Jay Reding.com

The Shrinking Deficit

Megan McArdle observes that the national budget will be nearly balanced by the time George W. Bush leaves office, provided that current trends continue:

Thanks to George Bush’s amazing deficit reduction plan, the budget deficit is now only 1.2% of GDP. If this trend continues, by the time George Bush leaves office, the budget will be within a hair’s breath of being balanced. I can only hope that Democrats don’t squander this precious legacy of fiscal responsibility.

Just kidding! Not about the budget deficit, I mean, but about the reason for it. The reason the budget deficit has closed is a combination of economic growth and increasing inequality, which has allowed the government to collect more revenue on a smaller base. The rich really are different–they pay higher tax rates.

McArdle argues that it’s not Presidential policy that drives these changes, but larger macroeconomic factors. While that’s certainly true to a point, I don’t think that one can dismiss the role of Bush’s tax policies in driving those two factors of economic growth and income. The economic growth of the past few years has come in spite of the collapse of Enron and WorldCom, in spite of the aftereffects of the September 11 attacks and in spite of high oil prices. There’s a very strong argument to be made that the last few years of economic growth are attributable to a national policy of low taxes encouraging productive investment. That isn’t the whole story, but it is a very crucial part of why these last few years have seen solid levels of economic growth.

It’s also interesting that the standard Democratic argument against the Bush tax cuts is that they reduce the tax burdens on the rich. Yet the empirical evidence suggests that the tax burden is shifting the opposite way. Ms. McArdle is correct: the tax base is shrinking, and more is being gathered from a smaller subset of the population. From an economic perspective, that’s helping fuel the reductions in the deficit. Politically, such a thing can foster a sense of entitlement and dependence which is unhealthy over the long term.

The evidence indicates that the Bush tax cuts did what they were supposed to do: increase economic growth and tax revenue. The fact is that in 2003 the Congressional Budget Office predicted $2,421 billion in income tax revenues for 2007. The predicted tax revenue for 2007 now is $2,574 billion. The deficit has decreased to 1.5% of GDP, which is lower than it has been for 24 of the last 30 years. Economic growth remains strong despite the sub-prime mortgage scare and the unemployment outlook for the last few quarters has been revised upwards to show continued job growth.

All the fundamentals are working, but the real problems are spending and entitlements. It won’t matter whether we’re running a deficit or a surplus when the bill for Social Security and Medicare comes due. None of the reduction in the deficit came from cuts in spending, with spending still increasing far above the rate of inflation. The looming entitlement crisis guarantees that any advances made in the next few years will be nothing compared to the liabilities incurred when the Baby Boomers start hitting retirement age. The priorities for the next administration must be in reigning in both the out-of-control levels of spending and the equally out-of-control levels of mandatory entitlement spending. If those problems aren’t fixed, none of the progress of the last few years will matter much.

UPDATE: Ramesh Ponnuru notes that tax cuts do lower overall revenue. I would argue that it is possible to have a tax cut that pays for itself, but that would require a much higher marginal rate than we’ve had in decades. The reason why the Bush tax cuts should get some credit for the surge in revenues is because of their collateral effects. One of the biggest sources of increased revenue was on strong corporate profits, and those can be attributed to a combination of low interest rates and tax policy that is conducive to new investment.

Ultimately, federal revenues are much more dependent on the overall health of the economy than on tax policy. Worrying about maximizing federal revenue is the wrong approach; the primary concern should be in maximizing overall economic growth. The Democrats tend to obsess over the former, while the Republicans look to the latter. Tax cuts won’t necessarily bring an economy out of recession by themselves like some Republicans claim, nor will they cause one as some Democrats claim. Monetary policy has a big impact, as does productivity, the balance of trade and other factors large and small.

That doesn’t mean that tax cuts aren’t sound policy—they most certainly are, but the case that tax cuts by necessity pay for themselves isn’t the strongest.

4 responses to “The Shrinking Deficit”

  1. Mark says:

    I see a month in hiding hasn’t improved your common sense. Where’ve you been anyway? Were you the guy mugging Air America hosts?

    By yours and McArdle’s logic, all of us in the sweating classes should volunteer to tax 50% pay cuts. That way, inequality would increase further and the rich would be responsible for even more of the overall tax burden. The rhetorical leaps of faith you guys attempt to foist upon us still manage to stun me some days.

  2. Jay Reding says:

    Were you the guy mugging Air America hosts?

    You do realize that there was no mugging

    Besides, I wouldn’t know an Air America host (other than Franken) if I saw one… especially since they’d be virtually indistinguishable from any other ranting lunatic on the street these days.

    By yours and McArdle’s logic, all of us in the sweating classes should volunteer to tax 50% pay cuts. That way, inequality would increase further and the rich would be responsible for even more of the overall tax burden. The rhetorical leaps of faith you guys attempt to foist upon us still manage to stun me some days.

    Um, she’s talking about inequality in tax burdens, not income inequality. They’re not at all the same thing.

  3. Mark says:

    “Um, she’s talking about inequality in tax burdens, not income inequality. They’re not at all the same thing.”

    One is the direct result of the other. As the nation’s wealth gets consolidated into fewer and fewer hands, it’s only natural that the income tax burden will follow suit. McArdle’s argument seems to be that revenues would not be flowing in at the same pace if the economic growth of the last five years was more evenly distributed rather than centrallized almost exclusively in the bank accounts of those who were subject to the largest rate cuts. That’s quite a stretch.

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