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HERITAGE FOUND.
I
ond.Quarter Economic Growth Figures Probably Will Be Wrong - Heritagehttp://www.heritage.org/heritage/library/categories/theory/fyi114.html
WHY THE SECOND QUARTER ECONOMIC GROWTH FIGURES PROBABLY WILL BE
WRONG
William W. Beach
John M. Olin Senior Fellow in Political Economy
and
Gareth Davis
Research Assistant
The Heritage Foundation
FYI No. 114
July 29, 1996
Chart 1: GDP Growth and Magnitude of Error in Advance Estimate
Chart 2: Trend and Quarterly Real GDP Growth 1976-1996
On August 1, the Department of Commerce's Bureau of Economic Analysis (BEA) is scheduled to release its
preliminary or "advance" gross domestic product (GDP) growth estimate for the second quarter of 1996. This number, good
or bad, inevitably will make front-page news and may have a significant impact on the presidential campaign. Just as
inevitably, this preliminary number most likely will turn out to be wrong, for quarterly GDP data historically have been
subject to substantial later revisions, sometimes so significant that the original estimate tells nothing about the course of the
economy.
A single quarter estimate of the growth in GDP usually is a poor signal of the long-term direction of economic growth.
Consider the following examples:
The GDP growth estimate for the first quarter of 1996 has been revised downward by 21 percent (from 2.8 percent to
2.2 percent).
During the last year of the Bush Administration, the first quarter 1992 advance estimate of GDP suggested an
annualized growth rate of 2.0 percent. The subsequent revision of the GDP for that quarter showed that growth in the
quarter actually was at an annualized rate of 4.7 percent. This is a 135 percent revision between the preliminary and
final estimates.
As it turns out, the BEA underestimated the growth rate during the Reagan Administration in 63 percent of its
advance estimates. During the Clinton Administration, the BEA so far has overestimated the growth rate on over 69
percent of the occasions on which it published advance estimates.
The BEA concedes that in 12 percent of the quarters between 1978 and 1991, the advance GDP growth estimate
failed even to indicate correctly whether growth was positive or negative.
The average divergence between the advance estimate of GDP growth and the final GDP growth rate between 1976
and 1996 was equivalent to 50 percent of the value of the final GDP growth rate.
WHY DOES QUARTERLY GDP FLUCTUATE so MUCH?
Measuring GDP changes is a very complex task, made all the more difficult by the fact that quarterly GDP figures are
very volatile.
Gross domestic product (GDP) represents the total value of goods and services sold for final consumption by U.S. firms
and individuals. It consists of four major components: personal consumption; investment (including business inventories and
both residential and nonresidential fixed investment); net exports; and government purchases of goods and services.
Fluctuations in any of these individual components of GDP in a given quarter can cause large changes in the quarterly
growth rate. The components which typically have the largest and most common fluctuations are changes in business
inventories and in government purchases.
A glance at the quarterly GDP growth figures for the last quarter of 1995 illustrates this point. Despite an annualized
growth rate in personal consumption expenditures of 1.2 percent and a respectable annualized increase in nonresidential
fixed investment of 3.1 percent, overall annualized growth in this quarter was at a recession-like low of 0.5 percent. The
reason: An annualized fall in government purchases of over 12 percent during the winter shutdown of 1995-1996 drove
down GDP during this quarter.²
Similarly, a number of one-shot factors probably will drive a significant increase in GDP for the second quarter of 1996.
One leading econometric consulting firm, the St. Louis-based Macroeconomic Advisers,3 for example, cite a number of
factors to support their prediction of a 3.7 percent annualized growth rate for this quarter. These factors include the complete
recovery of government purchases following the winter shutdown, the end of the UAW strike at General Motors, an increase
in the number of home mortgage refinancings stimulated by lower interest rates (which put extra cash into the hands of
consumers), and the economy's recovery after the harsh winter weather.
07/30/96 20:44:59
ond Quarter Economic Growth Figures Probably Will Be Wrong - Heritagehttp://www.heritage.org/heritage/library/categories/theory/fyi114.html
The extent to which these short-term factors can influence quarterly growth figures can be gauged by looking more
closely at what is happening to business inventories. Due to the GM strike and the harsh winter, business inventories fell
substantially in the first quarter of 1996 as production experienced a slowdown. Macroeconomic Advisers predicts that over
38 percent of their projected growth in GDP (1.4 percent from a total annualized growth rate of 3.7 percent) in the second
quarter of 1996 will come solely from firms restocking their inventories as production gets fully back on line.
WHY ADVANCE ESTIMATES OF GDP GROWTH TEND TO BE WRONG
Measuring GDP is a massive and complicated undertaking that involves attempting to record the total sales of all goods
for final consumption for the entire United States. The BEA produces its estimates based on sample sales data from a number
of individuals and firms, collected during every month. Prices for thousands of individual items are estimated using sample
data. Taken together, these comprise virtually millions of data points.
The problem is that when the advance estimate is published only 30 days after the close of the quarter, not all of these
data have been examined or are even available. In 1984, for example, top BEA official Robert Parker noted that for sales
of all consumer goods, other than autos and trucks, only data from the first two months of the quarter were available when
advance estimates of national income were being made.⁴ To estimate the GDP growth in such a case, with data either
missing or unexamined, BEA economists must rely on a combination of extrapolation and guesswork. But given the
turbulent nature of quarterly GDP changes, this guesswork often is very inaccurate. These factors mean that large revisions
need to be made as the complete dataset becomes available and is examined in full by the BEA.
The revisions also tend to be large because the GDP growth rate is a rate of change. Thus, errors of a small magnitude in
total GDP can lead to large errors in the growth rate. For example, if the actual GDP growth rate is 2 percent, even a small
error in total GDP could translate into a large error in the actual growth rate, perhaps even 50 percent. In this context, it is not
surprising that advance GDP growth estimates often vary substantially from the real figures.
Unfortunately, despite the fact that advance GDP growth estimates are subject to frequent and large revisions, they are
quickly seized upon by politicians of both parties either to support their own records or to attack those of their opponents.
And unlike the publication of advance estimates, revisions of these quarterly data by the BEA hardly make the news. This
process of correcting and finalizing GDP estimates can last for months even years -- following that initial release and can
result in huge revisions which tell a completely different story about how well the economy performed.⁵ Chart 1 shows the
difference between the initial "advance" estimates of the real annualized growth rate of GDP and the most up-to-date
revisions of these figures for the period since 1976.
Chart 1 shows the difference or "error" between the advance and the most up-to-date revised estimate of the GDP
growth rate. The "magnitude of the initial error" refers to the amount by which the advance GDP growth rate was later
revised. Thus, if the advance estimate was a 3 percent annualized growth rate and the revised rate was 2 percent, the absolute
error was 1 percentage point, which represents a revision of 33 percent.
In most cases, the error is substantial; on a number of occasions, it exceeds the real growth rate itself. Among recent
examples of large errors is the first quarter of 1992, when the BEA's advance estimate of GDP growth underestimated the
real annualized growth rate by a factor of 135 percent (the advance annualized real growth estimate was 2.0 percent; real
annualized growth in that quarter was actually 4.7 percent, according to the latest revision). The BEA also has revised
downward its estimate of the growth rate for the first quarter of 1996 by a factor of almost one-third.
An analysis of the revisions contained in the BEA's monthly Survey of Current Business over the 20-year period from
1976-1996 shows that these recent examples fit a general pattern over many years. In the 80 quarters between the first
quarter of 1976 and the first quarter of 1996, the average magnitude of the total revision in annualized real GDP growth
amounted to 1.4 percent of GDP. The average quarterly annualized growth rate in GDP over this period was 2.8 percent.
This means that the average divergence of the advance estimate of GDP growth from the actual revised figure was equivalent
to 50 percent of the value of the actual revised growth rate. According to BEA economist Allan Young, "advance" GDP
growth figures failed even to show correctly whether GDP growth was negative or positive in 12 percent of all quarters over
the period 1978-1991.6 Taking the Reagan years as an example, the BEA's advance figures underestimated the growth rate in
roughly two-thirds (63 percent) of all quarters. Likewise, during the Clinton era, the BEA so far has overestimated the rate of
growth in about 70 percent of all of its advance estimates.
WHY IT MAKES MORE SENSE TO LOOK AT TRENDS IN GDP
Because of the poor accuracy of advance estimates of GDP and the extreme volatility of quarterly GDP growth rates, a
far better picture of the economy emerges from looking at the underlying trends. Chart 2 shows the trend⁷ in economic
growth compared with the revised quarterly GDP growth rates between the first quarter of 1976 and the second quarter of
1996.⁸
The data in Chart 2 show two major patterns in the rate of economic growth in recent years: an acceleration in growth
rates between the first quarter of 1992 and the final quarter of 1994 and a deceleration in the growth rate beginning after the
peak in 1994 and continuing through to the current period. Both the expansion and the slowdown in the economy, however,
have been punctuated by misleading "spikes," or individual quarters when the GDP growth rate diverged from the trend. For
2 of 3
ond Quarter Economic Growth Figures Probably Will Be Wrong - Heritagehttp://www.heritage.org/heritage/library/categories/theory/fyi114.html
example, during the first quarter of 1993, in the middle of an expansion, the growth rate of GDP fell to zero. More recently,
the economy showed strong above-trend growth in the third quarter of 1995.9
As can be seen from Chart 2, individual quarterly GDP numbers are a rough and often misleading signal of the
long-term and medium-term strength of the economy. Quarterly GDP figures can fluctuate widely because of factors that are
unique to that quarter and which pose no long-term implications for economic prosperity.
CONCLUSION
Americans should not be lulled into a false sense of either economic prosperity or impending economic decline by
estimates of the economy's performance during a single quarter. The advance estimates that are scheduled to be released on
August 1 are likely to be revised considerably in the weeks and months to come. And even if these quarterly snapshots
actually were accurate, quarterly GDP numbers fluctuate considerably for reasons unconnected with the long-term economic
growth rate. Americans should not allow themselves to be deceived by these numbers and the political posturing surrounding
them; rather, they should pay attention to the longer term patterns in the economy.
Chart 1: GDP Growth and Magnitude of Error in Advance Estimate
Chart 2: Trend and Quarterly Real GDP Growth 1976-19
ENDNOTES
1. The authors would like to thank Mark Wilson, Rebecca Lukens Fellow at The Heritage Foundation, for his
contributions to this study.
2. Bureau of Economic Analysis Statistical Release, June 28, 1996. This can be viewed on the World Wide Web at:
http://www.stat-usa.gov/BEN/ebb/bea/gdp.bea
3. Macroeconomic Advisers, The U.S. Economic Outlook, June 8, 1996, pp. 6-8. The forecast model used by
Macroeconomic Advisers is recognized generally as the industry leader. In 1995, Macroeconomic Advisers won the
Blue Chip Consensus Forecasting award. Macroeconomic Advisers also won this award in 1993 and would have won
it again in 1994 except for a rule against winning two times in a row. Their forecast and analysis are confirmed by
Bureau of National Affairs Special Report No. 127, Economic Outlook, July 2, 1996, which surveyed 22 top
econometric firms and found the average forecast of GDP annualized growth for the second quarter of 1996 to be 3.8
percent.
4. Robert N. Parker, "Revisions to the Initial Estimates of Quarterly Gross National Product of the United States,
1968-83," paper presented at University of Florence, Italy, November 1984, pp. 11-12.
5. GDP data, in addition to undergoing three reviews in the months immediately following collection, undergo
large-scale periodic revisions, known as "benchmarking." The most recent large-scale benchmarking of GDP figures
came in January 1996, when the BEA revised and improved all GDP figures dating back to World War II. Among the
revisions was the adoption of a chain-weight measure to adjust the figures for inflation, changes in the treatment of
depreciation, and the use of new data from the IRS and the 1991 Census. See Bureau of Economic Analysis,
"Improved Estimates of the National Income and Product Accounts for 1959-95: Results of the Comprehensive
Revision," Survey of Current Business, January/February 1996, p. 1.
6. Bureau of Economic Analysis, Survey of Current Business, Vol. 73, No. 10 (October 1993), p. 29.
7. Depicted using an 8-quarter moving average. Moving averages are widely used by economists and government
agencies to remove fluctuations from data. They do this by summing and then averaging the change in a variable over
a set number of periods. In this case, the moving average trend estimate for a quarter is the mean of GDP growth for
that quarter and the seven preceding quarters. This moving average has the effect of filtering out large fluctuations in
individual quarters while capturing the long-term pattern of change. For example, a once-off upwards fluctuation in
growth in one particular quarter will change this moving average by a factor of only one-eighth of the change in the
point estimate, but sustained growth over a number of periods will have a larger effect on the moving average. In all
cases, the latest revised GDP growth figures are used. The real growth rate is measured in Chained 1992 dollars.
8. The annualized real growth in GDP during the second quarter of 1996 is forecast at 3.7 percent by Macroeconomic
Advisers.
9. It is important to emphasize that while the growth figures presented in Chart 1 represent the most up-to-date
revisions, they are by no means final. All of the data, and especially the data from the most recent quarters, will
continue to undergo checking
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07/30/96 20:45:02
JUL. 24. 1996 5:44AM
NO.962 P.2/19
THE
HERITAGE
LECTURES
No. 565
Taxes, Deficits and
Economic Growth
By Daniel J. Mitchell
The
T
JUL.24.1996
5:44AM
NO.962
P.3/19
The
Heritage Foundation
The Heritage Foundation was established in 1973 as a non-partisan, tax-exempt policy
research institute dedicated to the principles of free competitive enterprise, limited
government, individual liberty, and a strong national defense. The Foundation's research
and study programs are designed to make the voices of responsible conservatism heard in
Washington, D.C., throughout the United States, and in the capitals of the world.
Heritage publishes its research in a variety of formats for the benefit of policy makers:
the communications media; the academic, business, and financial communities; and the
public at large. Over the past five years alone The Heritage Foundation has published some
1,500 books, monographs, and studies, ranging in size from the 927-page government
blueprint, Mandate for Leadership III: Policy Strategies for the 1990s, to the more frequent
"Critical Issues" monographs and the topical "Backgrounders," "Issue Bulletins," and
"Talking Points" papers. Heritage's other regular publications include the Business/Education
Insider, and Policy Review, a quarterly journal of analysis and opinion.
In addition to the printed word, Heritage regularly brings together national and
international opinion leaders and policy makers to discuss issues and ideas in a continuing
series of seminars, lectures, debates, briefings, and conferences.
Heritage is classified as a Section 501(c)(3) organization under the Internal Revenue
Code of 1954, and is recognized as a publicly supported organization described in Section
509(a)(1) and 170(b)(1)(A)(vi) of the Code. Individuals, corporations, companies, associa-
tions, and foundations are eligible to support the work of The Heritage Foundation through
tax-deductible gifts.
Note: Nothing written here is to be construed as necessarily reflecting the views of The Heritage
Foundation or as an attempt to aid or hinder the passage of any bill before Congress.
The Heritage Foundation
214 Massachusetts Avenue, N.E.
Washington, D.C. 20002-4999
U.S.A.
202/546-4400
JUL. 24. 1996
5:45AM
NO.962
P.4/19
Taxes, Deficits, and Economic Growth
By Daniel J. Mitchell
Even assuming the Clinton Administration's forecast for this year is accurate, the United
States economy's performance since 1989 will have been the worst seven-year period since
the end of World War II. Adjusted for inflation, median household income has declined by
6.6 percent since Ronald Reagan left office. 1 And while the unemployment rate is reason-
ably low, many Americans are worried about the future and fear their children will be the
first generation to have a lower standard of living than its parents.
The economy's sub-par performance has triggered a debate on how best to stimulate eco-
nomic growth and boost income. The good news is that all sides of the debate agree that the
key to economic growth is capital formation-increasing the levels of savings and invest-
ment (including investments in human capital). The bad news, however, is that there is a
significant disagreement over the policy changes that will best meet that goal. On one side
are those who argue that high tax rates dampen incentives and believe that correcting the
anti-savings, anti-investment bias of the current income tax code will improve the econ-
omy's performance. The flat tax, they would argue, offers the best opportunity to generate a
substantial and positive impact on job creation and income growth. The other side of the de-
bate is dominated by those who believe the most important variable is the budget deficit.
They argue that a lower budget deficit will lead to significant reductions in interest rates
and that lower interest rates will spur higher levels of investment.
Finally, no discussion of economic growth would be complete without addressing the size
of government. Regardless of whether it is financed through taxes or borrowing, govern-
ment spending represents a transfer of resources from the private sector to the public sector.
If government spends that money in a way that generates a sufficiently high rate of return,
the economy will benefit. If the rate of return is below that of the private sector, however,
then the rate of growth will be slower than it otherwise would have been.
Needless to say, the debate over growth has important policy implications. Should taxes
be increased or decreased? Should the budget be balanced and, if so, how quickly? Is the
deficit the real problem, or is it a symptom of an underlying problem of too much govern-
ment? What is the impact of tax reform? What types of government spending count as
investment? If certain policies increase growth, should that higher growth be included in
government economic and revenue estimates?
Careful analysis of the historical and theoretical evidence yields three important conclu-
sions that can help guide policymakers as they focus on the nation's economic problems:
1
U.S. Bureau of the Census Current Population Reports: Series P60-189, "Income, Poverty, and Valuation of
Non-Cash Benefits: 1994." (Washington, D.C.: U.S. Government Printing Office, 1996).
Daniel J. Mitchell is McKenna Senior Fellow in Political Economy at The Heritage Foundation.
He spoke at 3 conference on Investment. Risk Capital. and Economic Growth, sponsored by the Swedish Stock
Exchange and the Center for Business and Policy Studies, in Stockholm. Sweden. on May 14, 1996.
ISSN 0272-1155 © 1996 by The Heritage Foundation.
NO.962
P.5/19
JUL. 24. 1996 5:45AM
1) The tax system is taking too much money out of the productive sector of the economy. Per-
haps even more important, the structure of the tax system is grossly flawed and imposes a
particularly steep penalty on the very behaviors-saving and investing-that are needed to
promote growth.
2) Government borrowing is morally wrong because it imposes bills on future generations, 2
but the deficit should not drive economic policy. Contrary to what both political parties ar-
gue, there does not seem to be a strong relationship between the budget deficit and interest
rates. Nor is there much reason to believe that lower interest rates, by themselves, will have
a pronounced effect on investment. Mpreover, focusing on the deficit can undermine sound
economic policy by leading some to view higher taxes as an appropriate policy option.
3) Government spending is too high. Many programs fail to generate an adequate rate of re-
turn (and many, such as welfare programs. almost certainly have a negative return and have
made things worse). Not all government spending, needless to say, is dependent on "rates
of return," but legislators should fully understand that funding programs with money that
could be more productively used by the private sector will result in less economic growth.
Finally, for those who do view the deficit as the key variable, there is ample evidence that
slowing the growth of spending-not higher taxes-is the only way to achieve a balanced
budget.
Why Capital Matters
As stated above, there is very little controversy about what causes growth. There is near-
unanimous agreement that salaries and wages are linked closely to productivity. The only
way to raise the income of workers permanently-assuming no change in their skills-is
through savings and investment. Simply put, workers are paid on the basis of what they pro-
duce, and giving them better tools allows them to produce more. The level of capital
formation, for instance, largely explains why workers in the United States, Germany, and Ja-
pan earn more than workers in Brazil, India, and Nigeria. Similarly, workers in America
today earn more than their parents because of net investment (increases in the capital.
stock). As a result, they are more productive, generating more output per hour of labor.
Economists of all persuasions recognize this relationship between investment and wages.
Paul Samuelson, for example, a Nobel Laureate economist who endorsed Bill Clinton for
President, has written:
What happens to the wage rate now that each person works with more capital
goods? Because each worker has more capital to work with, his or her
marginal product rises. Therefore, the competitive real wage rises as workers
become worth more to capitalists and meet with spirited bidding up of their
3
market wage rates.
Another example is taken from a 1991 report on economic growth prepared by the staff of
the Joint Committee on Taxation, then controlled by the Democrats:
2
This moral argument is less stringent if the debt was incurred to win a war or for some other purpose which
presumably yields benefits to future generations.
3
Paul A. Samuelson and William D. Nordhaus. Economics, 12th Edition (New York: McGraw-Hill. Inc., 1985).
p. 789.
?
JUL. 24. 1996
46AM
NO.962
P.6/19
When an economy's rate of net investment (gross investment less
depreciation) increases, the economy's stock of capital increases. A larger
capital stock permits a fixed amount of labor to produce more goods and
services. The larger a country's capital stock, the more productive its workers
and, generally, the higher its real wages and salaries. Thus, increases in
investment tend to cause future increases in a nation's standard of living.
5
According to a 1989 report on economic growth published by the Congressional Research
Service:
Capital deepening has been and will likely continue to be a central force for
accelerating growth and potential output over the medium term. But as we
have seen, a permanent increase in the long-term rate of growth will hinge on
the United States' ability to increase the pace of technical advance and
innovation. However, both of these routes to faster growth will be contingent
upon the ability to increase the level of investment spending-more
spending for capital equipment and more spending for research and
development. To finance higher investment will, in turn, require that
Americans raise the national rate of savings. 6
Or consider the views of the White House. In the 1994 Economic Report of the Presi-
dent, the Administration noted that:
The reasons for wanting to raise the investment share of the GDP [gross
domestic product] are straightforward: Workers are more productive when
they are equipped with more and better capital, more productive workers
earn higher real wages, and higher real wages are the mainspring of higher
living standards. Few economic propositions are better supported than these
-or more important.
Competing Theories of Growth
Every economic school of thought-even Marxism-agrees that capital formation is the
key to rising living standards. This happy consensus, however, does not translate into agree-
ment about how to spur more savings and investment. In the political economic debate, at
least in America, there are basically three (actually two and one-half) views on how to pro-
mote economic growth. These are:
Old-Fashioned Keynesianism. This is the half-theory because it has so few adherents in
America. In periods of economic sluggishness, Keynesians believe the government should
increase spending, financed by borrowing, to give the economy a shot in the arm. This
spending is supposed to stimulate aggregate demand, which causes private sector behavior
to perk up. With a handful of exceptions, such as the failed 1993 stimulus bill, this
approach does not receive much attention in Washington.
4
Depreciation refers to the amount of capital that is used up or wears out during each period. For instance, a
machine may have a life expectancy of five years. In order to measure increases in the capital stock accurately,
increases in investment should be adjusted to reflect depreciation.
5
"Tax Policy and the Macroeconomy: Stabilization, Growth, and Income Distribution." Joint Committee on
Taxation report for House Committee on Ways and Means. December 12, 1991. P. 21.
6
Craig Elwell. "The Goal of Economic Growth: Lessons from Japan, West Germany and the United States,"
Congressional Research Service. July 17. 1989.
3
JUL.24.1996
5:46AM
NO.962
P.7/19
1950s Republican/1990s Democrat Balanced Budget Orthodoxy. The title is made
up because this school of thought does not really have a name. Proponents of this
approach. which is dominant in Washington. believe that the economy hinges on changes
in the budget deficit. Contrary to old-fashioned Keynesianism, however, this orthodox
approach argues that reducing the budget deficit is the key to economic growth. The
theory works as follows: A lower budget deficit leads to lower interest rates, lower
interest rates lead to more investment, more investment leads to higher productivity, and
higher productivity means more growth. Although some of the proponents favor smaller
government as a philosophical goal, the balanced budget crowd does not think taxes have
a major effect on incentives to engage in productive behavior. As a result, they are
skeptical of tax cuts and instead are willing to raise taxes.
The Free Market. Another made-up title because other options-supply-side,
conservative, classical liberal-do not capture the central tenet, the free-market approach
believes that the keys to economic growth. at least in terms of fiscal policy, are the size of
government and the structure of the tax system. In short, the free-market approach
believes that total spending, regardless of whether it is financed by taxes or borrowing,
hinders the economy's performance by transferring scarce resources from those in the
private sector who have incentives to use them wisely to politicians and bureaucrats who
oftentimes respond to political incentives. Because the size of government matters, free
market advocates would prefer a government with a $1 trillion budget and a $200 billion
deficit to a government with a $2 trillion budget that was balanced. On the tax side of the
ledger, free market supporters believe taxes affect incentives to work, save. and invest. A
major goal of these folks, therefore, is radical tax reform designed to minimize tax rates
and eliminate multiple taxation of capital. These reforms, it is believed, will boost capital
formation, which will increase productivity, which means faster economic growth.
Who Is Right?
The policy debate in Washington largely revolves berween Options 2 and 3 (though there
is also a fight amongst supporters of Option 2 over the size of government-Should the
budget be balanced at level "X" or level "X+Y?"). Stripping away much of the rhetoric, the
victor in this struggle depends on which set of relationships is more robust:
1) Are balanced budget proponents right that interest rates will fall significantly once deficit
spending comes to an end? And are they correct in believing that investment is very sensi-
tive to interest rates?
2) Are free market supporters correct in believing that there is an inverse relationship between
economic growth and the size of government? Even more important, are they accurate in
stating that decisions to work, save, and invest are significantly altered by the tax code?
In some sense, both sides are right. Unless economists want to repeal the laws of supply
and demand. there can be no doubt that lower budget deficits will lower interest rates. And,
all other things being equal, lower interest rates should mean more investment. It is also un-
ambiguously true that lower taxes will reduce the price of providing labor and capital to the
economy. And it is certainly accurate to note that a large government, by reducing the cost
of not working, will adversely affect the economy's performance.
The real question is the magnitude of these effects. Would balancing the budget really re-
duce interest rates by two percentage points? Is the level of investment primarily driven by
the interest rate? Just how sensitive are decisions to work, save, and invest to the rate of
4
NO.962
P.8/19
JUL. 24. 1996 5:46AM
taxation? To what extent do government spending programs actually undermine work ef-
fort?
Doubts Regarding Balanced Budget Orthodoxy
There is ample reason to question the robustness of the interest rate argument. According
to the theory, lower budget deficits should result in lower interest rates. Yet there is little
evidence to suggest that interest rates are significantly affected by changes in the U.S.
budget deficit. This does not mean that the laws of supply and demand have been repealed.
It simply means that in world capital markets, a shift of $30 billion, $40 billion, or $50 bil-
lion is unlikely to have a dramatic effect and can easily be overwhelmed by other factors
such as monetary policy and demand for credit.
Even if interest rates fall by a significant amount, the second link in the balanced budget
chain of reasoning is very weak. Yes, interest rates must affect investment choices, but it ap-
pears that this variable is dwarfed by other influences. 8 Why invest, for instance, if there is
no hope of making a profit? Real interest rates were negative during the 1930s in America,
yet investment was moribund because investors did not see many opportunities to earn an
adequate rate of return. Likewise, real interest rates were high in America during much of
the 1980s, yet investment rose because people saw ways to make money. Moreover, since a
large portion of investment is self-financed on the part of business, it is difficult to see how
interest rates would have a dramatic impact.
All things being equal, it is a good idea to balance the budget. And, yes, lower interest
rates will promote investment. Balancing the budget, however, is not a silver bullet for the
economy. This approach is especially short-sighted if it is used as a reason to raise taxes or
block pro-growth tax cuts. As the following section illustrates, changes in tax policy can
have a pronounced effect on the economy's performance.
Why Free Market Supporters Are Right About Taxes and Capital Formation
The attached appendices provide a sampling of empirical work on the impact of taxes. To
put that work in context, however, it is useful to walk through an example illustrating just
how heavy the tax burden is on savings and investment. Between personal income taxes,
corporate income taxes, capital gains taxes, and estate taxes, a single dollar of investment in-
come can be subject to as many as four layers of tax in America. Added to that burden are
provisions of the law, such as depreciation and the alternative minimum tax, which force tax-
payers to overstate their income. Adding insult to injury is the heavy compliance cost of the
current system.
The following example illustrates why savings and investment suffer in the current tax cli-
mate. A taxpayer has $100 of income and must decide what to do with it. He can consume
the $100. spending it on food, vacations, clothing, haircuts, or some other product or service,
in which case (with the exception of possible sales taxes) he will receive close to $100 in
goods and services for his money. Or he can invest in the stock of a start-up company with
7
For a complete discussion of the scholarly research on deficits and interest rates, see "Government Deficit
Spending and Its Effects on Prices of Financial Assets." Department of the Treasury, May 1983.
8
Aldona Robins. Gary Robins, and Paul Craig Roberts, "The Relative Impact of Taxation and Interest Rates on
the Cost of Capital," in Dale Jorgenson and Ralph Landau. eds., Technology and Economic Policy (Cambridge,
Mass.: Bellinger Press. 1986).
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the potential to provide new jobs to the community and produce goods that consumers de-
sire. If the company succeeds, the investor most likely will profit. If it fails, he will lose his
$100.
In this case, the investment bears fruit and yields a 10 percent rate of return, enabling the
company to produce $10 of annual income for every $100 invested. Under the current tax
code, 35 percent is skimmed off to pay the corporate income tax, leaving only $6.50 out of
the original $10. This $6.50 then goes to the investor as a dividend. But there are other
taxes. Depending on the investor's income, the personal income tax will take as much as
39.6 percent of his $6.50, leaving him with less than $4.00 of annual income from a "success-
ful" $100 investment. In addition, he may face applicable state and local income taxes.
Finally, if the investor ever decides to sell the stock, he will be hit by one of the highest
capital gains taxes in the industrialized world. To make a bad situation even worse, he will
be taxed on the nominal gains, often meaning that taxes are paid on assets that have lost
value in real terms (and do not forget that the person who sold him the stock originally may
have been subject to capital gains taxes on that sale). The final insult is the estate and gift
tax. Successful entrepreneurs who try to accumulate an estate to pass on to their children
are penalized by inheritance taxes which can confiscate 55 percent of a deceased's assets.
Thanks to the tax code, a fortunate investor-one who actually earns money on his in-
vestments-may have to send more than 80 percent of his earnings to the government, not
to mention having already paid taxes on the money used for the investment in the first
place. Thus, government tax policy has created a very tilted playing field. By punishing sav-
ing and investment, the tax code encourages both individuals and businesses to consume
rather than to build for America's future.
Since taxes have such a dramatic impact on incentives to work, save, and invest, it should
come as no surprise that major tax changes almost always have a significant impact on the
economy. Herbert Hoover's decision in 1930 to increase the top tax rate from 25 percent to
63 percent certainly contributed to the Depression. Lyndon Johnson's surtax on income tax
liabilities, enacted in 1968, together with an increase in the capital gains tax helped end the
1960s expansion. Large tax increases, including inflation-induced bracket creep, contrib-
uted to the economy's dismal performance under Jimmy Carter. George Bush's record tax
increase in 1990 was a principal cause of the recent recession and subsequent anemic recov-
ery. And the sub-par performance of today's economy, particularly the decline in median
household income, almost certainly is attributable in part to the record tax increase pushed
through Congress in 1993 by Bill Clinton.
The Answer: The Flat Tax
Each of the tax code's many shortcomings can be addressed by targeted legislation, but a
far better approach is simply to replace the existing system with a flat tax. There have been
many flat tax proposals over the years, but they all share certain key features. These are:
One low tax rate. All flat tax proposals have a single tax rate that applies to all income
subject to tax. The actual rate imposed varies, but the upper limit would be about 20
percent. The Armey-Shelby flat tax legislation, for instance, begins with a 20 percent rate
which phases down to 17 percent after a couple of years.
Tax income only once. Flat tax proposals are designed to eliminate the tax code's bias
against capital formation by ending the double- (and sometimes triple- and quadruple-)
taxation of income generated through savings and investment. The key principle is that the
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tax code not discriminate against income that is used for savings and investment as
opposed to income that is consumed.
Elimination of deductions, credits, and exemptions. All pure flat tax proposals
eliminate provisions of the tax code that bestow preferential tax treatment on certain
behaviors and activities. Included in this would be special tax breaks for businesses and
corporations and, for individual taxpayers, the home mortgage interest deduction, the
charitable contributions deduction, and the state and local mortgage interest deduction.
Eliminating these "loopholes" solves the problem of complexity, allowing taxpayers to
file their tax returns on a postcard-sized form.
Benefits of a Flat Tax
By addressing the many problems of the existing tax code in one fell swoop, the flat tax
would have an immediate and dramatic positive impact. Included among the benefits are:
Faster economic growth. A flat tax would spur increased work, saving, and investment.
According to many economists, the rise in productive behavior would likely add one
percentage point to the annual rate of economic growth. How significant is this? An
increase in the growth rate of just one-half of one percentage point would boost an
average family of four's yearly income by more than $5,000 after ten years.
Instant wealth creation. Eliminating the second, third, and fourth layers of taxation on
capital income would significantly boost the value of all income-producing assets.
According to Professor Dale Jorgenson of Harvard University, enactment of a flat tax
would immediately boost wealth by some $1 trillion.
Simplicity. The 600-plus tax forms of the current system would be swept into the trash
and replaced by two simple postcard-sized forms. Wage, salary, and pension income
would be reported on the individual form and business and capital income would be
reported on the business form. Neither form would require more than a few minutes to
complete, substantially reducing the 5.4 billion-hour yearly burden of today's tax code.
Fairness. All taxpayers and all income would be treated equally. A taxpayer with ten
times the taxable income of his neighbor would pay ten times as much in taxes.
Successful entrepreneurs no longer would be penalized by discriminatory tax rates, and no
longer would the politically well-connected by able to benefit from special loopholes and
preferences.
An end to micromanagement and political favoritism. All deductions, credits.
exemptions, loopholes, and preferences would be eliminated under a flat tax. Politicians
would lose their ability to pick winners and losers, reward friends and punish enemies, use
the tax code to impose their values on the economy. Investment decisions would be
guided by economic forces rather than tax considerations.
Increased civil liberties. The complexity of the tax code makes it nearly impossible for
either taxpayers or IRS agents to follow the law. A greatly simplified tax code would
eliminate virtually all of the conflicts and controversies that make the IRS one of the most
feared agencies of the federal government.
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The Spending Problem
While current tax policy represents a huge impediment to economic growth, policymak-
ers also must focus on the size of government. To the extent that politicians and
bureaucrats do not spend money as wisely or efficiently as it would be spent in the private
sector, economic growth will lag as government increases in size. More specifically, many
government programs do not generate benefits (or minimize costs) to the economy that ex-
ceed those which would have occurred had the money remained in private hands.
The appropriate approach for policymakers is to determine whether spending for a given
program will yield enough benefits to offset the loss of the money to the private sector (in-
cluding the incentive and compliance costs of collecting taxes). A certain level of
transportation spending, for instance, will facilitate economic growth by permitting the effi-
cient flow of goods and services. Policymakers should debate, of course, whether the
spending could be privatized or conducted at the state and local level. And to the extent
they believe it has to be conducted by Washington, they should do their best to ensure that
funding is allocated according to sound guidelines rather than pork-barrel politics. Other
types of spending, such as crime prevention, also may help the economy by reducing the
cost of crime.
In too many cases, however, there is strong reason to believe that the federal government
is spending money in ways that do not produce good results for the economy. Some pro-
grams, such as welfare, reduce the cost of not working and inevitably undermine productive
economic behavier. Other types of spending, such as the budgets for regulatory agencies,
can have significantly negative rates of return because of the heavy costs they impose on
the private sector. Unfortunately, policy makers usually do not subject government pro-
grams to this type of cost/benefit analysis.
Note that one important conclusion from using this approach is that the deficit is not the
critical variable. The key is the size of government, not how it is financed. Taxes and defi-
cits are both harmful, but the real problem is that government is taking money from the
private sector and spending it in ways that often are counter-productive. As a result, fiscal
policy should focus on reducing the level of government spending, with particular emphasis
on those programs that yield the lowest benefits and/or impose the highest costs. The im-
portance of reducing spending, it should be noted, exists regardless of whether the budget
happens to be balanced and is not contingent on changes in the tax system (just as reform-
ing the tax system and adopting other pro-growth tax changes should not be contingent on
what happens to the spending side of the ledger).
Conclusion
There is no magic formula to boost growth. The economy can only grow if people work
more or work better. Unfortunately, much of the world has adopted policies that impose in-
creasingly steep tax penalties on those who add to the economy's wealth. Compounding the
damage of these policies are spending programs that shield people from taking responsibil-
ity for their own lives. The combination has been an unmitigated failure.
This raises a particularly important issue for those on the left. They must decide what is
more important: keeping a tax system that may satisfy an ideological impulse to punish suc-
cess, or adopting a system that helps boost the living standards of the less fortunate. It is
certainly true that modest reforms like reducing the tax rate on capital gains or big reforms
like the flat tax will boost after-tax income of the rich. The empirical evidence, however,
9
shows that other income classes will benefit as well - and may benefit even more.
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Critics of tax reform complain that it is nothing more than "trickle-down" economics that
relies on tax cuts for the "rich" to boost wages. Such rhetoric may be useful politically, but
it cannot change economic reality. Economist John Shoven has explained:
The mechanism of raising real wages by stimulating investment is sometimes
derisively referred to as "trickle-down" economics. But regardless of the label
used, no one doubts that the primary mechanism for raising the return to
work is providing each worker with better and more numerous tools. One can
wonder about the length of time it takes for such a policy of increasing saving
and investments to have a pronounced effect on wages, but I know of no one
who doubts the correctness of the underlying mechanism. In fact, most
economists would state the only way to increase real wages in the long run is
through extra investments per worker. 10
For a profession usually chided for its lack of agreement, economists are nearly unani-
mous in their recognition that capital formation is the key to economic growth
Policymakers seeking to boost living standards and take-home pay face two competing op-
tions for how best to achieve the goal of more savings and investment: Should they focus on
the deficit or should they shrink the size of government and reform the tax system? While
these goals need not conflict, to the extent there is a division, there should be little doubt
that a myopic fixation on the deficit will not necessarily produce the right policy results.
Adopting a flat tax, by contrast, combined with long-overdue reductions in the level of gov-
ernment spending, will generate the desired outcome of a more prosperous economy.
9
Barry J. Seldon and Roy G. Boyd, "The Economic Effects of a Flat Tax (Draft)," National Center for Policy
Analysis, Dallas. Texas (forthcoming).
10 John B. Shoven, "Alternative Tax Policies to Lower the U.S. Cost of Capital." in Business Taxes, Capital Costs
and Competitiveness. American Council for Capital Formation Center for Policy Research, July 1990. p. 3.
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APPENDIX 1:
Taxes Affect Decisions to Work
Joint research by economists from Princeton University and Brigham Young University,
based on a random survey of physicians, found that a one percentage point increase in mar-
ginal tax rates is associated with a reduction of as much as 1.11 percent in hours worked. 11
A University of California economist found that because of the Tax Reform Act of 1986
(which lowered tax rates), the work effort of high-income married women rose by 0.8 per-
cent for every one percent their after-tax wages increased. 12
Another economist found that "Husbands of retirement age, 60 and over, show substan-
tial variation in hours of work, related systematically to wages and income in the expected
way." Moreover, "Wives in all age groups are quite sensitive to wages and income. 13 In
other words, as after-tax income falls, so does the incentive to work.
Two other economists estimated that "wives' labor supply will increase by 3.8 percent" in
response to a reduction in the marriage penalty. 14
A comprehensive study in The Journal of Human Resources found that taxes reduce married
males' hours of work by 2.6 percent and married females' by between 10 percent and 30 per-
15
cent.
According to a statistical study in Econometrica, yearly hours of work for white married
16
women increase by 2.3 percent for every one percent increase in after-tax earnings.
While husbands are not as sensitive to taxes as wives, the impact of taxes on their behav-
ior is nonetheless dramatic. One study found that they work eight percent less than they
would in the absence of taxes. 17 This indicates a loss in economic output of at least $1,000
per person. 18
All studies acknowledge that higher after-tax incomes increase incentives to work by in-
creasing the "price" of leisure, but some assume this effect is offset because lower taxes
allow workers to achieve a certain level of income by working fewer hours. While this trade-
off is relevant when looking at individual choices, two economists note that "the
generalization of the individual analysis to the economy as a whole is invalid" because "It
will be impossible for all individuals to consume both more goods and more leisure as the in-
11 Mark Showalter and Norman K. Thurston, "Taxes and Labor Supply of High-Income Physicians." unpublished
manuscript. October 21. 1994.
12 Nada Eissa. "Taxation and Labor Supply of Married Women: The Tax Reform Act of 1986 as a Natural
Experiment." unpublished manuscript. September 1994.
13 Robert E. Hall. "Wages, Income. and Hours of Work in the U.S. Labor Force," in G. Cain and H. Watts. eds..
Income Maintenance and Labor Supply (Chicago: Markham. 1973).
14 Jerry Hausman and Paul Ruud. "Family Labor Supply with Taxes." American Economic Review. Vol. 74, No. 2
(May 1984), PP. 242-248.
15 Robert K. Triest. "The Effect of Income Taxation on Labor Supply in the United States." The Journal of
Human Resources. Vol. XXV. No. 3, PP. 491-516.
16 Harvey S. Rosen. "Taxes in a Labor Supply Model with Joint Wage-Hours Determination," Econometrica, Vol.
44, No. 3 (May 1976). PP. 485-507.
17 Jerry Hausman. "Labor Supply." in Henry J. Aaron and Joseph A. Pechman. eds., How Taxes Affect Economic
Behavior (Washington, D.C.: The Brookings Institution, 1981). PP. 27-83.
18 Robert E. Hall and Alvin Rabushka, Low Tax Simple Tax, Flat Tax (New York: McGraw-Hill Book Co., 1983).
10
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dividual work-leisure analysis implies. 19 The actual economy-wide response to changes in
tax rates will be higher than almost all studies indicate. 20
One econometric model found that a one percent reduction in tax rates increased work ef-
fort for lower-income workers by 0.1 percent, for middle and upper-middle-income workers
21
by 0.25 percent, and for upper-income workers by more than 2.0 percent.
19 James Gwartney and Richard Stroup. "Labor Supply and Tax Rates: A Correction of the Record." American
Economic Review, Vol. 73. No. 3 (June 1983). PP. 446-451
20 This is confirmed by other economists. See. for example, Paul Craig Roberts, "The Breakdown of the
Keynesian Model." The Public Interest, No. 52 (Summer 1978), PP. 20-33; Norman B. Ture, "The Economic
Effects of Tax Changes: A Neoclassical Analysis." in Richard H. Fink. ed., Supply-Side Economics: A Critical
Appraisal (Frederick, Md.: University Publications of America. 1982); and William G. Laffer, "Virtues and
Deficiencies of Supply-Side Economics Viewed From an Austrian Perspective," unpublished manuscript.
September 28, 1990.
21
Michael K. Evans, "New Developments in Econometric Modelling: Supply-Side Economics," in Fink.
Supply-Side Economics: A Critical Appraisal.
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APPENDIX 2:
Taxes Reduce Savings and Investment
In a book on taxes and capital formation, Norman B. Ture and B. Kenneth Sanden noted,
"The bias against saving in the present tax system results from the fact that, with few excep-
tions, taxes are imposed both on the amount of current saving and on the future returns to
such saving, whereas the tax falls only once on income used for consumption. ,,22
Economist John Shoven estimates that a reduction of 23 20 percent in the top rate for capital
gains would cause the stock market to rise by 3 percent.
Undersecretary of the Treasury Lawrence H. Summers has written that "increases in the
real after-tax rate of return received by savers would lead to substantial increases in long-
run capital accumulation." Further, "bequests may account for a large fraction of national
capital formation," which strengthens the argument that taxes influence savings. 24
A study in The American Political Science Review noted that "Nations.. where the extractive
[tax] capacity of government did not significantly increase, relative to the economic prod-
uct, have, in a sense, opted for an increasing rate of private capital accumulation. ,,25
Analyzing the decline in savings, a study by three experts concluded that Social Security
and other transfer programs have led to a "decline in U.S. saving. 26
Two other economists also concluded that Social Security reduces savings because work-
ers no longer worry as much about retirement. 27
Econometric results, according to a study published in the Journal of Public Economics,
"suggest that dividend taxes have important effects on investment decisions" and that "an
increase ,,28 of 10 percent in the stock market would raise the investment rate by about 15 per-
cent.
Writing in the National Tax Journal, three economists found "significant effects for the af-
ter-tax return on saving, after-tax cost of borrowing, or both." The Reagan tax cuts "had a
major impact on U.S. economic growth. ,,29
22 Norman B. Ture and B. Kenneth Sanden. The Effects of Tax Policy on Capital Formation (Washington, D.C.:
Institute for Research on the Economics of Taxation, 1977).
23 Shoven, "Alternative Tax Policies to Lower the U.S. Cost of Capital."
24 Lawrence H. Summers, "The After-Tax Rate of Return Affects Private Savings." American Economic Review,
Vol. 74. No. 2 (May 1984). PP. 249-253.
25 David Cameron, "The Expansion of the Public Economy: A Comparative Analysis," The American Political
Science Review. Vol. 72 (1978), pp. 1243-1261.
26 Jagadeesh Gokhale. Laurence J. Kotlikoff. and John Sabelhaus. "Understanding the Postwar Decline in United
States Saving: A Cohort Analysis." unpublished manuscript, November 1994.
27 Lawrence H. Summers and Chris Carroll, "Why Is United States National Saving So Low," Brookings Papers
on Economic Activity, Vol. 2 (1987), PP. 607-635.
28 James M. Poterba and Lawrence H. Summers. "Dividend Taxes. Corporate Investment, and 'Q'." Journal of
Public Economics 22 (1983). PP. 135-167.
29 Allen Sinai. Andrew Lin. and Russell Robins. "Taxes, Saving, and Investment: Some Empirical Evidence,"
National Tax Journal, Vol. XXXVI. No. 3 (1983). PP. 321-345.
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APPENDIX 3:
Growth Is Weaker When Government Penalizes Economic Behavior
A 1983 World Bank study of 20 countries found that low-tax nations experience faster
growth. generate more investment, and enjoy 30 more rapid increases in productivity and
standards of living than high-tax nations.
The tax system imposes between 22 cents and 54 cents of losses for every dollar raised,
according to a labor-supply economist. For working wives, the losses are even higher: more
than 58 cents for very dollar of tax revenue. 31
Another study found that each 1.0 percent increase in the federal tax burden reduces eco-
32
nomic growth by 1.8 percent and lowers national employment by 1.14 percent.
According to a statistical study published in the American Economic Review, for every dollar
33
paid to the federal government in taxes, 33.2 cents is lost to the economy.
The increased tax burden between 1965 and 1980 drove an estimated 1.9 million people
out of the U.S. labor force. 34
Statistical research published in Lloyd's Bank Review has found that in the U.K. each one
percent rise in payroll taxes causes hiring to fall by approximately 1.4 percent. The same
35
study estimated that each $1 of additional tax revenue COSTS $3 in lost economic output.
A study printed in the American Sociological Review concluded that "Increases of one per-
cent in the tax burden relative to household income are directly associated with a 2.8
36
percent decline in economic growth over three years, or just under one percent annually.
An American Economic Review study found that every dollar of taxes could impose as much
as $4 of 37 lost output on the economy, with the probable harm ranging between $1.32 and
$1.47.
A 1981 analysis of the Swedish economy in the Journal of Political Economy found "The es-
timated long-run effects [of high marginal tax rates] are sufficient to explain up to 75
percent of the recent decline in the measured growth of the Swedish GNP. 38
30 Keith Marsden. "Links Between Taxes and Economic Growth: Some Empirical Evidence." World Bank Staff
Working Paper No. 605. 1983.
31 Hausman. "Labor Supply."
32 William C. Dunkelberg and John Skorburg. "How Rising Tax Burdens Can Produce Recession." Cato Institute
Policy Analysis No. 148, February 21, 1991.
33 C.L. Ballard. J. B. Shoven. and J. Whalley, "General Equilibrium Computations of the Marginal Welfare Costs
of Taxes in the United States," American Economic Review. Vol. 75. No. 1 (1985). PP. 128-138.
34 Otto Eckstein. "Tax Policy and Core Inflation. A Study Prepared for the Use of the Joint Economic
Committee" (Washington. D.C.: U.S. Government Printing Office. 1980). See also L. Godfrey, "Theoretical
and Empirical Aspects of the Effects of Taxation on the Supply of Labour" (Paris: Organization for Economic
Cooperation and Development. 1975).
35 Michael Beenstock. "Taxation and Incentives in the U.K.." Lloyd's Bank Review, No. 134 (October 1979). PP.
1-15.
36 Roger Friedland and Jimy Sanders. "The Public Economy and Economic Growth in Western Market
Economies." American Sociological Review. Vol. 50 (August 1985), PP. 421-437.
37 Edgar K. Browning. "On the Marginal Welfare Cost of Taxation." American Economic Review, Vol. 77. No. I
(March 1987), PP. 11-23.
38 Charles E. Stuart, "Swedish Tax Rates, Labor Supply, and Tax Revenues." Journal of Political Economy. Vol.
89, No. 5 (1981). pp. 1020-1038.
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According to a former Treasury Department official, between 75 percent and 80 percent
39
of the additional wealth generated by increased savings and investment goes to workers.
Another study in the Journal of Political Economy estimated that the corporate income tax
costs more in lost outpur than it raises for the government. The "excess burden" is "123 per-
cent of revenue. 1,40
A 1984 study in the American Economic Review estimated "20.7 cents of welfare loss per ad-
ditional dollar of tax revenue. ,,41
A study of U.S. taxes at the state level found that low-tax states grew 35 percent faster
than high-tax states berween 1970 and 1980.4² The relationship 43 between growth and taxes
among the states has been shown in literally dozens of studies.
Another economist was able to illustrate a very strong inverse relation between average
44
per capita growth rates and average tax rates on income and profits in developed countries.
According to an article in the Journal of Political Economy, based on worldwide data, in-
creasing the tax burden by ten percentage points will reduce annual growth by two
percentage points. 45
In a paper presented at the World Bank, two economists uncovered an "impressive nega-
tive relation between the rate of growth and the ratio of tax revenue to GDP" 1146 as well as a
"negative association between growth and the 'marginal' income tax rate.
Of the explosive growth of Hong Kong. Taiwan, Singapore, and South Korea, Hoover
economist Alvin Rabushka has written that
The four Asian tigers adopted supply-side tax policies decades before the
Reagan and Thatcher revolutions. Finance ministers oversaw systems of
taxation that featured low rates and/or low levels of direct taxation of
individuals and businesses, the absence of or very light charges on capital
income (interest, dividends, capital gains), and a smorgasbord of inducements
for domestic and foreign enterprises to invest and reinvest in each economy.
47
39 Norman B. Ture, "Supply Side Analysis and Public Policy," in David G. Raboy. ed., Essays in Supply Side
Economics (Washington, D.C.: Institute for Research on the Economics of Taxation, 1982).
40 Jane G. Gravelle and Laurence J. Kotlikoff. "The Incidence and Efficiency Costs of Corporate Taxation When
Corporate and Noncorporate Firms Produce the Same Good," Journal of Political Economy. Vol. 97, No. 4
(1989). PP. 749-780.
41 Charles Stuart, "Welfare Costs per Dollar of Additional Tax Revenue in the United States." American
Economic Review, Vol. 74. No. 3 (June 1984), PP. 352-362.
42 Richard K. Vedder. "Rich States. Poor States: How High Taxes Inhibit Growth." Journal of Contemporary
Studies. Fall 1982. PP. 19-32.
43 See Bruce Bartlett, "Impact of State and Local Taxes on Growth: Bibliography." Alexis de Tocqueville
Institution. 1995. and Richard K. Vedder. "Do Tax Increases Harm Economic Growth and Development?"
Arizona Issue Analysis. Report No. 106, September 20, 1989 (Annotated Bibliography).
44 Charles Plosser. "The Search for Growth." unpublished manuscript, August 1992.
45 Robert G. King and Sergio Rebelo, "Public Policy and Economic Growth: Developing Neoclassical
Implications." Journal of Political Economy, Vol. 98 (October 1990). PP. S126-S150.
46 William Easterly and Sergio Rebelo, "Fiscal Policy and Economic Growth: An Empirical Investigation."
unpublished manuscript, March 1993.
47 Alvin Rabushka, "Tax Policy and Economic Growth in the Four Asian Tigers," Journal of Economic Growth,
Vol. 3. No. 1.
14
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Other studies have found that the economy is harmed when government spends tax reve-
nue:
A National Bureau of Economic Research study, using worldwide data, found that an in-
crease "in government spending and taxation of 10 percentage points was predicted to
decrease long-term growth rates by 1.4 percentage points. ,,48
According to Daniel Landau, "The results of this study [published in the Southern Eco-
nomic Journal] suggest a negative relationship exists between the share of government
consumption expenditure in GDP and the rate of growth of per capita GDP. 1149
Two economists found that increases in U.S. government outlays for social programs "are
associated with reductions in the growth rate. 1,50
48 Eric M. Engen and Jonathan Skinner. "Fiscal Policy and Economic Growth," National Bureau of Economic
Research. Working Paper Series. No. 4223, December 1992.
49 Daniel Landau. "Government Expenditure and Economic Growth: A Cross-Country Survey," Southern
Economic Journal. Vol, 49 (January 1983). PP. 783-792.
50 John McCallum and Andre Blais. "Government, Special Interest Groups, and Economic Growth." Public
Choice. Vol. 54 (1987).
15
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The
Herîtage Foundation Backgrounder
1086
No.
The Heritage Foundation
214 Massachuserts Avenue, N.E.
Washington, D.C. 20002-4999
(202) 546-4400
http://www.heritage.org
The Thomas A. Roe Institute for Economic Policy Studies
July 19, 1996
THE HISTORICAL LESSONS
OF LOWER TAX RATES
Daniel J. Mitchell
McKenna Senior Fellow in Political Economy
INTRODUCTION
T
he 1996 presidential campaign has rekindled the debate over tax reductions.
Among the proposals being considered are an across-the-board reduction in tax rates, the
repeal of rate increases imposed in 1990 and 1993, the deductibility of payroll taxes, and
a modified flat tax. But regardless of the particular features of each change under consid-
eration, the argument is the same. Proponents argue that lower tax rates will spur eco-
nomic growth by reducing the penalty on working, saving, and investing. Opponents dis-
agree, claiming that the economy is doing fine and that tax rate reductions, if enacted,
will help the rich disproportionately while widening the deficit.
Fortunately, there is a way to judge the desirability of lower tax rates. The United
States has had three major episodes of tax rate reductions-the 1920s, 1960s. and 1980s.
By looking at how the economy performed during these periods, and by examining what
happened to the deficit and the degree to which different income classes were affected, it
is possible to gain useful evidence about the desirability of tax rate reductions today.
The evidence provides strong support for those who believe the economy is weak and
favor reductions in tax rates. Recent history is especially compelling. Tax rate increases
in 1990 and 1993 boosted the top rate to 39.6 percent (and over 42 percent including the
Medicare payroll tax). This means a 50 percent increase in the tax burden on work, sav-
ing, investment, and entrepreneurship when compared with the 28 percent rate in effect
when Ronald Reagan left office. The effect has been dismal:
During the post-Reagan era, the economy has experienced its worst seven-year
performance since the end of World War II.
Real median family income. the best measure of living standards for the average
American, has fallen by more than $2,000 since Reagan left office.
Note. Nothing written here IS to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt
10 aid or hinder the passage of any Dill before Congress
NO.960
P.3/13
JUL. 24. 1996
5:21AM
Assuming there is no change in policy, the Congressional Budget Office esti-
mates that economic growth for the next ten years will average less than 2.1 per-
cent annually. 1 This is
Chart 1
well below the post-
World War II average
Median Family Income has Fallen by More than
$2,000 Since Reagan Left Office
of 3.2 percent.
Real Family Income, 1994 Dollars
$42.000
The economy's sub-
standard performance in
$41,000
recent years should come
$40,000
as no surprise. As seen be-
$39,000
low, major changes in tax
policy inevitably affect
$38,000
growth.
$37,000
Across-the-board tax
$36,000
rate reductions in the
1920s reduced the top
1977
1981
1989
1994
rate from 71 percent
Source: Bureau of the Census Department of Commerce.
to 24 percent. The
economy boomed, growing by 59 percent between 1921 and 1929.
In 1930, Herbert
Chart 2
Hoover raised tax
rates from 25 percent
Maximum Income Tax Rate
to a maximum of 63
percent, and Franklin
100%
Roosevelt boosted
90
them to 79 percent
80
later in the decade.
70
The 1930s, to put it
60
50
mildly, are not remem-
8
bered as one of the
30
American economy's
2
20
better decades.
10
Across-the-board tax
1920
1930
1940
1950
1960
1970
1980
1990
rate reductions intro-
Source: Tax Foundation.
duced by President
John F. Kennedy reduced the top rate from 91 percent to 70 percent. These lower
rates, along with substantially lower taxes on savings and investment, are associated
with the longest economic expansion in American history. 3
1
Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006, May 1996.
2
It is important to note that tax policy is just one of the many ways government can influence the economy and should receive
neither full credit nor full blame for how well the economy performs. In the 1930s, for instance, contractionary monetary
policy and protectionist trade policy also contributed to the economy's poor performance.
3
The lower tax rates were phased in between 1964 and 1965. The lower taxes on capital went into effect in 1962.
2
NO.960
P.4/13
JUL.24.1996
5:21AM
The Johnson surtax, enacted in 1968 during the administration of President Lyn-
don Johnson, combined with the inflation-induced bracket creep of the 1970s
(subjecting taxpayers to higher rates even though their real incomes had not
changed), resulted in a decade of stagflation.
Reagan's across-the-board tax cuts ushered in America's longest peacetime expan-
sion, helping to create 20 million new jobs and pushing incomes and living standards
to record highs.
Chart 9
The tax rate in-
All Groups Earn Higher Incomes During
creases imposed un-
Reagan Boom
der George Bush and
Change in Real Family income 1981-1989
25%
Bill Clinton, as out-
lined below, are asso-
20
ciated with the slow-
est growing econ-
IS
omy in 50 years and
10
a decline of more
than $2,000 in the av-
5
erage family's in-
come.
Bottom 20
Second
Middle
Fourth
Top 20
If legislators want to
Percent
Quintile
Quintile
Quintite
Percent
unleash stronger growth
Source Bureau of the Came Department of Commerce,
and more prosperity, the
best tax policy would be the flat tax. Under that proposal, all three major problems of the
current tax code-high rates, anti-capital bias, and complexity-would be minimized.
To the extent that politicians are reluctant to adopt a flat tax, however, any change that
moved in the right direction would be helpful. If history is any guide, any tax rate reduc-
tion, whether a 15 percent across-the-board cut, a repeal of the Bush and Clinton tax
hikes, or some other reform, would boost the economy and raise living standards.
LOOKING AT CASE HISTORIES
The effect of tax rates on economic activity should not be overstated. The economy, af-
ter all, can be affected significantly by trade policy, regulatory policy, monetary policy,
and many other government actions. Even within the context of fiscal policy, tax rates
are not the only critical issue. Both the level of government spending and where that
money goes are very important. And even when looking only at tax policy, tax rates are
just one piece of the puzzle. If certain types of income are subject to multiple layers of
tax, as occurs in the current system, that problem cannot be solved by low rates. Simi-
larly, a tax system with needless levels of complexity will impose heavy costs on the pro-
ductive sector of the economy.
Keeping all these caveats in mind, there nonetheless is a distinct pattern throughout
American history: Simply stated, when tax rates are reduced, the economy prospers, tax
revenues grow, and lower-income citizens bear a lower share of the tax burden. Con-
versely, periods of higher tax rates are associated with subpar economic performance and
stagnant tax revenues.
3
NO. 960
P.5/13
JUL. 24. 1996
5:22AM
The 1920s
Under the leadership of Treasury Secretary Andrew Mellon during the Administra-
tions of Presidents Warren Harding and Calvin Coolidge, tax rates were slashed from
the confiscatory levels they had reached in World War I. The Revenue Acts of 1921,
1924, and 1926 re-
duced the top rate
Chart 4
I
from 73 percent to 25
Lower Tax Rates in the 1920s Meant More Tax Revenue
percent.
$1,200
Personal INCOME Tax Revenues Millions of Dollars
Top income Tax Rate
100%
Spurred in part by
90
lower tax rates, the
1,100
80
economy expanded
Top Income Tax Rate
income Tax Revenue
70
dramatically. In real
1,000
60
terms, the economy
900
so
grew 59 percent be-
40
tween 1921 and 1929,
800
30
and annual economic
20
700
growth averaged more
10
than 6 percent.
1921
1922
1923
1924
1925
1926
1927
1928
Notwithstanding (or
Sources Tax Foundation: The Mellon and Kennedy Tax Cus A Review and Analysis Staff Study. joint
Economic Committee, Nine 18. 1982.
perhaps because of)
the dramatic reduction
Chart 5
in tax rates, personal
Rich Pay More Following 1920s Tax Cuts
income tax revenues
Tax Collections from
increased substantially
Share of Income Tax Burden
the Rich (Milons or Dollars)
80%
$1,000
during the 1920s, ris-
Share of Income
Tax Burden Sorne
ing from $719 million
by the Rich
800
60
in 1921 to $1,160 mil-
lion in 1928, an in-
600
crease of more than
40
Tax Collections
61 percent (this was a
400
from the Rich
period of no infla-
4
20
tion).
200
The share of the tax
1921
1922
1923
1924
1925
1926
1927
1928
burden borne by the
Nome The Rich VI delived M those - incomes above $50.000.
rich rose dramatically.
Source: The Fision and Kennedy Tax CLAS A Review vo Staff Study. joint Economic Committee. june 18, 1982
As seen in Chart 5,
taxes paid by the rich (those making $50,000 and up in those days) climbed from
44.2 percent of the total tax burden in 1921 to 78.4 percent in 1928.
4
Bureau of the Census, Historical Staristics of the United States: Colonial Times to 1970, Part 1 (Washington, D.C.: U.S.
Government Printing Office, 1976).
4
JUL. 24. 1996
:22AM
NO.960
P.6/13
This surge in revenue was no surprise to Mellon:
The history of taxation shows that taxes which are inherently excessive are
not paid. The high rates inevitably put pressure upon the taxpayer to
withdraw his capital from productive business and invest it in tax-exempt
securities or to find other lawful methods of avoiding the realization of
taxable income. The result is that the sources of taxation are drying up;
wealth is failing to carry its share of the tax burden; and capital is being
diverted into channels which yield neither revenue to the Government nor
profit to the
people.
Chart 6
The 1960s
Kennedy Tax Cuts Boosted Revenue
President Kennedy
Billions of Dollars of Tax Revenue
$160
Top Income Tax Rate
100%
proposed a series of
Top Tax Rate
150
90
tax rate reductions in
140
80
1963 that resulted in
130
70
legislation the follow-
120
8
ing year dropping the
110
Tax.Revenue
so
top rate from 91 per-
40
100
cent in 1963 to 70 per-
30
cent by 1965. 6
90
20
80
10
The Kennedy tax cuts
helped trigger the
1961
1962
1963
1964
1965
1966
1967
1968
longest economic ex-
Source: Tax Foundation: Budget of the us Government FY 1997. Office of Paragement and Budget
pansion in America's
history. Between
Chart 7
1961 and 1968, the in-
Rich Pay More Under Kennedy Tax Cuts
flation-adjusted econ-
Percent change, 1963-1966
omy expanded by
100%
more than 42 percent.
80
On a yearly basis, eco-
60
nomic growth aver-
aged more than 5 per-
6
cent.
20
Tax revenues grew
0
strongly, rising by 62
-20
percent between 1961
and 1968. Adjusted
for inflation, they
so
&
$50 6 $100 8 $500 6 $1.000
plus
rose by one-third.
Income in Thousands of Dollars
Seares: The Medon and Kennedy Tax Cuts A Review and Analysis Staff Study, joint Economic Committee. June 18. 1982
5
Andrew Mellon, Taxation: The People's Business (New York: Macmillan, 1924).
6
The Kennedy boom also was helped along by reductions, occurring in 1962. in the tax burden on investment and capital gains.
5
NO.960
P.7/13
JUL. 24. 1996
5:22AM
Just as in the 1920s, the share of the income tax burden borne by the rich increased.
Tax collections from those making over $50,000 per year climbed by 57 percent be-
tween 1963 and 1966, while tax collections from those earning below $50,000 rose
11 percent. As a result, the rich saw their portion of the income tax burden climb
7
from 11.6 percent to 15.1 percent.
According to President Kennedy:
Our true choice is not between tax reduction, on the one hand, and the
avoidance of large Federal deficits on the other. It is increasingly clear that
no matter what party is in power, so long as our national security needs
keep rising, an economy hampered by restrictive tax rates will never
produce enough revenues to balance our budget just as it will never
produce enough jobs or enough profits. Surely the lesson of the last decade
is that budget deficits are not caused by wild-eyed spenders but by slow
economic growth and periodic recessions and any new recession would
break all deficit records. In short, it is a paradoxical truth that tax rates are
too high today and tax revenues are too low and the soundest way to raise
the revenues in the long run is to cut the rates now. 8
The 1980s
President Reagan presided over two major pieces of tax legislation which together re-
duced the top
tax rate from
Chart 8
70 percent in
Did Tax Cuts Cause the Deficit?
1980 to 28 per-
cent by 1988.
Budget Deficit in Billions of Dollars
Tax OR
Economy
Tax Cvt
Gramm-Rudman
Bush Tax Hike
The eco-
$300
Erecued
Gen Net
Fully
Takes Effect
$290
Tax City
Implementad
$270
nomic effects
250
of the Reagan
$221
$212
$221
$208
tax cuts were
200
dramatic.
$185
$155
When Reagan
150
took office in
$150
$153
$128
1981, the econ-
100
$74
omy was being
50
$79
choked by high
$40
inflation and
was in the mid-
1980
1982
1984
1986
1988
1990
1992
dle of a double-
Fiscal Years
Source: Budget of the US Government FY 1997, Office of Management and Budget
dip recession
(1980 and
1982). The tax cuts helped pull the economy out of the doldrums and ushered in the long-
7
Joint Economic Committee. "The Mellon and Kennedy Tax Cuts: A Review and Analysis," June 18, 1962.
8
John F. Kennedy, speech to Economic Club of New York, December 14, 1962.
6
NO.960
P.8/13
JUL.24.1996
5:23AM
est period of
Chart 9
peacetime eco-
nomic growth
Rich Pay Greater Share of Income Tax Burden
in America's
After Reagan Tax Cuts
history. During
Percent of Total Personal income Taxes Part
the seven-year
60%
1981
1990
1981
1990
Reagan boom,
economic
so
growth aver-
40
aged almost 4
percent.
30
Critics charge
20
that the tax cuts
caused higher
10
deficits, but
they misread
Top 1% of Taxpayers
Top 10% of Taxpayers
the evidence.
Source Tax Foundation.
The Reagan tax
cut, though ap-
proved in 1981, was phased in over several years. As a result, bracket creep (indexing
was not implemented until 1985) and payroll tax increases completely swamped Rea-
gan's 1.25 percent tax cut in 1981 and effectively canceled out the portion of the tax cut
which went into effect in 1982. The economy received an unambiguous tax cut only as
of January 1983. Thereafter, personal income tax revenues climbed dramatically, increas-
ing by more than 54 percent by 1989 (28 percent after adjusting for inflation).
Contrary to conventional wisdom, it was the "rich" who paid the additional taxes. The
share of income taxes paid by the top 10 percent of earners jumped significantly, climb-
ing from 48.0 percent in 1981 to 57.2 percent in 1988. The top 1 percent saw their share
of the income tax bill climb even more dramatically, from 17.6 percent in 1981 to 27.5
9
percent in 1988.
One of the chief architects of the Reagan tax cuts was then-U.S. Representative Jack
Kemp (R-NY). According to Kemp:
At some point, additional taxes so discourage the activity being taxed,
such as working or investing, that they yield less revenue rather than more.
There are, after all, two rates that yield the same amount of revenue: 10 high
tax rates on low production, or low rates on high production.
9
Joint Economic Committee. Annual Report, 1992.
10 Jack Kemp. An American Renaissance: A Strategy for the 1980s (New York: Harper and Row, 1979).
7
NO.960
P.9/13
JUL. 24. 1996
5:23AM
THE LESSONS
1) Lower tax rates do not mean less tax revenue.
The tax cuts of the 1920s: Personal income tax revenues increased substantially
during the 1920s, despite the reduction in rates. Revenues rose from $719 million in
1921 to $1164 million in 1928, an increase of more than 61 percent (this was a period
of virtually no inflation).
The Kennedy tax cuts: Tax revenues climbed from $94 billion in 1961 to $153 bil-
lion in 1968, an in-
Chart 10
crease of 62 per-
cent (33 percent af-
Tax Revenues Nearly Doubled During 1980s
ter adjusting for in-
$1,400
Billians of Dollars
flation).
$1.300
The Reagan
$1,200
tax cuts: Total tax
$1,100
revenues climbed
$1,000
by 99.4 percent
$900
during the 1980s,
$800
and the results are
$700
even more impres-
$600
sive when looking
$500
at what happened
to personal in-
1980
1982
1984
1986
1988
1990
1992
1994
come tax reve-
Source: Budget of the us Government FY 1997. Office of Management and Budget.
nues. Once the
economy received an unambiguous tax cut in January 1983, income tax revenues
climbed dramatically, increasing by more than 54 percent by 1989 (28 percent after ad-
justing for inflation).
2) The rich pay more when incentives to hide income are reduced.
The tax cuts of the 1920s: The share of the tax burden paid by the rich rose dra-
matically as tax rates were reduced. The share of the tax burden borne by the rich
(those making $50,000 and up in those days) climbed from 44.2 percent in 1921 to
78.4 percent in 1928. 11
The Kennedy tax cuts: Just as happened in the 1920s, the share of the income tax
burden borne by the rich increased following the tax cuts. Tax collections from those
making over $50,000 per year climbed by 57 percent between 1963 and 1966, while
tax collections from those earning below $50,000 rose 11 percent. As a result, the rich
12
saw their portion of the income tax burden climb from 11.6 percent to 15.1 percent.
11 Joint Economic Committee, "The Mellon and Kennedy Tax Cuts."
12 Ibid.
8
NO.960
P.10/13
JUL. 24. 1996
5:23AM
The Reagan tax cuts: The share of income taxes paid by the top 10 percent of earn-
ers jumped significantly, climbing from 48.0 percent in 1981 to 57.2 percent in 1988.
The top 1 percent saw their share of the income tax bill climb even more dramatically,
from 17.6 percent in 1981 to 27.5 percent in 1988. 13
THE 1990s: IGNORING THE LESSONS OF THE PAST
Chart 11
Unlike reductions
in tax rates, in-
Lower Tax Rates Work: Revenues Grew Faster
creases in tax rates
Under Kennedy and Reagan
have a history of fail-
Average Annual increase in Real income Tax Revenues
ure. The Hoover and
4.79%
Roosevelt tax in-
5%
creases of the 1930s
4
certainly contributed
to the dismal econ-
3
22%
1,53%
omy during the
134%
2
Great Depression.
Tax revenues fell
1
0.01%
during much of the
period, and the defi-
1953.
1962-
1969-
1981-
1990-
cit increased. And as
1961
1969
1976
1989
1995
Chart 11 shows, the
Source: Budget of the us Government FY 1997, Office of Management and Budget
high tax rates of the
1950s resulted in
Bracket Creep -
sluggish revenue
The Inflation Tax Did Raise Revenue
growth. Ignoring
As Chart 11 shows revenues do not grow quickly when tax:rates
history, both Demo-
arehigh. The one exception to this pattern occurred during the late
crats and Republi-
1970s wheninglation pushed taxpayers into higher and higher tax
cans at the time ar-
brackets (there were more than 20 separate tax rates at the time).
gued that tax rates
Ironically) the victims of bracket creep-the ones who paid the addi-
reaching over 90
tionalitax were lower- and middle income taxpayers. The rich at-
percent could not be
readywere in the high bracket and thus were not affected. More-
cut for fear of reve-
over since those with lower earnings receive more than 80 percent
nue loss. Moreover,
of theirincame from wages and salaries, it was very difficult at least
the 1970s, which be-
in the short run for them to make behavioral changes to escape
the higher taxes Rich taxpayers, on the other hand, receive the bulk
gan with the
of their earnings in the form of dividends, interest, capital gains, and
Johnson surtax and
business income The timing and composition of these earnings can
later were hit by
easily be altered to protect the taxpayer from confiscatory tax rates
bracket creep, trig-
(which helps explain why higher tax rates aimed at the rich almost at
gered the tax revolt
ways fail to generate additional tax revenue). So politicians seeking
and the Reagan tax
higher revenues can claim some historical evidence on their side but
cuts.
only if they are willing to take more money from the poor and mid-
die class through the hidden tax of inflation.
13 Joint Economic Committee. Annual Report, 1992.
9
NO.560
P.11/13
JUL. 24. 1996
5:24AM
Perhaps
Chart 12
T
more than
any other
Higher Tax Rates, Lower Revenue
decade, how-
ever, the
1990s make
1989
1996
1989
1996
1989
1996
the best argu-
50%
ment against
39.6%
40
higher tax
rates. In
30
28%
both 1990
19.2%
19.1%
and 1993,
20
the economy
8.6%
was sub-
10
8.5%
jected to re-
cord tax in-
Top Tax Rate
Tax Revenues
Personal Income
creases, the
as % of GDP
Tax Collections
ostensible
as % of GDP
Source: Bureau of the Census Department of Commerce.
purpose of
which was
to raise revenue to reduce the budget deficit. As Chart 12 illustrates, however, these in-
creases backfired. Total tax revenue, as a percent of economic output, is expected to be
lower this year than it was when Reagan left office. 14
Significantly, the modest decline in revenues relative to gross domestic product (GDP)
is due to the slower growth in personal income tax revenues. As shown in Chart 12, indi-
vidual income tax revenues totaled 8.6 percent of economic output in 1989. By 1996-
two large tax increases later-individual income tax revenues had fallen to 8.5 percent
of economic output. In other words, the tax that was increased the most accounts for the
drop in tax revenue as a share of national output.
High tax rates are bad for the economy. High tax rates that increase the deficit by re-
ducing the growth of tax revenue are even worse. What makes recent history especially
tragic is that the economic and budgetary losses could have been avoided if Bush and
Clinton had simply kept Reagan's policies in place. In 1989, the Congressional Budget
Office projected that the budget deficit, which then was $152 billion, would continue to
fall for the next five years assuming no change in Reagan's policies. As of 1995-again,
two large tax increases later-the budget deficit had risen to $164 billion, and it is pro-
jected by the CBO to reach more than $400 billion by 2006 if Clinton's policies are left
in place.
The dismal budget numbers, however, tell only part of the story. The economy has
been the real victim of higher tax rates. As Chart 13 shows, the post-Reagan era has seen
the slowest growth of any seven-year period since the end of World War II. As discussed
earlier, this slow growth has left people with more than $2,000 less income when infla-
14 This is a particularly stunning statistic, since collections normally rise as a percentage of GDP over time in a system with
graduated rates.
10
NO.960
P.12/13
JUL.24.1996
5:24AM
tion is taken into account. The biggest losers have been the poor. As Chart 14 illustrates,
income for the bottom 20 percent has fallen the most during the Bush/Clinton era. The
politicians who imposed the higher taxes, needless to say, argued that the rich would be
the ones to suffer.
Chart 13
1.81 Percent Average Annual Growth Since Reagan Left Office is Worst
Seven-Year Economic Performance Since End of World War II
Average Annual Growth
Kennedy/
Nixon/
Reagen
Clinton
Eisenhower
Johnson
Johnson
Ford
Carter
Bush
T%
6
7-Year Moving
5
Average
4
3
2
I
0
-1
-2
-3
1955
1960
1965
1970
1975
1980
1985
1990
1995
Source: Economic Report of the President Coundi of Economic Advisers February 1996.
Chart 14
Lower and Middle Income Families Suffer
Most During High Tax, Post-Reagan Era
6%
Percent Change in Real Income 1989-1994
4
2
0
-2
A
-6
-8
-10
Bottom 20
Second
Middle
Fourth
Top 20
Percent
Quintile
Quintile
Quintile
Percent
Source: Bureau of the Census. Department of Commerce.
11
NO.960
P.13/13
JUL.24.1996
5:24AM
CONCLUSION
The economy is limping, incomes have been falling, tax revenues are stagnant, and it
is projected that the deficit will more than double in the next ten years. This is the legacy
of higher tax rates and a tax code that punishes working, saving, and investing. History
shows clearly that the way to reverse this trend is to cut tax rates. Legislation to reduce
rates would do this. Better still, Congress should scrap the current system as quickly as
possible and replace it with a flat tax that treats all taxpayers equally and minimizes the
burden on productive behavior.
HERITAGE STUDIES ON LINE
Heritage Faundation studies areavallable electronically organeral line incarions. On the Internet,
The Heritage Foundation 's world wide web home page address Leww heritage.org.
Benkmark it fornswunformationdaty
Heritage studiessalso or envoliable OFF CompuServe as part afthe.Town Halliforum A joint project of The Heritage
Foundation-and National Beginni. Town Halls comesting place for consematives to exchange informationand
opinions on 0 wide variety of subjects. For wore information online,Type GO TOWNHALL or call 800-441-4142
12
on Crunch"?: How the 1993 Budget Plan Affected the Economy - Heritagwww.heritage.org/heritage/library/categones/budgetax/bg1078.hfm
The
Heritage Backgrounder
IS THERE A "CLINTON CRUNCH"?: HOW THE 1993 BUDGET PLAN AFFECTED THE
ECONOMY
By Scott A. Hodge. Grover M. Hermann Fellow in Federal Budgetary Affairs; William W. Beach, Visting Fellow, Tax
Analysis; John S. Barry, Policy Analyst; Mark Wilson, Rebecca Lukens Fellow in Labor Policy; Joe Cobb. John M. Olin
Fellow in Political Economy
The Heritage Foundation
Backgrounder No. 1078
May 1, 1996
Table 1: Opportunities Lost The 1993 Budget Plan Cost America:
Table 2: Employment, Wage, and Compensation Growth, Current Expansion vs. Previous Expansions
Chart 1: Employment, Wage, and Compensation Growth, Current Expansion vs. Previous Expansions
Chart 2: $208 Billion in Potential Gross Domestic Product Lost
Chart 3: OBRA-93 Undercut Income. Wages. and Savings of American Families
Chart 4: Long-Term Economic Effects of OBRA-93: Lost Potential Gross Domestic Product
Chart 5: 1.28 Million Cars and Light Trucks Not Sold due to OBRA-93
Appendix: Economic Impact of the Omnibus Budget Reconciliation Act of 1993 (OBRA-93)
INTRODUCTION
The American economy currently exhibits relatively low levels of inflation, interest rates, and unemployment. Yet
millions of workers remain anxious about their economic security. The relatively good economic news, combined with the
widespread dissatisfaction among Americans with the nation's economic performance, seems to be a paradox. But an analysis
of underlying policies and economic trends suggests an answer to this puzzle.
Using the Washington University Macro Model (WUMM)¹ -- a major economic model of the U.S. economy also used
by the federal government and many Fortune 500 companies -- economists at The Heritage Foundation investigated how the
economy would likely be performing today had Congress not raised taxes in 1993 as the nation was coming out of the
1990-1991 recession. 2 The results of this analysis shed light on why Americans are so anxious about the economy's
performance. According to the Heritage analysis, the 1993 tax hike, championed by the Clinton White House, did indeed
produce what some critics have referred to as a "Clinton Crunch" -- a larger tax bite for families combined with a stagnation
in incomes and an economy performing well below its potential.³
The Heritage analysis indicates that, compared with how the economy would have performed without the 1993 tax
legislation, Clinton's 1993 tax and budget plan will have:
1 of 11
05/01/96 09:45:46
on Crunch"?: How the 1993 Budget Plan Affected the Economy - Heritagwww.heritage.org/heritage/library/categornes/budgetax/bg1078.htn
Cost the economy $208 billion in
Table 1
output from 1993 through 1996,4 in
today's dollars.⁵ This lost output is equal
to nearly $2,100 for every household in
Opportunities Lost
America. Last year, without the 1993
economic package, gross domestic
The 1993 Budget Plan Cost America:
product (GDP) would have grown $66
billion more than it actually did absent
the change.
1.2 million additional private sector jobs
- Cut the number of private jobs
created by 1.2 million between 1993
$208 billion in economic output
and the end of 1996. Including the
forecast for 1997, the total employment
cost of the 1993 tax increase grows to
40,600 new business starts
nearly 1.4 million lost job
opportunities.6
$112 billion in wages and salaries
- Delivered only 49 percent of the new
revenues predicted by the
Congressional Budget Office from the
$264 billion in disposable income
increase in personal and corporate tax
rates between FY 1994 and FY 1996.
When compared with the 1.2 million
$138 billion in personal savings
lost jobs, the tax hike has depressed
potential employment growth by 17,600
jobs for every $1 billion it achieved in
1.3 million new car and light truck sales
deficit reduction.
Cut $112 billion, in today's dollars,
$42.5 billion in durable goods orders
out of potential employee wages and
salaries between 1993 and 1996.
Cut the growth in real personal
disposable income of Americans by $264 billion in today's dollars between 1993 and 1996 -- equal to over $2,600
less disposable income for every household in America.
Cut the potential sale of automobiles by 773,700 and light trucks by 504,000 between 1993 and 1996. Some 1.1
million of the nearly 1.3 million lost vehicle sales would have been produced domestically. In 1996, Heritage
calculates that this loss in auto and truck sales will cost a projected 60,100 jobs across all industries.
Cut the value of business investment in durable goods by $42.5 billion in today's dollars; $15.4 billion of this is
lost investment in computers.
Some proponents may argue that even if the economy is not performing up to its potential today, this slow growth
period is necessary to reduce federal deficit spending which, in turn, will promote greater future growth. Yet many respected
economists maintain that this will not be the case with the 1993 tax increase and budget deal: Increased taxes (and
particularly increased marginal tax rates) will permanently decrease economic activity below its potential. Similarly, the
Heritage analysis, using the WUMM economic model and forecasts of future economic activity, supports this theory.
According to the Heritage analysis, nearly every major economic indicator is projected to be weaker under current law than
would have been possible without passage of the 1993 tax increase and budget act between now and 2004. Specifically:
Gross domestic product is projected to be lower in each year. In 2004 alone, GDP is projected to be $122.5 billion
lower in today's dollars than would have been possible without passage of the 1993 tax increase and budget deal.
Real personal disposable income is projected to be lower each year. In 2004 alone, Americans will see $142
billion less in disposable income than would be possible without the 1993 tax increase and budget deal.
In short, American workers are right to feel that they should be better off today than they are. President Clinton's 1993
economic plan turns out to have deprived Americans of a higher standard of living by cutting the economy's growth
potential, leading to a slower rise in employee compensation, household income, industrial output, and most other measures
of a prosperous economy.
HOW IS THE ECONOMY REALLY PERFORMING?
Despite a flow of quite good economic news in recent months, many Americans feel anxious about their economic
security, complaining of stagnating family incomes, less money in their paychecks after taxes, and a belief that the economy
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is performing below its full potential. They simply do not accept that the economy is, as the President claims, the "healthiest
it has been in 30 years."
In the latest Economic Report of the President, the White House maintains that the general health of the economy is
good and credits the creation of 8 million new jobs to the passage of the Omnibus Budget Reconciliation Act of 1993
(OBRA-93), which, the report says, "set the stage for this economic expansion and resurgence, by enacting historic deficit
reduction while continuing to invest in technology and education.
By contrast, House Majority Leader Richard Armey (R-TX) cites OBRA-93, which enacted the largest tax increase in
history, as the culprit for the anxiety Americans are now feeling. Calling this condition the "Clinton Crunch,"9 Armey claims
workers are experiencing the dual effect of an actual decline in real wages and higher taxes. With fewer of their own dollars
in their pockets to meet the needs of their families, he says, workers understandably have a heightened sensitivity to
changing economic conditions, corporate layoffs, and downsizing.
Who is right? Is the economy performing up to its potential. as claimed by the White House? Or are Americans
suffering from the "Clinton Crunch," as claimed by Armey?
Americans have good reason to be confused about the direction in which the nation's economy is headed. On the one
hand, there is good news in statistics showing continued economic growth, relatively low unemployment, and record highs in
the stock market. And as the Clinton Administration points out, the economy has created nearly 8 million jobs over the past
three years, 93 percent of them in the private sector. Clinton also claims credit for reducing the federal budget deficit for
three consecutive years: According to the Economic Report of the President, passage of the 1993 economic plan "put the
country solidly on the road to fiscal responsibility.' "10
But other economic statistics indicate a less rosy picture for Americans in recent years. For example, existing studies
and government data indicate:
Since 1992, real median family income has stagnated even though more adult women are working than ever
before. Since September 1993, both real average hourly earnings and real average weekly earnings have
stagnated.12
- Since the third quarter of 1993, the real median weekly earnings for women have decreased 3.0 percent, while men's
real earnings have stagnated. 13 Over the same period, real hourly compensation (which includes benefits as well as
wages) has not increased significantly. 14
- Fifty percent of major U.S. companies eliminated jobs in the twelve months ending June 1995, up from 47 percent
the year before. 15
More Americans are working two or more jobs to make ends meet. In March 1996, 7.9 million Americans were
working two or more jobs, up 10.2 percent since March 1994. 16
Less than one-third of all workers displaced from full-time jobs found new jobs that pay the same as their old ones. 17
The median weekly earnings of their new jobs averaged 8.2 percent less than their old jobs, and over 14 percent less
for workers 45 to 55 years old. 18
From March 1995 to March 1996, 325,000 high-paying manufacturing jobs disappeared. 19
THE ECONOMY IS LAGGING BEHIND PREVIOUS EXPANSIONS
Thus, while the economy is no longer in a recession, and indeed is experiencing modest growth, many Americans are
still having trouble making ends meet and corporate layoffs have many workers thinking twice about the security of their
jobs. But is this just part of a typical business cycle? Experience suggests "no." Although total employment has increased in
recent years, the current economic expansion -- which began in March 1991 and is now some 59 months long -- is not
progressing as well as it should when compared with the three previous post-World War II expansions lasting longer than 58
months. These expansions occurred from February 1961 to December 1969, from March 1975 to January 1980, and from
November 1982 to July 1990. 20 The failure of this economy to perform as well as similar expansions gives a clue as to why
many Americans are concerned about their economic future.
It is interesting to compare this expansion with the average of these previous expansions. To be sure, the patterns of
each expansion do differ, so data for each expansion are provided in Table 2, as well as the average.
During the current expansion:
The gross domestic product has increased less than half as much as the average of previous post-war recoveries.
Industrial production has increased just over half as much.
Total employment has grown only half as much as the average of previous post-war recoveries.
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The number of high-paying manufacturing jobs has declined by 273,000, compared with an average increase of
almost 2 million at a similar point during previous economic expansions.
The number of unemployed Americans has declined by less than half the number during previous economic
expansions.
- - Real median family income has declined by a total of 3.2 percent during the first four years of this expansion,
compared with an average increase of 8.8 percent during the first four years of previous expansions. 21
- Real median weekly earnings for full-time workers have declined by 2.6 percent during the current expansion,
compared with an increase of 3.1 percent during the 1982 to 1986 expansion. 22
Thus, despite the Administration's cheerful outlook. the economy is not performing well when compared with similar
points during the three previous expansions of similar lengths. The question is "why?" Would the economy have been
performing less well today without OBRA-93, as the Clinton Administration claims, or did the tax increase slow down an
economy in recovery and put many workers into a wage and job squeeze, as critics claim?
THE 1993 BUDGET DEAL
Virtually all economists agree that Washington can alter the course of the economy to some degree through its tax and
spending decisions. This influence is particularly evident when Congress and the President enact tax and spending policies
that affect income from work or investment. For example, Washington can reduce employment and workers' take-home pay
by increasing tax rates on wages and salaries. Higher rates take money directly out of workers' pockets and make work less
attractive. Conversely, lower tax rates increase the incentives for men and women to work, start new businesses, or invest in
training and equipment for workers. In short. tax rate changes either lower or raise the cost of labor. depending on the
direction of the rate movement. Commonly, lowering labor costs leads to a higher demand for labor. When combined with
lower capital costs stemming from lower taxes on capital, greater levels of economic activity are attained.
When Congress and the President adopt policies that alter economic life in some significant fashion. there will be a
difference between how the economy then performs and how it would have performed had policy not been changed. These
differences between actual and potential performance can be estimated statistically using models of the U.S. economy that
capture the economic impact of policy changes. Generally speaking, these models allow analysts to "simulate" the impact of
tax and spending decisions that could have been made -- or not made by Congress and the President. and then compare the
simulation with what actually occurred. This is what the Congressional Budget Office routinely does when Congress is
considering tax and spending legislation.
There have been two major tax and spending plans enacted in recent years. These were in 1990 and 1993. American
taxpayers were told that large tax increases in each of these plans would lead to a significant reduction in federal deficits and
spur long-term economic growth. In this study, Heritage analysts used the WUMM model to investigate the effects of the
1993 budget deal. There were two reasons for the decision to focus on the 1993 agreement: First. by 1993, the economy was
largely in recovery from the 1990-1991 recession, so the impact on the expansion of the 1993 plan could be isolated more
easily. And, second, focusing on the 1993 economic plan allowed analysts to test the Clinton thesis that the plan has
produced "the healthiest economy in three decades. "23
The 1993 budget plan (OBRA-93) raised taxes $241 billion over five years and called for $77 billion in entitlement
program savings and $69 billion in discretionary program savings by 1998. 24 The tax law changes included two new
personal tax brackets (36 and 39.6 percent) and an extension of the Medicare payroll tax to cover all wages. The motor fuel
tax was increased 4.3 cents per gallon, and the tax on Social Security recipients' income from personal savings was increased.
Congress and the President agreed to raise the corporation income tax to 35 percent and to restrict business meal and
entertainment deductions.
The small entitlement savings came mostly from reductions in Medicare payments to doctors and hospitals and
increased charges to Medicare beneficiaries. OBRA-93 delayed cost of living adjustments for military and civil service
retirees and limited Medicaid payments to the states. Small reductions also were made in veterans benefits, farm programs,
and student loans.
THE FINDINGS
The comparison of the real and simulated economies suggests that OBRA-93 was not as beneficial to the economy as
the White House claims. Indeed, it damaged the economy and living standards in several ways. Specifically, the Heritage
analysis finds that:
1. Economic growth has been slowed.
The economy would have grown significantly faster without the Clinton tax increases and spending reductions
of 1993. These policy changes will have cost the economy $208 billion in today's dollars in output from 1993 through
1996, equivalent to nearly $2,100 in lost GDP for every household in America. In 1995, GDP would have grown by
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nearly 0.90 percent more, or $66 billion in today's dollars, than it actually did. The model forecasts that GDP in 1997
will be 1.0 percent lower than it could be without the 1993 tax hike, or about $95.5 billion in today's dollars.
2. The pace of business formation has been slowed.
Heritage analysis shows more new businesses would have been incorporated without Clinton's 1993 package.
This is due to the relationship between gross domestic product and new business incorporation. In general, for every
$1 billion in GDP, about 195 new businesses are incorporated. Thus, the $208 billion fall in GDP due to the 1993
legislation will have prevented the formation of 40,600 new businesses between 1993 and the end of 1996. 25
What This Means: The loss of new businesses means not only a loss of valuable entrepreneurs, but also the
loss of many new jobs. The Small Business Administration (SBA) estimates that five new jobs are created with each
new business establishment. Using the SBA estimate, the loss of 40,600 new businesses between 1993 and 1996 will
have meant the loss of 203,000 new jobs.
3. Job growth has been slowed.
The economy produced 1.2 million fewer private sector jobs between 1993 and 1996 than it would have
without the tax increase and budget changes of 1993. President Clinton claims credit for more than eight million new
jobs during his Administration, so far, with roughly seven million of these in the private sector. But the Heritage
analysis indicates that 1.2 million additional Americans could have been working without his policy changes. If the
forecast for 1997 is added to these figures, the total private employment cost of the tax increase grows to nearly 1.4
million.
26
It must be noted that the loss of potential civilian employment is one of the more remarkable findings of the
analysis, based on the model's design. It is also one of the more controversial. While it is the Heritage Foundation's
policy to accept the model's macroeconomic results and assumptions (other than the action of the Fed -- see box, page
8) and not make adjustments in these results through statistical work performed outside the model. this particular
effect of OBRA-93 deserves a brief explanation. The model's measurement of how much employment will change
when taxes change (the so-called tax elasticity of employment) sits roughly in the middle of the professionally
accepted range for such measurements: The model contains a factor of .29 percent change for every one percent
change in labor income, and the standard range among economists goes from .12 to .37 percent. These elasticities
mean that a 10 percent increase in take-home pay leads to an increase in the labor supply of between 1.2 and 3.7
percent.
The designers of the WUMM model caution users regarding the output of the model's employment equations.
However, Heritage economists decided to accept the model's results because further investigations and calculations
using other data bases gave general support to the conclusions in this Heritage study. If the rate changes associated
with OBRA-93's increases in payroll and income taxes are applied only to the incomes of those with more than
$70,000 in income, we calculate that potential employment was at least 350,000. Of course, the increase in tax rates
also negatively affected investment decisions, which resulted in slower growth of job-creating new businesses and
business expansion. For example, Heritage calculates that the loss in potential capital stock may account for an
additional decrease of 470,000 jobs. When these and other capital effects are combined with the direct and minimal
employment effects, the calculation derived from the model of 1.2 million in 1996 between actual and potential
employment appears reasonable. 27 Even using lower elasticities favored by some economists would mean an
employment effect of at least 400,000 lost jobs.
What This Means: Heritage calculates approximately 203,000 of the potential lost jobs between 1993 and the
end of 1996 were a result of new businesses that were not formed. The remainder of lost potential jobs, some 1
million, most probably results from existing businesses that hired fewer employees than they otherwise would have or
expanded less.
4. The growth in household income and savings has been cut.
When the job losses are combined with higher taxes on working families, a disturbing picture of lost household
income growth emerges.
The growth in wages and salaries has been cut. The 1993 legislation will have cut $112 billion, in today's
dollars, out of employee wages and salaries between 1993 and 1996, when compared with the pattern that
otherwise would have occurred. Extending the analysis to 1997 would mean $162 billion in total lost wages
and salaries, again in today's dollars.
What This Means: In 1996 alone, the Heritage analysis shows that the Clinton program depressed the growth
in wages and salaries by $46.5 billion in today's dollars, roughly $465 for every household in America. The loss of
potential income means that families spent less than they could have spent on food, clothing, transportation, medical
care, and other necessities for their families. Indeed, in a typical month, the average household spends $251 on
groceries, $160 on medical costs, and $40 on education. 28 The addition of $465 in purchasing power for the typical
household means an average of 1.8 months of groceries, or 2.9 months of medical bills, or 12 months of educational
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expenses in a typical year.
The growth in personal disposable income has been cut. The 1993 budget deal raised taxes on millions of
American households and will have cut overall real personal disposable income by $264 billion in today's
dollars from 1993 through 1996 equal to over $2,600 less disposable income for every household in
America. In 1996. households will have nearly 2 percent, or $101 billion, less money to spend on education.
food, medical care, and other items than they would have had without the 1993 legislation.
What This Means: Total personal disposable income measures both wage income and non-wage income from
such things as investments. Besides lost future wages, the Heritage analysis shows that the Clinton tax increase and
budget plan will have cost households $152 billion in non-wage income, in today's dollars, between 1993 and the end
of 1996. This is equal to $1,500 for every American household. In 1996 alone, the average household will realize
$550 less in non-wage disposable income, nearly double the amount the Bureau of Labor Statistics estimates the
average household spends on appliances each year. 29 Many households use income from non-wage sources to make
large purchases such as the down payment on a new car, a washing machine, and other appliances. Alternatively,
families may use this income to finance extraordinary events such as weddings, college education, or vacations.
The growth in personal savings has been cut. Between 1993 and the end of 1996, the 1993 budget plan will
have reduced personal savings by roughly $138 billion in today's dollars. This cut in family savings means
that future consumption of the things for which families save, principally housing and education, will be lower
than it would have been. If 1997 is included, savings will have been cut by a total of $192 billion, in today's
dollars.
What This Means: The three things households save for most are education, housing, and retirement. To
illustrate the impact of these lost savings, Heritage analysts distributed the $138 billion in lost savings to families with
children, young families saving to purchase a home, and those saving for retirement, based upon age and population.
We then assumed that this amount would grow at an everyday interest rate of 5 percent, to see what important
purchases these three groups could make in the future with their respective accumulated savings. Each of the
following amounts is what could be purchased with the future value of each group's portion of the $138 billion in lost
savings:³
$432 billion for higher education expenses; and
: $335 billion for buying homes; and
$3.6 trillion for retirement.
Had the portion of this $138 billion we allocated to families with children been allowed to earn interest for the
average number of years available for savings in the under-18 age group, then the cumulative amount could have
purchased a four-year college education for 7 million students at $14,000. Had the foregone savings we allocated to
young families saving to purchase a home (the age group 18 to 35), been allowed to grow for 18 years, the total sum
could have resulted in 17 million future home sales where a $20,000 down payment is required. And had the portion
of this $138 billion allocated to people above the age of 35 -- those saving for retirement -- been allowed to grow for
the average number of years before this cohort retires, the future value could have resulted in 6.4 million 15-year
retirement annuities paying $37,500 per year.
The growth of household wealth has been cut. The 1993 legislation will have reduced the growth of
household net wealth by $111 billion from between 1993 and 1996. The WUMM model defines net
household wealth as a sum of personal savings, the purchase of automobiles and other durables, the existing
household stock of durable goods and personal capital gains.
5. The reduction in the deficit attributable to the 1993 plan has been small.
The President maintains that taxes had to be raised in 1993 to reduce mounting federal debt. 31 He now points to
a fall in the deficit as justification for the 1993 legislation. But the Heritage analysis indicates that the weak economy
produced by the tax hike will have generated far less new revenue, and thus less deficit reduction, than the
Congressional Budget Office (CBO) had predicted for FY 1994 through the end of FY 1996. On the other hand, the
analysis indicates that the modest amount of savings predicted from the spending cuts will materialize. These findings
suggest that if OBRA-93 had enacted few or no tax increases to slow the economy, but more spending cuts, the
deficit would be far less today than it is.
In 1993, CBO predicted that OBRA-93 would lower the cumulative deficits between FY 1994 and FY 1996 by
$171 billion. Some $50 billion of these savings -- 29 percent of the total -- was to come from spending cuts, including
$17 billion in net interest savings and asset sale proceeds. The remaining $121 billion in deficit reduction -- 70
percent of the total -- was to come from the new revenues generated by the increase in tax rates.
The Heritage analysis indicates that OBRA-93 will have produced just 74 percent of the deficit reduction CBO
had estimated, or a total of $127 billion. 32 This, however, does not tell the whole story. While the spending cuts will
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have produced slightly more savings than CBO predicted, $52 billion (excluding asset sale proceeds), accounting for
41 percent of the overall deficit reduction achieved, 33 the tax increase accounts for roughly 54 percent of the total,
having delivered far less new revenue than was promised.
The Heritage analysis shows that the tax increase will have produced just $68 billion in actual deficit
reduction between FY 1994 and the end of FY 1996, just 56 cents of actual deficit reduction for every new
dollar CBO predicted would be generated.
However, excluding the roughly $16 billion in new revenues generated by the increase in the motor fuels tax,
the analysis shows that the increase in personal and corporate tax rates produced only 49 percent of the new
revenues CBO predicted would be generated.
Thus, comparing the actual amount of deficit reduction produced by the 1993 tax hike between 1994 and
1996, with the 1.2 million potential new jobs lost, it can be said that the 1993 tax increase will have meant the
loss of over 17,600 new jobs for every $1 billion it achieved in deficit reduction.
The Heritage analysis of the near-term consequences of the 1993 tax increase largely confirms the results of a
recent study by noted Harvard University economist Martin Feldstein and Daniel Feenberg, an economist at the
National Bureau of Economic Research. Their analysis of the impact of the 1993 tax increase on individual behavior
shows that the higher tax rates placed on upper-income taxpayers encouraged these individuals to change their
economic behavior and, thus. report lower taxable income. As a result, in the first year it took effect, the 1993 tax rate
increase raised just 45 percent of the "revenue that would have been collected if taxpayers had not changed their
behavior.
Moreover, Feldstein and Feenberg discovered that the 1993 tax hike caused considerable inefficiencies in the
economy, what economists call "deadweight losses." "This means that for every dollar of additional revenue collected
by the government as a result of the higher tax rates, taxpayers experience a decline in their well-being equivalent to
three dollars as a result of the induced changes in work, in the form of compensation, and in tax deductible
expenditures. "35 In other words, conclude Feldstein and Feenberg, "the structure of the 1993 tax increase thus made it
a very inefficient way of increasing revenue.
This analysis so far has examined what might be called the short-term effects of the 1993 package. The current
debate is about these short term effects. with the White House claiming benefits to today's economy. But for there to
be a complete verdict on the 1993 tax and budget plan, one needs to project into the future, to explore whether the
short-term effects analyzed above are merely a prelude to future growth.
THE LONG-TERM PICTURE
To estimate the longer-run future effects of the 1993 plan, Heritage analysts used the WUMM model to extend the
simulation of potential economic performance without passage of the 1993 tax increase and budget deal through 2004. The
results of this simulation were then compared with the baseline economic projections under current law and including the
1993 tax increase and budget deal produced by the owners of the WUMM model in December 1995. The comparison
shows that nearly every major economic indicator is projected to be weaker under current law than would have been possible
without passage of the 1993 tax increase and budget act between now and 2004. Specifically, the Heritage analysis
concludes:
Gross domestic product is projected to be lower in each year. In 2004 alone, GDP is projected to be $122.5 billion
lower in today's dollars than would have been possible without passage of the 1993 tax increase and budget deal.
Real personal disposable income is projected to be lower each year. In 2004 alone, Americans will see $142 billion
less in disposable income than would be possible without the 1993 tax increase and budget deal.
Employment is projected to be less in every year. By 2004, 1.5 million fewer jobs will be created because of the 1993
tax increase and budget deal.
CONCLUSION
While there is good news in the economy, such as low interest rates, low inflation, 8 million new jobs, and lower
federal deficits, many workers and their families feel that the recovery is anemic as far as they are concerned. The Clinton
Administration is taking credit for good economic news and asserts that the news is a justification of its economic policies;
specifically, the 1993 budget deal, which included the largest tax increase in history.
The evidence does not support the Administration's claim that the 1993 budget plan triggered stronger economic
growth. On the contrary, the critics of the 1993 legislation appear to be correct that because of it Americans are caught in
what some refer to as the "Clinton Crunch," the dual effect of declining real wages combined with higher taxes. The analysis
by Heritage Foundation economists, using the WUMM model, indicates that OBRA-93 has had a damaging impact on the
nation's economy. Removing the effects of OBRA-93 in an econometric simulation shows that the economy would have
been performing better today had Congress not enacted the legislation.
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Thus, President Clinton is right to point to the 1993 budget deal as creating today's economic climate. But rather than
create a better climate, the legislation has cast a dark shadow over the economy.
APPENDIX: TECHNICAL NOTES
Appendix: Economic Impact of the Omnibus Budget Reconiliation Act of 1993 (OBRA-93)
Notes on the Simulation
The simulation of the Omnibus Budget Reconciliation Act of 1993 (OBRA-93) was developed using the Washington
University Macroeconomic Model of the United States economy. The baseline is that produced by the model in December
1995. Only those variables in the model that reflect federal tax and spending policies were modified to create the simulation.
Both the baseline case and the simulation incorporated the model's Federal Reserve reaction function. Specifically, Heritage
economists made the following decisions regarding tax and spending data inputted into the model for the simulation:37
- Tax Changes -- Most changes in tax policy were initiated in the first quarter of 1993 to account for the retroactive
nature of the tax increases included in OBRA-93.
1. The maximum federal corporate tax rate was restored to its "pre-OBRA-93" level to account for the one percentage
point rate increase included in OBRA-93.
2. The statutory depreciation period for nonresidential structures was restored to its "pre-OBRA-93" level of 31.5
years. The corporate capital consumption allowance, as a percentage of total capital consumption allowance, was
increased to accommodate the shorter depreciation periods within the simulation.
3. The federal statutory income-weighted marginal tax rates on wages, dividends, and interest were restored to their
"pre-OBRA-93" levels.
4. The average federal personal tax rate was adjusted to account for lower marginal tax rates within the simulation
compared to actual levels.
5. The federal statutory income-weighted marginal Social Security tax rate on wages and salaries was re-set to its
"pre-OBRA-93" level.
6. Federal collections from social insurance taxes were adjusted to account for the repeal of the cap on earnings
subject to the Medicare tax.
7. Federal collections from indirect business taxes were adjusted for the extension and increase of the motor fuels tax
account.
8. Federal collections from business taxes were adjusted to account for non-rate changes in the business income tax
code.
- - Mandatory Spending Changes
1. The actual spending level for Medicare was increased for each fiscal year by the amount the Congressional Budget
Office estimated in September 1993 that OBRA-93 changes would save -- a total of $55.8 billion between 1994 and
1998.
2. The actual spending level for Medicaid transfers was increased for each fiscal year by the amount the
Congressional Budget Office estimated in September 1993 that OBRA-93 changes would save -- a total of $7.1
billion between 1994 and 1998.
3. The actual spending level for personal transfers was adjusted for each fiscal year by the amount the Congressional
Budget Office estimated in September 1993 that OBRA-93 changes in federal employee retirement and health
benefits, veteran benefits, and the Earned Income Tax Credit would create a net total of $6.7 billion of
increased spending between 1994 and 1998. The increased spending for the Earned Income Tax Credit more than
offset the savings from reforming federal employee retirement and health benefits, and veterans benefits. Therefore,
the simulation actually calls for less spending on personal transfers than actually occurred during the past three years.
4. The actual spending level for other grants-in-aid was adjusted for each fiscal year by the amount the Congressional
Budget Office estimated in September 1993 that OBRA-93 changes in federal farm programs, the food stamp
program, and "other" mandatory programs would save -- a net total of $7.2 billion between 1994 and 1998.
5. The proceeds from FCC electromagnetic spectrum auctions and the savings from changes in federal family
education loans were added to the unified deficit but not included in the NIPA-based spending accounts.
- - Discretionary Spending Changes -- The actual spending levels for non-defense purchases, defense purchases, and
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federal grants to state and local governments were adjusted for each fiscal year by the amount the Congressional
Budget Office estimated in September 1993 that OBRA-93 changes in discretionary spending would save -- a total of
$68.5 billion between 1994 and 1998. This was evenly distributed among the three separate accounts.
- - Spending Projections FY 1999 - FY 2004 -- CBO September 1993 estimates extended through FY 1998. For fiscal
years 1999 through 2004, the underlying growth rates were assumed.
Other Technical Notes
- Personal Savings -- The Heritage analysis concludes, among other things, that the tax policy changes of 1993
undercut personal savings by $138 billion. The estimates of long-term consumption effects were calculated as
follows. The foregone personal savings were distributed across an array of seven age groupings by the percentage of
people that fall in each grouping. This array consists of population estimates made by the U.S. Bureau of the Census
for 1995.³⁸
- - For those people 18 years old or less, the distributed personal savings were allowed to grow until their 18th year at a
compounded rate of 5 percent. The sum of this compounding ($432 billion) was divided by $14,000 to arrive at the
estimate of 7 million people who could pay for four years of state university education.
For those people between the ages of 18 and 35, the distributed personal savings were allowed to grow at a
compounded annual rate of 5 percent until their 35th birthday. The sum of this compounding ($335 billion) was
divided by $20,000 to arrive at the estimate of 17 million home sales that might be effected by potential home
purchasers having $20,000 for a down payment and other home-buying costs.
For those people between the ages of 35 and 65, the distributed savings were allowed to grow at a compounded
annual rate of 5 percent until their 65th birthday. The sum of this compounding was $3.6 trillion. To this sum was
added the amount of distributed personal savings for people above age 65. It was assumed that this amount is
consumed as it is received. Therefore, the total amount available for retirement was $3.6 trillion. This $3.6 trillion
estimate was divided by $37,500 (an estimate of annual living costs at retirement for the cohort aged 35 and above) to
arrive at the estimate of 6.4 million 15-year retirement annuities.
Endnotes:
1. This study was prepared by The Heritage Foundation using the Washington University Macro Model. The
methodologies, assumptions, conclusions. and opinions herein are entirely those of The Heritage Foundation. They
have not been endorsed by, nor do they necessarily reflect the views of, the owners of the model.
2. This model is celebrated throughout the economics profession for its excellent forecasting accuracy and rich
analytical capabilities. It is widely, used in the private sector to guide business plans and in the public sector to
estimate the economic implications of policy change. The WUMM team won the Blue Chip Consensus Forecasting
Award for 1995.
3. The tax increase was contained in the Omnibus Budget Reconciliation Act of 1993 (OBRA-93).
4. All figures in calendar years except for deficits, which are expressed in fiscal years. The 1996 component is based on
the WUMM December 1995 forecast of the U.S. economy during 1996.
5. Figures throughout this study are expressed in 1995 constant dollars.
6. See the discussion of these employment results on page 11 of this study.
7. See, for example, Martin Feldstein and Daniel Feenberg, "The Effect of Increased Tax Rates on Taxable Income and
Economic Efficiency: A Preliminary Analysis of the 1993 Tax Rate Increases," National Bureau of Economic
Research Working Paper 5370, November 1995.
8. Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 1996), p. 3.
9. Representative Dick Armey, "A Republican Agenda to Reverse the Clinton Crunch," Heritage Lecture No. 556,
speech given at The Heritage Foundation on February 27, 1996.
10. Economic Report of the President, 1996, p. 3.
11. Bureau of Census, Internet site http://www.census.gov/ftp/pub/hhes/www/incpov.html. and published in "1994
Income and Poverty Estimates," October 1995.
12. Bureau of Labor Statistics, Internet site http://stats.bls.gov:80/cgi-bin/surveymost?ee, or as published in "Employment
and Earnings," various issues.
13. Bureau of Labor Statistics, "Usual Weekly Earnings of Wage and Salary Workers," various issues.
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14. Economic Report of the President, 1996, p. 332.
15. American Management Association, "Corporate Downsizing, Job Elimination, and Job Creation," 1995.
16. Bureau of Labor Statistics. "The Employment Situation," BLS Press Release, April 1994 and April 1996.
17. Jennifer M. Gardner, "Worker Displacement: A Decade of Change," Bureau of Labor Statistics Monthly Labor
Review, April 1995. The BLS definition of displaced workers refers to persons with 3 or more years of job tenure that
lost their jobs because their plant or company closed or moved, there was insufficient work for them to do, or their
positions or shifts were abolished.
18. Most of the change in earnings can be accounted for by the loss in firm-size wage premiums as workers have moved
from larger to smaller firms. All else being equal, larger firms pay 12 to 23 percent more than smaller firms. See
Wesley Mellow, "Employer Size and Wages," Review of Economics and Statistics, August 1982, and Charles Brown
and James L. Medoff, "The employer size-wage effect," Harvard Institute of Economics Research Discussion Paper
No. 1202, 1986.
19. Bureau of Labor Statistics. Internet site http://stats.bls.gov:80/cgi-bin/surveymost?ee, or as published in "Employment
and Earnings," various issues.
20. The data comparisons made in this section refer to similar points in time during these four expansions. For example,
average employment growth from March 1991 to the present (59 months) is compared with the average employment
growth from February 1961 to December 1965 (59 months), from March 1975 to January 1980, and from November
1982 to October 1987.
21. U.S. Bureau of the Census, "Income and Poverty 1995," http:/www.census.gov/ftp/pub/hhes/www/incpov94.htm1.
These are the most recent data available.
22. Data on median weekly earnings are not available on a consistent basis prior to 1979.
23. There are limits to the historical changes economists can make in structural macroeconomic models. Clearly the
major limitation is the time period. While economies rarely experience major changes in the span of a few years,
structural stability is far less likely over longer time periods. The six years of changes in variables in the WUMM
model needed to measure the 1990 tax increase would have stretched prudent econometric practice to its limits. A
number of prominent macroeconomists have written on the deleterious effects of the 1990 budget deal. For a
summary of these viewpoints, see Daniel J. Mitchell, "The Impact of Higher Taxes: More Spending, Economic
Stagnation, Fewer Jobs. and Higher Deficits," Heritage Foundation Backgrounder No. 925, February 10, 1993, and
Daniel J. Mitchell, "Why Higher Tax Rates on Income Will Slow Growth, Cost Jobs," Heritage Foundation
Backgrounder No. 942, May 25, 1993.
24. Congressional Budget Office, The Economic and Budget Outlook: An Update (Washington, D.C.: U.S. Government
Printing Office, 1993), Table 2-2, p. 29.
25. This estimate is derived from a statistical analysis of the relationship between the number of new business
incorporations and real GDP over the period 1959-1994. Overall a decrease in GDP of $1 billion was found to be
associated with a decrease in the number of new business incorporations by an average of 194.957 over this period.
(The estimate had an R-squared of .92748, a standard error of 9.35, and a t-statistic of 20.852.) Multiplying this
figure by the $208 billion lost from GDP over 1993-96 (as a result of the Clinton tax increase) gave an estimate of
40,600 fewer new businesses. Figures for GDP and business formation came from the 1995 and the 1996 Economic
Report of the President (Washington, D.C.: U.S. Government Printing Office, 1996), Tables B-2 and B-92,
respectively, pp. 282, 385.
26. The estimate of lost potential employment results from increases in taxes on the wages and salaries of upper income
Americans, on the income of corporations, and on capital, an effect that stems from lengthening the period of
depreciation on capital goods as well as taxing interest, dividends, and capital gains at higher rates. Such tax increases
reduce capital formation and promote consumption. By increasing both the cost of capital and the cost of additional
labor, the rate of business expansion and formation falls below potential which, in turn, reduces the potential growth
of employment.
27. Most labor economists view tax increases as being equivalent to wage decreases, but they hold sharply divergent
views about the degree of change in employment that results from a change in the tax rate on labor income. See Mark
Killingsworth, Labor Supply (New York: Cambridge University Press, 1983), Chapter 6, esp. pp. 356-360. This
variation in the amount of labor that is supplied as the wage level changes is called the "wage or income supply
elasticity of labor." More specifically, the supply elasticity of labor is a measurement of the percentage change in the
amount of labor that is supplied from a one percent change in the compensation of labor. The professional literature
contains estimates of the labor supply elasticity that range from. 12 to. 37 percent for every one percent change in
total labor income (which become negatively signed when analyzing the effect of taxes on labor supply). See
Killingsworth, Labor Supply, pp. 119-125, Table 3.2 to 3.5. Also see comparable variation in the demand elasticities
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for labor in Daniel S. Hamermesh. Labor Demand (Princeton, N. J.: Princeton University Press. 1993), Tab
elasticity of labor supply used in the Washington University Macro Model is 0.29 percent and lies within th
midrange of the estimates contained in this literature.
28. U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditures in 1993, Report 885. Decem
Table 4. The figures are an average of all consumer units and have been adjusted to 1995 dollars.
29. Bureau of Labor Statistics, Consumer Expenditure Survey, 1992-93. September 1995, p 27. Figures have be
adjusted for inflation.
30. See Technical Notes for a full description of how these figures were calculated. It should be noted here, ho
the foregone savings is distributed to three different age groupings that each save for only one of the three P
Allowing only one purchase for each group significantly simplified an otherwise complicated problem. The
that is saving for education (those people under age 18) is not saving for a home purchase. The group that i:
for a home purchase (aged 18 through 35) is not saving for retirement. And the group saving for retirement
and above) is saving only for retirement.
31.
11 because the deficit has increased so much beyond my earlier estimates and beyond even the worst offici.
government estimates from last year. We just have to face the fact that to make the changes our country nee
Americans must contribute today " President Clinton, "Address to the Nation," February 15, 1993.
32. The FY 1996 forecast does include some spending cuts enacted by the 104th Congress and signed by the Pr
Heritage analysts. however, are unable to estimate these effects at this time.
33. A disproportionate share of the savings from spending cuts, $33 billion or 63 percent, are achieved in FY I'
34. Feldstein and Feenberg, "The Effect of Increased Tax Rates on Taxable Income and Economic Efficiency:
Preliminary Analysis of the 1993 Tax Rate Increases."
35. Ibid. p. 3.
36. Ibid. p. 21.
37. For further information or clarification, please contact the authors.
38. See U.S. Government Printing Office, Economic Report of the President Together with the Annual Report
Council of Economic Advisers (Washington, 1996), Table B-30, p. 315.
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901
WIN
DEMOCRATIC
NATIONAL
COMMITTEE
'96
Donald I.. Fowler. National Chair Christopher J. Dodd. General Chair
THE DNC RESEARCH DEPARTMENT
TO: Jason -
Gene asked about this,
FAX:
Heritage still hasn't released
the study Dole referred to,
FROM:
RESEARCH However, I found a recent
Nat
study on the FY 97 budget.
PHONE:
202-479-5130
RE:
DATE:
PAGES, INCLUDING COVER: 13
MESSAGE:
GROUPFILE
-
Democratic Party Headquarters 430 South Capital Street, S.E. Washington. D.C. 20003 202.863.8000 FAX: 202.863.8174
l'isiad fill by ilir Democratic National Contributions 10 Ilir Democratic National Committee am unt 1111 deductible.
002
Dole Lays Out Conservative Vision, Criticizes "Touchy-Feely' Liberals
By Dad Bals
A12
spend more money, that's vision. If you want
state be said would be crudal to No hopes of
damaged the American economy and, citing
D make enda meet and to have single-parent
Westington The Gall United
to spend another billion, boy. that's vision."
unseating President Clinton in the W. Dole
an unnamed study, claimed that the higher
amilies struggling to pay the bills, Dole said,
Dole said his views were old-fashioned and
promised to fight true cuts for families
taxes had resulted in the loss of 1 million
We've got to listen," be said. "We've got
HERSHEY, Pa, April 10-Senate Majori-
straightforward.
with children while balancing the budget and
jobs, had reduced economic output by $200
to act."
ty Leader Robert 1. Dole (R-Ken) outlined .
9 want to make America better," be said.
pledged to appoint conservative judges to
billion and lowered wages by 3102 billion.
Dole said the best way to help struggling
ponservative governing agenda here tonight
9 want people to find jobs 1 want poor peo-
the federal court.
Nelson Warfield Dole's campaign spoken-
families would be to enace the 8500 per child
and assailed critics who claim be has 00 vi-
pie to and good-paying jobs to get off wet
Dole's speech, although short on specifica,
What could be better than to have
man, said Dole was previewing the results of
family tax credit that Republicans have advo-
sinn as "Loudry-feely" liberals and members
are.
offered a preview of what are likely to be the
of the sews media who only want to spend
more jobs created to this state where the up-
main themes of his campaign against Clinton.
a Heritage Foundation study that has not yet
cated throughout the 104th Congress.
Dole's quick trip to Pennsylvania marked
money 8 more government programa
employment rells chrink and shrink and
Dole tald his autience that, unlike sorde poli-
been released
the beginning of four days of campaigning
To asked D for about whit's Bob Dole's
shrink? What would be better than to have
ticlane, he intends to govern on the same b.
Date also accused Clinton of setting for
that will take him to Texas and lowe for
vision for America," the presumptive Repub-
the American Legion and VFW out of bust
sues on which be campaigne-a veiled aitl-
slow growth in the economy, despite criticle-
fund-raising events.
licen presidential tominee and
@@@@ because we didn't have conflicts to
clam of the president, whom he said had
ing then-President George Bush for a weak
He will return to Pennsylvania early next
"Well it's not that hard for me, but is b for
couse we bad peace around the world Der
promised tax cute and delivered 0 tax in-
economy in the 1992 campaign
week for another day of campaigning in ad-
come of these liberals and the media They
cause we had strong leadership?"
crease.
America "can do better than to have two
vance of the state's Republican primary on
want some touchy-feely thing. They want to
Speaking to . pro-business eudience in a
Due said Clinton's 1993 tax increase had
parent families working "from daws to dusk
Tuesday.
A14
THERSDAY, Area 11. 1996
THE WASHINGTON PUST
CAMPAIGN '96
Quillen Closing Out 34 Years in House
Republican Rep. Retiring; Rep. LaughlinDoses Primary
By John E. Vang
became have mid they seek PO
House career has been spent tending
Washington Post Staff Webse
election. Ten of those lawmaters
to his constituents in northeastern
sunning for the Senate while two,
Tennessee. For many years be was
Rep Sames H "Imary" Quilec (R-
Texas Democratic Repa John Bryant
the togaRepublican 00 the important
Tenn) said resterday be would not
and [m Chapmange were defeated in
House Rule Committee, where be
TUD for realection this fall, ending .
their bids for their party's Senate
showed a willingesta work with
34-year House career.
nomination?
Democrate. In 1990, be gaver of his
91 be 81 at the end of this term
In addition, Rep. Greg Laughlin (R-
ranking minority spot to the more
and my wife code me," said Quilica,
TEL) a turmer Democrat, lost a ori-
confrontational Rep. Gerald 0.H. Sot
who is tied with Rep. Joseph M
mary race Tuesday, becoming the
0000 (R-N.Y.). When Republicans
McDade (E-Pa) as the most sentify
first incumbent to be defeated for TO
took control of the House last year,
Rouse Republican. Quillen's wife,
election this year.
Solomon became chairman and Quil-
Cecile, has been a for segaral years
Quilien had often been considered a
len was given the title chairman
ETP. JAMES a 'SIMMT'
la addition, Rep.
likely candidate for retirement. He
emeritus.
"my wife needs mu"
wid earlier this with be would not
Ded quintuple bypase Dgery in
Republicans should have bittle prob-
a . Courth Maise term to order to
March 1993 and began donsting cam-
tem keeping Quillen's district, which
federal government to the states.
run for guardior this as Last week,
paign funds to Tennessee hospitals
la solidly Republicon. President
It will be our nation's governore who
23:31
two-term New Rampubire Cov. Steve
and colleges because be dif not es.
George Bush WOD $3 percent of the
will be on the tront lines of policy de
Merrill (R) unexpectedly announced
pact to run for reclection in 1994. He
vote b 1992 despite the presence of
cisions that will greatly affect our
that be was leaving politics to spend
changed blue mind and, despite giving
then Tennessee Sen. Albert Gore Jr.
quality of life,' be eaid.
more time with his family.
way about $800,000, otill had
on the Democratic ticket, which CAS-
Voters in Zeliff's southeastern New
The two retirements bring to 65
$475,000 on hand for the race. He
ried the state.
Hampshire district have been reliably
the cumber of lawmakers who are not
WOD with 79 percent of the vole.
Zelifi, 59, said be was leaving the
Republican, giving Bush # carrow vic-
trying to return to the House this
A self-made man whose education
House to try 10 become part of the
tory there is 1992 even though Presi-
year, as 27 Democrate and 18 Repub-
caded with high school, Quillep's
important transfer of gower bom the
dent Clinton carried the state.
04/12/96
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Clinton's
FY
1997
Budget
ment
Lives
On
-
Heritage
http://www.townhall.com/
es/bedgettax/bg1071.html
The
Heritage Backgrounder
CLINTON'S FY 1997 BUDGET:
THE ERA OF BIG GOVERNMENT LIVES ON
Scott A. Hodge
Grover M. Hermann Fellow in Federal Budgetary Affairs
The Heritage Foundation
Backgrounder No. 1071
March 11, 1996
INTRODUCTION
Just weeks after telling the nation, in this year's State of the Union address, that the "era of big
government is over," Bill Clinton indicated that the obituary notice was somewhat premature when he
delivered his a 20-page FY 1997 budget to Congress. In contrast to the Balanced Budget Act of 1995
(BBA), which he vetoed last fall, the latest Clinton budget would mean $1,927 in higher taxes and $3,155
in higher spending for every household in America over the next seven years. This is the eighth budget
plan Clinton has delivered to Congress in a year; and, except for the FY 1996 budget submitted last
February (which called for $200 billion deficits through the end of the decade), each has been short on
specifics and long on promises.
While Clinton claims his FY 1997 budget will eliminate the federal deficit by FY 2002 using
Congressional Budget Office (CBO) estimates, it does so only by using the same assortment of smoke,
mirrors, and other gimmicks that has made taxpayers increasingly cynical about Washington's
commitment to budget-making. Even worse, although the Clinton budget balances on paper, it flinches
from making the tough decisions needed to eliminate wasteful and outmoded programs, end welfare as
we know it, save Medicare from bankruptcy, or transfer failing federal programs to the states.
The FY 1997 Clinton budget is not the end of big government, it is the embodiment of it. Clinton's
plan, for example:
Increases federal spending by $361 billion over the next seven years and hikes tax revenues by
$526 billion;
Spends a total of $12.16 trillion over the next seven years, or $306 billion more than the vetoed
Balanced Budget Act of 1995. That means $3,155 more for every household in America;
Raises a total of $11.4 trillion in tax revenues over seven years, $187 billion more than the BBA,
and $1,927 more in taxes for every household in America;
Allows $119 billion more deficit spending through 2002 than the BBA, which is equivalent to
passing along $1,227 per household in debt to the next generation of American workers;
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Fails to eliminate a single program of any significance;
Fails to eliminate even one Cabinet-level agency,
Increases entitlement spending by $365 billion over the next seven years while failing to save
Medicare from bankruptcy, end welfare as we know it, or protect states from the exploding costs
of Medicaid; and
Spends $111 billion more on discretionary programs than the BBA while calling for billions more in
spending on programs that have failed or become obsolete, that duplicate others, or that should be
transferred to state and local government control.
The FY 1997 Clinton budget signals not the end of big government, but the continuation of
status-quo government.
CLINTON 8, TAXPAYERS 0¹
Despite a campaign promise to balance the budget in five years while providing tax cuts for
working families, President Clinton has consistently resisted congressional efforts to enact a balanced
budget plan with tax cuts. In addition to vetoing the Balanced Budget Act of 1995, Clinton presented
four budget plans to Congress during 1995 each time falling far short of balancing the budget,
according to the Congressional Budget Office. After a year of prodding, Clinton presented a fifth budget
plan on January 5, 1996. CBO certified - at least on paper -- that this new proposal would balance the
budget by 2002. Closer review of each of the budget plans proposed by Clinton during the past year,
however, including the FY 1997 budget, shows that the White House has never been serious about either
balancing the budget or providing meaningful tax relief. It seems interested only in finding ways to spend
more taxpayer dollars while appearing to agree that the budget should be balanced.
Clinton Budget #1
In February 1995, the Clinton Administration responded to the 1994 election results by presenting a
status-quo FY 1996 budget to the new Congress. This budget deviated little from "baseline" forecasts
which projected $200 billion deficits through the end of the decade. According to CBO, the President's
February budget would increase the deficit from an estimated $177 billion in 1995 to $276 billion in
2000. Spending would grow an average of 5 percent per year, some $422 billion in all in just five years.
The February Clinton budget did propose a few modest privatization initiatives, such as selling the
Power Marketing Administrations, portions of the Strategic Petroleum Reserves, the Naval Petroleum
Reserves, and portions of the National Weather Service. It also proposed terminating a few small
programs and consolidating some 270 programs into 27 new programs. In addition, the budget proposed
a "Middle Class Bill of Rights" which included a modest $300-per-child tax credit for families that have
children below age 13 and who earn less than $60,000 per year. But the Administration did little to fight
for any of these proposals. On May 19, the Senate defeated Clinton's budget plan by a vote of 99 to O.
Clinton Budget #2
On June 13, 1995, after months of criticizing congressional efforts while offering no plan of his
own, Clinton presented a second budget plan which he claimed balanced the budget in ten years, by FY
2005. This Clinton plan, barely 30 pages in length, fared no better than his first effort under CBO
scrutiny. According to CBO, in addition to not balancing the budget, this plan would produce $200
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scrutiny. According to CBO, in addition to not balancing the budget, this plan would produce $200
billion deficits for at least the next ten years.
The second budget plan also included the modest tax cut for families with children in addition to tax
deductions for higher education and expanded Individual Retirement Accounts (IRAs).
Due to revised economic forecasts, the Administration later said that this plan would balance the
budget in nine years. However, the CBO maintained that it would never balance the budget. Indeed, CBO
found less than $400 billion in legitimate deficit reduction in this Clinton offer -- $350 billion short of the
total seven-year deficit reduction in the Balanced Budget Act.
Clinton Budget #3
On December 7, the day Clinton vetoed the Balanced Budget Act of 1995, he presented yet a third
budget plan. The Administration claimed that this plan also would balance the budget in seven years but
was more in line with the President's priorities than the one he had vetoed.
Once again, CBO found that the Administration's numbers failed to reach a balanced budget by
2002. While this plan proposed larger savings from discretionary spending programs and welfare reform
than the June budget, it also proposed smaller savings in Medicare and Medicaid. In total, Clinton's third
budget produced only $385 billion in credible deficit reduction over seven years - $365 billion short of
the savings achieved by the BBA he had vetoed. Moreover, according to the CBO, instead of balancing
the budget in FY 2002 as advertised, it would leave a deficit of $115 billion in that year.
Clinton Budget #4
On December 15, after two weeks of negotiations with congressional leaders, Clinton presented a
fourth budget plan. But this plan was mostly an iteration of Budget Plan #3 and contained no new policy
recommendations.
The CBO scored this plan as $69 billion out of balance in FY 2002. The Administration tried to
make up for its shortcomings in reducing the deficit by challenging CBO technical and economic
estimates. The Administration had been arguing for weeks that CBO's economic assumptions were too
conservative and thus required excessively deep spending cuts to balance the budget. In other words, the
Administration wanted to have it both ways: Claiming that it wanted to balance the budget, it actually
wanted to spend more money as the budget was moving toward balance.
On December 18, the House defeated this plan by a vote of 412 to 0.
Clinton Budget #5
On January 6, 1996, Clinton presented a fifth budget plan to Congress. This plan, largely adapted
from a proposal by Senate Democrats, was certified by CBO to balance the budget in seven years, at least
on paper.
It is likely that Clinton never would have submitted this plan had it not been for the conditions
Congress included in the continuing resolution passed on January 5, 1996. These conditions stipulated, in
effect, that a bill to provide operating funds for unappropriated federal programs through January 26
would not be sent to the President until he submitted a seven-year balanced budget plan scored by the
CBO.
"
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Though it mathematically balances the budget in seven years, the fifth Clinton budget falls far short
of being credible. The reasons:
In the fifth Clinton budget, most of the heavy lifting of deficit reduction was required in the two
years following the end of Clinton's possible second term as President. Indeed, 62 percent of the plan's
$583 billion in deficit reduction fell in FY 2001 and FY 2002. For example, the plan called for $102
billion in Medicare savings over seven years, but 63 percent of these savings was to come in the last two
years. Similarly, the plan called for $37 billion in discretionary spending cuts beyond the savings needed
to achieve a "hard freeze" in these programs, yet 95 percent of these additional savings fell in the last two
years.
While the fifth Clinton budget plan called for $87 billion in gross tax cuts ($17 billion in net tax
cuts) over seven years, these cuts were "sunsetted" in FY 2001 one year before the budget would be
balanced. This means taxes would have to be raised. Mathematically, such a ploy "boosts" tax revenues
by at least $15 billion in FY 2002 and thus requires fewer spending cuts to achieve a balanced budget.
The overall size of the tax cut proposal is reduced by the plan's call for $60 billion in new revenue from
closing "corporate loopholes."
Some 43 percent of the revenues generated from these tax hikes would be received in FY 2002.
Clinton Budget #6
The sixth Clinton plan was submitted to Congress on January 9. It moved only slightly beyond the
previous plans, modestly increasing the proposed savings from Medicare, Medicaid, and welfare reform
while boosting the net size of the tax cuts to $85 billion. Overall, this Clinton plan would produce nearly
$160 billion less in budget savings than the last congressional offer and nearly $70 billion less in deficit
reduction. Moreover, the White House still avoided the fundamental reforms in Medicare, Medicaid, and
welfare needed to achieve budget savings and restructure the programs.
Clinton Budget #7
The seventh Clinton plan was submitted to Congress on January 18. This budget plan was
essentially identical to the January 9 plan except that it substantially increased the amount of new
revenues it would generate from closing "corporate tax loopholes" and other such devices. Because of
these new revenues, the net size of the tax cut would be reduced to a mere $36 billion over seven years.
Clinton Budget #8: The FY 1997 Budget
Like the seven budget plans that preceded it during the past year, the FY 1997 Clinton budget,
presented to Congress February 5, would force hard-working Americans to pay higher taxes in exchange
for more spending on programs which have become old and obsolete, or which are ripe for termination,
privatization, or transfer to state control. Moreover, each plan ignores the fundamental problems facing
the government's major entitlement and welfare programs. Clinton has shirked his responsibility to
address, for instance, a Medicare program facing insolvency, a Medicaid program that is bankrupting
state budgets, and a welfare system that perpetuates a culture of poverty.
WHAT CLINTON'S FY 1997 BUDGET WOULD MEAN
The eight Clinton budgets clearly demonstrate that this President envisions a government that has a
balanced budget but somehow remains largely unchanged from government with perpetual $200 billion
deficits. In other words, Clinton wants it both ways. He says he wants a balanced federal budget, but he is
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deficits. In other words, Clinton wants it both ways. He says he wants a balanced federal budget, but he is
not willing to challenge the size and scope of government as a credible balanced budget plan requires.
The boldest proposal the Administration can muster is to "reinvent government," which, in practice,
amounts to putting a new paint job on a house whose foundation is collapsing under its own weight.
American taxpayers sent government a very clear message in the 1994 election: They do not want useless
and obsolete programs merely to waste their money more efficiently. They want the budget to be
balanced in a timely fashion, and they want the result of this effort to be a smaller, less costly government.
The Clinton FY 1997 budget would leave less money in the pockets of working families and more
money in the hands Washington's big spenders.
It spends money taxpayers cannot afford. The 20-page FY 1997 Clinton budget proposes to
"balance the budget" in FY 2002 while boosting spending $361 billion over the next seven years. It would
spend a total of $12.16 trillion over the next seven years, $306 billion more than would be spent under
the Balanced Budget Act the President vetoed last December. This amounts to $3,155 more government
spending for every household in America.
It takes more of their money in tax revenues. The Clinton budget assumes federal tax collections
will grow an astonishing $526 billion by FY 2002, a jump of nearly 39 percent. Also, the Administration
expects the government to collect a total of $11.4 trillion in tax revenues over the next seven years, $187
billion more than under the BBA. This amounts to $1,927 more in taxes for every household in America.
It adds to tomorrow's debt burden. Because the Clinton budget fails to control federal spending, it
would add $755 billion in accumulated deficits to the national debt, even while promising to balance the
budget over seven years. Compared to the BBA, this is $119 billion more deficit spending over seven
years, equivalent to transferring $1,227 per household in added debt to the next generation of American
workers.
Balancing the Budget Without Lifting a Finger
As was the case with Clinton's previous "balanced budget" plans, the only way the FY 1997 budget
can be made to balance at least on paper is by leaving the real work of deficit reduction to a future
President and Congress. How does it do this?
First, the Clinton plan purports to save nearly $596 billion over the next seven years, but less
than 40 percent of these savings is achieved during the first five years. The painful task of
accomplishing 61 percent of the plan's deficit reduction falls to the first Congress and President elected in
the next century. Indeed, some 54 percent of the plan's Medicare savings and 60 percent of its Medicaid
savings will fall beyond a possible second Clinton term in office.
Second, while Clinton claims his budget balances according to Congressional Budget Office
assumptions, it does not. Clinton makes his job of balancing the budget in FY 2002 easier by
challenging or ignoring CBO assumptions.² For instance, CBO currently projects a $228 billion deficit
in FY 2002. Clinton, however, reduces that projection to $221 billion by challenging one of CBO's
technical assumptions, thereby avoiding the need to cut $7 billion in spending. Also, Clinton's budget uses
Office of Management and Budget (OMB) estimates of proposed spectrum auction proceeds, rather than
CBO estimates, to produce an additional $11 billion in deficit reduction in FY 2002 again, to avoid
having to produce real spending cuts. The Senate Budget Committee reports that if honest accounting
methods were used, Clinton's budget would produce a $9 billion deficit in FY 2002, not the balance the
Administration claims.
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Administration claims.
Modest Tax Cuts, More Tax Increases
The Clinton budget also manipulates its proposed tax cuts in order to avoid having to make tough
choices on curbing spending. The budget proposes a meager $98.5 billion in gross tax cuts over seven
years, equivalent to returning just 8 cents of every $1,000 in taxes the government expects to collect. The
centerpiece of the plan is a tax credit for dependent children that begins at $300 per child and increases to
$500 per child in 1999 3 However, Clinton "sunsets" the child credit after FY 2001, increasing taxes on
these families by over $17 billion in 2002 the year Clinton promises to balance the budget.
The Clinton budget proposes to generate $59.4 billion in new tax revenues by "cutting corporate
tax subsidies, closing loopholes, and improving tax compliance."2 This amount exceeds the
Administration's proposed seven-year savings in Medicaid ($59 billion) and is nearly 50 percent greater
than its proposed welfare cuts ($40 billion). These new revenues effectively reduce the net size of the tax
cut package to $39 billion, equal to a cut of just 3 cents for every $1,000 taxpayers will send Washington
over the next seven years.
One of the major contributing factors in the Clinton budget's ability to "balance" the budget in FY
2002 is the temporary nature of the tax cuts combined with the permanent nature of the new tax
revenues. The new tax measures purportedly generate $11.9 billion in FY 2002. When this amount is
added to the $17 billion tax hike on families resulting from the unseating of the child tax credit, the result
is $29 billion in deficit reduction, roughly 15 percent of Clinton's total deficit savings in FY 2002. Again,
there is no need to make tough choices on real spending cuts.
The Failure to Address Exploding Entitlement Growth
Regrettably, Clinton proposes no credible solutions to the serious problems facing the nation's
major entitlement programs, such as Medicare, Medicaid, and welfare. The meager savings the
Administration proposes to achieve from these programs fall far short of stemming the tide of red ink in
the near term -- and far short of the fundamental changes needed to keep these programs from collapsing.
The White House has been warned repeatedly of the need to curb runaway entitlements:
CBO projects that, if nothing is done to slow the overall growth of entitlement programs, they will
grow by $465 billion over the next seven years, a 63 percent increase. Worse yet, CBO expects
entitlements to consume 57 cents of every dollar spent by the federal government in 2002 over 8 cents
more than is spent today.
The long-term forecasts reported by the Bipartisan Commission on Entitlement and Tax Reform,
headed by Senators Robert Kerry (D-NE) and John Danforth (R-MO, now retired), are even more
troubling. These projections suggest that entitlements will become a liability that cannot be sustained by
the federal government, by the economy, or by the taxpayers.
Some examples of the Commission's findings:
Example: "The gap between Federal spending and revenues is growing rapidly. Absent
policy changes, entitlement spending and interest on the national debt will consume almost
all Federal revenues in 2010. In 2030, Federal revenues will not even cover entitlement
spending.
C
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Example: "By 2030, unless appropriate policy changes are made in the interim, projected
spending for Medicare, Medicaid, Social Security, and Federal employee retirement
programs alone will consume all tax revenues If all other Federal programs (except
interest on the national debt) grow no faster than the economy, total Federal outlays would
exceed 37 percent of the economy. Today, outlays are 22 percent of the economy 1.6
Example: "The share of Medicare Part B cost paid by enrollees as monthly premiums has
been shrinking since the program began. When the program started, the enrollee and the
Federal government had a 50-50 partnership - each paid 50 percent of the cost. Today, the
Federal government pays 70 percent of Part B costs; by 2030 the government's share is
projected to increase to 92 percent.'
Entitlements grow as a share of budget. Under the proposed FY 1997 Clinton budget, overall
entitlement spending would increase by $365 billion (nearly 50 percent) over the next seven years. While
the Clinton plan would slow the aggregate growth rate of these programs to an average of roughly 6
percent per year from a CBO-projected average of 7.2 percent per year, entitlement programs will
increase substantially as a share of the overall federal budget. Currently, mandatory programs consume
48.7 cents of every dollar spent by the federal government. The Clinton budget plan would increase the
share of federal spending dedicated to these programs to 58.8 cents of every federal dollar by FY 2002.
One reason is Clinton's failure to address significantly the systemic problems within these programs.
The other reason is that Clinton's budget plan achieves more than 55 percent of its overall deficit savings
from discretionary programs -- which comprise just 36 percent of federal spending. As these annually
appropriated programs shrink as a share of total spending, a greater share of the federal budget is
consumed by "uncontrolled" entitlement spending.
Medicare is left at risk. In April 1995, the Medicare Trustees issued a warning that the Medicare
Hospital Insurance (HI) Trust Fund was in severe financial imbalance and that Congress should take
"timely action to establish long term financial stability for the program. 8 Indeed, recent figures from the
Health Care Financing Administration (HCFA) show that in 1995, the HI program paid out $35.7 million
more in benefits than it took in through the HI payroll tax, thus forcing HCFA to reduce the trust fund's
accrued balance to pay its bills. This is a sign that the HI trust fund, which is expected to go bankrupt by
the year 2002, could face a financial crisis even earlier than has been feared.
Despite these warning signs, the Clinton Administration's Medicare reform proposal falls short of
restoring the long-term solvency of the program. Even though the President's budget promises to reduce
the growth of Medicare spending by $124 billion over the next seven years compared to CBO
projections, it provides too few details to justify such claims. The plan purports to allow beneficiaries
more choices from the private sector, but it does not replace today's defined benefit program with a
defined contribution program that truly gives America's seniors an unprecedented opportunity to choose
their own health plan and range of benefits.
Furthermore, the President's budget proposal maintains a heavy taxpayer subsidy of Medicare's Part
B premiums by requiring beneficiaries to pay only 25 percent of Part B program costs. The original Part
B program required beneficiaries to pay premiums which reflected one-half of program costs. Maintaining
the taxpayer subsidy at 75 percent means there are not enough incentives to encourage enrollees to
compare the costs and benefits of more efficient private alternatives with the costs and benefits of the Part
B program. The more the subsidy is reduced, the more level the playing field between private-sector plans
and government. The elderly would have incentives to choose more efficient plans in the private sector.
The likely result: not just a reduction in the subsidy, but a significant reduction in gross budget outlays for
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The likely result: not just a reduction in the subsidy, but a significant reduction in gross budget outlays for
Medicare.
More Medicaid costs are shifted to the states. The Clinton Medicaid reform proposal would
exacerbate the crisis facing most state governments: growing Medicaid costs that are siphoning off
precious resources from such other priorities such as education, prisons, and infrastructure. Heritage
Foundation analysts have calculated that "if no changes are made to current law, the states and the
District of Columbia probably will need to raise taxes or cut other spending by $146 billion over seven
years in order to meet their mandated obligations."
Clinton's proposal would control federal Medicaid costs by some $59 billion over seven years by
implementing a "per capita cap" on the amount Washington sends to states to provide health care for the
poor and elderly. But this purported reform retains Medicaid's existing entitlement structure by
maintaining most of the current eligibility requirements in Title XIX of the Social Security Act.
Maintaining these federal strings could impose an additional $47.4 billion in Medicaid costs on already
financially strapped states 10
Limiting federal Medicaid expenditures while increasing the financial exposure of the states is
irresponsible. The President's proposal does not allow states the flexibility they need to design benefit
packages or other major program parameters. If the federal government is going to cap its Medicaid
expenditures, the states must be allowed to establish new benefit packages, provider reimbursement
systems, and -- most important -- eligibility criteria. While the Administration's proposal allows for some
limited changes in managed care enrollment, it represents a large unfunded mandate to the states because
they will not have the freedom to control costs as dictated by the federal per capita caps. The magnitude
of an such an unfunded mandate will vary from state to state because of differences in population.
However, a large state, such as California, could face additional costs of $4.4 billion from the per capita
cap.
Welfare reform ignores the root causes of poverty. The Clinton welfare reform proposal will
hardly make a dent in the massive federal welfare system that has cost taxpayers $5.5 trillion since 1965.
The federal welfare system is a vast network of 78 interrelated, overlapping, means-tested programs
designed to assist poor or low-income Americans. The cost to all levels of government was $350 billion
in 1994, with Washington contributing 72 percent. This amounts to $3,400 for every taxpaying household
in America.
Clinton proposes to trim the welfare state by an unnoticeable $40 billion over the next seven years.
Real reform would send programs back to the states with only a few necessary strings attached, but the
Clinton plan keeps the existing structure of federal anti-poverty programs and talks vaguely about giving
flexibility to the states. Clinton also talks in tough terms about imposing real work requirements on
welfare recipients but the reforms drafted by the Administration contain only sham work requirements.
The most serious flaw in the Clinton welfare plan is its failure to address one of the major root
causes of poverty: illegitimacy. Since 1965, the percentage of children born out of wedlock has grown
from 7 percent of all children to 32 percent an almost five-fold increase. Rather than deal substantively
with this problem, the Clinton plan simply tries to address the symptoms by spending more on job training
and child care programs.
Spending Initiatives That Outweigh Spending Cuts
While stating that "government should not do for individuals what they can do for themselves," the
Clinton budget outlines a sweeping agenda of spending initiatives in areas such as education, high
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Clinton budget outlines a sweeping agenda of spending initiatives in areas such as education, high
technology, crime fighting, and the environment. Remarkably, the discussion of this new spending falls
under the heading "Spurring Economic Growth," thus confirming the Administration's strange and
obsolete notion that directed government spending, not private spending, is the key to creating jobs and
economic growth. Nowhere, however, does Clinton's budget provide even a hint of how it intends to
achieve the $297 billion in discretionary spending cuts that comprise 55 percent of its deficit reduction
plan. These details, presumably, will be outlined in the Administration's full FY 1997 budget, due to be
published this month.
Clinton's spending initiatives would add yet another layer of bureaucracy to the hundreds of failed
programs currently funded in the federal budget in areas the President claims are priorities. Clinton has an
obligation to explain to taxpayers why these hundreds of existing programs have failed, and why they
have not been eliminated, before trying to justify pumping even more money into these areas.
Some of these new spending priorities include:
Job training. The budget proudly states that the Administration has shifted more money into job
training programs and would increase funding for Skill Grants for dislocated workers. Yet:
The General Accounting Office (GAO) reports that 14 separate federal departments and agencies
currently fund some 164 job training programs at a cost to taxpayers of roughly $25 billion per
year. Moreover, the few controlled studies that have been conducted show that these programs
have little or no success either in putting people to work or in raising their wages.
Education. The Administration claims it has shifted more money to education programs such as
Goals 2000 and the Safe and Drug-Free Schools and Communities program: Now Clinton wants new
programs to "connect every classroom to the information super-highway," in addition to expanded
work-study for college students, merit scholarships for high school students, and charter schools. Yet:
The Department of Education already manages roughly 240 programs, dozens of them targeted to
the same students for whom Clinton would create new programs. Indeed, Goals 2000 does little to
benefit students; it primarily funds state bureaucracies and duplicates many programs currently
operated by the states. Also, many states already are experimenting with reform initiatives such as
charter schools and do not need Washington's help. Moreover, there are some 240 programs
targeted to "at-risk youth" scattered throughout such agencies as the Departments of Education,
Health and Human Services, Justice, and Labor. Creating more programs targeted to these young
people only adds to the bureaucracy.
Science and technology "investments." The Clinton budget places great emphasis on maintaining
Administration's investments in high-technology spending. Yet:
These myriad "investment" programs have turned out to be little more than expensive corporate
welfare. There is evidence to suggest that these programs not only do not create jobs, but actually
may induce the recipient corporations to downsize their research and development departments. 11
Many corporations figure there is no reason to fund their own R&D if Washington will pick up the
tab for them.
Crime. The Clinton budget "fully funds the President's Community Oriented Policing Services
(COPS) initiative," which the Administration claims will put 100,000 new police officers on the street.
Clinton claims this program is responsible for the hiring of 23,000 new policemen to date. Yet:
o "
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The problem with Clinton's promise to put 100,000 new police officers on the street by 2000 is that
the math does not work. The 1994 crime bill, which authorized the COPS initiative, provided $8.4
billion in federal funds over six years, enough money either to put only 20,000 permanent new
policemen on the street or to pay 100,000 officers less than $15,000 per year. Since police officers
make more than the minimum wage, state and local governments that accept these federal funds
will have to finance the remaining cost themselves a cost that could total $28 billion over six
years. 12 Congress would change this program from a matching grant to a simple block grant,
allowing local governments to use the funds for other law enforcement-related purposes such as
purchasing equipment, paying overtime, and establishing neighborhood programs. Clinton has
rejected these reforms, and the reason is obvious: Block granting the funds will not force local
governments to pay for Clinton's campaign promises.
Discretionary Spending "Cuts"
The Clinton FY 1997 budget proposes to spend $111 billion more on discretionary programs than
the Balanced Budget Act the President vetoed, while claiming to save $297 billion over seven years from
these programs. How can this be true? The truth is these savings are calculated from the CBO "baseline,"
which projects higher spending on discretionary programs in future years. Thus, simply freezing
aggregate spending on these programs at FY 1995 levels "saves" $258 billion over seven years. The
roughly $40 billion in additional "savings" (bringing the total to $297 billion) is due to Clinton's proposal
to spend less in future years, below what was spent in 1995. However, the Clinton budget would
implement 95 percent of these cuts in FY 2001 and FY 2002, thus leaving the tough decisions to a future
President and Congress.
CONCLUSION
The eΓa of big government is far from over. The Administration's repeated use of gimmicks and
accounting ploys to "balance the budget" casts doubt on its sincerity in negotiating a balanced budget
plan with Congress. At every turn, Clinton fought attempts to cut spending, or even to reduce the growth
in spending. Clinton challenged CBO's conservative economic assumptions because they required greater
savings to balance the budget. In other words, he wanted more money for favored programs while
claiming to support a balanced budget. Clinton repeatedly called on Congress to reduce the size of the
BBA's tax cut package, not because eliminating the tax cuts would balance the budget any faster (say in
five years rather than seven), but because smaller tax cuts would allow more money for government
spending. The record is clear: Bill Clinton prefers keeping money in the hands of Washington bureaucrats
to keeping it in the pockets of American taxpayers.
The author is grateful to Heritage analysts John Liu and Robert Rector for their contributions to
this study.
Endnotes:
1. This section is derived largely from the forthcoming Heritage Foundation publication Issues '96:
The Candidate's Briefing Book. Sources for figures: Congressional Budget Office and House
Budget Committee, Majority Staff.
2. For a detailed analysis of these gimmicks, see Senate Budget Committee, Majority Staff, Budget
Bulletin No. 5, February 12, 1996.
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3. The Administration's child credit begins phasing out for families with incomes above $60,000 and
reaches zero at $75,000 in family income. Only families with children under age 13 (ages 12 and
below) are eligible for the credit. For a detailed analysis, see Scott A. Hodge, "Balanced Budget
Talking Points #5: Clinton's $300-Per-Child Tax Cut Plan Denies Tax Relief to 23 Million
Children," Heritage Foundation F.Y.I. No. 78, December 11, 1995.
4. Clinton FY 1997 Budget, p. 14.
5. Bipartisan Commission on Entitlement and Tax Reform: Final Report, January 1995, P. 4.
6. Ibid., p. 8.
7. Ibid, P. 18.
8. 1995 Annual Report of the Board of Trustees of the Federal Hospital Insurance Trust Fund, April
3, 1995, p. 4.
9. William W. Beach, "Updated Estimates of the Costs to the States of Not Reforming Medicaid and
the Additional Costs of Adopting Per Capita Caps," Heritage Foundation F.Y.I. No. 81, December
18, 1995. P. 1.
10. Ibid.
11. Gilbert M. Gaul and Susan Q. Stranahan, "High-Tech Handouts," a seven-part series published in
The Philadelphia Inquirer, June 3 to June 10, 1995.
12. Scott A Hodge, "The Crime Bill's Faulty Math Means a $28 Billion Unfunded Liability to the
States," Heritage Foundation F.Y.I. No. 29, August 16, 1994.
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