June 13, 2003 | Backgrounder on Federal Budget
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' views unfavorably.
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.
When 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.
Yet 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.
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.1 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 GDP.
The 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 section).
The 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.2 The GBR displays the futility of government "pump-priming," intended to alter total demand in the short run.
This 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.
If 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 stimulus.
The 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 1940s economics.
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 textbooks."3 Only students taking upper-level economics courses move beyond Samuelson and into the last 60 years of economic thought.
The 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.
Like 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.4 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.
Tax 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 for growth.
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.
Yet 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.
In 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 1989.5
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 growth.
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.6 (See Chart 1.)
In 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.
The 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 rates.
Harvard economist Robert Barro studied the economies of 12 major industrialized countries and found that:7
This 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.8 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 increases.
That 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.
The past recession means the economy will create $5 trillion less wealth over the 2002-2011 period than the CBO had projected in January 2001.9 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 budget surplus.
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.
The 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.10 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.
So 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 eliminates jobs.
The 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.
By 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.11
So 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.
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.13 (See Charts 3 and 4.)
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.
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 stereotypes.
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.
In a 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.
New 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."14
In 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.15 (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 retirees.
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 congressional action.
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 in prison.
In 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.
A 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."
The 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.
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.16
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.17 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 vanishes.
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.18 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 1990s.
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.
4. In John Maynard Keynes' defense, he wrote during the Great Depression, when people feared bank failures so much that they actually did store their savings in their mattresses. In that environment, redistributing income to consumers would lead to more economic activity.
5. See Daniel J. Mitchell, Ph.D, "Lowering Marginal Tax Rates: The Key to Pro-Growth Tax Relief," Heritage Foundation Backgrounder No. 1443, May 22, 2001, at www.heritage.org/Research/Taxes/BG1443.cfm.
8. These calculations compare the Congressional Budget Office's January 2001 estimate with its March 2003 estimate. These two baselines were linked together using intermediate CBO budget estimates released in January 2001, January 2002, March 2002, August 2002, January 2003, and March 2003.
9. The different 2002-2011 GDP estimates are from Congressional Budget Office, "The Budget and Economic Outlook: Fiscal Years 2002-2011," p. 135, and "The Budget and Economic Outlook: Fiscal Years 2004-2013," p. 144.
11. U.S. Department of the Treasury data provided by the Tax Foundation, at www.taxfoundation.org/prtopincometable.html.
12. A recent study showed that 80 percent of Californians in the bottom income quintile moved into a higher income quintile within 12 years. See Michael Dardia, Elisa Barbour, Akhtar Khan, and Colleen Moore, "Moving Up? Earnings Mobility in California," California Policy Review, April 2002, at www.sphereinstitute.org/pdf/CPR_v1n4.pdf.
14. See Bob Herbert, "Casualties at Home," The New York Times, March 27, 2003; "Mugging the Needy," The New York Times, April 3, 2003; "Trouble in Bush's America," The New York Times, May 8, 2003; and "The Reverse Robin Hood," The New York Times, June 2, 2003.
15. This period includes both a Democratic President and a Republican President and Republican Congresses (except for the brief Democratic Senate). Breaking the five-year increase down by President shows larger increases under President Bush than under President Clinton.
16. See Brian Riedl, "The Case Against a Federal Bailout of the States," Heritage Foundation Executive Memorandum No. 857, February 4, 2003, at www.heritage.org/Research/Budget/em857.cfm.