July 13, 2005

July 13, 2005 | WebMemo on Federal Budget

The Tax Cuts Are Working, Yet Spending Challenges Remain

The Office of Management and Budget's Mid-Session Review shows surging tax revenues decreasing the projected budget deficit. Working families and businesses sending more taxes to Washington is not worthy of celebration, but the underlying cause of this revenue increase-an improved economy-is good news. Lawmakers, however, should not use this good news as an excuse to shirk their responsibility to rein in spending.

A strong economy and a growing tax base are exactly what proponents of the 2003 tax cuts predicted. The 2001 tax cuts, which relied more on an immediate tax rebate than reducing marginal rates, did not create the incentives to work, save, and invest needed to boost productivity and grow the economy. Thus, the 2001 tax cuts could not reverse the job losses and declining revenues that stemmed from the 2001 recession. By contrast, the 2003 tax cuts accelerated scheduled marginal tax rate reductions, reduced taxes on business investment, and reduced the double taxation of dividends and capital gains. Each of these tax cuts was linked to a productive activity.

 

One of the productive activities that benefited from the 2003 tax cuts was business investment. Reducing the taxation of capital encouraged businesses to expand and invest, which they did. After declining or remaining nearly flat for nine straight quarters, business investment has increased between 5 and 18 percent in each of the seven quarters following passage of the 2003 tax bill.[1] By powering economic growth with business investment, rather than just consumption, the 2003 tax cuts created a framework for substantial long-term economic growth.[2]

 

The 2003 tax cuts also returned many Americans to work. Since the passage of the 2003 tax cuts, 4 million new jobs have been created. Today's 5-percent unemployment rate-the lowest since September 2001-means that many Americans left unemployed by the 2001 recession have now returned to work and become taxpayers.[3]

Overall, tax revenues declined slightly between 2001 and 2003, then increased 5 percent in 2004, and are now on pace to gain 15 percent in 2005.[4] This is not to suggest that tax cuts fully pay for themselves. Rather, the right tax policies can remove barriers to economic growth and sufficiently expand the tax base to replenish many (but not necessarily all) of the revenue losses from lower tax rates. Revenue estimates based on static models that do not look at how taxes affect employment or business behavior will diverge significantly from real-world results. The failure to use dynamic modeling is why government projections of tax revenue have been too low.

Too many observers will focus on how higher revenues reduce the projected FY 2006 budget deficit. The budget deficit remains the most overrated government statistic. Government spending (which diverts resources from the productive private sector to the less-productive government) and tax policies (which distort and reduce working, saving, and investing) each strongly influence economic growth. The difference between those two numbers-the budget deficit-is less important. The record-low interest rates of the past 4 years show that modest budget deficits do not harm economic growth. However, taking money from the private sector harms economic growth, regardless of whether that money is seized through taxes or borrowing.[5]

The only way to restrain long-term tax rates and budget deficits is to restrain long-term spending. The danger is that lawmakers may use the reduced budget deficit as an excuse to continue expanding the federal government. Federal spending has already jumped 33 percent since 2001, to a peacetime record of $22,000 per household. Over the next decade, as the first baby boomers retire, Medicare is projected to grow by 9 percent per year, Medicaid by 8 percent per year, and Social Security by 6 percent per year. Defense, homeland security, and other discretionary spending priorities will also force upward pressure on spending. No economic boom will provide enough tax revenue to keep up with this runaway spending. Unfortunately, lawmakers are preparing to spend this unprojected tax revenue as fast as it comes in-for example, by enacting a budget-busting highway bill.

 

Instead, lawmakers must recognize that sustained long-term spending increases will eventually require long-term tax increases that would reduce economic growth and kill jobs. Their first step should be entitlement reform and delaying implementation of the new Medicare drug entitlement next year. It is not responsible for lawmakers to commit to spending $2 trillion over the next two decades on a new entitlement without producing any plan to pay for it. This expensive new entitlement is the main reason Medicare spending is projected to leap by $101 billion over the next two years.

Lawmakers should also enact a federal Taxpayers' Bill of Rights statute that limits annual spending increases to the inflation rate plus population growth. Such a law would force lawmakers to do what families already do: set priorities and make trade-offs. A federal Taxpayers' Bill of Rights would create a framework to save as much as $4 trillion over the next decade, which is enough to make the recent tax cuts permanent, fix the Alternative Minimum Tax, transition Social Security to personal accounts, and reduce the budget deficit.[6]

Increased tax revenues show once again that the 2003 tax relief is working. Yet long-term spending projections remain dire. Lawmakers should not abandon efforts to rein in spending.

Brian Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs in the Thomas A. Roe Institute for Economic Policy Studies, and Rea S. Hederman, Jr., is Manager of Operations and a Senior Policy Analyst in the Center for Data Analysis, at The Heritage Foundation.

About the Author

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

Rea S. Hederman, Jr. Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis

Show references in this report

[1] Bureau of Economic Analysis/Haver Analytics.

[2] See Daniel J. Mitchell, Ph.D., "A 'Supply-Side' Success Story," Heritage Foundation Webmemo No. 775, June 7, 2005, at http://www.heritage.org/Research/Taxes/wm755.cfm.

[3] Bureau of Labor Statistics/Haver Analytics.

[4] Congressional Budget Office, "Monthly Budget Review," July 7, 2005 at http://www.cbo.gov/showdoc.cfm?index=6513&sequence=0.

[5] See Daniel J. Mitchell, Ph.D., "The Impact of Government Spending on Economic Growth," Heritage Foundation Backgrounder No. 1831, March 15, 2005, at http://www.heritage.org/Research/Budget/bg1831.cfm.

[6] See Brian Riedl, "Restrain Runaway Spending with a Federal Taxpayers' Bill of Rights," Heritage Foundation Backgrounder No. 1793, August 27, 2004, at http://www.heritage.org/Research/Budget/bg1793.cfm.