the available pool of money for new investment.

Individual Retirement Accounts (IRAs) reduce the tax bias against savings by either deferring taxes on income placed into the special accounts or by making the interest hm such acc ounts tax-exempt. Unfortunately, the 1986 Tax Refm Act sharply restricted the amount of taxdeferred income that families could place in such accounts. Lawmakers can undo this mistake, without increasing the budget deficit, by enacting a back-ended version of the IRA which makes interest tax exempt. Such a reform would boost savings and so increase the pool of funds available for productive new investments.

Another advantage of the back-ended IRA: according to the CBOs static model, this proposal will gener ate $3.5 billion of additional =venue over five years 15 Many experts believe that reducing the tax rate on savings and investment would so stimulate economic growth that overall federal tax revenues would rise.Ihus, according to these analysts, tax cuts o n investments and savings would help reduce the defEit. However, this view is not shared by the Congressional Budget Office or the Joint Tax Committee of the Congress. According to the economic models employed by these organizations, such tax cuts will la p e money for theTreasrrry.Thus, these tax cuts must be paid for by either increases in taxes elsewhere or via spending cuts. While Heritage analysts disagree with this latter view, CBO revenue loss estimates are being assumed for the purposes of this study 15d Reduce taxes on business investment by indexing depreciation schedules for inflation In most industrialized countries, fms effectively are allowed to Uuct the full cost of new plant and equipment from their taxable profits in the year the purchase is m ade much like any other business expense. In the U.S however, arcane depreciation schedules force firms to wait many years for tax deductions on major investments of new plant an& equipment. Indexing depreciation schedules for inflation-giving the present value equivalent of immediate expensing-would bean important fvst step toward achieving a fairer tax treatment of investments, and thereby boosting new investment.

Another advantage This refm will generate $22.1 billion of additional revenue over five years.

Because this group of tax changes would improve productivity, and thereby raise the wages of parents and other workers, they are profoundly pro-family. However, higher government spending, whether financed by more taxes or borrowing, is not pro-family because it drains resources from the productive sector of the economy and inhibits wage growth.

The mults of productivity improvement could be dramatic. If improving the private in vestment climate through the tax code allowed the U.S. to restore product ivity and wage growth to the rates enjoyed in the 1950s and 19609, the average parent could expect real hourly wages to grow by nearly fm percent in the next decade. This would mean a huge relief in the financial pressures on today's beleaguered families E lement #4: Cut the Deflclt In Half The pro-family and pinvestment tax cuts consume nearly all of the first-year savings created by the two percent spending cap. This means the serious business of cut ting the deficit in half begins in the second year of t he plan. But since the savings produced by the cap grow in magnitude each year, the impact on the deficit would be substantial after the major tax =lief proposals had been phased in.

The cap generates some $224 billion in annual savings below the baseline spending level projected for fiscal 19

98. Since $64 billion of these fifth-year savings 8~e dedicated to funding the tax cuts, the remaining $160 billion 8~e then used to cut the projected CUTTING THE DEFICIT IN HALF billions) Five Year 1993 1994 1995 19 96 1997 1998 TOE1 I m Deficit Reduction Schedule 0.0 6.1 42.3 75.4 121.5 160.0 405.3 16 $320 billion deficit in half The preceding table shows the five-year deficit reduction schedule Element #5: Introduce Spending Cuts to Achieve the Two Percent Cap Find i ng over $500 billion in savings will require quick and effective short-term as well as long-term strategies to reduce spending. In the short term, considerable savings can be achieve by bundling dozens of off-the-shelf spending cuts already developed by t h e Congressional Budget Office (CBO) and the General Accounting Office (GA0)-both are research arms of Congress. The long-term cuts needed to complete the task will re quire tougher political choices and significant reforms of major programs. Those will ta k e longer to accomplish years but have yet to receive congressional action. For example, in February 1981, the Congressional Budget Office-then under the leadership of Alice M. Rivlin, currently Deputy OMB Director-published the first of its annual reports on spending cuts and revenue raising options for reducing the deficit.16 M~Y of the spending cut options sug gested by CBO then are still valid today because Congress has ignored them.

Further, while still Chairmiq of the House Budget Committee, OMB Direc tor Leon Panetta, put forwar$many of the same recommendations in a deficit reduction plan he proposed last year There are many sound ideas for cutting federal spending that have been discussed for The spending cuts mommended by Rivlin and Panetta include R educe funding on highways Institute private financing of the Strateglc Petroleum Reserves Increase waterway user fees Reduce funding for Environmental Protection Agency (EPA) Construction Grants Eilmlnate Farm Deflclency Payments Reduce fundlng for AMTRAK Repeal the 1931 Davis-Bacon Act Eliminate marlime Industry subsidies Reduce the funding for impact Aid Modify Trade Adjustment Asslstance 16 he Congressional Budget Ofice, Reducing the Fedcral Budget: Strategies and Examples, Fiscal Years 1982 1986 Febuar y 1981 17 Leon E. Panetta, Balanced Budget Amendment Optwns, Committee on the Budget, U.S. House of Representatives May 26, 19

92. See also, Scott A. Hodge, A Lawmakers Guide to Balancing the Federal Budget, Heritage Foundation Backgrounder No. 9

01. June 9,1992 17 Block grant funding for Aid to Families with Dependent Children (AFDC) and Medicaid administrative costs; and End the Airport Grants-in-Aid program These would be an excellent starting point for achieving the required savings under the t wo percent spending cap. The appendix to this study includes 100 such spending reduc tion measures.drawn from .the-work-of-Panemand Rivlin. If all of these reforms were in itiated this year, they would save taxpayers some $275 billion over five years-more than half the total savings needed to fund this plan. By .themselves, these savings are more than enough to fund both the family tax cuts and the pro-investment tax cuts.

Most taxpayers would have little objection to most of the recommendations listed in the Appendix. However, the spending reductions needed to complete the $509 billion package will need reforms in more politically sensitive programs. But identifying these tougher choices does not need to be done immediately, because the necessary first-ye ar savings would be achieved by the recommended cuts in the Appendix. This breathing space would allow steps to be taken to overcome the political obstacles to major program reductions.

Empaneling a Commission. The most promising way to develop a more exte nsive package of cuts, while at the same time shielding lawmakers from much of the political cost of making these tough choices, would be by empaneling a commission modeled on the one established to close obsolete military bases.

The Base Closing Commissi on successfully identified and eliminated obsolete military bases with the minimum amount of political pain. It did so because it provided Congress even those members whose bases weTe affected-with political cover. Congress agreed in advance that it would allow the commission the fieedom to determine objec tively which bases should be closed, and that lawmakers would conduct an up-and-down vote on the Commission's entire package, without amendment. The result: Although Con gress had been unable to close a single obsolete base since 1977, the xtxommendations generated by the Base Closing Commission will lead to the eventual closure of over 100 facilities.

Some experts, such as those at the Pmgressive Policy Institute, a Washington, D.C based research organiz ation close to the moderate Democratic Leadership Council, have urged Clin on to establish a commission to draw up ways of eliminating wasteful federal subsidies.'s While there is merit to evaluating the economic value of such things as tim ber subsidies, agriculture subsidies, and selected tax credits, there are many other govern ment activities that deserve similar scrutiny by a commission. Thus the mandate of this commission should be expanded to include a broader spectrum of possible programs for refom or elimination. This should include entitlement programs, programs that duplicate 18 Will Marshall and Martin Schram, eds Mandale for Chunge (New York Berkley Books, 1993).The PPI-proposed commission would evaluate spending or spending-related subsidies s u ch as rural housing loan subsidies, NASA's space sration,TennesseeValey Authority activities, and wastewater matment grants. Also, the commission would investigate "subsidies" passed along through the tax code such as the deductibility of certain business expenses privatepurpose bonds, and the depreciation of rental housing 18 others, those that axe obsoletel$ ineffective, and those which are state, local, or private not federal-responsibilities Understanding Political Nuances. The composition of such a co m mission should be bipartisan and include current Members of Congress and respected former members. This would bring a strong element of credibility and accountability for tough recommenda tions A commission composed of respected private sector individuals , like the 1984 Grace Commission, probably would have more credibility among the general public. But one problem is that legal problems might arise For instance, there might be legal challen ges to the idea of Congress being bound to enact, say, changes in entitlement programs requixed by a private commission. In addition, cutting major programs is a complicated political task. It would be better to have commissioners who well understand the delicate political nuances involved-something the Grace Commission did not appreciate.

Members of the commission should be given a fixed amount of time, say six months to identify the $235 billion in savings needed for the last four years of the plan. All domestic spending should be open for review by members, but tax in creases should be explicitly off the table. Once completed, the commission's spending cut package should be sent to Congress for an up-anddown vote without amendment Element 46: Enact Budget Process Changes to Achieve Long-term Spending Control Any compre h ensive plan of the scale of Putting Families First will require changes and reforms in the budget rules. If properly designed, these reforms will assure that the deficit continues on a downward path toward balance. All of these reforms would be wise polic y even if the government were not in a fiscal crisis. Today they are just more urgent. For instance, there axe a host of rules, accounting procedures, and congressional mandates that limit the executive branch's right to manage federal programs in a cost-e f fective and innovative way. Some legislated quirements stop agencies from even study ing certain ways to save money.

Putting Families First requires five changes in the budget rules 1) Reinstate the strlct deficit reduction targets once required by the Gramm RudmabHollings law.

Although it is often criticized, the Gramm-Rudman law was an effective spending con trol measure during Ronald Reagan's second term because it disciplined Congress with fued deficit targets that were enfarced by automatic spending cuts, called a sequester.20 The 1990 budget agreement, however, gave OMB the power to adjust the deficit targets for "technical and economic" reasons, a device which, in practice, allows spending and deficits to grow unchecked 19 S. Anna Kondratas and St ephen Moore BreaLing the Entitlements Deadlock with a Presidential Commission,"

Heritage Foundation Buckgrounder No. 469, November 13,1985 20 Daniel J. Mitchell Save the Gramm-Rub Sequester Heritage Foundation Buckgrounder No. 763 April 3,1990 19 CALCULATI NG SPENDING ENFORCEMENT CAPS 15.9 19.0 25.8 38.2 64.2 NewSpendingTargets 1500.7 1516.7 1543.6 1585.0 1619.0 22.0 61.3 101.2 159.7 224.2 Source: Office of Management and Budget, Budget Baselinesl Historical Datal and Alternatives for the Future, Januarv 19 9 3 President Clinton did have the opportunity on January 21 to reinstate the fuced Gramm Rudman targets. But he.declined the chance. The White House should rethink this posi tion, because the 1990 budget agreement showed that any deficit reduction plan wit h out these strict rules is a meaningless exercise at taxpayer expense 2) institute strlct spending targets linked to the deficit amounts One of the shortcomings of Gramm-Rudman was that it focussed solely on deficit con trol, and had no provisions for c.on t rolling spending. Spending thus could climb to record levels and Congress could not be held accountable-as long as it raised enough new revenues to meet the legal deficit targets. As spending soared, Congress found itself on a never-ending quest to find n ew revenue sources to match the required deficit targets. It was only Ronald Reagans adamant opposition to tax inmases, and George Bushs (tem parary) Read My Lips tax pledge that held Congress in check.

Spending targets introduce a different dynamic. As sh own in the table below, the proposed spending targets would be calculated by adding the projected revenues in a given year to that years deficit target. This rule effectively states: Given what we know to be the fume growth in revenues, what level of spen d ing will.insm that we meet our deficit reduction schedule? To keep Congress on track, the targets should be enforced by a sequester. This means that if spending grows above the legal targets, the sequester mechanism is triggered, cutting spending across-t h e-board down to the targeted level hold Congress to this deficit reduction schedule and free up the additional savings needed to pay far the tax relief package As discussed earlier, limiting the annual growth of domestic spending two percent will 3) Maint ain the flrewall between total domestic spending and defenselinternational spending.

Certain budget rules called firewall~~-cur~ently separate domestic and defense spending. These fvewalls prevent funds from being taken from one category and used to financ e increased spending in the other. In fiscal 1994, these rules will change, allowing funds to be shifted between defense spending and domestic discretionary spending 20call994 This will ensure that any additional defense cuts are used for a real peace div i dend, not gobbled up by new domestic programs. A true peace dividend should be returned to the taxpayers or used for deficit reduction The firewalls should remain in place for at least the next five years, not changed infis 4) Eliminate the budget rules p r eventing the use of discretionary savings to offset tp cuts The:l99Obudget.agreement created-rules blocking the use of discretionary savings to pay or tax .relieEfor Americanfamilies. So today, only mpalatable cuts in entitlement programs or increases in o ther taxes can pay for family tax relief. The current rule thus is anti-family and anti-economic growth. Them is no sound fiscal reason to protect pork barrel programs, such as bee research and the National Fertilizer Development Center from being elimina ted so that the savings could be returned to American families.

Removing this role would encourage Congress to look for savings to finance tax relief.

This refonn is similar to the reforms included in the Family Tax Relief Act of 1991 (S 1846) introduced that year by Senator Bill Bradley, the New Jersey Democrat 5) Eliminate the budget rules preventing the savings achieved from asset sales or through privatization from being used to reduce the deficit or to offset tax increases.

Few taxpayers are awm that Congress has passed a number of rules that actually prevent the executive branch from selling government assets to the private sector or even from contracting many government functions to private providers. These rules effective i y stop the government from saving money by becoming more efficient bnpb: Currently there are 37 laws blocking privatization, including measures that ex empt 70 percent of federal commercial services from competition Example: provisions in the Gramm-Rudman law and in the 1990 budget agreement prohibit the proceeds from selling government assets from being counted against the deficit.

Privatization has a solid track recard of reducing costs while improving efficiency.

Local governments routinely contract wi th private fms to provide services ranging from building maintenance and street sweeping to even police and !?re services. And private companies routinely sell off less desirable assets to raise cash during hard times. For in stance, airlines sell mutes, c onglomerates sell divisions, real estate companies sell land and publicly held companies sell more stock. The federal government could save hundreds of billions of dollars by employing the same sound techniques used by local governments and private firms C ONCLUSION Bill Clinton promised American taxpayers that he would put people fmt. However with the economic plan he plans to release on February 17, Clinton may end up putting Washington first by repeating the fiscal policy mistakes of the Bush Administrat i on. The reason is that it is not the deficit, but government spending, that is a drag on the economy. That is the problem that must be solved. A myopic focus on the deficit in 21 evitably leads to calls for more taxes on cash-strapped American families, w hich in variably leads in practice to deficit increases.

But a plan such as Puffing Families First can break the tax and spend cycle which has made the public increasingly cynical of Washington's ability to manage its fiscal affairs.

The Heritage plan not only tackles the causes, instead of the symptoms, of America's budget problem but also gives taxpayers a stake in the deficit reduction process, by rewarding them for supporting real cuts in government spending. Such an approach is the only. strategy tha t will build the public support needed to rein in Washington's profligate ways.

Scott A. Hodge Grover M. Hemann Fellow in Federal Budgetary Affairs 22 APPENDIX The spending cut recommendations contained in this Appendix were derived from the following sour ces Congiessional Budget Office, Reducing the Federal Budget: Strategies and Examples Fiscal Years 1982-1 986, February 1981 Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, February 1983 Leon E. Panetta, Balanced Budget Am e ndment Options, Committee on the Budget, U.S. House of Representatives, May 26,1992 The savings estimates presented hen are, by and large, Congressional Budget Office figures calculated for Panetta in May of last year. Then are insufficient budget data at this time to update these figures. Thus, in some cases, the estimates contained in the Ap pendix m.ay underestimate the actual savings achieved by the spending teform proposals 23 W 9 a 3 4 0 e v 4 0 e VI e 8 u 4 P u 51 8 cr 24 L E in 0 h 3 in 0 h 3 8 v) an in v) v) in c c v) c qi v 88 a 3 0 8 8 9 P v in 25 Y,Y) a 99 ii 9 8 c v 9 8 c v 8 v 3 v s v f s I 0 H B C m E 26 27 I l a I i 8 3 z s 3 0 a 9 4 9 4 9 4 el v 1 v 4 8 E e B s s D I L E E 8 3 28 29 30

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