The Economy and Taxes Under George W. Bush

George W. Bush is coming to power at a point when the economy seems to be headed south. Evidence is arriving from many parts of the economy; a few of the signs are slow retail sales at Christmas, a crash in the technology part of the stock market, and slack markets in many capital goods (illustrated by the bankruptcy of LTV, the third largest steel manufacturer). While the new administration faces a weak economy, the fiscal position of the Federal government is about as strong as it has ever been. Most forecasters see budget surpluses piling up for the next ten years.

The conjunction of these two events, macroeconomic weakness and budgetary strength, presents an opportunity for the administration to carry out one of the more desirable promises of the Bush campaign—an across-the-board tax reduction. The budgetary surplus gives Bush room to cut taxes without hurting the necessary operations of the Federal government, and the downturn in the economy can be used as another justification for the cuts. Macroeconomic theory posits that tax cuts are one of the measures that can be effectively used to counteract what we have been experiencing in the last several months—the fluctuations in the economy known as the business cycle.

Bush can make two arguments for the tax cut. The first, the long-term argument, is concerned with moving resources away from the Federal government and into the private sector. The second, the short-term argument, involves countering the business cycle. Let us first examine this second argument.

Exactly what causes the business cycle is not absolutely clear to scholars, newspaper pundits, economists, actuaries, anthropologists, astro-logists, and others who claim expertise at interpreting the economy. This statement is true in spite of the protests of all the above people. While current monetary and macroeconomic practices have done much to prevent the gross economic downturns—depressions—that characterized the 1890s and 1930s, the general instability of capitalist economies still remains. Modern economies rise and fall in irregular patterns, and the experience in the 1960s and 1970s in many countries demonstrated that governments are unable to completely eliminate these fluctuations. In fact, these efforts often increased the fluctuations. While government cannot totally smooth out an economy, certain measures can be taken to attenuate these vacillations.

Macroeconomic theory posits that there are several policies that can be used to counteract the downturns that are a part of a business cycle. Keynesians, the mainstream school of macroeconomics, argue that government can counter the business cycle by either spending more money without increasing taxes or lowering taxes without decreasing spending. (Keynes and Keynesian are dirty words to many conservatives. What has happened is that the term, Keynesian, became identified with certain government policies of the 1960s and 1970s. These policies had about as much to do with the ideas of the late John Maynard Keynes as the practices of the Spanish Inquisition had to do with the teachings of Jesus Christ.) To prevent inflation, the actions recommended by Keynesians can be accompanied by a rational monetary policy that does not grossly increase the money supply. By making the economy use more resources than it would otherwise, these measures can lead to greater economic activity. Thus, as
a measure to counteract recession, a tax cut is only one way recommended by macroeconomists.

Tax cuts are not preferred by many in the political establishment. Instead of cutting taxes, many of these Washingtonians would prefer to increase government spending. In contrast, tax reduction is a fiscal measure dealing with the business cycle, that is consistent with the long term goals of conservatives—lessening the influence of government.

Tax cuts as they have been presented both by the political campaigns and by serious commentators are ways to redistribute the resources of a society. Lowering taxes essentially moves them from the governmental to the private sector. It is the belief of most conservatives and ostensibly the Republican Party that the wealth of the nation is too concentrated in the Federal government. This is not to say that the Federal government is not necessary or that even most programs are not useful. It is to say too many resources go into government, and even the most necessary programs could do their job with fewer resources.

The most obvious way to correct this mal-distribution would be to specifically cut the areas where there is either inefficiency or outright waste. The problem is that the present political situation makes such direct action very difficult. Even though the Republican Party has either had the Presidency or been in ostensible control of one or more of the Houses of Congress for most of the last twenty years, the beneficiaries of government have formed a coalition that blocks overt moves to lower spending. These groups are the basis of the situation that has come to be called gridlock.

Essentially, these groups prevent a direct rational attack on wasteful and useless government spending. When revenues are rising, as they are now, these organizations can get increased funding without any explicit examination of the merits of their requests. In contrast, if there is a lack of funding, the agencies will have to go to Congress and make explicit arguments for the increases. While it is difficult to directly cut Federal programs, it is also hard to explicitly increase them. This is a silver-lining to gridlock, and this political situation is the reason a tax cut is the most efficient way to prevent the enlargement of Federal programs.

Are there potential drawbacks to a tax cut? Four arguments have been heard. They are; (1) tax cuts will lead to deficits that will lower business confidence; (2) these deficits will also lead to inflation; (3) tax cuts will interfere with the elimination of the national debt, and (4) tax cuts will stop the necessary increases in spending required by the government.

Some allege that deficits first lower business confidence and second increase inflation. Empirical evidence refutes the first contention, and both empirical evidence and economic theory refute the second. The 1980s and 1990s were both decades of growing prosperity and large deficits. In the periods from 1982 to 1999, the major stock market index, the Dow-Jones Average, increased more than tenfold in a time of constant deficits.

Economic theory argues that it is not the deficit per se that causes inflation. Rather, inflation is caused by the inordinate increases in the money supply that often accompany deficits that will create rising prices. The experience of the 1970s, 80s, and 90s confirms this theory. In the 1970s, there were both deficits and large doses of inflation; while in the 1980s, the inflation abated at the same time that the deficits actually increased. In the 1990s, the deficit continued until 1999, but they were accompanied by far less inflation than occurred in the 1970s. (The inflation of the 1970s has often been attributed to oil price increases, but in the last two years, 1999-2001, oil prices have risen just as much as they did in 1974, and we have not had a major inflationary episode.) This situation can be explained by the differences between the rather loose monetary policy of the 1970s and the tighter policies of Paul Volcker and Alan Greenspan in the last two decades. Exper
ience supports the thesis of economic theory that unsound monetary policies not deficits cause inflation.

The third argument against a tax cut is that lowering or eliminating the national debt would make the country better off. Instead of giving the money back to the private sector in the form of tax cuts, the argument here is that paying off the national debt would also return resources to the public. Three problems exist with this argument. First, it is not clear that the goal of no national debt is desirable in itself. One position is a superficial "crowding out" argument, which states that by refinancing its debt the government diverts resources from private sector investment thereby lowering long term growth in the private sector. (This is not to be confused with the logical but not confirmed "crowding out" theory concerned with continuous deficit financing.) To see the flaw in the argument, one has to examine how a government deals with its debt. Essentially, the debt consists of bonds or loans that come due at given dates. As long as the government does not l
ower its debts, it is constantly paying back the old due bonds by selling new bonds. What this argument leaves out is that in recycling its debt the government puts the money back into the economy by paying back the old bondholders. Consequently, except for minimal transactions costs, refinancing the national debt imposes no cost on the private economy. While the act of paying off the national debt will put resources into the private economy, so will reducing taxes—but only quicker.

A second question on liquidating the national debt is what would the nation be like without a national debt. Actually there is no relevant information on this situation. In the 1830s, the United States paid off its national debt, but depressions and wars soon brought the debt back. (Note that this was in the 1830s—not the 1930s, and the depressions and wars that put the government back into debt occurred in the 1830s and 1840s—not the 1930s and 1940s. Deficit spending is not an invention of the 20th century.) Few countries have existed without a national debt. Just how society would be different is not clear. (One interesting problem with a debtless economy is the control of the money supply. At present, the Fed manipulates the money supply by buying—increasing the supply—and selling—restricting the supply—government bonds. With no debt and no bonds, the Fed would have to use some other asset—say—private bonds, stocks or even porkbellies. In
trading these securities, the Fed could either increase the money by buying the asset or decrease money by selling it. One problem would be the undue influence they could have on particular sectors by choosing to trade there.) If there is so little known about a debt-free society, why would anyone seriously advocate policies leading to it?

Furthermore, it is not clear that the national debt will actually be reduced with no tax cut. Just as likely, more resources will be funneled to the present spending programs. This tendency is ever-present under any administration—especially with a divided Senate.

Also not clear is whether the reduction in the debt will ever occur under any circumstance or, for that matter, whether a tax cut would stop the reduction of the debt. On the one hand, the ten year projections of surpluses are made under very optimistic assumptions, and much could go wrong. Thus, these surpluses may never materialize—even with no tax cut. On the other hand, if the current projections are correct, reducing taxes even a great deal more than planned may very well result in no deficits.

The last argument against a tax cut is that it will lower revenue so much that the government will not be able to maintain and increase its present spending programs. Given the obviousness of the above analysis, a very plausible hypothesis is that this is the real motivation behind tax cut opponents and that the issues of confidence, inflation, and debt reduction are smokescreens.

If the present projections of government revenue are right, however, there are likely to be no shortfalls for these programs—even with a tax cut. The real issue, then, is control of resources. The worry of tax cut opponents is not maintaining the present level of government. Rather, they fear that a tax cut will prevent the present programs from growing.

As long as tax rates remain at their present levels, a larger part of the nation’s resources will be under the control of the government—a situation obviously desired by people who believe in larger government. If instead of lowering taxes the government embarks on a policy to retire the debt, it will have the option to reverse this policy and increase spending at any time. With a tax cut, the only way the government agencies obtain more resources is to either raise taxes or incur deficits. Either of these actions will have unacceptable political costs unless there are good reasons for the increases. Given the present political situation, a tax cut is the most effective way to stop the spending increases.

President Bush has inherited a soft economy and a government with overflowing surpluses. This situation gives him the opportunity to cut Federal taxes. A tax cut would help attenuate the present short-term macroeconomic downturn without cutting important Federal programs. But more significantly, it would keep resources out of the control of the Federal government and give greater scope to the private sector—the major center of creativity in the American economy.

Robert P. Rogers is an Associate Professor of Economics at Ashland University and an Adjunct Fellow at the Ashbrook Center.