Will New Taxes Erase Red Ink?

By Michael Fumento

Investors Business Daily, February 10, 1993
Copyright 1993 Investors Business Daily

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As Yogi Berra is supposed to have said, "It’s dèjà vu all over again."

During the 1990 budget summit, President Bush, his Office of Management and Budget Director Richard Darman, and Congress insisted that in order to balance the nation’s books, a painful tax increase would be required. However, the plan would include $2 in spending cuts for every $1 increase in taxes.

The taxes were painful indeed, especially to Bush, whose violation of his "no new taxes" pledge helped cost him re-election.

But the spending cuts didn’t come through. The 1991 deficit, which before the summit was projected at $253 billion, instead swelled to $269 billion.

The 1992 deficit, which had been projected at $262 billion, grew to over $314 billion. In 1990, the year before the budget agreement took effect, the deficit was only $152 billion.

But the 1990 budget deal was itself a rerun from eight years ealier, when Reagan, urged on by his OMB director, David Stockman, and Congress, signed the Tax Equity and Fiscal Responsibility Act of 1982. That pact was supposed to deliver about $3 in budget cuts for each dollar in taxes.

The deficit, which Stockman had predicted would fall by $300 billion in response to the agreement, fell by only $40 billion over four years, and that was only because the economy enjoyed an unprecedented boom from Reagan’s tax cuts.

Again, the spending cuts never appeared.

Rather, from 1982 to 1986 the only domestic spending that saw its upward trend actually cut was defense.

Now, with the deficit bigger than ever, President Clinton has converted his pledge to cut middle-class Americans’ taxes into a call for "sacrifice," a euphemism for higher taxes.

But Clinton’s OMB director, Leon Panetta, has insisted as his predecessors did that we will get $2 in budget cuts for every $1 increase in taxes.

Don’t count on it, economics say.

"It didn’t work for Darman, it didn’t work for Stockman, and it’s not going to work for Clinton," said former Reagan administration economist Paul Craig Roberts.

Consider what happened with the 1990 budget package.

The agreement was presented as a cumulative reduction of nearly $500 billion in the deficit over a five-year period. Of this, $160 billion was projected to come from new taxes.

On the savings side, $120 billion was to come from cuts in hypothetical increases in domestic spending, with $91 billion from defense and $59 billion from reduced spending for debt servicing.

Of course, the tax increases went through. So did the defense cuts. But other spending went up.

This year alone, spending overall will likely increase 12% over last year, a pace almost four times the government estimate of the rate at which the economy will grow.

When the 1990 budget deal was concluded, the 1991-95 deficit was projected at $770 billion. The latest CBO estimate for that period, which now includes two years of actual data, places that figure at $1.447 trillion.

Opposite Effect

Thus, far from cutting $500 billion from the deficit, it appears the budget deal will add far more than that, more than doubling the original estimate.

Yet the experiences of 1982 and 1990 are nothing new.

Economists Richard Vedder, Lowell Gallaway, and Christopher Frenze, in a paper prepared for the House of Representatives Joint Economic Committee in 1987, found that from 1947 to 1986, for every $1 in new taxes, the government spent an additional $1.58. That figure was later revised downward to $1.50.

This trend toward spending all new tax revenue and then some is apparently accelerating. A 1991 study by Vedder and his colleagues looking at the period from 1947 to 1990, found a real increase to $1.59 in new spending for each $1 of revenue.

This "$1.59 study" found that higher tax revenues actually were linked with lower government spending on goods and services.

"There is no relationship between non-defense purchases and taxation," it said. "Regarding defense spending, a dollar in new tax revenues is estimated to be associated with a 39-cent reduction in defense spending."

In other words, the increased taxes not only didn’t buy a reduced deficit, they didn’t buy anything. Taxpayers got less for more all the way around.

Where Did It Go?

So where did the money go?

It went to transfer payments, mostly entitlement programs, the three biggest of which are Social Security, Medicare, and Medicaid, according to budget figures. The 1991 report stated, "Thus new tax initiatives seem to be closely tied to efforts to redistribute income rather than offer new governmental services."

Said Roberts: "Every time they do this, the economy is impacted and the revenue is never realized. They allot some of the revenues to deficit reduction and play around with the rest of them this goes for deficit reduction and this goes for unmet social needs."

He added: "The upshot is they can spend more and still project a reduced deficit," albeit only a paper one that later proves to be a large increase in debt.

Among the spending increases included in the 1990 budget agreement were $400 million in Medicaid expansion, a $2.3 billion increase in highway spending, and $20 billion in new money for specific local projects - also known as pork.

The 1990 budget deal also scrapped the Gramm-Rudman-Hollings Act. While Congress never strictly adhered to it, Gramm-Rudman appears nonetheless to have restrained congressional spending.

"The purpose of the 1990 deal was to get rid of Gramm-Rudman and to increase spending under a facade," said Stephen Moore of the Cato Institute, a Washington-based libertarian think tank. "It was a great fraud, and now we’re going (back) to the 1990 budget deal all over again."

Sixty-eight percent of Democrats in Congress, according to a recent poll, favor increasing taxes for the ostensible purpose of closing the deficit, though only 11% of the Republicans do.

Another problem with the government’s frequent estimates of the impact of tax increases on the deficit is that they use so-called static models. A static model basically doesn’t factor in the impact the tax increase itself would have on future economic output.

Thus, the models assume that people who are taxed higher won’t try to find a way to avoid paying taxes, or that higher taxes on goods and services won’t result in slower activity.

"When you raise taxes you lessen the rewards for activities that raise production," said Michael Schuyler, an economist at the Institute for Research on the Economics of Taxation in Washington. "People work fewer hours, they work less hard, or find ways to channel work efforts into nontaxables, such as working for benefits rather than cash - which is legal - or taking earnings under the table - which is illegal."

Such was the case with the 10% "luxury tax" slapped on boats, airplanes, jewelry and cars.

Would-be buyers stayed away from the market after the tax was imposed. While the House Economic Committee estimated that the luxury tax - not counting the portion on cars - would bring in $31 million for fiscal year 1991, it brought in just over half that.

Meanwhile, the yacht industry was so devastated by the lack of new buying that hundreds if not thousands of workers lost their jobs.

According to a paper prepared for the House Joint Economic Committee, the net result was $24.2 million lost to the government. Thus, on the whole, the government lost money.

Since Clinton was elected, financial publications have been brimming with advice to upper-bracket taxpayers on sheltering their wealth. The wealthy are wasting no time in taking that advice, with the most notable example being Disney CEO Michael Eisner, who cashed in $119 million in stock options in December.

Similarly, lowering tax rates on wealthy people can - seemingly paradoxically - increase revenue from them.

Thus from 1981 to 1988, when the top tax rate fell from 70% to 28%, tax revenues paid by the top 5% of earners actually rose by 50%. Despite this, some Clinton aides and members of Congress are pushing to have the new top marginal rate pushed even higher than 36%, all the way to 40%.

Strangely enough, the possibility of actually taking in less revenue from better-off Americans may be of little concern to Clinton’s policy-makers.

Political analyst Kevin Phillips explains that higher marginal rates on wealthier Americans would be a political tool to leverage more tax money out of the middle class.

"The energy tax might fly if they’ve got it wrapped in the 36% top (Marginal) income tax rate, the millionaire’s surtax and enough stuff so that the average person thinks the levels above him or her get it," Phillips said.

"He (Clinton) is doing it for symbolic purposes," said Cato’s Moore. "I can’t think of anything stupider than to raise those rates. I predict it will be a money loser.

Slowing Economy

Aside from the effect of making high earners earn less, report less, or use shelters more, tax increases can reduce revenues by slowing the economy, as many economists believe was the case with the 1990 increase.

"Every economic text in print for the last half century says that if you raise taxes you restrict the economy," Roberts said. "All tax hikes are contractionary fiscal policy."

"If you finance government through borrowing, you’re soaking up resources from credit markets. Whether you’re crowding out a family seeking a mortgage or a small business seeking a loan to expand, it has an effect," added Daniel Mitchell, an economist at the Heritage Foundation in Washington. "But if you finance it through taxation, you’re still taking away capital that could have been used for those same things."

"In a sense," he said, "they’re like two frying pans. You don’t help yourself by jumping from one to the other."

It is for this reason that California Gov. Pete Wilson says he has sworn off raising taxes to close the state’s yearly deficits.

"Given the economic climate, we can’t afford to lose more jobs," Wilson has said.

Wilson’s own experience in his first year as governor was to agree to a large tax increase to balance the state budget, only to find it way out of balance the next year.

Spending Cuts First

"You don’t pay the dollar first and say, ’Be a nice guy and get me two dollars later,’" said Murray Weidenbaum, director of the Center for the Study of American Business at Washington University in St. Louis. "You don’t pass the tax bill until the spending cuts are passed. Then, if you do a good enough job on the spending side, you don’t have to raise taxes."

An additional problem this time around may be that the president is not as serious about cutting the deficit as Reagan and Bush were. Already, Clinton is proposing boosting federal spending on Medicaid, already the fastest growing entitlement program, by $4 to $11 billion this year.

At the same time, his Secretary of Health and Human Services, Donna Shalala, has proposed an unspecified increase in government spending on AIDS research, treatment, and prevention and other social and medical areas, labeling them "economic stimulus."

Meanwhile, the pattern of trying to make all the cuts out of the defense budget is also continuing.

Clinton has proposed a reduction in the armed forces budget four times that Bush proposed, even as Clinton backed off on the idea of limiting the growth of Social Security benefits.

Critics say that the deficit monster could be declawed far more easily than government leaders have led us to believe, because the economy continues to expand. Last week, the government reported that the economy grew 3.8% in the last quarter of 1992, the strongest growth in four years.

Notwithstanding Clinton’s effort in trying to take credit for growth in a period that concluded 20 days before he took office - "I think there is a lot of response to the efforts we are making now," he said - it certainly is possible to "grow out of the debt" as Clinton and supply-siders have claimed.

No Cuts Needed

And it can be done without a single actual budget cut.

Explained Roberts, "If they merely froze spending for two years at the inflation level, the deficit would no longer be a problem."

At the projected deficit level for 1993, those two years would need only a 2.7% rate of growth.

But can the government exercise such extreme self-control as keeping its hands off extra revenue for two years? Roberts and other have their doubts.

"When Clinton talks about sacrifice," said Roberts, "he means the private sector, not the government."


Read Michael Fumento’s additional work on the Clinton administration, on economics, and on politics.