Feb 21 2010

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Spending, Not Tax Cuts, Cause Deficits

As we start appropriations season in this election year, tax cuts are back in the news.

President Obama spent a good portion of his State of the Union talking about his “Happy Meal” tax cuts, implemented through the Stimulus bill, as well as his proposed tax cuts for small businesses this year.

Given all the tax cut chatter, you would be forgiven if you thought that this enthusiasm represented a change of heart instead of a more diabolical change in appearance.

The fact is that the Obama Administration and most Democrats remain hostile to the kind of tax cuts that have any real hope of restoring confidence to the market and mobilizing capital to jump-start the economy; and none more so that the “holy grail of greed,” President Bush’s tax cuts on Americans earning more than $200,000.

The President’s FY 2011 budget submission allows the Bush tax cuts on higher income earners to expire at the end of 2010. The net effect is a huge tax increase on some of the most talented and productive investors and innovators in our economy at a time when those skills are at a premium.

The move also violates the iron law of economic downturns; that you do not raise taxes in the middle of a recession.

Specifically, the President’s budget would have the effect of raising the top tax rate from 35% to 39.6% for high income earners, and further limit personal exemptions and deductions. It would also raise the tax rate on capital gains and dividends from 15% to 20%.1

There are no end of Democratic justifications put forward to defend this essentially “anti-growth” increase: tax fairness; social justice; even deficit reduction. And President Obama has even developed a specific narrative to support his course. He is fond of using the Bush tax cuts as both an example of and proof of an irresponsible and discredited Republican governance philosophy, because the tax cuts were not “paid for.”

“Most of the [debt] was the result of not paying for …two tax cuts….”2

Having put so much time into the development of these arguments and narrative, do they, in fact, hold up?

First, tax fairness and social justice.

Certainly there is broad agreement for a progressive tax system where you pay more as you earn more. But there is also an enduring cross-current of moral indignation from the Left with regard to high income earners not paying “their fair share.”

So what exactly is a fair share?

According to IRS data, the top 1% of earners in the US pays 37% of all income taxes. The top 10% of earners pay almost 70%. This is in contrast to the bottom 50% who pay just 3% of income taxes.

Does progressive mean that most pay none and a relative few pay the rest?3

As you think about that, consider this paradox.

The number of million dollar tax filers increased from 180,000 in 2003 to 300,000 in 2005. Ah Ha! More proof of leftist horrors that the “filthy rich” are walking away with the store under the Bush tax relief, yes? But before you run for the pitchforks, consider that the total taxes paid by those households rose by 80% in those two years, from $132 billion to $236 billion.4

So those high income earners were actually paying more, despite the fact that they were being taxed less.

How is that possible, you ask?

Simply put, higher taxes discourage work and investment. It is an axiom that capital will flow to those places where it is most effective and gets the highest return. Lower tax rates on production, work, investment and overall risk-taking will spur and multiply those tax-paying activities, creating additional revenue for the government.

It is simple as it is proved.

So, back for a moment to the liberal argument that the tax cuts were not “paid for.”

From this comes the narrative that “reckless” tax cuts cause deficits, because they create formidable and irresponsible holes in federal revenues which are required to finance government programs, which in turn, force mass borrowing to keep the government afloat.

That reasoning is fundamentally flawed by the facts of history, if only we can look beyond slogans and rhetoric.

First, Reagan.

He was downright “reckless” from a Democratic perspective. Reagan cut the top tax rate from 70% to 28% during his term. By conventional Democratic calculations, this should have resulted in a monumental loss in revenues.

But that didn’t happen. In fact, the opposite happened.

Look for yourself.5

Year Federal Revenues
1981 $ 619.5 billion
1982 $ 608.8 billion*
1983 $ 612.9 billion
1984 $ 683.2 billion
1984 $ 745.1 billion
1986 $ 781.8 billion
1987 $ 867.8 billion
1988 $ 925.0 billion
Net Increase +$ 306 billion or 33%

*Decline attributable to 1981-82 recession and negative economic growth

Cut tax rates on production and investment, and private sector will increase government revenues through increased economic activity that creates jobs and wealth.

It’s that simple.

Far from starving the government for revenues, the Reagan tax cuts added more than 30% to the budget in eight years, and in the process triggered the longest peacetime economic expansion in modern American history. Additionally, unemployment dropped nearly in half from 10.8% in 1982 ended at 5.5% in 1988. Inflation, which was 11% in 1980 dropped by more than half to 5.5% in 1988. GDP increased by 38%. This represented the creation of $ 1.9 trillion in new national wealth, and over the course of the expansion, 40 million new jobs.

It was nothing short of an economic renaissance.

So what about Bush and his $1.35 trillion tax cut?

The Bush plan was controversial because it cut the Clinton tax increase on wealthy earners in half.6

Again, as with Reagan, it was predicted that the tax cut package, which was comprehensive, would create a stunning hole in the government’s budget by starving the Feds of revenue.

But it didn’t happen.

Year Federal Revenues
2001 $ 1.8 trillion
2002 $ 1.8 trillion
2003 $ 1.8 trillion
2004 $ 1.9 trillion
2005 $ 2.1 trillion
2006 $ 2.4 trillion
2007 $ 2.3 trillion
2008 $ 2.4 trillion
Net Increase +$638 billion or 25%

Bush posted gains despite inheriting the Clinton “Tech Bubble” recession and then the economic downturn after 9-11, and the costs of homeland security and the War on Terror.

In fact, the original 2001 tax cuts and the 2003 acceleration of those tax cuts and new allowances for businesses were credited with keeping the American economy stable after the global instability provoked by 9-11.

By the numbers, federal revenues increased by 25% during Bush’s term. Between 2004 and 2006, the rate of revenue increases was 29%.7

And as President Obama refers to Bush’s term as “the Lost Years,” no one seems to mention that there were 25 straight quarters of economic growth between QIV of 2001 and QIV of 2007.

More impressive still, the nation’s GDP grew by 40% between 2001 and 2008, or $4.2 trillion; an expansion equal to the entire GDP of Japan for 2008.8/9

No, to understand the deficits, you need to focus on the other side of the ledger, which Democrats are reluctant to highlight; federal spending.

As any American family knows, no amount of wage increases or bonuses will make up for personal spending patterns that exceed the rate that income increases.  And this is true on the federal level.

During Reagan’s eight years, revenues increased by 33%. But outlays approved by Congress increased cumulatively by 35%. That increase occurred despite the fact that inflation was cut in half. The difference between revenues and congressional outlays was the deficit.

For Bush’s term, revenues increased by 25%, but government spending increased by stupefying 39%10. This includes the funds committed in the last three months of Bush’s term to combat the financial crisis through the TARP program; 75% of committed monies which have since been paid back in 2009.  But even looking at spending in 2007, the increase is still 31%. This accounts for the deficits during Bush’s term.

In both cases, federal spending outstripped already robust increases in federal revenues.

The only time in recent American history where deficits have become surpluses, has been when the rate of government spending growth has been less than the rate of growth of government revenues.

Between 1993 and 2000, overall congressional spending increased at one half the rate of the increase in revenues. The steady growth in revenues and the restraint in spending allowed the budget to be brought into balance and surplus in Clinton’s last three years.11

Clinton of course, raised taxes on the wealthy in 1993 on the “fair share” argument, and liberals’ credit this tax increase and fresh revenues for bringing the budget into balance.

Actually no.

In the two years after the tax increase in 1993, with no recession, tax revenue increases to the Treasury actually declined as a percentage, year over year. From 8% in 1993-94 to 7% in 1994-95, to 1% in 1995-96.12

The robust increase in revenues after 1996 can be attributed, in part, to President Clinton cutting the capital gains tax in 1997.

In 1995-96, the last two years with the 28% capital gains tax rate, the government collected $59 billion and $85 billion respectively in capital gains receipts. Four years later, capital gains tax revenues had almost doubled to $149 billion (all in 2006 adjusted dollars.).

Additional revenues can be attributed to the private sector and the creation and surge of the technology bubble on the economic side, which in turn was made possible by the clear regulatory environment created by divided government, with the spending adverse GOP in charge in Congress.

For reference, government outlays in the 1993-1995 period increased by 7%. In the years of GOP control of Congress after 1994, the rate of growth never exceeded 4%; and it was as low as 2% in 1997 and tenths of a percent in 1999.13

Tax increases did not create the Clinton surpluses. Economic growth, tax cuts and spending restraint did.

But the dubious Democratic revnue model has been tested, ironically by a Republican president.

Bush 41 approved tax increases in 1990 that raised the top rate for wealthy earners to 31%, among other increases, ostensibly to balance the budget. Yet, while revenues to the Treasury increased by 5% between 1989 and 1990 – before the tax increase – revenues grew only by 3% for the period between 1990 and 1992, after the tax increase.

In the meantime, with the Democrats in control of Congress during 1989-1992, spending exploded with deficits rising from $266 billion in 1991 to $326 billion in 1992, again, despite the tax increase.14

If you want an example of the Obama model in action, look no further than results of the Bush 41 tax deal with Congress in 1990.

This brings us to taxing the rich as a tool of deficit reduction.

OMB estimates that the tax hike that begins in January will generate $678 billion in revenue for the Treasury over ten years, or $68 billion a year.15

For comparison purposes, that amount of revenue, per year ($67 billion), pays for a week of President Obama’s FY 2011 budget spending.16

But budgeters, and particularly liberals, fail to see that capital is dynamic, not static. Capital is, after all, managed by people, and it is their intentions and perceptions of the risk/reward paradigm that will ultimately decide where the money will be channeled.

Capital and its owners are not “captive,” to President Obama’s tax raising hubris. In a globalized economy, money will move away from diminished returns to places where there is a better return on investment.

Two predictions on what the Obama tax increase will trigger.

First, there will be a fall off in the stock market toward the end of 2010 as wealthy investors cash in before the tax increase kicks in, so they can take their profits and escape taxation. This will create a perceptions problem and a real problem with financial instability with claims of “recovery” as capital flees equities and the stock market drops, with any number of unintended consequences.

Second and longer term, it is much less likely that the Treasury will ever see the full $678 billion over the next decade, since capital will simply move to where it can get a better return. This has the regrettable impact of depriving the US market of at least some of that capital for investment, innovation and jobs creation at home.

It the end, it is the irony of President Obama’s commitment to social justice that his highly ideological view of wealth creation will likely hobble – not incentivize – robust economic recovery, meaning enduring hardship for the very people in whose name Obama and liberals claim to be working for.

1. www.washingtonpost.com

2. President Obama State of  the Union, 1/2010

3. www.irs.gov

4. Ibid

5. http://www.fms.treas.gov/mts/index.html

6. Ibid

7. Ibid

8. Ibid

9. World Bank/CIA Factbook

10. All figures presented are by calendar instead of fiscal year, to reflect each president’s entire term.

11. http://www.fms.treas.gov/mts/index.html

12. Ibid

13. Ibid

14. Ibid

15. Ibid

16. www.cbo.gov

1 comment

  1. Marina

    You have really interesting blog, keep up posting such informative posts!

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