May 1, 1996 | Backgrounder on Federal Budget
Opportunities Lost...The 1993 Budget Plan Cost America:
Table 2: Employment, Wage, and Compensation Growth, Current Expansion vs. Previous Expansions
Chart 1: Employment, Wage, and Compensation Growth, Current Expansion vs. Previous Expansions
Chart 2: $208 Billion in Potential Gross Domestic Product Lost
Chart 3: OBRA-93 Undercut Income, Wages, and Savings of American Families
Chart 4: Long-Term Economic Effects of OBRA-93: Lost Potential Gross Domestic Product
Chart 5: 1.28 Million Cars and Light Trucks Not Sold due to OBRA-93
Appendix: Economic Impact of the Omnibus Budget Reconciliation Act of 1993 (OBRA-93)
The American economy currently exhibits relatively low levels of inflation, interest rates, and unemployment. Yet millions of workers remain anxious about their economic security. The relatively good economic news, combined with the widespread dissatisfaction among Americans with the nation's economic performance, seems to be a paradox. But an analysis of underlying policies and economic trends suggests an answer to this puzzle.
Using the Washington University Macro Model (WUMM)1
-- a major economic model of the U.S. economy also used by the
federal government and many Fortune 500 companies --
economists at The Heritage Foundation investigated how the economy
would likely be performing today had Congress not raised taxes in
1993 as the nation was coming out of the 1990-1991
recession.2 The results of this analysis shed light on
why Americans are so anxious about the economy's performance.
According to the Heritage analysis, the 1993 tax hike, championed
by the Clinton White House, did indeed produce what some critics
have referred to as a "Clinton Crunch" -- a larger tax bite for
families combined with a stagnation in incomes and an economy
performing well below its potential.3
The Heritage analysis indicates that, compared with how the economy would have performed without the 1993 tax legislation, Clinton's 1993 tax and budget plan will have:
Cut $112 billion, in today's dollars, out of potential employee wages and salaries between 1993 and 1996.
In short, American workers are right to feel that they should be better off today than they are. President Clinton's 1993 economic plan turns out to have deprived Americans of a higher standard of living by cutting the economy's growth potential, leading to a slower rise in employee compensation, household income, industrial output, and most other measures of a prosperous economy.
How is the Economy Really Performing?
Despite a flow of quite good economic news in recent months, many Americans feel anxious about their economic security, complaining of stagnating family incomes, less money in their paychecks after taxes, and a belief that the economy is performing below its full potential. They simply do not accept that the economy is, as the President claims, the "healthiest it has been in 30 years."
In the latest Economic Report of the President, the White House maintains that the general health of the economy is good and credits the creation of 8 million new jobs to the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA-93), which, the report says, "set the stage for this economic expansion and resurgence, by enacting historic deficit reduction while continuing to invest in technology and education."8
By contrast, House Majority Leader Richard Armey (R-TX) cites OBRA-93, which enacted the largest tax increase in history, as the culprit for the anxiety Americans are now feeling. Calling this condition the "Clinton Crunch,"9 Armey claims workers are experiencing the dual effect of an actual decline in real wages and higher taxes. With fewer of their own dollars in their pockets to meet the needs of their families, he says, workers understandably have a heightened sensitivity to changing economic conditions, corporate layoffs, and downsizing.
Who is right? Is the economy performing up to its potential, as claimed by the White House? Or are Americans suffering from the "Clinton Crunch," as claimed by Armey?
Americans have good reason to be confused about the direction in which the nation's economy is headed. On the one hand, there is good news in statistics showing continued economic growth, relatively low unemployment, and record highs in the stock market. And as the Clinton Administration points out, the economy has created nearly 8 million jobs over the past three years, 93 percent of them in the private sector. Clinton also claims credit for reducing the federal budget deficit for three consecutive years: According to the Economic Report of the President, passage of the 1993 economic plan "put the country solidly on the road to fiscal responsibility."10
But other economic statistics indicate a less rosy picture for Americans in recent years. For example, existing studies and government data indicate:
The Economy is Lagging Behind Previous Expansions
Thus, while the economy is no longer in a recession, and indeed is experiencing modest growth, many Americans are still having trouble making ends meet and corporate layoffs have many workers thinking twice about the security of their jobs. But is this just part of a typical business cycle? Experience suggests "no." Although total employment has increased in recent years, the current economic expansion -- which began in March 1991 and is now some 59 months long -- is not progressing as well as it should when compared with the three previous post-World War II expansions lasting longer than 58 months. These expansions occurred from February 1961 to December 1969, from March 1975 to January 1980, and from November 1982 to July 1990.20 The failure of this economy to perform as well as similar expansions gives a clue as to why many Americans are concerned about their economic future.
It is interesting to compare this expansion with the average of these previous expansions. To be sure, the patterns of each expansion do differ, so data for each expansion are provided in Table 2, as well as the average.
During the current expansion:
Thus, despite the Administration's cheerful outlook, the economy is not performing well when compared with similar points during the three previous expansions of similar lengths. The question is "why?" Would the economy have been performing less well today without OBRA-93, as the Clinton Administration claims, or did the tax increase slow down an economy in recovery and put many workers into a wage and job squeeze, as critics claim?
The 1993 Budget Deal
Virtually all economists agree that Washington can alter the course of the economy to some degree through its tax and spending decisions. This influence is particularly evident when Congress and the President enact tax and spending policies that affect income from work or investment. For example, Washington can reduce employment and workers' take-home pay by increasing tax rates on wages and salaries. Higher rates take money directly out of workers' pockets and make work less attractive. Conversely, lower tax rates increase the incentives for men and women to work, start new businesses, or invest in training and equipment for workers. In short, tax rate changes either lower or raise the cost of labor, depending on the direction of the rate movement. Commonly, lowering labor costs leads to a higher demand for labor. When combined with lower capital costs stemming from lower taxes on capital, greater levels of economic activity are attained.
When Congress and the President adopt policies that alter economic life in some significant fashion, there will be a difference between how the economy then performs and how it would have performed had policy not been changed. These differences between actual and potential performance can be estimated statistically using models of the U.S. economy that capture the economic impact of policy changes. Generally speaking, these models allow analysts to "simulate" the impact of tax and spending decisions that could have been made -- or not made -- by Congress and the President, and then compare the simulation with what actually occurred. This is what the Congressional Budget Office routinely does when Congress is considering tax and spending legislation.
There have been two major tax and spending plans enacted in recent years. These were in 1990 and 1993. American taxpayers were told that large tax increases in each of these plans would lead to a significant reduction in federal deficits and spur long-term economic growth. In this study, Heritage analysts used the WUMM model to investigate the effects of the 1993 budget deal. There were two reasons for the decision to focus on the 1993 agreement: First, by 1993, the economy was largely in recovery from the 1990-1991 recession, so the impact on the expansion of the 1993 plan could be isolated more easily. And, second, focusing on the 1993 economic plan allowed analysts to test the Clinton thesis that the plan has produced "the healthiest economy in three decades."23
The 1993 budget plan (OBRA-93) raised taxes $241 billion over five years and called for $77 billion in entitlement program savings and $69 billion in discretionary program savings by 1998.24 The tax law changes included two new personal tax brackets (36 and 39.6 percent) and an extension of the Medicare payroll tax to cover all wages. The motor fuel tax was increased 4.3 cents per gallon, and the tax on Social Security recipients' income from personal savings was increased. Congress and the President agreed to raise the corporation income tax to 35 percent and to restrict business meal and entertainment deductions.
The small entitlement savings came mostly from reductions in Medicare payments to doctors and hospitals and increased charges to Medicare beneficiaries. OBRA-93 delayed cost of living adjustments for military and civil service retirees and limited Medicaid payments to the states. Small reductions also were made in veterans benefits, farm programs, and student loans.
The comparison of the real and simulated economies suggests that OBRA-93 was not as beneficial to the economy as the White House claims. Indeed, it damaged the economy and living standards in several ways. Specifically, the Heritage analysis finds that:
The economy would have grown significantly faster without the Clinton tax increases and spending reductions of 1993. These policy changes will have cost the economy $208 billion in today's dollars in output from 1993 through 1996, equivalent to nearly $2,100 in lost GDP for every household in America. In 1995, GDP would have grown by nearly 0.90 percent more, or $66 billion in today's dollars, than it actually did. The model forecasts that GDP in 1997 will be 1.0 percent lower than it could be without the 1993 tax hike, or about $95.5 billion in today's dollars.
Heritage analysis shows more new businesses would have been incorporated without Clinton's 1993 package. This is due to the relationship between gross domestic product and new business incorporation. In general, for every $1 billion in GDP, about 195 new businesses are incorporated. Thus, the $208 billion fall in GDP due to the 1993 legislation will have prevented the formation of 40,600 new businesses between 1993 and the end of 1996.25
What This Means: The loss of new businesses means not only a loss of valuable entrepreneurs, but also the loss of many new jobs. The Small Business Administration (SBA) estimates that five new jobs are created with each new business establishment. Using the SBA estimate, the loss of 40,600 new businesses between 1993 and 1996 will have meant the loss of 203,000 new jobs.
The economy produced 1.2 million fewer private sector jobs between 1993 and 1996 than it would have without the tax increase and budget changes of 1993. President Clinton claims credit for more than eight million new jobs during his Administration, so far, with roughly seven million of these in the private sector. But the Heritage analysis indicates that 1.2 million additional Americans could have been working without his policy changes. If the forecast for 1997 is added to these figures, the total private employment cost of the tax increase grows to nearly 1.4 million.26
It must be noted that the loss of potential civilian employment is one of the more remarkable findings of the analysis, based on the model's design. It is also one of the more controversial. While it is the Heritage Foundation's policy to accept the model's macroeconomic results and assumptions (other than the action of the Fed -- see box, page 8) and not make adjustments in these results through statistical work performed outside the model, this particular effect of OBRA-93 deserves a brief explanation. The model's measurement of how much employment will change when taxes change (the so-called tax elasticity of employment) sits roughly in the middle of the professionally accepted range for such measurements: The model contains a factor of .29 percent change for every one percent change in labor income, and the standard range among economists goes from .12 to .37 percent. These elasticities mean that a 10 percent increase in take-home pay leads to an increase in the labor supply of between 1.2 and 3.7 percent.
The designers of the WUMM model caution users regarding the output of the model's employment equations. However, Heritage economists decided to accept the model's results because further investigations and calculations using other data bases gave general support to the conclusions in this Heritage study. If the rate changes associated with OBRA-93's increases in payroll and income taxes are applied only to the incomes of those with more than $70,000 in income, we calculate that potential employment was at least 350,000. Of course, the increase in tax rates also negatively affected investment decisions, which resulted in slower growth of job-creating new businesses and business expansion. For example, Heritage calculates that the loss in potential capital stock may account for an additional decrease of 470,000 jobs. When these and other capital effects are combined with the direct and minimal employment effects, the calculation derived from the model of 1.2 million in 1996 between actual and potential employment appears reasonable.27 Even using lower elasticities favored by some economists would mean an employment effect of at least 400,000 lost jobs.
What This Means: Heritage calculates approximately 203,000 of the potential lost jobs between 1993 and the end of 1996 were a result of new businesses that were not formed. The remainder of lost potential jobs, some 1 million, most probably results from existing businesses that hired fewer employees than they otherwise would have or expanded less.
When the job losses are combined with higher taxes on working families, a disturbing picture of lost household income growth emerges.
What This Means: In 1996 alone, the Heritage analysis shows that the Clinton program depressed the growth in wages and salaries by $46.5 billion in today's dollars, roughly $465 for every household in America. The loss of potential income means that families spent less than they could have spent on food, clothing, transportation, medical care, and other necessities for their families. Indeed, in a typical month, the average household spends $251 on groceries, $160 on medical costs, and $40 on education.28 The addition of $465 in purchasing power for the typical household means an average of 1.8 months of groceries, or 2.9 months of medical bills, or 12 months of educational expenses in a typical year.
What This Means: Total personal disposable income measures both wage income and non-wage income from such things as investments. Besides lost future wages, the Heritage analysis shows that the Clinton tax increase and budget plan will have cost households $152 billion in non-wage income, in today's dollars, between 1993 and the end of 1996. This is equal to $1,500 for every American household. In 1996 alone, the average household will realize $550 less in non-wage disposable income, nearly double the amount the Bureau of Labor Statistics estimates the average household spends on appliances each year.29 Many households use income from non-wage sources to make large purchases such as the down payment on a new car, a washing machine, and other appliances. Alternatively, families may use this income to finance extraordinary events such as weddings, college education, or vacations.
What This Means: The three things households save for most are education, housing, and retirement. To illustrate the impact of these lost savings, Heritage analysts distributed the $138 billion in lost savings to families with children, young families saving to purchase a home, and those saving for retirement, based upon age and population. We then assumed that this amount would grow at an everyday interest rate of 5 percent, to see what important purchases these three groups could make in the future with their respective accumulated savings. Each of the following amounts is what could be purchased with the future value of each group's portion of the $138 billion in lost savings:30
Had the portion of this $138 billion we allocated to families with children been allowed to earn interest for the average number of years available for savings in the under-18 age group, then the cumulative amount could have purchased a four-year college education for 7 million students at $14,000. Had the foregone savings we allocated to young families saving to purchase a home (the age group 18 to 35), been allowed to grow for 18 years, the total sum could have resulted in 17 million future home sales where a $20,000 down payment is required. And had the portion of this $138 billion allocated to people above the age of 35 -- those saving for retirement -- been allowed to grow for the average number of years before this cohort retires, the future value could have resulted in 6.4 million 15-year retirement annuities paying $37,500 per year.
The President maintains that taxes had to be raised in 1993 to reduce mounting federal debt.31 He now points to a fall in the deficit as justification for the 1993 legislation. But the Heritage analysis indicates that the weak economy produced by the tax hike will have generated far less new revenue, and thus less deficit reduction, than the Congressional Budget Office (CBO) had predicted for FY 1994 through the end of FY 1996. On the other hand, the analysis indicates that the modest amount of savings predicted from the spending cuts will materialize. These findings suggest that if OBRA-93 had enacted few or no tax increases to slow the economy, but more spending cuts, the deficit would be far less today than it is.
In 1993, CBO predicted that OBRA-93 would lower the cumulative deficits between FY 1994 and FY 1996 by $171 billion. Some $50 billion of these savings -- 29 percent of the total -- was to come from spending cuts, including $17 billion in net interest savings and asset sale proceeds. The remaining $121 billion in deficit reduction -- 70 percent of the total -- was to come from the new revenues generated by the increase in tax rates.
The Heritage analysis indicates that OBRA-93 will have produced just 74 percent of the deficit reduction CBO had estimated, or a total of $127 billion.32 This, however, does not tell the whole story. While the spending cuts will have produced slightly more savings than CBO predicted, $52 billion (excluding asset sale proceeds), accounting for 41 percent of the overall deficit reduction achieved,33 the tax increase accounts for roughly 54 percent of the total, having delivered far less new revenue than was promised.
The Heritage analysis of the near-term consequences of the 1993 tax increase largely confirms the results of a recent study by noted Harvard University economist Martin Feldstein and Daniel Feenberg, an economist at the National Bureau of Economic Research. Their analysis of the impact of the 1993 tax increase on individual behavior shows that the higher tax rates placed on upper-income taxpayers encouraged these individuals to change their economic behavior and, thus, report lower taxable income. As a result, in the first year it took effect, the 1993 tax rate increase raised just 45 percent of the "revenue that would have been collected if taxpayers had not changed their behavior."34
Moreover, Feldstein and Feenberg discovered that the 1993 tax hike caused considerable inefficiencies in the economy, what economists call "deadweight losses." "This means that for every dollar of additional revenue collected by the government as a result of the higher tax rates, taxpayers experience a decline in their well-being equivalent to three dollars as a result of the induced changes in work, in the form of compensation, and in tax deductible expenditures."35 In other words, conclude Feldstein and Feenberg, "the structure of the 1993 tax increase thus made it a very inefficient way of increasing revenue."36
This analysis so far has examined what might be called the short-term effects of the 1993 package. The current debate is about these short term effects, with the White House claiming benefits to today's economy. But for there to be a complete verdict on the 1993 tax and budget plan, one needs to project into the future, to explore whether the short-term effects analyzed above are merely a prelude to future growth.
The Long-Term Picture
To estimate the longer-run future effects of the 1993 plan, Heritage analysts used the WUMM model to extend the simulation of potential economic performance without passage of the 1993 tax increase and budget deal through 2004. The results of this simulation were then compared with the baseline economic projections -- under current law and including the 1993 tax increase and budget deal -- produced by the owners of the WUMM model in December 1995. The comparison shows that nearly every major economic indicator is projected to be weaker under current law than would have been possible without passage of the 1993 tax increase and budget act between now and 2004. Specifically, the Heritage analysis concludes:
While there is good news in the economy, such as low interest rates, low inflation, 8 million new jobs, and lower federal deficits, many workers and their families feel that the recovery is anemic as far as they are concerned. The Clinton Administration is taking credit for good economic news and asserts that the news is a justification of its economic policies; specifically, the 1993 budget deal, which included the largest tax increase in history.
The evidence does not support the Administration's claim that the 1993 budget plan triggered stronger economic growth. On the contrary, the critics of the 1993 legislation appear to be correct that because of it Americans are caught in what some refer to as the "Clinton Crunch," the dual effect of declining real wages combined with higher taxes. The analysis by Heritage Foundation economists, using the WUMM model, indicates that OBRA-93 has had a damaging impact on the nation's economy. Removing the effects of OBRA-93 in an econometric simulation shows that the economy would have been performing better today had Congress not enacted the legislation.
Thus, President Clinton is right to point to the 1993 budget deal as creating today's economic climate. But rather than create a better climate, the legislation has cast a dark shadow over the economy.
Appendix: Economic Impact of the Omnibus Budget Reconiliation Act of 1993 (OBRA-93)
Notes on the Simulation
The simulation of the Omnibus Budget Reconciliation Act of 1993 (OBRA-93) was developed using the Washington University Macroeconomic Model of the United States economy. The baseline is that produced by the model in December 1995. Only those variables in the model that reflect federal tax and spending policies were modified to create the simulation. Both the baseline case and the simulation incorporated the model's Federal Reserve reaction function. Specifically, Heritage economists made the following decisions regarding tax and spending data inputted into the model for the simulation:37
1. The maximum federal corporate tax rate was restored to its "pre-OBRA-93" level to account for the one percentage point rate increase included in OBRA-93.
2. The statutory depreciation period for nonresidential structures was restored to its "pre-OBRA-93" level of 31.5 years. The corporate capital consumption allowance, as a percentage of total capital consumption allowance, was increased to accommodate the shorter depreciation periods within the simulation.
3. The federal statutory income-weighted marginal tax rates on wages, dividends, and interest were restored to their "pre-OBRA-93" levels.
4. The average federal personal tax rate was adjusted to account for lower marginal tax rates within the simulation compared to actual levels.
5. The federal statutory income-weighted marginal Social Security tax rate on wages and salaries was re-set to its "pre-OBRA-93" level.
6. Federal collections from social insurance taxes were adjusted to account for the repeal of the cap on earnings subject to the Medicare tax.
7. Federal collections from indirect business taxes were adjusted for the extension and increase of the motor fuels tax account.
8. Federal collections from business taxes were adjusted to account for non-rate changes in the business income tax code.
1. The actual spending level for Medicare was increased for each fiscal year by the amount the Congressional Budget Office estimated in September 1993 that OBRA-93 changes would save -- a total of $55.8 billion between 1994 and 1998.
2. The actual spending level for Medicaid transfers was increased for each fiscal year by the amount the Congressional Budget Office estimated in September 1993 that OBRA-93 changes would save -- a total of $7.1 billion between 1994 and 1998.
3. The actual spending level for personal transfers was adjusted for each fiscal year by the amount the Congressional Budget Office estimated in September 1993 that OBRA-93 changes in federal employee retirement and health benefits, veteran benefits, and the Earned Income Tax Credit would create -- a net total of $6.7 billion of increased spending between 1994 and 1998. The increased spending for the Earned Income Tax Credit more than offset the savings from reforming federal employee retirement and health benefits, and veterans benefits. Therefore, the simulation actually calls for less spending on personal transfers than actually occurred during the past three years.
4. The actual spending level for other grants-in-aid was adjusted for each fiscal year by the amount the Congressional Budget Office estimated in September 1993 that OBRA-93 changes in federal farm programs, the food stamp program, and "other" mandatory programs would save -- a net total of $7.2 billion between 1994 and 1998.
5. The proceeds from FCC electromagnetic spectrum auctions and the savings from changes in federal family education loans were added to the unified deficit but not included in the NIPA-based spending accounts.
Other Technical Notes