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Friday, January 17, 2003

Deficit Musings-OMB director Mitchell Daniels is in hot water for suggesting that deficits might be permanent fixtures for the rest of the decade. Given that they're cooking up the '04 budget now, the question that comes to mind of whether economic growth and political restraint will allow for a surplus to occur anytime soon. There are three ways to get rid of a deficit; cut spending, raise taxes or allow economic growth to increase the tax base. Spending cuts aren't likely, nor are tax increases; in fact, we're looking at cutting taxes in order to goose the economy. How will the increasing national debt affect the budget and the economy? Daniels points out that low interest rates make the debt burden affordable at the present time, but that low interest rate is predicated on low inflation; that might not be the case in the future. If inflation crops back up, interest rates will rise and more of the budget will be consumed by interest payments. An increased federal debt will tend to increase interest rates even if inflation stays low, for the government will be competing with corporations, municipalities and individuals for capital. Econ textbooks on both left and right will refer to this as the "Crowding-out effect" and Krugman rightly rips Council of Economic Advisers chair Glenn Hubbard for neglecting this basic concept. If the national debt is sucking up money that could have been used to buy new equipment and start new businesses or expand existing ones, it would be a long-term drag on the economy. However, if that debt is due to a simulative tax cut, the lower tax rates might help offset the higher interest rates, creating a lower cost of capital. If the economy will grow as a result of a tax cut, there might be more revenue coming in than one would expect, since the lower tax rate would be applied to a bigger tax base. Here's a basic example. Let's say that we have a 20% tax rate and a $10 billion tax base; that would bring in $2 billion. Let's then cut taxes to 18%. Static analysis would assume that tax revenues would go down by $200 million (2% of 10 billion) to $1.8 billion. However, if the economy grew to 10.5 billion as result of the tax cut, revenues would $1.89 billion, only a loss of $110 million. If the simulative effect of the tax cut took the tax base up to 11.5 billion four years down the line, revenues would then be $2.07 billion, higher than before we made the cut. How simulative would the tax cut be? Good question. Dynamic analysis would allow for the concept of reducing the amount of lost revenue in a tax cut, but figuring out what percentage of growth would be due to a tax cut is tricky. Krugman's not comfy with the idea
Will this alcoholic eventually go back on the wagon? Not for a while; he has too many enablers. The Congressional Budget Office will soon start using "dynamic scoring" to assess proposed tax cuts — that is, it will build in the supply-side assumption that tax cuts raise the economy's growth rate, and therefore generate indirect revenue gains that offset the direct revenue losses. In the past, budget officials have opposed this practice, because it's so easy to slide from objective analysis into wishful thinking. With Republicans controlling both the White House and Congress, does anyone doubt that future C.B.O. analyses will take a very favorable view of big tax cuts for rich people?
It also seems easy to slide from objective analysis into pessimistic thinking. Krugman might be afraid of GOP economic Pollyanna, but the static Eeyore of the Keynesians isn't helpful either. An overly optimistic economic forecast would overstate revenues after a tax cut, but a static analysis would understate revenues. I don't have a magic recipe for deficits and tax cuts, except that if Congress can keep a lid on spending, the deficits will go away with time as the economy grows. A tax cut will trade a bigger deficit now for a faster-growing economy, which will lead to surplusses down the line, if spending is contained.

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