Myths, misconceptions, and errors
increasingly are confusing the public debate on taxes, spending,
and budget deficits.
Economic misinformation begins with
politicians, who are usually more concerned with winning the next
election than with seeking "economic truth." And winning generally
requires presenting their own views favorably and their opponents'
However, precise economic theories and
ambiguous data results rarely produce the sound bites needed for a
30-second political hit piece. Consequently, politicians routinely
oversimplify complex principles, manipulate data to serve their own
ends, and reverse their positions as guided by polling data. It is
the public's duty to hold politicians accountable for the policies
they enact based on failed economics.
political leaders communicate to their constituents, the media
transmit and often analyze those messages. How Americans view the
world, their government, and the economy is therefore largely
influenced by what the media tell them.
media reports often contain economic misinformation. Reporters do
not purposely mislead their readers and viewers: They have a nearly
impossible job. Journalists with little or no academic training in
economics are asked to define, explain, and often settle debates in
an increasingly complex academic field where debates often come
down to dueling statistical models.
Added to the mix are politicians who
recklessly twist the field's principles and data to suit their
political agendas. Is it, therefore, any wonder that economic
mythology has become widespread?
paper refutes 10 common myths about taxes, spending, and budget
deficits that are spread by politicians and reporters.
Government spending "pumps new money into the economy."
Every dollar that government injects into the economy must first be
taxed or borrowed from it.
Lawmakers and reporters often repeat the
Keynesian myth that government spending "pumps new money into the
economy." They assert that if the economy's total demand is
lacking, government can act as a consumer and make purchases
itself. Since the gross domestic product (GDP) is the sum of all
purchases on final goods and services, these government purchases
will add to GDP.
This raises the obvious question: Where
does the government get the money that it pumps into the economy?
The government does not have its own money, so every dollar the
government pumps into the economy must first be taxed or borrowed
from it. This means
that government spending does not create new income; it merely
shifts existing income.
Economists differentiate between two types
of government spending. "Transfer payments," such as Social
Security and farm subsidies, tax or borrow money from one group and
transfer it to another group. Even Keynesian economists acknowledge
that transfer payments only move existing income and do not affect
second type of government spending is "direct purchases" from the
private sector--for example, the Defense Department buys fighter
jets from Boeing, and Medicare buys health care services from
doctors. Keynesians believe these purchases expand GDP. In fact,
they are counted as part of GDP. Yet the money spent on them had to
be first taxed or borrowed from people who otherwise would have
spent the money themselves. Consequently, these government
purchases merely displace private purchases, leaving total economic
activity unchanged. This is true even if taxpayers saved their
money instead of spending it (as explained in the next
reality that every dollar government injects into the economy must
first be taxed or borrowed has been termed the "Government Budget
Restraint" (GBR) by The Wall Street Journal's Robert Bartley. The GBR displays the
futility of government "pump-priming," intended to alter total
demand in the short run.
does not necessarily mean that government spending can never help
the economy. Under certain circumstances, the right government
spending could add to the economy's long-term supply side.
Sustained economic growth requires consistent investment in public
infrastructure (such as roads), private capital (to expand
businesses and technologies), and human capital (such as education
and a motivated workforce). These investments create economic
growth by helping businesses to produce and sell more goods and
services more efficiently. The private sector, motivated by profit,
funds most investment needs by itself.
private investment falls short for some reason, governments could
tax consumers to fund investment (although excessive taxes would
harm investment and worker motivation, negating the policy's
effects). Investment expands the economy not because new money is
pumped into it, but because structural changes increase its
long-run capacity for growth. These structural changes can take
years, so government spending will not provide short-run economic
government "pump-priming" myth and other Keynesian myths became
widespread through Paul A. Samuelson's introductory economics
textbook Economics, which was introduced to college students in
1948. While the economics profession has long since abandoned much
of Keynesianism, Samuelson's textbook has not been replaced with a
more suitable one, leaving two generations of college freshmen
(including today's lawmakers and reporters) exposed to outdated
Samuelson has acknowledged his extended
influence by saying "I don't care who writes the nation's laws--or
crafts its advanced treaties--if I can write its economics
students taking upper-level economics courses move beyond Samuelson
and into the last 60 years of economic thought.
Contemporary economic growth theory has
moved well beyond simplistic 1940s economics. It is time for
Congress and the media to catch up.
Tax cuts help the economy by "putting money in consumers'
The right tax cuts help the economy by creating incentives to work,
save, and invest.
Government Budget Restraint shows that government spending does not
"pump new money into the economy" because government must first tax
or borrow that money from the economy. Tax cuts represent the flip
side of the previous section's government spending example.
government spending, the money for tax cuts does not drop out of
the sky. It comes from investment (if financed by budget deficits)
or government spending (if offset by spending cuts). Every dollar
government "puts in consumers' pockets" means one fewer dollar in
governments', businesses', and investors' pockets.
Keynesians argue that government can
increase total spending by transferring money from savers to
spenders--an argument that assumes that taxpayers store their
savings in their mattresses, thereby removing it from the
economy. In reality,
nearly all Americans either invest their savings (where it finances
business investment) or deposit it in banks (which quickly lend it
to others to spend). Therefore, the money is spent whether it is
initially consumed or saved.
cuts do not increase the economy's short-run demand because they
must be offset by equal reductions in investment and/or government
spending. However, the right tax cuts can add substantially to the
economy's long-term supply side. As stated in the previous section,
economic growth requires that businesses efficiently produce
increasing amounts of goods and services, and that requires
consistent business investment and a motivated, productive
workforce. Yet high marginal tax rates--defined as the tax on the
next dollar earned--serve as a disincentive to engage in those
activities. Reducing marginal tax rates on businesses and workers
will increase incentives to work, save, and invest. These
incentives create more business investment and a more productive
workforce, both of which add to the economy's long-term capacity
Because supply-side tax cuts are not
designed simply to "put money in people's pockets," their
proponents are not overly concerned with whether recipients are
rich or poor. The best tax cuts maximize long-run economic growth,
which in turn raises incomes across the board. Should a $1 capital
gains tax cut, which can induce enough investment and worker
productivity to create $10 in new long-term economic growth, be
rejected because much of that $1 in lower taxes will go to
wealthier individuals? The $10 in new economic growth matters much
more than who receives the $1 tax cut.
reporters and lawmakers propose demand-side tax cuts to "put money
in people's pockets" and "get people to spend money." The 2001 tax
rebates serve as an example: Washington borrowed billions from
investors and then mailed that money to families in the form of
$600 checks. This simple transfer of existing income had a
predictable effect: consumer spending increased and investment
spending decreased by a corresponding amount. No new wealth was
created because the tax rebate was unrelated to productive
behavior--no one had to work, save, or invest more in order to
receive a rebate.
contrast, marginal tax rates were reduced throughout the 1920s,
1960s, and 1980s. In all three decades, investment increased and
economic growth followed: the inflation-adjusted GDP increased by
59 percent from 1921 to 1929, 42 percent from 1961 to 1968, and 34
percent from 1982 to 1989.
Instead of asking which tax cuts will put
money in consumers' pockets, reporters and lawmakers should ask
which policies will best encourage the work, savings, and
investment needed to expand the economy's long-term capacity for
Budget deficits substantially increase interest rates.
Budget deficits have only a trivial effect on interest rates.
Higher interest rates have become the
chief argument against any policy that would increase the budget
deficit. Since 2000, the $236 billion budget surplus has been
replaced by an estimated $300 billion budget deficit. However,
instead of increasing, the real interest rate on the 10-year
Treasury bond has actually dropped from 3.7 percent to 2.3
percent. (See Chart
theory, higher demand for a commodity will cause higher prices.
Money is no different: An increase in the demand for borrowing
money will increase the price of borrowing money (i.e., the
interest rate). This is true regardless of whether the borrower is
a government, a corporation, or an individual.
more important question is by how much the interest rate will
increase, and that depends on how much is being borrowed and
whether the market is large enough to absorb that amount. Today's
global economy is so large--trillions of dollars move around the
globe each day--that it can easily absorb the federal government's
borrowing without triggering a substantial increase in interest
Harvard economist Robert Barro studied the
economies of 12 major industrialized countries and found that:
- Real interest rates depend on the total
debt relative to GDP, not the annual change in budget deficits. The
debt-to-GDP ratio shows whether an economy is large enough to
absorb the total level of public debt. America's debt-to-GDP ratio
was over 100 percent after World War II, was at 50 percent in 1994,
and is just 36 percent today.
- Overall debt-to-GDP ratios across the 12
countries matter more than what happens in one country. If one
country borrows to finance its debt, capital seekers can still find
cheap capital in other countries, thus averting the shortage that
would raise interest rates.
- A 1 percent increase in America's
debt-to-GDP ratio raises interest rates by approximately 0.05
percent. If all 12 countries increased their ratios by 1 percent,
interest rates would increase by approximately 0.1 percent.
- These small movements are usually
overwhelmed by larger trends affecting real interest rates, such as
economic growth and expectations of future inflation.
President George W. Bush's tax cuts wiped out the projected budget
The 2001 recession and new government spending caused 78 percent of
the declining surplus projection.
myth will surely be repeated hundreds of times before the 2004
election. In January 2001, the Congressional Budget Office (CBO)
projected a combined 2002-2011 budget surplus of $5,610 billion.
Now the CBO projects a cumulative deficit of $376 billion for those
10 years. According
to CBO data, 46 percent of the drop in the surplus is due to the
sluggish economy and the correction of prior forecasting errors.
(See Chart 2.)
Congress and the President caused another 32
percent of the decline by spending more money than projected. Much
of this was defense-related, but large increases in programs like
education and farm subsidies contributed to the spending
leaves 22 percent of the decline caused by tax relief provided by
President Bush's 2001 tax cut and the 2002 economic stimulus
bill--and even that may be an overestimation because it assumes
that tax relief did not prevent an even deeper recession.
past recession means the economy will create $5 trillion less
wealth over the 2002-2011 period than the CBO had projected in
January 2001. This
represents $5 trillion less income for businesses to create jobs
and families to make ends meet. Yet Congress and the media seem
most concerned about how the government will have $5 trillion less
wealth to tax, as evidenced by their obsessive focus on the lost
Instead of trying to recover the
government's lost tax revenue, Congress should enact policies that
create long-term economic growth so that families and businesses
can recover their own lost wealth.
The "wealthiest 1 percent" of taxpayers are just millionaires who
pay fewer taxes every year.
Most are actually small businesses, which are assuming more of the
tax burden every year.
Politicians often deride policies aiding
the "wealthiest 1 percent" of Americans. Reporters paint pictures
of fat cat millionaires eating lobster in their cavernous mansions,
indifferent to the poverty their wealth undoubtedly caused.
facts, however, paint a far different picture. Of the 750,000
taxpayers who pay the highest marginal tax rate of 35 percent--the
top 0.5 percent of all taxpayers--more than two-thirds report
small-business income. While corporations pay the corporate
income tax, most small businesses pay the individual income tax.
These small businesses are generally concentrated in the higher
income tax brackets.
when politicians call for higher taxes on the top 1 percent, they
are really proposing higher taxes on small businesses. Prior to the
2003 tax cut, these small businesses paid a higher top tax rate
(38.6 percent) than most large corporations (35 percent). Yet
businesses with fewer than 100 employees represent 98 percent of
all businesses and create 36 percent of all jobs. They are the
engines of new job creation, and taxing them out of business only
wealthiest 1 percent--again, mostly small businesses--are not
undertaxed. In 2000, they earned 21 percent of the income and paid
37 percent of all individual income taxes. Businesses also bear
nearly all the cost of the 15.3 percent payroll tax, including the
half that is removed from their employees' paychecks.
comparison, the bottom 50 percent of all taxpayers earn 13 percent
of all income and pay just 4 percent of all individual income
taxes--and that percentage is dropping rapidly.
Overall, the intense focus on "income
distribution" is misguided, because:
- It assumes that the economy is a fixed pie
and that one group's wealth causes another group's poverty. In
reality, the economy is expanding, and all income classes are
getting wealthier. Some incomes will grow faster than others, yet
the vast majority of Americans enjoy rising incomes throughout
their lifetimes. Even America's "poor" would be considered
middle-class in Europe and upper-class almost anywhere else. By
contrast, socialist countries (e.g., North Korea, Cuba, and the
former Soviet Union) have achieved relative income
equality--everyone is equally poor.
- People often move across income ranges.
Much of the bottom half consists of younger, unmarried workers who
move into the top quarter as they marry and enter their peak
earning years before dropping back down after retirement. Accordingly, lifetime
incomes (and taxes paid) are much more equal than one-time "income
distribution" snapshots would show.
- The term "income distribution" implies
that the nation's wealth simply falls from the sky and that
Washington has a duty to distribute this bounty fairly. But wealth
and income are not "distributed," they are created. When Microsoft
turns sand into computer chips, it is creating wealth where none
existed. A farmer who grows a field of corn is creating wealth.
These workers and businesses should have the right to keep much of
the wealth they create.
President Ronald Reagan's tax cuts caused the budget deficits of
Real tax revenues increased 28 percent during the 1980s, but
spending increased 36 percent.
many politicians and reporters have repeated this myth so often
that it has become conventional wisdom. No evidence accompanies
this claim beyond the correlation that both tax relief and budget
deficits occurred during the 1980s.
correlation does not guarantee causation. A basic examination of
1980s budget data shows that high spending, not low tax revenues,
caused the budget deficits.
Although President Reagan signed major tax
cuts into law in 1981 and 1986, inflation-adjusted tax revenue
increased by 28 percent during the 1980s--an even larger jump than
the 27 percent revenue increase during the high-tax 1970s. (See Charts 3 and
Yet budget deficits were larger in the 1980s
because inflation-adjusted federal spending increased by 36
percent. These budgets resulted from deals in which the Democratic
Congresses agreed to pass tax relief and increase defense spending
and President Reagan agreed to sign into law new domestic social
spending. This rapid increase in spending, not any alleged revenue
losses from tax relief, created the budget deficits.
Congressional Republicans are using their majority to enforce
Recent Republican Congresses have increased real spending by $404
billion in just five years.
Reporters and pundits too often limit
their analysis to oversimplified stereotypes. They begin with the
assumption that Republicans are wealthy, heartless, anti-tax budget
cutters and that Democrats are well-meaning, yet bumbling,
tax-and-spend liberals, and they seek stories that fit these
Despite reports of heartless budget
cutting, the past few Republican Congresses have distinguished
themselves by outspending their predecessors. Federal spending has
increased by an astounding $586 billion ($404 billion after
inflation) since 1998.
more meaningful context, Washington will spend $21,000 per
household in 2003, up from $16,000 in 1998. After adjusting for
inflation, this constitutes the largest five-year expansion of
government in half a century. Only during the height of World War
II did Washington spend more per household than it will this year.
While deficits are funding the increase right now, Washington
eventually will have to collect an extra $5,000 per household in
taxes to fund the extra $5,000 in spending.
Lawmakers often claim little control over
mandatory spending and ask to be held accountable only for
increases in discretionary spending, which is legislated on a
year-by-year basis. However, restricting the analysis to
discretionary spending does not make lawmakers appear any more
frugal. After holding at around $500 billion throughout the 1990s,
discretionary spending increased from $584 billion in 2000 to $843
billion in 2003--a 44 percent increase in just three years. (See
Chart 5.) The Republicans' image of spending restraint is clearly
undeserved, and their spending spree eventually will mean a higher
tax burden for businesses and families.
Congress is cutting domestic programs to fund defense.
Congress has added substantially more money to domestic programs
than it has added to defense.
York Times opinion columnist Bob Herbert has repeatedly asserted
that President Bush and congressional Republicans are slashing
domestic spending. He describes "gruesome" budgets with "drastic
cuts" designed to "weaken programs that were designed to help
struggling Americans." This "assault on society's weakest elements"
is allegedly "taking food off the tables of the poor" so that
Congress can instead fund "an ill-advised, budget-busting war" that
is pursued by a President with "outright hostility toward America's
poor and working classes."
While heavy on ad hominem attacks,
however, Mr. Herbert's columns are light on data supporting his
claims of dramatic budget cuts.
reality, the Republican Congress has not slashed non-defense
spending to fund the military. Table 1 shows that under the
Republican Congress, inflation-adjusted federal spending has jumped
22 percent in the past five years, and nearly two-thirds of that
increase is non-defense spending. (See Table 1.) This includes massive
new spending for farm subsidies, education, highways, health
research, and unemployment benefits. Substantial increases are even
going to lower priority programs, such as the Agricultural
Marketing Service (83 percent), Power Marketing Administration (104
percent), and Denali Commission (from $0 to $74 million). If debt
interest payments had not dropped by $106 billion, spending totals
would be even higher.
Thus, Washington's real budget problem is
spending too much, not too little. Lawmakers are refusing to set
priorities and instead are granting record spending increases for
all types of government programs. These guns-and-butter budgets are
similar to those that led to high taxes and economic stagnation in
the 1960s and 1970s. Federal borrowing can fund this spending in
the short run, but Congress eventually will have to raise taxes by
$5,000 per household to fund this reckless spending spree.
Social Security surpluses are saved in a trust fund for future
These surpluses, like all other tax revenues, are spent
Reporters and politicians repeatedly claim
that certain proposals will "raid the Social Security trust fund."
This is impossible because there is no Social Security trust fund
with any money to raid. Social Security surpluses are spent
automatically on other programs each year, regardless of
Social Security and corporate pension
funds operate in different ways. When a corporation collects
employee contributions, it can (1) store it in a safe until the
employee retires, (2) invest it in a low-risk external asset that
will return a slight profit, or (3) spend it on current expenses
like payroll or rent. With options 1 and 2, the initial
contribution will be waiting in the pension fund when the employee
retires. With option 3, the money is gone and the business cannot
pay its employee, likely landing the company's pension fund manager
Option 3 best describes how Social
1983, the Greenspan Commission proposed raising the Social Security
payroll tax well above the current benefit level as a way to make
Social Security solvent for future generations. The idea was to
"save" the surplus in a trust fund for future retirees. However,
federal law requires the Social Security Administration to "invest"
the money in Treasury bonds. In other words, the government lends
the money to itself. The Treasury Department then mixes it with all
other tax revenue, which is spent on programs like education,
foreign aid, and defense.
Around 2018, the Social Security program
will need to begin redeeming its bonds from the Treasury. Having
already spent the money, the Treasury will be unable to repay the
Social Security program. Consequently, taxpayers will be forced to
fund Social Security's 40 million retiring baby boomers from
scratch, without any of the surpluses that had been paid into the
Social Security program for the past 35 years.
far better parallel is a family that borrows money from its
retirement fund each year to pay for vacations and expensive
dinners. When they finally retire, their retirement fund consists
of nothing more than paper IOU's promising to repay the fund.
Another Social Security myth is that only
budget deficits cause money in the trust fund to be spent. Whether
it is President George Bush's tax cuts or Representative Richard
Gephardt's health care plan, critics regularly assert that any
policy increasing the budget deficit will mean "more money taken
out of the Social Security trust fund."
claim is likewise wrong. The entire Social Security surplus is
spent by the Treasury regardless of whether the budget is in
surplus or deficit.
- If the rest of the budget is in deficit,
the Social Security surplus is used to fund current government
- If the rest of the budget is in surplus,
the Social Security surplus is used to pay down the national
Either way, the Social Security program
does not actually save its surpluses for future retirees.
entire debate about budget deficits "raiding the trust fund" and
about building a "lockbox" is moot. All Social Security surpluses
have been and will continue to be spent on other programs
regardless of whether the budget is in surplus or deficit, and
regardless of whether taxes are raised or lowered.
A federal bailout of the states would help tax-weary state
U.S. taxpayers would fund the federal bailout.
State legislators are working to close
budget gaps that total $22 billion nationwide. These crises
resulted from state overspending. General fund revenues have
climbed 46 percent since 1990, but state spending climbed by 50
percent. Total state spending per year exceeded $1 trillion for the
first time ever in 2000 and has continued to rise.
State spending growth has even outpaced
federal spending growth, which has increased by "only" 29 percent
since 1990--and has included paying for two Gulf wars. If state
governments had committed themselves to growing no faster than the
federal government, they could have balanced their 2003 budgets and
had enough money left over to cut taxes by $525 per household. If
they had increased spending by no more than the rate of inflation,
they could have cut taxes by $1,372 per household. Instead, the
states created their own budget problems by spending all of their
new revenue and then some.
Regardless of who is to blame, sending
federal aid to states does not save taxpayers a dime because the
same taxpayers who fund state budgets also fund federal budgets. Just as some families
respond to unaffordable MasterCard debt by running up their Visa
debt instead, thereby solving nothing, a federal bailout runs up
families' federal tax bill in order to reduce their state tax
bill--also solving nothing.
Critics respond that 49 states are
hampered by their own balanced budget amendments and that 37 states
are losing tax revenue because they use federal income and taxes as
a starting point for calculating personal state taxes. However,
these policies were enacted by the states themselves, and they can
rewrite them as they see fit. If states now believe deficit
spending is wise, they should repeal their balanced budget
amendments. If states want their tax revenues to increase faster
than Washington's, they can enact new tax policies.
Meanwhile, a handful of states including
Wyoming, Michigan, and Colorado generally have resisted adding
extravagant programs over the past decade. As a result, their
shortfalls are far smaller than those of other states such as
California and New York. It is fundamentally unfair for California
lawmakers to go on a spending binge and then send the tab to
Wyoming taxpayers via Congress.
Basic accountability demands that the unit
of government that spends the money should have to collect the
taxes. If state spending is financed by state taxes, elected
officials cannot spend beyond their constituents' willingness to be
taxed. But when states can simply withdraw whatever money they need
from the federal ATM, the incentive to weigh benefits against costs
Granted, Washington should remove the
unfunded mandates that require states to spend their own tax
revenues on Washington's priorities, but unfunded mandates are
still an undeserved scapegoat for state spending. In reality, only
two significant mandates have been enacted since 1995, costing the
average state $9 million per year, or less than one-tenth of 1
percent of most states' general fund budget. Many of the "mandates" in education
and homeland security are not mandates at all: State participation
is voluntary, meaning states can opt out if federal funds do not
cover all costs. Although Medicaid is an unfunded mandate in need
of serious reform, states made the problem even worse by rapidly
expanding their expensive Medicaid programs throughout the
Reporters and state lawmakers see a
federal bailout as a free lunch. It is not. Taxpayers fund federal
bailouts the same way they fund state spending. Furthermore, if a
bailout induces states to continue spending recklessly on the
assumption that taxpayers from other states will bail them out, the
total cost to taxpayers will only increase.
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.