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CIAO DATE: 8/01
Putting Our Tax House in Order
On The Issues
March 2001
The weak economy, the large current government surplus, and the large long-run government deficit all argue for the immediate and permanent tax reductions that President Bush has proposed.
The Congressional Budget Office currently forecasts that the federal government surplus over the next ten years will total about $5.6 trillion, with $3.1 trillion of that "on budget." 1 The relatively cautious plan proposed by President Bush would dedicate a bit more than half of that surplus to tax relief. While there are significant risks to this forecast, the odds are that it will be revised upward in subsequent revisions. I expect this to happen for two reasons. First, academic research has shown that revisions tend to be positively correlated over time. 2 If there is an upward revision to today's CBO forecast, there is more likely to be another upward revision the next time as well. Second, we are currently in a period where compounding is making surpluses bigger and bigger over time, with the total surplus now estimated to be $889 billion in 2011 alone. Next year at this time, the CBO's ten-year forecast will include 2012 and remove 2002, which should, all else being equal, add approximately another $700 billion to the ten-year surplus estimate. Putting the two effects together, if the president's plan is passed as is, the odds are that next year the CBO on-budget forecast will still be in the neighborhood of $2 trillion. Relative to GDP, even that surplus would be remarkable by historical standards.
Some observers have noted that there is also a downside risk associated with the possibility of recession. However, the two effects I just mentioned would likely dwarf any other developments. The CBO recently estimated, for example, that a recession would lower the current ten-year forecast by only $140 billion. 3
As we consider options for the use of these surpluses, it is important that we remain aware that the surpluses are partly the result of marginal tax rate increases. Here I refer to what economists have dubbed "real bracket creep." Because of our progressive tax system, individuals are pushed into higher tax brackets when their incomes grow. When the economy expands, the incomes of Americans increase. Since our tax brackets are indexed to factor out inflation only, not real growth, a large number of taxpayers are pushed into higher tax brackets over time. These individuals are hit with automatic—if stealthy—marginal tax rate hikes. Recently, the boundary between the 15 and 28 percent brackets has begun to sweep through the center of the income distribution, and, accordingly, this effect is becoming quite large. For example, if we extrapolate recent trends, we see that more than 10 percent of taxpayers will move above the 15 percent bracket by 2010, with the majority of these individuals experiencing a 13-percentage-point marginal tax rate hike. 4 While the complexity of this issue makes precise statements concerning the revenue effects of real bracket creep difficult, make no mistake—a good portion of the surplus is attributable to these automatic tax hikes.
These high surpluses occur at a time when we face significant short- and long-run challenges.
Many signs indicate that the economy is slowing. The widely followed National Association of Purchasing Managers survey index, for example, is in a range that in the past has always signaled negative economic growth for the economy as a whole. If a few quarters of negative growth are strung together, then we will be in recession and many will experience painful disruptions to their lives. If the recession is typical, for example, roughly 3 million Americans will lose their jobs.
While it is impossible to know with certainty whether a recession is near, one thing is extremely clear. Fiscal policy, which is racking up large surpluses, is tighter now than it has ever been this close to a recession.
Bad medicine can make a sick patient worse. There is a significant risk that tight fiscal policy will be the influence, at the margin, that pushes the economy into recession, or a key factor making a recession worse. Indeed, the last time we approached a slowdown with restrictive fiscal policy, the economy responded to high surpluses and a general weakening in consumer demand by posting the steepest decline in real GDP in postwar U.S. history, dropping a whopping 10.3 percent (annual rate) in the first quarter of 1958. At the time, the surplus was about 1 percent of GDP. Currently, it is forecast to be more than twice that high.
There is no question that fiscal policy can help lower the risks of repeating that experience. While the theoretical response of the economy to a tax cut depends on monetary policy as well, macroeconomists who have analyzed the history of U.S. tax policy have generally found that the stimulus associated with a tax cut is from one to two times the size of the cut. 5 Accordingly, if the president's plan were accelerated into this year, we could expect GDP to be higher, all else being equal, by about 1 percentage point, with the effect taking from five to seven quarters from the passage of the bill to run its course. 6 Such a stimulus could significantly change the odds of recession.
That there is general agreement surrounding the positive effects of such a stimulus may be puzzling to those who have heard that economists generally agree that fiscal policy has had little effect in past recessions. Economists Christina and David Romer recently wrote an exhaustive study of the history of fiscal and monetary policy that clears up the mystery. 7 They found that fiscal measures generally have failed to push the economy out of recession because they have typically been too small to have much effect. Indeed, large fiscal stimulus packages have generally not been passed near cyclical troughs. Instead, they have historically emerged only because of slow recoveries, as was the case, for example, with the 1964 tax cut.
If the president's plan were passed today, it would be neither too slow nor too meek. Indeed, the economic data indicate that the economy posted positive growth in the fourth quarter of 2000. If a recession is underway, it began in early 2001, and there is ample time to do something about it. If the tax cut plan is delayed or rejected, we run a significant risk of repeating past mistakes.
I should note that the view that a stimulus could now be effective is not an endorsement of Keynesian tax policy. Back in the 1960s, many Keynesians believed that economic fluctuations could be offset by tax policy. If consumers tend to consume too little in a downturn, then government could, it was thought, fix that with tax policy. A big tax cut, timed correctly, would boost spending and help push the economy out of the doldrums. The Keynesian theory applied on the upside as well. Tax increases in good times were recommended to stop a booming economy from overheating.
It was Nobel-laureate economist Milton Friedman who first pointed out the key problem with such a policy regime: It only works if citizens are extremely shortsighted. Consider: If a temporary tax cut gives you $1,000 today, but you know that you will have to pay it back next year—with interest—how much will you change your behavior? If you're like most people, not very much.
This does not mean all government policies are ineffective. On the contrary, if firms and individuals are rational and forward looking, high taxes can have enormous negative effects on the long-run health of the economy. But if you just jigger taxes up and down from year to year, hoping to manipulate the economy, you will fail. Taxes can set the level of activity around which the economy fluctuates, but they have very little effect on the fluctuations themselves.
The president's tax cut is not Keynesian for one simple reason. He does not plan to raise tax rates as soon as the economy starts to boom again because the current surplus is large enough to accommodate his tax cut. Under the Bush plan, a taxpayer would pay lower taxes this year and again in the future. If experience is any guide, such permanent tax cuts are likely to have large positive effects. His plan takes us to a new and higher level.
Long-Run Challenges
Our current situation is unusual for another reason. While the short-run forecasts show a significant surplus, long-run forecasts indicate that there is a large deficit, mostly because of the Social Security payments due when the baby boomers retire. Until recently, almost every observer supported using a significant portion of even the on-budget surplus to retire government debt in anticipation of the coming deficits. However, surplus estimates have soared so much recently—by $2 trillion in the past year alone—that we must reexamine the effects of such a policy.
According to the Treasury Department, total government debt held by the public is a bit more than $3 trillion. With no change in tax policy, projected surpluses would pay down the entire debt by around 2008. Government could not choose to just hold the cash, as that would decrease the monetary base and cause a potentially destructive deflation. It will have to decide what to buy with that money. As much as half of existing government debt may be almost impossible to retire, since savings bonds, for example, often aren't redeemed until maturity, and because many holders of long-term treasury bills will be unwilling to sell them back to the government. Adjust for these factors and we may well be building a sizable hoard of assets in just a few years.
How big could the hoard get? Investing that much public money would likely mean the government purchase of stocks, because only equity markets are large enough to absorb such inflows and still remain liquid. Assuming the Treasury begins to invest surpluses in the stock market as soon as it has retired all the debt that it can and that these investments earn a 10 percent annual return, our government could be sitting on a stock-market portfolio worth about $20 trillion in twenty years. To put that in perspective, the current market value of all equities in the United States is about $17 trillion, according to the Federal Reserve. Projecting forward, the U.S. government could own about one-fifth of all domestic equities.
Federal Reserve chairman Alan Greenspan and others have cautioned against such a large-scale intrusion by the government into the private economy. While it is possible to contrive conditions under which such investments could be neutral, the potential for disruptive influences to emerge is significant. The experience with U.S. state governments has not been reassuring. As Sebastian Mallaby wrote recently in the Washington Post, "The California Public Employees' Retirement System has no tobacco stocks in its $171 billion portfolio, and several states bend over to invest in local companies." 8 As soon as the government picks and chooses which things to invest in, it will change prices and the allocation of resources. Think, for example, of the increase in price that occurs when a firm is placed in the S&P 500 index. Making the government list would be much, much better. This argues against allowing the surpluses to build up in anticipation of the Social Security shortfalls.
The best preparation for our long-run deficit is to put our tax house in order and use the tax code to stimulate savings and capital formation. On this, the Bush plan has much to recommend it as well. There is, for example, a wealth of evidence that lower marginal tax rates stimulate entrepreneurship and economic activity. 9 While I am unaware of a specific effort to provide an accounting of the dynamic benefits of the Bush plan specifically, two recent works identifying the likely benefits of tax reforms in general imply, by my calculations, that aggregate output will be between 2 and 4 percentage points higher ten years from now if the president's plan becomes law. While there is substantial uncertainty surrounding so complex a calculation, if this estimate turns out to be correct, then the output of the United States may be as much as $700 billion higher in 2011 if the president's proposal is enacted than it would be otherwise. That extra national income will certainly help our country face the economic challenges of the next decade.
Notes:
Note 1: Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2002-2011 (2001). Back.
Note 2: Alan J. Auerbach, "Tax Projections and the Budget: Lessons from the 1980s," working paper W5009, National Bureau of Economic Research, Cambridge, Mass., 1995. Back.
Note 3: Congressional Budget Office, "The Uncertainty of Budget Projections," chap. 5 in The Budget and Economic Outlook: Fiscal Years 2002-2011 (2001). Back.
Note 4: For details of the calculations, see Kevin A. Hassett, "A Tax Phantom is Stalking You," On the Issues, American Enterprise Institute, Washington, D.C., October 2000. Back.
Note 5: See, for example, Olivier Blanchard and Roberto Perotti, "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," working paper W7629, National Bureau of Economic Research, Cambridge, Mass., 1999; and Christina D. Romer and David H. Romer, "What Ends Recessions?" working paper W4765, National Bureau of Economic Research, Cambridge, Mass., 1994. Back.
Note 6: The timing is taken from Blanchard and Perotti. Since the president's plan is a permanent tax cut, the multiplier should likely be larger than historical estimates based on an empirical analysis of the many temporary cuts in postwar U.S. history. Back.
Note 7: C. Romer and D. Romer, "Recessions." Back.
Note 8: Sebastian Mallaby, "Greenspan on Going Private," Washington Post, February 5, 2001, p. A19. Back.
Note 9: See the review in Kenneth L. Judd, "The Impact of Tax Reform in Modern Dynamic Economies," in Transition Costs of Fundamental Tax Reform, ed. Kevin A. Hassett and R. Glenn Hubbard (Washington, D.C.: AEI Press, 2001). See also, D. Altig et al., "Simulating Fundamental Tax Reform in the United States," American Economic Review (forthcoming). Back.
Kevin A. Hassett is a resident scholar at the American Enterprise Institute. This essay is adapted from his testimony on February 13, 2001, before the House Ways and Means Committee and the Senate Budget Committee.
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