The Heritage Foundation

Backgrounder #1599 on Federal Budget

October 4, 2002

October 4, 2002 | Backgrounder on Federal Budget

The Disappearing Budget Surplus Highlights the Importance of Economic Growth

Opponents of tax cuts are using the disappearing budget surplus to justify their calls to repeal last year's tax cuts, but the government's own data do not support their claims.

According to the most recent budget surplus projections for 2002-2011 from the Congressional Budget Office (CBO), last year's estimate of a $5.6 trillion surplus has dwindled to just $336 billion.1 While many in Congress and the media blame the 2001 tax cuts for this decline, CBO data show that the tax cuts accounted for just 8 percent of the decline in the 2002 budget surplus and less than 25 percent of the 10-year decrease in the surplus.

Those who would politicize the CBO's findings and use them to justify imposing higher taxes on working families clearly miss their most important revelation: Because of the 2001 recession, the CBO's projection of the amount of wealth that would be created between 2002 and 2011 has fallen by an astounding $6.7 trillion. This decrease in projected wealth will leave Washington with less income to tax and lead to budget deficits. More important, it means that businesses and families will have $6.7 trillion less income to use to create jobs or make ends meet.

The rapid decline in the budget surplus clearly demonstrates the importance of creating wealth. While the disappearing surplus cannot be responsibly blamed on the tax cuts of 2001, examining the real causes of the decline--the 2001 recession and the correction of prior forecasting errors--can point the way to the steps that Congress and the Administration must take to boost the economy and reverse the problem. Reducing taxes will lessen the cost of working, saving, and investing for businesses and households and will unleash the economy's productive capacity.

Declining Revenues Dry Up Budget Surpluses

As Table 1 shows, from an accounting perspective, 80 percent of the decrease in the CBO's 2002 budget surplus projection resulted from a $376 billion decrease in estimated tax revenues. Most of this revenue decrease occurred in the category of the individual income tax, which is collecting 23 percent less in revenue this year than the CBO had estimated it would.2

Overall, the CBO's budget surplus projection for 2002-2011 has declined nearly $5.3 trillion. From the accounting perspective of Table 2, 42 percent of this decline is due to lower individual income tax revenues. An additional 25 percent results from increased net interest payments as budget deficits once again become the norm.3

The Role of the Economy and Stock Market

Although the accounting perspective presented above is useful, the policy perspective is superior, because it breaks down the causes of decreasing revenues and increasing spending. Specifically, it shows how economic factors as well as actions by Congress and the President directly affect changes in the budget surplus.

The three most commonly heard policy explanations for the declining budget surplus are the 2001 tax cuts, the declining stock market, and the recession. How much weight these explanations hold should depend on sound economic principles, not politics.

The 2001 Tax Cuts

Many in Congress and the media are quick to blame the 2001 tax cuts for the disappearing budget surplus.4 Senate Budget Committee Chairman Kent Conrad (D-ND), for example, has called the tax cuts "the biggest culprit in the disappearance of the surplus" and "a disaster for America."5 A closer look at the CBO's numbers shows these claims to be unfounded.

As Chart 1 illustrates, the 2001 tax cuts are responsible for only 8 percent of the decrease in the 2002 budget surplus projection, according to CBO data. 6 By contrast, new spending is responsible for nearly twice as much of this decline.7

It should not come as a surprise that tax cuts are playing such a small role in the 2002 budget, since the vast majority of the tax cuts have not even been implemented. The centerpiece of the tax cuts has been the lowering of the bottom marginal income tax bracket to 10 percent--a policy change designed to help struggling working families. Other marginal income tax rates have been reduced by merely 1 percent. The laws of mathematics render it impossible to blame a $470 billion budget surplus decrease on tax cuts of only a few hundred dollars per household.

Even when the tax cuts are fully implemented, they are not projected to play the overriding role in the decreasing budget surplus. Less than 25 percent of the $5.3 trillion decrease in the 10-year budget surplus projection is directly attributable to the 2001 tax cuts. (See Chart 2.) A larger culprit is increased net interest payments, which are now expected to cost more than $1.3 trillion over the next decade.8

Some policymakers are inflating the budgetary effects of the tax cut by adding the cost of the net interest payments to it. However, spending increases, not tax cuts, cause the budget deficits that result in rising net interest payments. Just as families are obligated to project their annual incomes and not spend beyond those levels, Congress is responsible for not spending more money than the government takes in. If Members of Congress refuse to adjust their annual spending projections to the reality of lower revenues, then those unrestrained spending increases will cause budget deficits and the resulting high net interest payments.

The Declining Stock Market

The stock market boom of the late 1990s resulted in investors paying capital gains taxes on increasingly large capital gains realizations. Accordingly, capital gains tax revenues increased from $27 billion in 1992 to $118 billion in 2000.9 Overall, the CBO estimates that higher capital gains created 30 percent of the increase in individual income tax revenues from 1995 through 1999.10

The stock market's rapid decline since mid-2000 has depressed capital gains revenues. It is now safe to assume that 2002 revenues will be significantly lower than the projected level of $125 billion and that the level may take several years to recover. As a result, individual income tax revenues may continue to show only minimal growth.

The Sluggish Economy

The chief causes of the decreasing budget surpluses have been the 2001 recession and the correction of prior forecasting errors. Chart 1 shows that a full two-thirds of the declining 2002 budget surplus was caused by these economic and technical factors.11 Even that amount excludes the 2002 economic stimulus legislation, which was enacted in response to the recession. Altogether, these recessionary and technical factors played a role in $364 billion of the $470 billion decline in the surplus.

Even if the economy recovers to the same annual growth rate that had been predicted before the recession, tax revenues will continue to drop compared with the CBO's January 2001 10-year projection. That is because the lower 2001 and 2002 gross domestic product (GDP) has created a permanently lower base on which economic growth can build. Returning to the constant 3.1 percent annual growth rate that had been predicted last year would now add 3.1 percent of a smaller economic pie.12

The CBO now projects that over the entire 2002-2011 period, the economy will add $6.7 trillion less wealth than it had projected in January 2001.13 This represents not only $6.7 trillion less income for businesses to create jobs and families to make ends meet, but also $6.7 trillion less wealth for the federal government to tax. (See Chart 3.) This loss of wealth is the main reason the $5.6 trillion budget surplus projected in 2001 has vanished.

Problems with the CBO's Projections

The CBO performed its budget projections as best it could, but Congress reduced the CBO's accuracy by handcuffing its analysts with two odd rules:

  1. Static Scoring. If a business triples its prices, will it also triple its revenues? Of course not, because many of its consumers will stop purchasing the product. In fact, raising prices can often decrease revenue if enough consumers decide to go elsewhere. Just as prices affect consumer behavior, taxes affect economic behavior by serving as a "price" that workers must pay for working, saving, and investing. While raising prices can induce consumers to stop purchasing a product, higher taxes on working, saving, and investing can induce taxpayers to cut back on those activities.

    Congress rejects this commonsense principle. Its Members seem to believe that tax rates do not affect the economy and that people will work, save, and invest the same amounts whether the ta x rate is 0 percent or 100 percent. Just like a misguided business that thinks tripling prices will triple its revenue, Congress assumes that higher tax rates will always increase revenue and lower tax rates will always decrease revenue.

    All serious economists know this to be nonsense; but this "static scoring" approach requires the CBO to assume that the 2001 tax cuts, which lowered the price of working, did not affect anyone's behavior, did not soften the recession, and did not create any tax revenue. A proper analysis utilizing "reality-based scoring," which incorporates decades of historical precedents, would show that the 2001 tax cut slightly reduced the severity of the recession and, over the next decade, will unleash economic growth and create new tax revenues.14 Thus, the real budgetary effect of the 2001 tax cut was less than the $38 billion listed above in footnote 6, and the 10-year effects should be significantly lower than the CBO's $1.3 trillion estimate.

  2. Slow Discretionary Spending Growth. Congress also requires CBO projections to assume that discretionary spending will grow no faster than the rate of inflation. Once again, theory is contradicted by reality. From 1998 through 2002, discretionary spending rose by an average of 8.5 percent annually at a time when the inflation rate hovered around 2.5 percent.

    Congress and the President are showing no signs of slowing these excessive discretionary spending increases, which exceed entitlement spending increases for the first time in over 30 years.15 If discretionary spending continues to grow at this 8.5 percent annual rate, discretionary spending increases from 2002-2011 will not be $797 billion, as estimated in Table 2, but $2,269 billion--nearly $1.5 trillion more.16

Conclusion

Those in Congress who are using the budget deficit as an excuse to play politics and call for higher taxes on struggling working families ignore the real problem of the economy. In the past year, the $6.7 trillion in new wealth that the CBO projected would be created over the next 10 years has vanished. This represents $6.7 trillion less for businesses to use to create jobs and increase wages, and for families to save for retirement or their children's education. The budget deficit resulting from the loss of tax revenues on that $6.7 trillion is just one more result of these economic woes.

Congress should pursue policies that recoup this $6.7 trillion in wealth. Past lessons from the 1920s, 1960s, and 1980s show that reducing tax rates is the best way to remove barriers to economic growth.17 Reducing taxes will reduce the price of working, saving, and investing and assure that businesses and individuals have the incentives needed to put the economy's productive capacity to work. Once the economy is growing and creating wealth, the budget projections will look more like they did in January 2001.

Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Brian M. Riedl Grover Hermann Fellow in Federal Budgetary Affairs
Thomas A. Roe Institute for Economic Policy Studies

Show references in this report

1. See Congressional Budget Office (CBO), The Budget and Economic Outlook: An Update, August 2002, p. 4.

2. Calculations based on data from ibid. and CBO, The Budget and Economic Outlook: Fiscal Years 2002-2011, January 2001, p. 4.

3. Ibid.

4. P.L. 107-16, the Economic Growth and Tax Relief Reconciliation Act of 2001.

5. Press conference by Representative John Spratt and Senator Kent Conrad, August 27, 2002, from Federak Document Clearing House transcript.

6. The 2001 tax cut totaled $38 billion in 2002, according to the CBO's pay-as-you-go estimate of H.R. 3090, the Job Creation and Worker Assistance Act of 2002, May 3, 2002, at http://www.cbo.gov/showdoc.cfm?index=3416&sequence=0.

7. Table 1 shows the 2002 spending estimate increasing by $94 billion. However, $6 billion of this comes from the 2001 tax cut (P.L. 107-16); $8 billion from the 2002 stimulus bill (P.L. 107-147); and $11 billion from economic and technical changes. This $25 billion is counted separately, leaving $68 billion in separate spending increases, or nearly twice as much as the $38 billion tax cut.

8. Calculated by Heritage Foundation analysts using data from CBO, The Budget and Economic Outlook: Fiscal Years 2002-2011, p. 4, and The Budget and Economic Outlook: An Update, p. 4. The 2001 tax cut budgetary estimate comes from the CBO's pay-as-you-go estimate of H.R. 3090.

9. CBO, The Budget and Economic Outlook: Fiscal Years 2002-2011, p. 60.

10. CBO, "Where Did the Revenues Go?" Revenue and Tax Policy Brief, August 13, 2002.

11. Economic factors are those whereby the economy grows more slowly than had been predicted and there is consequently less income to tax than had been predicted. Technical factors are those whereby a certain level of national income does not yield as much tax revenue. For instance, if income increases were concentrated among those who pay lower tax rates, the same new income would create less tax revenue than would have been the case if that income had gone to wealthy individuals in higher marginal tax brackets.

12. For example, a hypothetical $10 trillion economy growing by 3 percent adds $300 billion. For an economy hit by recession that shrinks to $9 trillion, the return of 3 percent growth will add just $270 billion.

13. The different GDP estimates for 2002-2011 are from CBO, The Budget and Economic Outlook: Fiscal Years 2002-2011, p. 135, and The Budget and Economic Outlook: An Update, p. 55.

14. Some critics cite the fact that some total revenues actually decrease after a tax cut as evidence that tax cuts do not affect economic behavior. However, reality-based scoring does not assume that tax cuts can never reduce tax revenue; it assumes only that the revenue loss often will be less than the static estimate. A 20-percent income tax cut may not fully pay for itself, but it may reduce revenue by only 10 percent as a result of people working harder, stimulating economic growth, and paying taxes on new income. In general, some types of taxes (such as capital gains and individual income) affect the economy more than others (such as sales and property).

15. See Brian M. Riedl, "How Washington Increased Spending by Nearly $800 Billion in Just Four Years," Heritage Foundation Backgrounder No. 1581, September 4, 2002, at http://www.heritage.org/Research/Budget/BG1581.cfm.

16. CBO, The Budget and Economic Outlook: An Update, p. 8.

17. See Daniel J. Mitchell, Ph.D., "Time for Lower Income Tax Rates: The Historical Case for Supply-Side Economics," Heritage Foundation Backgrounder No. 1253, February 19, 1999, at http://www.heritage.org/Research/Taxes/BG1253es.cfm.