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Backgrounder on Taxes

August 10, 1994

August 10, 1994 | Backgrounder on Taxes

One Year Later: How the Clinton Tax Hike Is Harming America

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998 August 10,1994 ONEYEARLATER HOW THE CLINTON TAXHKE BGAMERICA Daniel J. Mitchell McKenna Senior Fellow in Political Economy INTRODUCTION This wtkk marks the first a nniversary of 1993s record tax hike and the ill effects al ready are becoming apparent. The Clinton Administrations own numbers show that eco nomic growth and job creation remain considerably below levels normally found at this stage in a business cycle. T he White House figures also reveal that if any deficit reduc tion does occur, it will be only temporary and largely unrelated to the Presidents eco nomic policy. Worst of all, the Administrations budget numbers confirm that govern ment spending remains ou t of control, with rising deficits in future years entirely due to the unchecked growth of domestic spending programs.

These dismal results should not be suprising. Other Presidents who have followed high-tax policies also have experienced disappointing economic performances as a .re sult. Large payroll tax increases and bracket creep during the Carter Administration, for instance, helped stifle a robust economy and create the phenomenon known as stagfla tion. George Bush also inherited a strong economy, but his acquiescence to a large tax increase in 1990, combined with other significant reversals of his predecessors poli cies helped put an end to the longest peacetime expansion in Americas history.

The Clinton Administration insists that its tax plan is working and that history will not repeat itself. Unfortunately, the rosy picture being painted by the White House falls a part upon closer examination. Consider the following claims CLAlM #I: The Administrations economic policy has restored REALITY: This assertion ignores the fact that the recession ended in the spring of 199 1.

And even though President Clintons tax plan di d impose retroactive tax increases on small businesses, investors, upper-income individuals, and the estates of dead Ameri cans, even the White House is hard-pressed to argue that a tax increase beginning January 1,1993, caused a recession to end nearly t w o years earlier. The Administra tion can legitimately claim that 1991 should not count as a recovery because the econ omy experienced almost no growth, expanding by less than three-tenths of one per cent during the year. The same cannot be said for 1992, however, since the economy expanded at a 3.9 percent clip. Growth in 1993, the year of the Clinton tax increase slipped back to 3.1 percent and the Administrations new projections show only 3.0 percent growth in 19

94. As such, the best the Administration can claim is that last economicgrowth I5 IO 5 years budget deal has not yet caused the econ omys performance to slow down much com pared to the growth lev els President Clinton in herited.

The real story, how ever, is that the recovery under both Bush and Clinton has been woe fully inadequate. In the post-World War 11 pe nod, the U.S. economy traditionally has experi enced strong recoveries after an economic down turn, with real growth av eraging 5.34 percent for the three years following a recessions end . But the economys performance this time has fallen far 4 Chart I The Bush-Cllnton Recovery Lower-than-Average Economic Growth 20a 1 Ecor~wnt Gtuwth short of past recoveries, with growth averaging only 2.94 percent in the last three years. In other words, e conomic growth has been barely half as strong as that nor mally experienced at this stage of a business cycle. Average growth during this expan sion has not even reached the average of 3.1 percent for the post-World War II era-a figure which includes rece s sion years 2 1 Instead of taking credit for ending the recession and restoring economic growth, the 1 Administration should be trying to explain why the economys performance has been so weak. The reason for the poor growth figures, of course, is that the W hite House is pursu ing policies similar to those that helped cause the recession in the first place. Presidents Bush and Clinton both raised taxes. They both increased government spending and they both increased the burden of regulation and imposed costl y mandates. As a result, the economic downturn and subsequent weak recovery should not come as a surprise. Poli cies which raise the cost of productive economic activity inevitably result in less job creation, lower savings, and reduced investment I CLAIM # 2:The Administrations economic pollcy has helped create new jobs CLAIM #3:The Admlnlstratlons flsd policy Is brlnglng down the deficit REALITY: Projected short-term reductions in the budget deficit are largely unrelated to the Presidents policies I final f igures bear out the Administrations estimates, the 14 12 IO 8 6 4 2 REALITY: As is the case with economic growth, job creation has been unusually weak during this expansion. If the current expansion were producing an average number of jobs for a recovery, total employment would have jumped by 11.79 percent since the recession ended. But with tax increases and new regulations raising the cost of hiring new workers not to mention the threat of an employer man date in health re form), total em ployment has in creased by only 3.19 percent in the last three years. Thus while the White House likes to boast that more jobs have been created to date during the Clin ton years than were created dur ing the entire stration, officials should instead be trying to ex plai n why the nearly identical economic policies of thetwo Administrations have caused the rate of job creation in this recovery to be less than one-third the usual rate at this stage of a business cycle. This poor performance means millions of Americans are u n employed today who would have been working during an average recovery I Bush Admini Chart 2 The Bush-Clinton Recovery Fewer Jobs Created than Average prcent Increase in Total Emolownent I Year I Year 2 Year 3 Yean After End of Recession kurcr Depamnmtof L a bor. Bureau of Laba Stat 3 three-year decline in government borrowing will be the result of three factors. First and foremost, the deficit is falling because the economy has finally climbed out of the recession, albeit slowly. And even though the expansio n is very tepid by historical standards, incomes have risen slightly, some jobs have been created, and corporate profits have staged a mild recovery. All these factors mean the government collects more tax revenue. The expansion also has caused a slight de c line in how fast some government programs, such as unemployment insurance and food stamps, are grow ing. But as discussed earlier, the economy is growing much slower than normal. As such, the White Houses economic policies actually are causing the deficit to be higher than it would be if normal economic conditions applied.

The second reason for projected lower deficits is the cost shift for the bailout of the deposit insurance system. The large one-time costs of the savings and loan (SBrL) de posit insuran ce bailout artificially swelled the deficit between 1989 and 1992, adding 149 billion to the national debt in that four-year period. The government now is sell ing off the assets of seized SCQLS, however, and this is expected to generate $60.3 bil lion of revenue for the government between 1993 and 19

97. This huge shift, from a big budget expense to a significant revenue source, lowers the reported budget deficit.

Bill Clinton had the good fortune to capture thewhite House just as the shift took place, but it certainly is not due to his policies. More important, it clearly has no im pact on the long-term deficit.

The third reason the budget deficit is falling, and the one reason the Administration can take credit for, is the large reduction in defense sp ending. The Pentagons budget is expected to go down from $292.4 billion in 1993 to $257 billion in 1997, a decline of $35.4 billion. With the Administrations foreign policy in disarray, these sharp cuts may not be wise policy, but they do contribute to de f icit reduction CLAIM #4: The Administrations tax bill has produced low interest rates REALITY: Interest rates ac tually have been rising steadily ever since the Administrations budget package was ap- proved. As indicated in Chart 3, interest rates began a steady decline in 1989.This trend came to a halt, how ever, with the enact ment of the Presidents budget package. To be fair, the increase in in terest rates following adoption of the tax in crease has very little to do with fiscal policy and is related m o re to chart3 Ulnton Tax Hlke Reverses Interest Rate Decllne Interest Rate on Govanment Bonds toy 1 fears in financial markets of future inflation. Nonetheless, the White House can hardly 4 claim that its fiscal policy is resulting in lower interest rates when rates actually have been rising THE REAL STORY The White House has been trying to convince voters that last year's tax increase is working. But, every claim made by the Administration proves false upon closer scrutiny.

Yet the problem is not merely th e lack of good news on the consequences of 1993's re cord tax-hike. What is of great est concern is that as has been the case with previous Admini strations steering through large tax increases (such as those of Hoover, Carter, and Bush the Clinton tax hi ke is imposing heavy costs upon the economy. Most notably Rising budget deficits stration's own forecast, the budget deficit resumes its upward climb in 19

96. The Congressional Budget Of fice, estimates that budget deficits will swell to more than $360 bi llion by the year 2004 Y Surging domestic According to the Admini spending As Chart 4 shows, the rea son for rising deficits is the alarming growth of domes tic spending programs.

These programs, which are rising 78 percent faster than needed to keep pace with in flation, are projected to in crease by a total of $229 bil lion over the four years of the Clinton Administration.

Significantly, if spending for these programs simply olart 4 Surglng Domestlc Spendlng 1993 1994 1995 1996 1997 I998 1999 Soon Lead s to Rlslng Dcficlt 1 I 1994 1995 1996 1997 1998 1999 2WO 2001 2M)2 2003 2W held to the rate of inflation beginning in 1995, the five-year savings would be more than $367 billion and the budget deficit would fall to $70.1 billion by 1999 5 Soak the rich t a x hike backfiring The lions share of new taxes in last years tax package is supposed to come from increased income taxes on small businesses, savers, investors, and the well-to-do. Crit ics of the proposal pointed out at the time that higher tax rates wou l d discourage pro ductive economic activity and could actually cause tax revenue to be lower than it would be if taxes were not boosted. Known as the supply-side effect, this revenue shortfall results when taxpayers reduce their work effort, change their b ehavior, shift their investments, or take other steps to protect theirearnings from excessive taxation.

As a result, pro jections of tax revenues based on models which assume taxpayers are oblivious to chang es in the tax code almost always will be tic. This effect was seen after the 1990 tax in crease. Com pared with pro jections made before the tax increase was approved, the 1990 deal actu ally caused tax grossly optimis chart 5 Soak-the-Rlch Income Tax Hlk e Backfires Income Tax Revenues Lag Behind Other Tax Revenues I29 IO 8 6 4 2 94 to Date 1 revenues to fall by more than $3 for every $1 the 1990 tax bill was supposed to raise Since the Clinton economic program is so similar to that enacted during the Bush Administration, it should come as no surprise that history seems to be repeating itself.

According to the Treasury Department, personal income tax revenues are growing slower than other sources of tax revenue this fiscal year. Nine months into the fiscal year, personal income tax revenues are only 7.2 percent above their level at this point last year. Tax revenues from other sources, by contrast, are coming in at 1 1.2 percent above last years levels. Revenues from the tax that was raised the most have be e n growing far slower than revenues from tax sources which were increased by lesser amounts or not at all. The gap between personal income taxes and other taxes is con crete evidence that soaking the rich simply does not work. What makes these num bers par ticularly significant is that some of the income tax revenue came from the ret roactive tax increase, which is one tax increase that avoids the supply-side effect since it raised rates on income that was already earned.

The Administration should have antic ipated that higher income tax rates would be associated with slower income tax collections. In the 1980s, when tax rates were slashed, income tax collections soared, and the share of taxes paid by the rich rose 6 X Out of step with world trends In an in g l obal econ- omy, changes in domestic policies can have a'signifi cant impact on interna tional competi tiveness. Dur ing the 1980s policy makers in the U.S. un derstood and tage of this phenomenon, cutting tax rates and en couraging a surge in job creasing l y took advan Chart 6 U.S. Is Out of Step Wlth World-Wlde Reduction In Tax Rates Source: Congrraional ReseMh Service creating foreign investment in America. In recent years, other countries have followed the U.S. example, lowering their tax rates, oftentim e s dramatically. Tragically, U.S politicians seem to have forgotten the lessons of the 1980s. As seen in Chart 6, the United States has been raising tax rates during a period when most other nations are doing just the opposite CONCLUSION Policies that did n ot work for Herbert Hoover, Jimmy Carter, and George Bush are not working any better for Bill Clinton. The economy's weak performance, the dismal job creation numbers, and projections of higher spending and deficits are the inevitable results of a fiscal policy based on this flawed model. Critics maintained that the 1993 tax hike would harm the prospects for a solid recovery, not enhance them. They are al ready being proved correct 7

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