As the annual budget debate begins on Capitol Hill, policymakers are no doubt surprised to find themselves in a difficult position. Just a year ago, forecasters were predicting steady economic growth, and annual budget surpluses over $300 billion. Since then, the economy has fallen into recession, and the budget now appears headed for deficits.
Some policymakers have concluded from these twin problems that the federal budget drives the economy and that the projected deficits have caused or exacerbated the recession. Because they believe the 2001 tax cuts are responsible for the projected deficits, they propose repealing the tax relief measures in order to balance the budget and thereby spur the economy.
This misguided view is based on a misunderstanding of the relationship between the federal budget and the U.S. economy. Budget surpluses do not cause economic growth; they are a consequence of economic growth. Balancing the budget alone will not lower interest rates noticeably or increase the productive capacity of the economy, which would stimulate growth. However, policies that remove barriers to economic growth, such as cutting marginal tax rates, would stimulate the economy and in turn increase tax revenue and balance the budget as long as spending is kept in check.
Over the long run, federal budget deficits have resulted from overspending. Had the federal government simply held spending increases to the rate of inflation, it would have run budget surpluses in 28 of the 32 fiscal years since 1970. Instead, it increased annual spending by 852 percent--120 percent above the rate of the inflation.
Lessons can be learned from past experience with recessions and deficits. For example,
- In the early 1930s, President Herbert Hoover was faced with a severe recession that depleted tax revenues and threw the budget into deficit. Based on the mistaken view that the budget drove the economy, Hoover raised income tax rates and tariffs (import taxes) in an attempt to balance the budget. Instead, the taxes and tariffs reduced economic opportunity and undermined incentives to work, save, and invest; the economy collapsed; and the recession turned into the Great Depression.
- In the 1980s, President Ronald Reagan was also faced with a severe recession and increasing deficits. He responded by passing tax rate cuts designed to remove barriers to economic growth and end the recession. His approach proved the wiser course. These tax reductions began the longest peacetime economic expansion in American history up to that time--an expansion that increased tax revenues and eventually balanced the budget. Only runaway spending prevented it from happening sooner.
In the current recession, policymakers would be wise to avoid a Hoover-style reaction to the recession. Instead of repealing President George W. Bush's tax cuts and sacrificing the economy for their budget priorities, they should follow the Reagan model of focusing policy on family budgets and business growth by cutting tax rates further, ending the recession, and allowing the growing economy to provide the tax revenue needed to balance the budget.
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.
