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Backgrounder #1644 on Taxes

April 9, 2003

CBO Estimates: Spending Weakens the Effects of Pro-Growth Tax Relief

By

The Congressional Budget Office (CBO) recently released an economic or dynamic score of President George W. Bush's proposed 2004 budget.1 The most important aspect of this 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.2 The two key findings of the CBO analysis are:

  1. The economic growth proposals in the budget create approximately a million jobs per year for the first five years.
  2. Government spending will overwhelm many of the positive effects of lower tax rates.

The Big Picture

The CBO's two main economic simulations show that President Bush's tax relief proposals recover a significant portion of the reduced revenue.3 The CBO's use of the Global Insight (GI) model of the U.S. economy shows the President's budget aiding the economy enough to recover two-thirds of the reduced tax revenue. The Macroeconomic Advisers (MA) simulation, another model of the U.S. economy used by the CBO, shows recovery of over one-third of the lost tax revenues. (See Table 1.)

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

  • 1.6 million more jobs per year (1.2 percent increase), based on the Global Insight model, and
  • 550,000 more jobs per year (0.4 percent increase), based on the Macroeconomic Advisers model.

Increased Federal Spending Dampens the Tax Cut Boost

President Bush's budget would spend an additional $348 billion over current levels from 2004 to 2008. Of that total, refundable credits from the President's tax cut proposal represent $40 billion, and added net interest payments (which partially result from the tax cut) would cost $103 billion. A majority of new spending ($205 billion) represents regular government programs.

Much of this new spending would harm the economy and dampen the tax cut's positive effect. The 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 would reduce investment because (1) increased federal government purchases would leave less money for the private sector to invest and (2) increased government payments to individuals would induce individuals to increase their consumption at the expense of increased savings and investment.

The CBO assumes that the negative effects of government spending would overwhelm the positive effects of lower taxes. In other words, government spending frequently crowds out additional investment and employment, negating most of the positive investment incentives proposed by President Bush to help the economy.

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

Why the Simulations Assume Outlays Will Increase

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

These simulation results of federal outlays stem from higher interest rates projected by the two models. The GI model predicts that greater economic activity and heightened demand for consumer loans will drive up interest rates. The MA model also predicts that greater demand for loans will raise interest rates, but that model goes further and claims that higher federal budget deficits will themselves raise interest rates. However, there is very little empirical evidence 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 two models' different treatments of the relationship between interest rates and economic activity explain a large part of the difference between their estimated federal outlays. These different views of interest rates also explain some of the differences between their estimates of 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

The CBO report separates the economic effects of the President's budget into "cyclical" and "supply-side" components. "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 costs of working an additional hour, taking an additional job, or purchasing new equipment all have supply-side effects on economic growth.

Some have misinterpreted the report to define supply-side effects as those resulting from the President's tax proposals and the cyclical effects as whatever the business cycle would naturally bring regardless of tax policy. That is not the case. The cyclical effect shows how far the economy is moving toward its potential growth rate. The supply-side effect shows changes in the potential growth rate itself. In other words, the cyclical effect shows whether the economy is growing at capacity, and the supply-side effect shows whether the capacity itself has expanded.

The CBO's simulations state that the President's budget significantly increases cyclical growth but not supply-side growth. In other words, it will help the economy grow closer to its capacity but will not significantly increase the capacity itself. Given the fact that the economy has been growing well below its capacity for the past few years, increasing economic growth to its capacity level is a very strong argument for the President's budget.

CONCLUSION

The CBO's analysis of President Bush's budget proposal indicates that it would increase economic growth, create jobs, and recover much of the lost tax revenues. Congress should not passively assume that these economic benefits will happen on their own. Nor should Congress 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 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.

Appendix

Excerpts from Congressional Budget Office Analysis
of the President's Budgetary Proposals for Fiscal Year 2004

The President's tax proposals would encourage investment and economic growth:

The President's budget could also affect potential output by changing the mix of capital over time. The proposal with the greatest potential to change the composition of the capital stock is the one to reduce double taxation of corporate income. Some corporate income is taxed twice: once at the corporate level by the corporate income tax and again at the personal level by the individual income tax. That tax treatment creates a distortion in the allocation of capital, discouraging investment in the corporate sector relative to the housing and noncorporate business sectors. As a result, less capital is held in the corporate sector than is efficient. The taxation of dividends also encourages firms to finance investment with debt rather then equity (because interest payments on debt are deducted from tax at the corporate level and so only taxed once), which may also lead to economic inefficiencies. Reducing the tax on dividends would lessen those inefficiencies, thereby increasing overall economic output.4
However, some tax proposals in the President's budget would tend to reduce consumption by increasing the after-tax rate of return on savings. Accelerating and making permanent EGTRRA's [Economic Growth and Tax Relief Reconciliation Act of 2001] reductions in marginal tax rates, reducing the share corporate income subject to double-taxation, and expanding tax-free savings accounts would all reduce the marginal tax rates on income from savings.... Overall, those changes would increase the after-tax return on savings.5

However, new investment would be reduced by government consumption:

The economic impacts should not, of course, be evaluated on a dollar basis alone. For example, as noted above, the proposals would alter marginal tax rates on capital and labor. Over the long term, the effects of budgetary policies depend on the degree to which they alter incentives to acquire skills, work, save, innovate, and undertake investments. Indeed, a subset of the President's proposals are intended to increase those incentives. Those proposals would not operate in isolation, however. The remainder of the revenue proposals and those that would increase spending embody few such incentives. They likely would tend to reduce growth in the long run by increasing government and private consumption, at the expense of saving and investment.6

Investment would also be reduced by government-financed private consumption:

The President's budgetary policies would also influence private consumption in a number of ways. For one, the budget would increase disposable income through reduced taxes and increased transfer payments (such as a Medicare prescription drug benefit). That would tend to boost consumption, because people would probably spend some of that extra disposable income.7

Therefore, government spending reduces investment and economic growth:

Most of CBO's estimates indicate that the President's budget would increase the sum of private and government consumption on net, which would tend to imply somewhat less investment and a smaller capital stock.8
The primary supply-side effect in 2006 through 2008 is the crowding out of capital due to higher government and private consumption, which decreases output by about half a percent on average.9
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 private sector, which would tend to reduce investment.10
The President's budgetary policies would affect the size of the capital stock--the nation's stock of productive equipment such as factories and information systems--primarily through their impacts on government and private consumption and, therefore, on investment. The policies would directly increase government consumption relative to the level in CBO's baseline. That increased government consumption would tend to reduce investment in productive capital by reducing the resources available.11

Show references in this report

1. Congressional Budget Office, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, March 2003, at www.cbo.gov. "Dynamic" scoring of budgetary changes means using a model of the U.S. economy to determine how the proposed spending or revenue change would be likely to affect overall economic performance and, thus, federal fiscal results. For a discussion of how dynamic scoring works, see Daniel J. Mitchell, Ph.D., "The Correct Way to Measure the Revenue Impact of Changes in Tax Rates," Heritage Foundation Backgrounder No. 1544, May 3, 2002, at www.heritage.org/Research/Taxes/BG1544.cfm.

2. Daniel J. Parks, "Crippen Says He Will Keep Resisting Dynamic Scoring," Congressional Quarterly, June 14, 2002.

3. The CBO staff also used several esoteric, largely academic models in assessing the fiscal and economic effects of the President's 2004 budget proposals. Specifically, the CBO made assessments of how much difference it would make to fiscal and economic outcomes if (1) taxpayers either knew nothing or everything about future economic activity and (2) cared nothing about their children and grandchildren and consumed all of their income during their lifetimes or sacrificed their own comfort for the benefit of future generations.

4. CBO, An Analysis of the President's Budgetary Proposals for Fiscal Year 2004, p. 26 (emphasis added).

5. Ibid., p. 22 (emphasis added).

6. Ibid., p. 16 (emphasis added).

7. Ibid., p. 22 (emphasis added).

8. Ibid., p. 25 (emphasis added).

9. Ibid., p. 31 (emphasis added).

10. Ibid., p. 16 (emphasis added).

11. Ibid., p. 21 (emphasis added).

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