The Big Picture
The
CBO's two main economic simulations show that President Bush's tax
relief proposals recover a significant portion of the reduced
revenue.
The CBO's use of the Global Insight (GI) model of the U.S. economy
shows the President's budget aiding the economy enough to recover
two-thirds of the reduced tax revenue. The Macroeconomic Advisers
(MA) simulation, another model of the U.S. economy used by the CBO,
shows recovery of over one-third of the lost tax revenues. (See
Table 1.)
These estimates of revenue recovery stem
mostly from new jobs and increased economic growth. The GI model
estimates that economic growth from 2004 to 2008 would average 1.4
percent higher than the baseline level, while the MA model
estimates a 0.2 percent boost. Employment levels would jump under
both simulations:
- 1.6 million more jobs per year (1.2
percent increase), based on the Global Insight model, and
- 550,000 more jobs per year (0.4 percent
increase), based on the Macroeconomic Advisers model.
Increased Federal Spending Dampens the Tax
Cut Boost
President Bush's budget would spend an
additional $348 billion over current levels from 2004 to 2008. Of
that total, refundable credits from the President's tax cut
proposal represent $40 billion, and added net interest payments
(which partially result from the tax cut) would cost $103 billion.
A majority of new spending ($205 billion) represents regular
government programs.
Much
of this new spending would harm the economy and dampen the tax
cut's positive effect. The CBO concludes that by lowering taxes on
investment, the President's proposed tax cuts would increase
investment and consequently expand the economy. However, new
government spending would reduce investment because (1) increased
federal government purchases would leave less money for the private
sector to invest and (2) increased government payments to
individuals would induce individuals to increase their consumption
at the expense of increased savings and investment.
The
CBO assumes that the negative effects of government spending would
overwhelm the positive effects of lower taxes. In other words,
government spending frequently crowds out additional investment and
employment, negating most of the positive investment incentives
proposed by President Bush to help the economy.
The lesson is clear: Maximizing the
success of pro-growth tax cuts requires restraining federal
spending.
Why the Simulations Assume Outlays Will
Increase
Both
simulations assume that federal outlays from 2004 to 2008 will
increase by much more than the $348 billion proposed by President
Bush. The MA model shows an additional $236 billion in spending,
and GI shows an additional $75 billion. (See Table 1.)
These simulation results of federal
outlays stem from higher interest rates projected by the two
models. The GI model predicts that greater economic activity and
heightened demand for consumer loans will drive up interest rates.
The MA model also predicts that greater demand for loans will raise
interest rates, but that model goes further and claims that higher
federal budget deficits will themselves raise interest rates.
However, there is very little empirical evidence that modest
changes in the budget deficit will significantly increase interest
rates (recent budget deficits have coincided with decreasing
interest rates), so this assumption should be viewed with
skepticism.
The
two models' different treatments of the relationship between
interest rates and economic activity explain a large part of the
difference between their estimated federal outlays. These different
views of interest rates also explain some of the differences
between their estimates of economic growth and new tax revenue. If
interest rates remain low, economic growth and tax revenue should
be even higher than the simulations predict.
Why the Simulations Classify Most of the
Growth as Cyclical Rather than Supply-side
The
CBO report separates the economic effects of the President's budget
into "cyclical" and "supply-side" components. "Cyclical" changes
are caused by the business cycle, such as the unemployment rate
increasing during a recession and decreasing during a boom.
"Supply-side" changes increase the capacity of the economy. For
example, the costs of working an additional hour, taking an
additional job, or purchasing new equipment all have supply-side
effects on economic growth.
Some
have misinterpreted the report to define supply-side effects as
those resulting from the President's tax proposals and the cyclical
effects as whatever the business cycle would naturally bring
regardless of tax policy. That is not the case. The cyclical effect
shows how far the economy is moving toward its potential growth
rate. The supply-side effect shows changes in the potential growth
rate itself. In other words, the cyclical effect shows whether the
economy is growing at capacity, and the supply-side effect shows
whether the capacity itself has expanded.
The
CBO's simulations state that the President's budget significantly
increases cyclical growth but not supply-side growth. In other
words, it will help the economy grow closer to its capacity but
will not significantly increase the capacity itself. Given the fact
that the economy has been growing well below its capacity for the
past few years, increasing economic growth to its capacity level is
a very strong argument for the President's budget.
CONCLUSION
The
CBO's analysis of President Bush's budget proposal indicates that
it would increase economic growth, create jobs, and recover much of
the lost tax revenues. Congress should not passively assume that
these economic benefits will happen on their own. Nor should
Congress reduce the President's tax cut and still expect
substantial economic benefits. The CBO report shows that the only
way to create thousands of jobs and unleash economic growth is to
enact the President's entire tax package and restrain spending.
Brian M.
Riedl is Grover M. Hermann Fellow in Federal Budgetary
Affairs in the Thomas A. Roe Institute for Economic Policy Studies
at The Heritage Foundation.
Appendix
Excerpts from Congressional Budget Office
Analysis
of the President's Budgetary Proposals for Fiscal Year 2004
The President's tax proposals would
encourage investment and economic growth:
The President's budget could also affect
potential output by changing the mix of capital over time. The
proposal with the greatest potential to change the composition of
the capital stock is the one to reduce double taxation of corporate
income. Some corporate income is taxed twice: once at the corporate
level by the corporate income tax and again at the personal level
by the individual income tax. That tax treatment creates a
distortion in the allocation of capital, discouraging investment in
the corporate sector relative to the housing and noncorporate
business sectors. As a result, less capital is held in the
corporate sector than is efficient. The taxation of dividends also
encourages firms to finance investment with debt rather then equity
(because interest payments on debt are deducted from tax at the
corporate level and so only taxed once), which may also lead to
economic inefficiencies. Reducing the tax
on dividends would lessen those inefficiencies, thereby increasing
overall economic output.
However, some
tax proposals in the President's budget would tend to reduce
consumption by increasing the after-tax rate of return on
savings. Accelerating and making permanent EGTRRA's
[Economic Growth and Tax Relief Reconciliation Act of 2001]
reductions in marginal tax rates, reducing the share corporate
income subject to double-taxation, and expanding tax-free savings
accounts would all reduce the marginal tax rates on income from
savings.... Overall, those changes would increase the after-tax
return on savings.
However, new investment would be reduced
by government consumption:
The economic impacts should not, of
course, be evaluated on a dollar basis alone. For example, as noted
above, the proposals would alter marginal tax rates on capital and
labor. Over the long term, the effects of budgetary policies depend
on the degree to which they alter incentives to acquire skills,
work, save, innovate, and undertake investments. Indeed, a subset
of the President's proposals are intended to increase those
incentives. Those proposals would not operate in isolation,
however. The remainder of the revenue proposals and those that would increase spending embody few
such incentives. They likely would tend to reduce growth in the
long run by increasing government and private consumption, at the
expense of saving and investment.
Investment would also be reduced by
government-financed private consumption:
The President's budgetary policies would
also influence private consumption in a number of ways. For one,
the budget would increase disposable income through reduced taxes
and increased transfer payments (such as
a Medicare prescription drug benefit). That would tend to boost
consumption, because people would probably spend some of that extra
disposable income.
Therefore, government spending reduces
investment and economic growth:
Most of CBO's estimates indicate that
the President's budget would increase the
sum of private and government consumption on net, which would tend
to imply somewhat less investment and a smaller capital stock.
The primary
supply-side effect in 2006 through 2008 is the crowding out of
capital due to higher government and private consumption, which
decreases output by about half a percent on average.
The overall macroeconomic effect of the
proposals in the President's Budget is not obvious. For example,
some provisions in the proposals would lower marginal federal tax
rates on labor and capital income. By
themselves, those provisions would tend to increase labor supply,
investment in productive capital (such as factories and machines),
and the economy's output. However, the proposals also would promote
the consumption of goods and services by both the government and
private sector, which would tend to reduce investment.
The President's budgetary policies would
affect the size of the capital stock--the nation's stock of
productive equipment such as factories and information
systems--primarily through their impacts on government and private
consumption and, therefore, on investment. The policies would directly increase government
consumption relative to the level in CBO's baseline. That increased
government consumption would tend to reduce investment in
productive capital by reducing the resources available.