March 28, 2003

March 28, 2003 | WebMemo on Federal Budget

CBO Estimates Spending Weakens Effects of Pro-Growth Tax Relief

Quick hit: A Congressional Budget Office (CBO) budget score confirms that new spending will harm the economy and dampen much of the positive effect of President Bush's Economic Growth Package.

CBO's new report concludes that by lowering taxes on investment, the President's proposed tax cuts would increase investment and consequently expand the economy. New government spending, however, would reduce investment because: 1) the more the federal government finances purchases, the less money is left for the private sector to invest with; and 2) increased government payments to individuals would lead to individuals increasing their consumption, at the expense of increased savings and investment.

Helping the economy grow requires that Congress move forward with the President's entire Economic Growth plan, and also restrain federal spending.

CBO recently released a dynamic score of President Bush's proposed 2004 budget. The most important aspect of "An Analysis of the President's Budgetary Proposals for Fiscal Year 2004" is simply its existence, as the CBO has long claimed that dynamic scoring would be impossible to implement. Its two key findings:

  1. The Economic Growth Package creates nearly a million jobs.
  2. Government spending will overwhelm the positive effects of lower taxes.
The Big Picture

CBO's two main economic simulations both show President Bush's tax relief proposals recovering a significant portion of the lost revenue. The Global Insight (GI) simulation shows the President's budget aiding the economy enough to recover two-thirds of the lost tax revenue. The Macroeconomic Advisors (MA) simulation shows over one-third of the lost tax revenues being recovered (see table 1).

These revenue increases stem mostly from new jobs and increased economic growth. GI estimates that, from 2004 to 2008, economic growth would average 1.4 percent higher than the baseline level, while MA estimates a 0.2 percent boost. Employment levels would jump under both simulations:[1]

  • 1.6 million more jobs per year, based on Global Insights' 1.2 percent jump.
  • 550,000 more jobs per year, based on Macroeconomic Advisors' 0.4 percent jump.

Increased Federal Spending Dampens the Tax Cut Boost

President Bush's budget would spend $348 billion above the baseline level from 2004 to 2008. Of that total, refundable credits from the President's tax cut proposal represents $40 billion, and added net interest payments (which partially result from the tax cut) would cost $103 billion. The vast majority of new spending, $205 billion, represents regular government programs.

This new spending will harm the economy and dampen much of the tax cut's positive effect. CBO concludes that by lowering taxes on investment, the President's proposed tax cuts would increase investment and consequently expand the economy. However, new government spending, however, would reduce investment because: 1) the more the federal government finances purchases, the less money is left for the private sector to invest with; and 2) increased government payments to individuals would lead to individuals increasing their consumption, at the expense of increased savings and investment. CBO assumes the negative effects of government spending would overwhelm the positive investment effects of lower taxes. In other words, government spending crowds out additional investment and employment, and that will negate most of the positive investment incentives proposed by President Bush to help the economy.[2]

The lesson is clear: maximizing the success of pro-growth tax cuts requires also restraining federal spending.

Why the Simulations Assume Outlays will Increase

Both simulations assume that federal outlays from 2004 to 2008 will increase much more than the $348 billion proposed by President Bush. MA shows an additional $236 billion increase, and GI shows an additional $75 billion spending increase (see table 1).

The simulations apparently claim that higher interest rates would be the major cause of these new outlays. They assume that the projected budget deficits will substantially drive up interest rates, forcing the federal government to make larger interest payments on the national debt. There is very little empirical evidence showing that modest changes in the budget deficit will significantly increase interest rates (recent budget deficits have coincided with decreasing interest rates), so this assumption should be viewed with skepticism.

The assumption of higher interest rates also dampens the simulations' overall estimate of increased economic growth and new tax revenue. If interest rates remain low, economic growth and tax revenue should be even higher than the simulations predict.

Why the Simulations Classify Most of the Growth as "Cyclical" Rather than "Supply-side"

Both terms must be defined first. "Cyclical" changes are caused by the business cycle, such as the unemployment rate increasing during a recession and decreasing during a boom. "Supply-side" changes increase the capacity of the economy. For example, the cost of working an additional hour, taking an additional job, or purchasing new equipment all have supply-side effects on economic growth.

In practice, the distinction between cyclical and supply-side growth isn't always clear. Just like the President's proponents, the two simulations agree that passage of the President's budget will mark the beginning of new tax revenue growth. But there is one crucial difference: the simulations credit much of the coming economic growth not to the tax cuts, but instead to cyclical factors, meaning the economy will boom on its own even without tax cuts. That assumption seems overly optimistic.

The methodology used almost guaranteed these results. The simulations placed any drop in the unemployment rate - no matter what caused it - in the cyclical column. If the business cycle gets all the credit for the dropping unemployment rate, it will naturally get credit for much of the new economic growth, and the increased tax revenues. Supply-side tax cuts, however, are designed to create jobs and economic growth now and in the future, yet CBO counted much of those effects as cyclical.

There was another side effect of crediting all reductions in the unemployment rate to cyclical factors. It meant that modelers had to keep the unemployment rate constant to determine the supply-side effect. They did this by assuming extremely high interest rates in order to choke off all job growth, for the currently unemployed. Note that these high interest rates would not happen in the real world, they are merely a statistical device used to adjust the model. But this implausible assumption tainted the rest of the simulation because it caused economic growth and tax revenue estimates to plummet.

Congress should not sit back and assume a coming economic boom is guaranteed simply because of the business cycle. Nor should they reduce the President's tax cut and still expect substantial economic benefits. The CBO report shows that the only way to create thousands of jobs and unleash economic growth is to enact the President's entire tax package, and to restrain spending.

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.

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[1] The job growth is based on estimates of employment derived from CBO's August 2002 baseline forecast.

[2] An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, CBO, page 16, "The overall macroeconomic effect of the proposals in the President's budget is not obvious. For example, some provisions in the proposals would lower marginal federal tax rates on labor and capital income. By themselves, those provisions would tend to increase labor supply, investment in productive capital (such as factories and machines), and the economy's output. However, the proposals also would promote the consumption of goods and services by both the government and the private sector, which would tend to reduce investment," seen at /static/reportimages/61D3AE9010B5B51B5C6281830E0F9B58.pdf.

About the Author

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

Related Issues: Federal Budget