The Rapidly Declining Deficit
How's it happening? Look to the tax-rate cuts of 2003.
By Michael T. Darda
According to the Treasury department, the U.S. government took in a single-day record $61 billion in tax receipts on June 15. This surpassed the previous single-day high of $56 billion set on December 15, 2000. The recent surge in tax revenues is not just a one-day event. Fiscal year to date, total government receipts are up 15.5 percent, the fastest rate of increase on a comparable FYTD basis since 1981. The difference between the growth rate of tax revenues and the growth rate of government spending has widened to 8.4-percentage points, the largest since late 2000 when the budget was in surplus.
Not surprisingly, the recent tidal wave of tax receipts has ignited a furious debate about whether or not the Bush tax cuts are responsible for stimulating economic activity enough to actually boost overall tax-revenue collections. Classical economists refer to this as the Laffer curve, or the revenue-reflow, effect. In simple terms, if a tax cut stimulates the underlying activity being taxed, a revenue reflow will result. The reflow can offset or even surpass the volume of revenues that would have been collected under the higher tax rate and smaller tax base. Pro-growth tax-rate reductions on labor and capital in the 1920s, 1960s, 1980s, and then again in 1997 and 2003 all exhibited revenue-reflow effects, although some were stronger than others.
Despite the avalanche of historical evidence, some economists and policymakers question the validity of incentive-based revenue reflows and assert instead that the recent surge in tax-receipt growth has been caused by an increasing fraction of the workforce being ensnarled by the alternative minimum tax (AMT). They also argue that annual comparisons were made extremely easy due to the huge drop in revenues due to the 2000-02 stock market implosion and the 2001 recession that accompanied it. While there is some truth to these claims, they overlook several key facts.
The AMT, an increasing problem in its own right, does not explain the 45.2 percent fiscal year to date surge in corporate tax revenues and the 35 percent jump in non-withheld (i.e., capital gains) receipts. Fiscal year to date, corporate tax revenues are growing at 4.6-times the average rate of increase going back two decades. Moreover, rising profits and personal incomes, combined with the boom in housing, are increasing state and local tax revenues dramatically. According to the Nelson A. Rockefeller Institute of Government, state collections in the January-March quarter were up 11.7 percent, the strongest year-on-year growth for the comparable period since at least 1991. In other words, a broad rebound in economic activity, business profits, and asset prices has boosted the tax base and lifted revenues at all levels of government.
The tax-cut critics often suggest that tax revenues are growing because of the Fed's easy monetary policy. While the Fed's massive reflationary efforts during the last three and one-half years no doubt contributed to the strong rebound in economic activity (and thus the expansion of the tax base), there is strong evidence that the tax cuts in 2003 also played a large role in boosting growth and revenues. In order to see why, we need to draw a sharp distinction between the 2001 tax-cut bill, which was largely Keynesian in nature, and the 2003 tax cuts, which were decidedly supply-side.
The 2001 tax cuts combined small, glacially phased-in reductions in income-tax rates with credits and rebates designed to â Å“put money in peoples' pockets.â ? This traditional Keynesian stimulus technique has an incredibly poor track record. Tax credits and rebates simply shift money from one place to another, which can't â Å“create demandâ ? and doesn't stimulate behavior at the margin.
Conversely, the tax cuts passed in May 2003 were focused on dropping the top rates of tax on capital. The capital-gains tax (for gains held at least one year) was cut to 15 percent from 20 percent while the maximum tax rate on corporate dividends was slashed to 15 percent from 38.6 percent. The 2001 income-tax rate reductions (set to phase-in gradually) were made retroactive along with the tax cuts on capital and business-depreciation expensing. The economic response to the 2003 tax cuts was much more favorable than the stall-speed recovery that occurred in 2002.
Despite easy comparisons from the year before due to the recession, real GDP growth averaged just 2.3 percent at a quarterly annualized rate in 2002 while real non-residential business fixed investment averaged negative 5.9 percent growth. Since June 2003 (after the retroactive pro-growth tax bill became effective), real GDP growth has averaged 4.3 percent at a quarterly annualized rate while non-residential fixed investment has grown at a 10.8 percent pace. After slumping during and after the recession, the real capital-to-labor ratio has reached record levels recently, lifting wage and salary growth to a 7.5 percent annual rate. Although the Fed's easy monetary policies clearly have contributed to the growth rebound, it is important to remember that the fed funds rate averaged less than 2 percent during 2002 and the recovery that occurred was subpar in virtually every respect. All tax cuts are not created equal.
A dynamic analysis of the Bush tax cuts shows that long-run growth could be lifted by 0.85 percentage points as long as the lower-tax schedules on capital and labor remain in place. Ceteris paribus, an additional 0.85 percentage points of growth would augment revenues by $1.5 trillion during the next decade. The rebound in real economic growth since 2003 also suggests the fiscal deficit should fall to no more than 2 percent of GDP during the next year, less than the historical average going back to 1960.
Unfortunately, the finer points of dynamic scoring escape the â Å“logicâ ? of the no-growth neo-Malthusian Democrats and the root-canal contingent in the Republican party. Both would be well advised to look at the record of the Baltic states, some of which have had flat taxes for over a decade. Flat-tax countries have experienced superior macroeconomic performance and rapid tax-revenue growth despite undergoing the same unfavorable demographic trends that have plagued Western Europe and Japan. This is no accident.
Looking ahead, above-trend growth (and some added spending restraint) during the next several years could move the budget back into temporary fiscal surplus, but the emerging retirement of the baby-boom generation likely will pressure spending and push deficits higher after 2008. The solution to long-term deficits and impending demographic strains is to marry a market-based approach to monetary policy with an incentive-based approach to fiscal policy. This would lay the foundation for rapid growth and the gradual implementation of a fully funded ownership-based entitlement system.
â †Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn.
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