TCS Daily

Booboo Economics

By James K. Glassman - February 11, 2002 12:00 AM

Editors Note: This article was originally published in The American Enterprise

At last, we're headed for an honest debate between two different approaches to tax policy. The question on the table: Are higher taxes good or bad for an economy that has slowed down?

The battle is being joined because the Congressional Budget Office has pared its projections of U.S. budget surpluses. Last January, the projected surplus over the next ten years stood at $5.6 trillion. That number was re-estimated at $1.8 trillion in December.

Why the decline? Three reasons. Because it uses "static analysis" (simply viewing tax cuts as straight revenue reductions, ignoring any economic acceleration created by the lower levies), the CBO estimates that the tax cuts enacted in June will deprive Washington of $1.3 trillion over the next decade. Second, the economy has moved into a recession that economists did not factor in a year ago. And, third, the terrorist attacks of September 11 have led to boosts in federal spending.

In a speech on January 4, Senate Majority Leader Tom Daschle called the federal surplus decline "the most dramatic fiscal deterioration in our nation's history." That's nonsense. The decline may even be beneficial, since it could prevent legislators from embarking on the spending sprees that surpluses provoke.

But the argument presented in this speech by Daschle-the nation's top elected Democratic official-is important. He defined a fiscal position that is economically erroneous and politically perilous.

Daschle asserted "the rapidly disappearing surplus is a key reason long-term interest rates have barely budged" despite reductions in short-term rates by the Federal Reserve. "Investors understand that the dwindling surplus means the federal government may have to borrow money soon or, at the very least, won't be paying down nearly as much of the debt as had been expected. That is keeping rates higher than they would have been." Thus, tax cuts "probably made the recession worse."

This argument comes straight from the playbook of Clinton Treasury Secretary Robert Rubin. Rubin believes that a hike in marginal tax rates on the most productive Americans is what ignited the economic boom of the 1990s. His logic goes like this:

  • Lower taxes do not stimulate the economy. They don't change people's patterns of work or behavior. They simply deprive the Treasury of money, leading to lower surpluses or higher deficits.

  • Lower surpluses or higher deficits mean that interest rates will rise because the federal government crowds out other borrowers, who have to offer their debt at higher rates in order to attract lenders.

  • These higher interest rates damage the economy, causing recessions.

  • The solution is higher taxes.

After Daschle's speech, President Bush responded that taxes would be raised (or the previous cuts rescinded) "over my dead body!" Bush wants more tax cuts as the best cure for economic slowdown. So the battle lines have been drawn.

Daschle and Rubin are promoting what could be called Booboo Economics-because it's based on an intellectual mistake, a big fallacy. Paul Evans of Ohio State University has shown that there is no evidence that higher deficits are correlated with higher interest rates. AEI economists Charles Calomiris and Kevin Hassett demonstrate, likewise, that Japanese and U.S. interest rates have followed almost precisely the same patterns even though Japanese government debt soared and U.S. government debt fell. Look at Rubin's own era for further evidence: In 1996, with a federal deficit of $108 billion, the long-term bond averaged 6.2 percent; in 2000, with a surplus of $236 billion (a record), the bond averaged 6.5 percent.

Why don't federal borrowing levels dictate interest rates as Rubin suggests? Many reasons, but here's one that non-economists can understand: Federal debt is a small piece of a big pie. According to the latest Federal Reserve data, American people and institutions owe a total of about $19 trillion. Even if the federal debt rises by $200 billion in a year, the overall effect is to raise total national debt by just 1 percent.

What really counts in fiscal policy is not whether the government is collecting more than it spends but whether it is spending too much.

Lower taxes leave more dollars in the hands of individual Americans to invest and spend. Raising taxes in the middle of a slowdown is a good way to send the economy into a depression.

Is that the result you had in mind, Mr. Daschle?

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