July 16, 2004 | WebMemo on Federal Budget
Taxes, the Deficit & the Size of Government
June 25, 2004
Dan Mitchell, Senior Fellow at The Heritage Foundation
Bruce Bartlett, Senior Fellow at National Center for Policy Analysis
Scott Hodge, President of the Tax Foundation
Moderator: John Berthoud, President of the National Taxpayers Union
Senior Fellow in Political Economy, The Heritage Foundation
It is the size of government that matters, not necessarily how it is financed.
Isn't the deficit what is important? I would argue no. You have several countries in Europe, including many in Scandinavia, that have balanced budgets, and yet their governments are consuming more than fifty percent of GDP. Their economies are in the tank, unemployment rates are rising, per capita income is falling, and there is no private sector job creation. There is no nirvana in a balanced budget. Milton Friedman said many years ago that he would rather have a $500 billion budget with a $200 billion deficit, than a $1 trillion budget that was balanced. The point is we are better off with a smaller government with a deficit than with a bigger government where the budget is balanced. Why? Because government spending is associated with worse economic performance.
Not all government programs are created equal. Every government program has a rate of return, and we have to compare that rate of return from the government program with the rate of return those resources would generate in the private sector. In other words, government can't create wealth out of nowhere. When government spends money, it has to extract that money from the productive sector of the economy. Sometimes they tax the money out of the economy. Sometimes they borrow the money out of the economy. But in either case, each time the government spends one dollar, there is one dollar less in the private sector.
The effect of deficits on interest rates is very tiny. One way to think about this is that if you were to dump a pitcher of water into the Potomac, theoretically the water level would rise. Can you measure it? No. Well, that is the way deficits affect interest rates in the modern global economy. We have a global economy where two trillion dollars changes hands every day. So the argument that even a large change in government deficits is going to have an affect on interest rates just doesn't wash.
To the extent that we allow spending to go up and up, it will create pressure for higher taxes, it will put at risk the tax cuts Congress has passed over the last few years. To the extent that we allow spending to grow out of control, we are sowing the seeds for the Europeanization of America, which is certainly something we can all agree we don't want.
Government spending is the problem. We need to get back to what Ronald Reagan talked about: Government is the problem, it is not the solution.
Senior Fellow, National Center for Policy Analysis
We can probably run modestly-sized deficits forever, but because we have a retiring baby boom generation, the first of whom will retire in 2008, and the White House and Congress have added on a multi-trillion dollar drug benefit on top of massive amounts of pork-barrel spending, we have to ask some serious questions about how we are going to finance government.
There is now consensus among economists that we want to have the lowest possible tax rates and the broadest possible tax base.
Some people will argue that we don't need to worry about the revenue effect of tax cuts because whenever we cut taxes revenues will go up. The research suggests that Reagan's first tax cut only lost two-thirds of the revenue that the Treasury said it would. So there is a Laffer Curve effect in the sense that you don't ever lose as much revenue from cutting taxes as the static estimates would suggest. But the idea that we're going to magically balance the budget by cutting taxes is ludicrous. We have to be responsible and take care of the spending problem.
We need to clean up the tax code and get away from the government telling people how to spend their money, and how to live, and how to behave.
We ought to worry about the calls to repeal the Bush tax cuts, and in particular, cuts on the wealthiest Americans. The economic effects of raising taxes, especially on the highest-income Americans, will have a far greater effect than deficits on interest rates.
Repealing all of the Bush tax cuts would only reduce the deficit by one-third. What does that mean? It means that spending is the problem. And that is even on a static basis, which assumes that people won't change their behavior if you whack them with higher taxes. But we do know that people change their behavior if you raise their taxes, especially at the highest marginal rates. There is a misconception about the rich. There is a presumption that all the rich are the Michael Jordans, the entertainers, and that they won't change their spending behavior if you tax them a little more. That's not true. Those affected by the highest income tax rates are principally entrepreneurs and business owners. In fact, three-quarters of all those taxpayers hit by the 35 percent tax have business income in one form or another.
Now we don't need to love the deficit, but I think that we can certainly live with it until the economy begins to generate more and more tax revenues that will bring the deficit down naturally. That is, of course, unless Congress spends it before it hits the Treasury door.
Question: Could you explain the correlation between the deficit and interest rates?
Mr. Mitchell: It's not that deficits have no effect on interest rates; it's just that the empirical research indicates that the effect of deficits on interest rates is very small. We have a global capital market with trillions of dollars trading hands and all these other things like inflationary expectations and demand for credit. These are the things that are very important in terms of affecting interest rates, not whether the U.S. budget deficit is $100 billion higher or lower.
Question: Is it the deficit or the debt that is important regarding interest rates?
Mr. Bartlett: The deficit is merely the annual increment to the debt. And actually that's an interesting way to look at it. If we have a $3 trillion debt and we run a $100 billion deficit, that is only a 3 percent addition to the debt. It is the stock of debt that influences interest rates, not the annual increment.