161 January 14, 1982 THE CASE FOR TAX CUTS NOW INTRODUCTION As President Reagan prepares his budget for the 1983 fiscal year, the nation's economic barometers are signalling stormy weather. From both sides of the congressional aisle even from those who sh o uld know better cries are heard imploring Reagan to abandon his supply-side strategy, in operation less than four months. Yet there are strong arguments for the President.to stay resolutely on course. There even are calls for supply-side economics really t o be given a chance by accelerating the scheduled tax cuts and not, as some critics propose, postponing them than seven months ago, many seem to have forgotten even some in the Administration the fundamental reasons underlying the policy: that high margin a l tax rates destroy the kind of produc tive activities most needed in an economic downturn. The most important barrier to economic recovery today is the heavy load of taxes helping to keep factories idle, investment opportunities unexploited and, ultimate l y, willing workers unemployed Although the debate on the Reagan tax cuts occurred less Between 1965 and 1975 the average tax rates for the median income earner increased more than 35 percent. Those rates in- creased an additional 22 percent between 1975 a n d 1980, mainly due to inflation-induced tax bracket creep. The marginal tax rate faced by the median-income family of four in 1980 was 24 percent. Taking into account Social Security and state tax increases, the marginal tax rate facing the average Americ a n family is 40-44 pe2cent.l On the average, this amounts to some Paul Craig Roberts, Assistant Secretary of the Policy Statement Before the House Task Force Washington D.C July 27, 1981 Treasury for Economic on Economic Policy," 2 10,690 per household. Do es anyone seriously think that adding to this burden would create a more healthy economy?

Unless action is taken, however, an already over-taxed economy will be burdened with yet another stiff tax hike in 1982 A Social Security tax increase' of $13 billion greeted Americans on January 1 and they can look forward to income tax increases of 28 billion because of tax bracket creep.2 (See Appendix 1 The 10 percent personal tax reduction scheduled for July will only offset these automatic tax increases.

The oth er scheduled cuts are in large part only reductions of planned tax increases. The nature of the U.S. tax system permits massive tax increases to occur automatically because of inflation No direct legislation is required. Despite the much-publicized "Reaga n revolution1' in tax policy, the fully implemented tax cut will at best return the nation to the level of taxation in 19

78. Even with the cuts, total revenues will increase over $300 billion during the next five years to the Congressional Budget Office ( CBO tax levies will rise from $605 billion in 1981 to $923.3 billion in 1986 According And yet many in Congress and the Administration actually propose to reverse the economic slowdown by raising taxes even more. Apparently, the message that taxes are the major cause of our economic malaise has still not been universally learned.

Higher taxes do not reduce prices nor fight inflation. Higher taxes do not increase employment nor stimulate economic growth.

Rather, tax increases exacerbate the problems of unemployment low productivity, and economic stagnation.

Accelerating the tax cut would help relieve the heavy tax burden which supply-siders contend is a chief cause of economic deterioration in recent years spurred by Representatives Jack Kemp R-N.Y and Rob ert Walker R-Pa are urging the President to speed up the tax cuts by six months. They argue that with over 9 million Americans unemployed and the economy running at only about 75 percent of capacity fallow resources could be employed by enhancing the ince ntives for productive work and investment. Tax cuts, not tax increases they say, generate the long-term prosperity that, among other things, eventually will restrain and then eliminate the deficit.

These Congressmen have introduced a bill (H.R 4999) that would move up the tax cut scheduled for July 1982 to January and the July 1983 tax cut to January 19

83. While some hope for the full 25 percent tax rate reduction to be made effective immediately or, even better, that full indexing of tax brackets for inf lation be started now rather than 1985, most supply-siders seem to be coalescing around the Kemp-Walker proposal as a remedy for the current recession More than two dozen Congressmen 2 What the Tax Cut Really Does Human Events, November 21, 1981, p. 5. 3 S upply-siders figure that the quickest way to reduce the burgeoning deficit is to stimulate the economy to recovery thereby reducing expenditures for social welfare programs and increasing tax revenues recent increase in estimates of the proposed deficit a r e caused by a deteriorating economy, not by the upcoming tax cut. Expendi tures for unemployment compensation, food stamps, and other entitlements have increased rapidly since July, while the economic decline has reduced tax revenues A reinvigorated econo m y, however, could quickly.eliminate the budget deficit. The CBO estimates that for every one percentage point decline in the unemployment rate, the deficit is reduced $25 billion. A reduc tion in the unemployment rate from the current 9 percent to 6 perce n t could nearly wipe out the budget deficit for the coming year. While few think that accelerating the tax cut stimulates economic growth quite this powerfully, most supply-siders think it could shorten the recession and, in the long term, slash the defici t They point out that four-fifths of the Other analysts confirm the basic Kemp-Walker arguments A U.S. Chamber of Commmerce study finds that a six-month speed-up in the personal tax rate reductions would significantly stimulate real economic growth in 1982 and 1983, substantially reduce the unemployment rate, and increase business investment and producti vity without increasing the rate of inflation at all. Accord ing to the study, the measure provides taxpayers with more than 16 billion in relief in 1982 a n d more than $17 billion in 1983.3 While this falls far short of offsetting all the tax increases scheduled for those years, it does fully offset Social Security tax increases and tax bracket creep rated businesses by allowing entrepreneurs to retain a gre a ter share of their own earnings helps pull the country out of downturns and provides important sources of innovation and employment in times of recovery. Nearly 70 percent of all new jobs come from firms with twenty or fewer employees. In the Northeast, n e arly 100 percent come from these miniscule businesses.4 A tax code which rewards inherently risky entrepreneurial activity encourages an early exit from the current recession and a sustained recovery. David Smick, chief of staff for Congressman Kemp, writ e s: Ilentrepreneurial success in America is taxed and harassed more than in just about any other free industrialized country.Il5 Ninety percent of American firms, for instance, pay taxes through personal schedules, either 1 Tax cuts spur the entrepreneursh ip of small, often unincorpo Small business entrepreneurship Chamber of Commerce of the United States, Forecast Center, Letter to Jack Howard, Office of Congressman Walker, from Graciela T. Ortiz, November 19, 1981.

David M. Smick What Reaganomics is All About," The Wall Street Journal July 8, 1981.

Ibid. 4 as a partnership or as an unincorporated business activity. A tax cut speed-up should expand the pool of capital available to all businesses, but especially to capital-starved small enter prises. Lately , after the government takes its enormous bite of the available capital, and big business gathers up the rest, there is little left for smaller enterprises It is likely that much of the increased pool of saving will go to small enterprises now being crowd ed out of capital markets. And because most small businesses first get their start by borrowing funds from friends relatives, or small local banks, an acceleration of the personal tax cut could mean more funds from these sources.

Supply-siders feel the add itional relief is vitally important to avert a net tax increase that would deepen the recession and cause needless social suffering If there is one mistake that the Administration has made in economic policy,'I Kemp has remarked lit is in delaying the tax cut Adds Walker of tax cuts does not provide a sufficient measure of relief to the American worker and therefore doesn't provide enough time between the July 1 ten percent reduction and the end of the fiscal year for the economy to snap back in time to sh o w solid evidence of economic recovery He concludes that Ifif we have the opportunity to put people back to work we should take advan- tage of it The first round THE CRIES FOR TAX BOOSTS The Kemp-Walker arguments are falling on some deaf ears in Washington . According to recent reports, top White House and budget department officials almost unanimously advocate t.ax increases to balance the budget. Budget director David Stockman, Chief of Staff James Baker 111, Counselor to the President Edwin Meese 111, and Deputy Chief of Staff Michael K. Deaver reportedly favor a total of 45 billion in new taxes over the next two years some Treasury Department aides, oppose raising taxes substan- tially over the next few years. Recently, the President signalled once again his opposition to tax raises.

David Gergen told reporters, "The President is opposed to any new increases in taxes. He believes that the growing burden of taxation has been a major contributor to the economic deteriora tion of recent years. He also believes that the tax cuts passed ea r lier this year lay a strong foundation for economic recovery in 1982 and should not be changed The President's determined opposition to personal tax in creases finds strong substantiation in almost any economic theory. Since President Herbert Hoover raise d taxes at the outset of the Great Depression to balance the budget, almost all economists have agreed that taxes should not be raised in a recession.

Economic theories which battle over many points agree, in as It appears that only President Reagan himsel f, and possibly Communications chief 5 close to unanimity as they are likely ever to come, that tax increases in a recession further depress economic activity increase unemployment, and delay recovery. Keynesians think tax increases dampen aggregate deman d and reduce the national output monetarists contend tax increases reduce pressure on Congress to cut government spending the most important factor depressing the economy; and supply-siders think tax increases create disincen tives for work, saving and inv esting.

Despite the consensus of economic theory and this strong statement by the President, the calls for tax hikes continue.

And some fiscal conservatives who never accepted supply-side tenets in the first place are now resurfacing with gleeful warn ing s of the dire consequences of deficits allegedly arising from tax cuts. Even political liberals, blind to deficits caused by increased government spending in the last twenty years, suddenly are singing the praises of a balanced budget.

Jimmy Carter's Secr etary of the Treasury, calls for a tax increase on gasoline; syndicated columnist George F. Will argues for a windfall profits tax on deregulated natural gas; and Senate Majority Leader Howard Baker floats the ideas of a national sales tax or excise tax o n liquor and cigarettes scored a victory of sorts in a December sense-of-the-Senate resolution urging tax increases to balance the budget G. William Miller This tax hike momentum There have been near victories of a similar sort in the I I White House. In f a ct, so many presidential advisors have rushed I to the tax hike side that Ronald Reagan seems, at times, the sole remaining keeper of the supply-side faith It is said, regrettably not only in jest, that the President is now the supply-side llmoletl inside his own White House.

Supply-side leaders on Capitol Hill are disturbed by the readiness of top budget and White House officials to reverse the Administration's economic program. Many feel betrayed by the President's advisors who so easily have conceded th e intellectual grounds for the supply-side tax cuts their original fears that Reagan was surrounding himself with advisors not deeply committed to his economic program This seems to confirm IS IT A REAGAN RECESSION There is little evidence that supply-sid e economics has failed. Yet this does not prevent House Speaker Thomas (Tip O'Neill (D-Mass.) from referring to the "Reagan recession," or the "Reagan deficit," implying that the current slowdown is a result of Administration policies the evidence to the c o ntrary. For example, the current economic slowdown started at least by the second quarter of 1981 when economic production first fell and when in July, the unemployment rate increased to from 7 percent to 7.2 percent of the workforce O'Neill clearly is ig n oring 6 By this early date, however, none of the major planks of the Reagan economic program were in place cut did not even take effect until October 1 at least two months after the recession had begun. The budget cuts also cannot be blamed for the econom ic slowdown. Most of the cuts are only now becoming effective. The FY 1981 budget contained insig- nificant cuts in a few programs and hiked overall spending by over $80 billion. during the Reagan Administration cannot be blamed for the recession.

During t he first quarter of the year, the Federal Reserve aggres sively expanded the money supply. While many believe this was reckless for other reasons, the policy cannot be blamed for an immediate recession. Only regulatory reform has been implemented to any d e gree, since the Administration can eliminate regulation without congressional action No one has suggested that deregu lating business causes economic slowdowns The across-the-board tax Even the monetary policy of the Federal Reserve There were signs in fa c t, of an impending recession before the Reagan Administration took office. In a memorandum entitled Avoiding a GOP Economic Dunkirk Jack Kemp and others warned of a gathering economic storm which threatened a recession early in the President's term thorou g hly disordered credit and capital markets, punishingly high interests rates high inflation expectations, and the possibility that the federal budget could'become an automatic coast-to-coast soup line dispensing remedial aid with almost reckless abandon. T h e memorandum argued that attempts to cut the budget would fail in a recessionary environment. Their solution was to avert recession by enacting tax cuts to spur economic growth and lower inflation expectations For this reason the memorandum concluded dilu t ion of the tax cut program in order to limit short-run static revenue losses during the remainder of FY 1981 and FY 1982 would be counter-productive the timing and magnitude of the tax cuts ultimately enacted by Congress. When the cut was introduced by Ke m p in July of 1977 the reductions amounted to 30 percent in one year. When Reagan decided to make the Kemp proposal the centerpiece of his economic recovery plan in the summer of 1979, he wooed moderates by agree ing to phase in the reductions over three y ears starting January 1, 19

81. In the 1981 fight with Congress, Reagan was forced to make the most damaging concessions: 1) the size of the tax cut was reduced from 30 percent to 25 percent; 2) the first stage of the tax reduction was delayed from January 1, 1981 to October 1 and, 3) in a final concession, the other two stages of the cut were similarly delayed six months. This meant that taxpayers realized only a 1.25 percent effective cut in 1981 tax rates and will not get their 10 percent cut until 1982 done, moreover, about the automatic increases in other taxes They warned that Reagan would inherit This advice was ignored as multiple concessions were made in Nothing has been 7 TAX CUTS: A BOON TO BUDGET CUTS Supply-side economists are not alone in favo r ing speeding-up the tax cut say, reducing government revenues is one way to force a reduction in the federal budget extra tax revenues out of the hands of Congress. Milton Friedman contends that III am in favor of cutting taxes at any time under any prete n se for any reason in almost any way and worse tax cuts, of course, but the most important thing is to keep your eye on is cutting taxes.Il6 Friedman and others favor additional tax cuts primarily as a way of changing the trend of recent years toward great e r centrali zation and regulation of the economy spending, Friedman notes, causes the private sector to contract in order to release resources to the government rarely has been tried, the reverse can also occur. spending is reduced, resources are released t hat allow the private sector to expand Many other economists urge tax cuts because, they In short, these economists want to keep There are better Every increase in government Although it As government DEFICITS AS A SCAPEGOAT ironically, precisely those po l itical figures most responsible for the staggering increases in government spending over the past twenty years. They are, quips Milton Friedman, born-again budget balancers. Most seem to be concerned only with deficits caused by tax cuts and not when they are caused by spending increases It is thus a fair question whether they are sincerely opposed to an unbalanced budget, especially during times of recession, or whether they are simply setting the stage for tax increases followed by further spending incre a ses The reason they are born-again budget balancers and are now talking about raising taxes is not because they've fundamentally changed their view, but because they recognize that the most effective way to hold down government spending is to hold down go v ernment revenue." Would raising taxes result in a balanced budget their concern is to enact higher taxes in order to keep budget deficits down,lf he says so that the government can resume big spending programs as soon as the present public drive for lower taxes and spending passes.Il7 tives worried that unbalanced budgets harm the economy. warns these conservatives in rather strong language that they should not be tricked into supporting tax increases Many sounding the loudest alarms about budget deficits are According to Friedman Friedman does not think so They are talking as if Their real motive is to keep taxes up Some arguing for tax increases, however, are fiscal conserva-.

Friedman If fiscal I I Milton Friedman, Human Events interview, December 5, 198 1 Ibid. 8 I I conservatives join with the liberals in supporting tax increases, says Friedman They will prove that they have learned absolutely nothing from the history of the past 30 years and they ought to have their heads examined u Former Chairman of the Council of Economic Advisors Paul McCracken also chastizes conservatives for wanting to delay tax cuts until the budget is balanced. on any tax action until the budget is balanced writes Dr.

McCracken is simply leading us down the road to yet higher le vels of public spending and budgets chronically in the red.Il8 The strategy of holding off DEFICITS AND TAX CUTS Yet the high deficit projections scare many people into believing that higher taxes or what is now the newest addition to government newspeak, llrevenue-enhancerslf must be tolerated.

In absence of further budget cuts, the 1982 deficit is now expected to increase to $109.1 billion 152.3 billion the following year and $162 billion in 1984 argue that accelerating the tax cut would further cut gove rnment revenues by almost $34 billion in 1982 and 1983, widening the deficit yet further Opponents of the Kemp-Walker initiative These critics ignore history. Higher taxes have rarely created a balanced budget. For twenty years tax revenues have leaped an nually higher through inflation-induced budget creep and explicit tax hikes passed by Congress. The result a budget still deep in the red. What happens, it seems, is that higher taxes merely feed the insatiable appetite of higher spending.

Deficits, of cou rse, do matter. The Treasury borrowing needed to cover the deficit elbows private investors out of capital markers, increases interest rates, and pressures the Federal Reserve to increase the money supply (this is called monetizing the debt as well in the private sector. Much of the analysis of deficits, moreover is incomplete and confuses economic causes and effects. cause of current U.S. economic problems is high government spend ing, rising tax rates, and an unstable money supply. High deficits are the symptoms of these problems and will persist until the government-imposed barriers to economic development are lifted.

Until government spending is reduced, an anemic private sector will be starved for funds. Until high taxes are cut sharply disincentives t o work, save and invest will prevent an economic recovery. Until money growth is reduced and made stable, an unpredictable inflationary environment will depress saving and render long-term investing too risky But taxes depress private sector activity Ever y increase in taxes is accompanied by a shrinkage The Paul W. McCracken, "Reagan's Tax Plan Makes Sense," The Wall Street Journal June 10, 1981 9 These impediments to economic growth are the culprits chiefly causing deficits, not the tax cuts has been the r esult of a deteriorating economy.g Before the recession, the Office of Management and Budget (Om) was estimat ing the deficit at $42.5 billion for FY 1982 52.7 billion for FY 1983 and $44.2 billion for FY 1984 however, Om's deficit estimates have soared b y $230 billion for the three years. A deteriorating economy accounts for over 80 percent of the increase in deficit estimates. Over $185 billion of this increase results not from the Reagan program but from a sinking economy tive Kemp, the increased defici t s are caused by three factors:1 Most of the current deficit Since that July prediction According to an analysis prepared by Representa 1) Reduced government revenues because of unemployment business bankruptcies, and relative decreases in wages, rents and profits. This alone accounts for a surge in the deficit of 142 billion 2) Increased government spending for unemployment compensa tion, food stamps and many other social programs which increase during times of economic slowdown hike the budget deficit by 11.8 billion 3) Higher interest rates than predicted added $31.5 billion to the cost of financing the national debt.

Many believe accelerating the tax cut will reduce and even- tually e liminate the budget deficit by creating the foundation for a prosperous economy by tax cuts sharply increases government receipts by raising wages, profits, and rents, and reduces government spending by dampening the need for social services. Each one per c entage point decrease in the unemployment rate narrows the deficit by about $25 billion. As Congress increasingly balks at making further budget cuts, supply-siders argue that the only feasible means of controlling the deficit is to accelerate economic re c overy with a tax cut The stepped-up economic growth induced A growing number of leaders support accelerating the tax cut including, it appears, Ronald Reagan, top Treasury officials business organizations, and supply-side proponents on Capitol Hill. Paul C raig Roberts, Assistant Treasury Secretary for Economic Policy, is known to be promoting the idea along with other top leaders at Treasury. Moreover, the President in a recent interview with the Westinghouse Broadcasting Corporation, observed that the rec e ssion "might not have happened" if Congress had allowed all his tax-cut measures to begin retroactively to last January 1, as originally proposed, rather than being delayed This analysis is taken from a handout prepared by Representative Jack Kemp, "Anato my of a Deficit," undated and unpublished. lo Ibid. 10 nine months. III still believe that, had we gained on either of these two points, January or July, that this'recession might not have happened Reagan said.

The measure is also gaining strong endorsemen t from the business community. Both the U.S. Chamber of Commerce and the Wall Street Journal have provided vigorous support for faster tax cuts. The Journal concluded in a November 12 editorial that there would be far more confidence if the next 10 percen t tax cut were going into effect in January, not July. That is, if taxes were cut not less but MORE THE EVIDENCE ON DEFICITS The current debate on deficits shows a disturbing lack in knowledge of even the most rudimentary principles of monetary economics. Much of the problem stems from the flawed understand ing of the real versus imaginary effects of budget deficits.

Recent evidence indicates that the conventional wisdom on budget deficits is seriously in error. Separate studies by Robert Weintraub of the J oint Economic Committee, Robert Barro of the University of Rochester, and William Niskanen of the Council of Economic Advisors, have all found, contrary to popular opinion that high deficits need not cause high inflation or high interest rates if money gr owth is held constant.

Some recent historical cases back up these academic studies.

In 1973, the U.S. had relatively high inflation and high interest rates, but low deficits. Conversely, in 1975, the U.S. experienced large deficits but relatively low interest rates and inflation.

This experience is not unique to the U.S associated with stagnant economies as well as booming ones like Japan and Germany about 4 percent of their GNP in 1980 a deficit amounting to less than 2.3 percent of its GNP during this s ame period. Yet the U.S. had significantly higher inflation interest rates, and unemployment than either country, and much lower growth than Japan.ll Clearly, budget deficits do not explain differences in economic performance between countries.

Why don't high deficits necessarily cause rising interest rates and inflation? Most economists today believe that monetary growth is the key factor in causing high interest rates and inflation growth. As David Meiselman points out The relationship between money per unit of output and inflation may well be the most extensively tested proposition in all of economics with few, if any, exceptions.lIl2 Put crudely, inflation results when the Deficits have been The U.S. in comparison had Both countries ran budget deficits totalling Deficits are not even a ball park indicator of money l1 The Economist, November 21, 1981, p. 107 l2 David Meiselman, "Deficits, Money, and the Cause of Inflation," The Wall Street Journal, July 21, 1981. 11 money supply outpaces the growth in th e output of goods and services An accelerating money supply is also the cause of rising interest rates n important component of interest rates is inflation expectations compensates bondholders for receiving dollars of depreciating value. The major factor c ausing high interest rates today is the investing communityfs belief that inflation will continue to depress the value of their saving inflation will subside and one can expect that interest rates will accordingly decline.

The level of budget deficits, how ever, appears to indicate little about the rate of money growth not be a source of inflation unless the Federal Reserve is induced to expand the money supply what in economic jargon is called monetizing debt. The Fed monetizes the federal debt simply by b uying government bonds from the Treasury or from individuals.

Because the Fed is the nation's chief banker, it pays for the bonds by crediting bank reserves held at the central bank.

Whether the purchase is from individuals or the U.S. Treasury crediting bank reserves has the same effect as paying with newly printed money. Monetizing the debt increases the nationfs money supply and fuels inflation after a lag in time The inflation premium in interest rates If monetary growth is reduced 1 Government defici ts need Yet the Federal Reserve is not required to monetize the federal debt. The following Table indicates that the Fed has not always increased the money supply to finance government debt.

Meiselman writes, "Although the Fed blames deficits for causing i nflationary money growth, the evidence is that, from 1960 to 1980, there was no significant relationship between changes in money supply and changes in the national debt. Not only is there 1973 1974 1975 1976 1977 1978 1979 1980 1981a Table 1 Purchases Fe d eral of Debt Deficit Deficit by Fed Monetized 7.9 billion $9.2 billion 116 10.9 6.1 56 75.1 8.5 11 56.6 9.8 17 50.9 7.1 14 43.8 6.9 16 28.1 7.7 27 67.8 4.5 7 24.3 1.6 6 a Nine months Source: Federal Reserve data. 12 no legal or practical need to monetize increases in the debt, the Fed has not systematically done so.1113 The blame for the inflation plaguing our country in recent years should be placed squarely on the Federal Reserve Board's failure to provide a stable and declining growth in money supply.

Milton Friedman argues that the Fed has all the tools necessary to control the money supply and reduce inflation; it lacks only the will to use those tools wisely.

To argue that deficits may not cause inflation is not to say that deficits do not harm the e conomy. Deficits can be damaging they do matter. If the Federal Reserve does not buy the government debt or otherwise increase the money supply, the Treasury is forced to finance the debt by entering the private capital markets.

The increased demand for funds can lead to higher interest rates and a crowding out of business borrowers, if all other factors are kept constant.

The negative effects of budget deficits is a question of vital importance since the Administration is planning to run sizeable budget deficits over the next years. As. Table 2 shows the U.S. has run large budget deficits in every year since 1970.

Those expected under the Reagan Administration are the largest in absolute amounts since World War

11. Phillip Cag an, professor of economics at Columbia University and a visiting scholar at the American Enterprise Institute, has suggested that dollar figures are not a proper benchmark for comparison in a growing and especi ally in an inflationary economy.14 A commonl y used benchmark is to examine the budget deficit as a percentage,of GNP. This figure gives an idea of the burden of the government deficit on the total economy. A deficit of $80 billion for 1982 amounts to about 2.5 percent of GNP. While this figure is hi gher than most years since 1970, the percentage compares favorably with other years of recession like 1975-1976.

Expressing the federal deficit as a percentage of the GNP however, tells us little about the burden of federal credit demand on private capital markets. A more complete view is to measure all funds raised under federal auspices, including the decicit, as a percentage of private capital markets. Included in the measurement of total funds raised under federal auspices is not just the deficit which is only about half of government borrowing but guaranteed loans and government-sponsored enter prise borrowing. As Table 3 shows, total federal credit demand has grown dramatically as a percentage of the private capital market in the seventies. The federa l presence in capital markets grew from 21 percent to over 36 percent. As recently as 1965-1969 l3 Ibid. l4 Phillip Cagan The Real Federal Deficit and Financial Markets The AEI Economist, November 1981. 13 Table 2 Measures of the Federal Deficit, 1970-1982 Unified Budget Deficit Percent Fiscal Year Billions of GNP 1982 (est 1981 1980 1979 1978 1977 TQ 1976 1975 1974 1973 1972 1971 1970 80 57.9 59.6 27.7 48.8 44.9 13.0 66.4 45.2 4.7 14.8 23.3 23.0 2.8 2.5 2.0 2.3 1.2 2.3 2.4 3.0 4.0 3.0 0.3 1.2 2.1 2.2 0.3 N OTE: Fiscal years end June 30 from 1970 to 1976 and September 30 from 1977 to 19

82. TQ is the transitional (the third) quarter of 19

76. Estimated values for 1982 assume $80 billion deficit, growth in GNP over 1981 of 11 percent, a price increase of 9 percent, average interest cost of 12 percent, and growth in debt of $90-100 billion.

Source: Treasury Department and Board of Governors of the Federal Reserve System in Phillip Cagan, "The Real Federal Deficit and Financial Markets," The AEI Economist, Nove mber 1981, p. 2 the federal share of all public and private borrowing amounted to less than 16 percent markets will require a concerted effort to reduce, not only the deficit, but the off-budget borrowing represented by government sponsored agencies and g uaranteed loans in the budget, both categories of borrowing crowd out private borrowers as much as does the deficit.

In the seventies, the magnitude of government guarantees grew 233 percent the federal government guaranteed the loans of some 150-200 diffe rent programs. The best known are the student loan program Federal Housing Administration, Veterans Administration, and the Small Business Administration Any attempt to shrink the federal presence in the capital While not even included In 1981 Government b orrowing for sponsored agencies has also grown rapidly during the seventies. In 1981, the federal government raised over $27 billion for sponsored agencies, a staggering increase of over 450 percent since the 1970-1974 period. The 14 1 amounts borrowed by these agencies are not shown as a budget item although most were created by the government agencies are now privately owned, but carry on activities sanc- tioned by government legislation. They are permitted to borrow under the auspices of the U.S. Treasu r y and, therefore, attain the highest credit rating possible. Within this category is borrowing to benefit farming interests through the Farm Credit Bureau, Federal Land banks, Cooperatives, and many other farming agencies. The Federal Mortgage Association and the Federal Home Loan Bank Board, among many others, are permitted to borrow under federal auspices at risk-free interest rates to support their activities The sponsored Total funds raised Total funds raised under federal auspices Of which Federal bor r owing Guaranteed loans Government sponsored enterprise borrowing Federal share Table 3 Federal Share of the Credit Flows fiscal years, in billions of dollars 1955-59 1960-64 1965-69 1970-74 1975-79 1980 19 8 1 37.1 52.0 80.6 156.9 309.4 344.7 404.0 7.2 9. 6 12.6 32.4 2.1 4.5 6.4 13.0 4.7 4.4 5.2 14.4 83.7 124.3 146.7 56.0 14.8 70.5 32.4 71.0 48.0 0.4 0.7 1.0 5.0 12.9 21.4 27.7 of all public and private borrowing (in pecent 19.4 18.0 15.6 21.1 27 O 36.1 36.3 Includes all credit raised by nonfinancial borrowe rs, such as corporate and municipal borrowing; farm, business, consumer and mortgage loans, and foreign borrowing financial entities.

Excludes interbank loans and other credit extended between estimate I Source: Department of the Treasury; Federal Reserve Board. 15 I I This ravenous federal appetite for credit has become a major impediment to economic growth and prosperity. Undoubtedly, the federal demand for enormous amounts of credit has increasingly driven up interest rates and crowded out business borr owers from the capital markets. This factor appears to be a major cause of the stagnation of the private sector since a shrinking percentage of total capital is available to business and investors.

What does this evidence mean in the debate over accelerati ng the tax cuts the deficit further by cutting taxes. They say that speeding up the tax cut will only lead to more crowding out of the private sector at a time when business needs all the capital it can get.

Supply-siders, however, say that tax cuts power fully stimulate I the total funds raised in the capital markets after-tax return to saving, the tax cut is likely to increase accumulated capital more than the federal deficit it causes burden of government borrowing as a percentage of the credit market i s reduced, leaving a larger pool of capital for the should be self-financing, involving no crowding out of the private sector This is why supply-siders argue that the effects of deficits on inflation, interest rates, and economic growth depend on how the d e ficit is incurred. John F. Kennedy contended that there were two kinds of deficits both of which produced strikingly different outcomes. The first kind arose from wasteful spending increases; the second kind was caused by tax cuts. The choice is not betwe e n budget surplus and deficit, Kennedy concluded It is between two kinds of deficits a chronic deficit of inertia, as the unwanted result of inadequate revenues and a restricted economy or a temporary deficit of transition, resulting from a tax cut designe d to boost the economy, increase tax revenue and achieve a budget surplus.11 caused by unnecessary government spending. He accepted, however a temporary budget deficit resulting from a tax cut because it led to a healthy economy and eventual budget surplus The first type of deficit is a sign of waste and weakness he contended the second reflects an investment in the future.I1l5 Some argue that the nation cannot afford to increase By increasing the The private sector. An acceleration of the tax cut, therefor e , I Kennedy rejected a budget deficit The Undersecretary for Tax Policy at Treasury, Norman Ture uses similar logic to support tax cuts even when there is a budget deficit. According to Ture If the deficit results from tax or spending actions which depres s or inadequately stimulate private sector saving, it is indeed likely to be financed by a greater monetary expansion than would otherwise occur, which, in turn, may well result in accentuation of inflationary pressures l5 Representatives Bob Michel, Trent Lott, and Jack Kemp, The Classical Case for Cutting Marginal Income Tax Rates to colleagues in the House of Representatives, February 20, 1981, p. 78. 16 On the other hand, deficits resulting from a reduction of taxes on work, saving and investment, need n ot cause higher interest rates or inflation. According to Ture Supply-side tax reductions of the sort recently enacted, which reduce the relative cost of saving, are likely to generate a sufficient increase in private sector saving to eliminate the need f o r any monetary expansion to finance the deficit such tax cuts produce.!'16 the recent first stage of the tax cut, small though it is, may eventually pay for itself in increased saving. months of the 5 percent tax cut, saving increased almost $18 billion 1 9 81 to 5.1 percent in August to 5.4 percent in September and to 5.9 percent in October, the latest figures available There are early, though not yet conclusive indications that In the first two The savings rate increased from 4.6 percent in February Table 4 Percentage of Personal Total Amount Saved by Income Devoted to Individuals (billions Saving 1981 Jan.

Feb. I March April May June July Aug Sept Oct.

Nov 5.0 4.6 4.9 5.2 5.4 5.4 5.1 5.1 5.4 5.9 83.6 91.0 92.2 106.0 109.4 104.4 1 08: 2 94.9 106.6 135.1 124.0 I I Not available Source: Bureau of Economic Statistics Even relatively small changes in the percentage of income devoted to saving can, in the aggregate, mean enormous increases in saving and investment be attributed to the a l l-savers certificates, the fact is that in the two months following the initial 5 percent tax cut, the pool of saving available to investors and business entrepreneurs has increased impressively. This step-up in saving has occurred even though the major i n centives to savers IRA and Keogh Retirement While a portion of this increase can l6 Norman Ture, "New Directions in Economic Policy Tax Review, Vol. XLII, No. 9 (October 1981 I 17 plans, and the reduction in the top tax rates.on interest income from 70 pe r cent to 50 percent began only on January 1 increased capital formation will eventually translate into higher economic growth and more employment The Accelerating the tax cut will also provide incentives for the growing number of unemployed to give up gove r nment aid and seek employment in the private sector. The reason: tax cuts lure people back into the labor force by providing them a greater reward for the their work effort. Without these incentives, many find unemployment compensation or welfare more att ractive than working and in many instances it is. The combination of rising taxes on wage rates and the availability of substantial welfare benefits can make unemployment more attractive than working.

The General Accounting Office in 1979 found that for on e quarter of the unemployed, welfare benefits replaced more than 75 percent of their paychecks; for 7 percent, such benefits exceeded take-home pay. The Wall Street Journal reported that "On average unemployment benefits replace 64 percent of take-home pa y , and if work-related expenses such as transportation and child care are deducted, returning to work means giving up one's leisure for very This problem becomes especially severe in a recession when job opportunities may decline, take-home pay is reduced, and factories shut down. In such circumstances, the differential between unemployment insurance and take-home pay narrows yet further. Harvard Economist Martin Feldstein found that a marginal tax rate of 30 percent creates a disincentive to working that r aises unemployment by 1.25 percent and shrinks GNP and the tax base by the lost production of one million workers.18 In a recession, the number of unemployed is certainly swelled by disincentives created by high taxes.

CONCLUSION Many economists, even some supply-siders, mistakenly thought during last summer's tax debate that positive economic growth could be stimulated quickly by the watered-down tax cut bill.

Americans will not increase investing, saving, and working, however, until their tax rates actua lly fall. At the time the tax cut cleared Congress, the press reported the measure as '!bold and radical calling it the most massive cut in history. During the first two years of the Reagan program, however, the effect of the tax cut on net wealth of taxp a yers is trivial after counting taxes which rise automatically took effect retroactively and the top personal income bracket came down from 70 percent to 50 percent January 1, positive Although the business tax cuts l7 Michel, Lott, Kemp, op. cit p. 23 l8 I bid p. 24. 18 supply-side effects probably cannot be expected until the total tax burden on capital and labor is brought down significantly The result is that relatively few gains from the tax cut plan will be evident by November economics might be judged a failure even before the strategy has been tried exacerbated by those who diluted the original Reagan tax cut and delayed its effects remedy that mistake and give the private sector a breather from further tax hikes The chief danger is that supply-side A s for the recession, its severity probably has been Accelerating the personal tax cuts will Thomas M. Humbert Walker Fellow in Economics I APPENDIX 1 Table 1 I Combined Effects on Individual Tax Payments of Personal Tax Cuts and Social Security Increases a n d Bracket Creep in billions Increase Personal Calendar Social Bracket Tax Net Year Securit9 Creep Total Cuts* Change 1981 6 1982 13 1983 19 1984 26 13 19 4 15 28 41 -41 0 53 72 I -84 -12 77 103 116 -13 Increase in tax rates plus increase in base above tha t consisted with growth of incomes Rate reductions, indexing, and reduction-of marriage penalty.

Source: Office of Tax Analysis