Two Cheers for Congress’s Tax Plan

The political landscape in Washington has undergone an immense change over the last couple of years. Budget surpluses, not deficits now occupy the attention of our elected officials. How do they handle an unexpected surplus, a bonanza calculated to be $1 trillion more over 15 years than anticipated only six months ago?

The Republican Congress wants to use the surplus to reduce taxes while protecting Social Security and paying down the federal debt. The tax package recently passed by both houses of Congress reduces taxes by $792 billion over 10 years by cutting all income tax rates by one percentage point, phasing out the “marriage tax penalty,” eliminating the estate tax, reducing capital gains tax rates, and enhancing investments in IRAs.
The Republican plan is based on the conclusion by the non-partisan Congressional Budget Office (CBO) that an $800 billion tax reduction would not come at the expense of shoring up Social Security.

President Clinton has threatened to veto the congressional tax bill when it is sent to him in September, calling it “irresponsible” and a threat to necessary programs like environmental protection and education. The president originally claimed that most of the surplus should be used for debt reduction, but his current plan actually uses less of the surplus for this purpose than does the congressional plan. The president calls for a tax cut, albeit one far smaller than Congress’s, but the fact is that under the president’s plan, most of the surplus would be used to increase spending by the federal government.

There are a number of good reasons for a tax cut. One of the most important is that federal tax revenues as a percentage of gross domestic product (GDP) have climbed to a peacetime high of 20.7 percent from 17.8 percent at the start of the Clinton presidency. This increase in government revenues is the result of a rapidly growing economy that has pushed people into higher tax brackets. Thus, nearly three percent of GDP has been shifted from taxpayers to the federal government without legislative action. The only other time in US history that the federal government took as great a percentage of GDP right before the Reagan tax cuts of 1981. Indeed, the federal tax burden was lower during World War II than it is today.

Meanwhile, military budgets have declined precipitously. At the peak of the Reagan defense buildup in 1985, defense expenditures constituted 6.2 percent of GDP. The current figure is about 3.5. If revenues have increased while defense spending has declined by over 2.5 percent of GDP since the height of the Cold War, why can’t the Clinton administration concur with Congress that the burden on the American taxpayer should be reduced, especially since the CBO projects a tax burden of over 21 percent without a tax cut?

Critics of tax cuts offer three responses to this question. The first is reflected in the president’s comments cited above: if taxes are cut, both entitlements and non-defense discretionary spending will have to be curtailed. The second is that only the “rich” will benefit from a major tax cut. The third is that by putting more spending power in the hands of consumers, a tax cut will be inflationary, creating upward pressure on both consumer prices and interest rates. How do tax cut advocates answer these charges?

First, despite all the talk about “the end of big government” and “reinventing government,” inflation-adjusted domestic spending by the federal government has spiraled up during the Clinton presidency. During the last four fiscal years, real domestic spending has increased by $74 billion. This increase was partially offset by a $34 billion reduction in real defense spending over the same period. But had it not been for an increase of $312 billion in real tax receipts, the net effect would have been an increase in the budget deficit rather than a $254 billion surplus. The federal government is hardly being starved for funds and locking in new spending will shift the tax burden to the future.

The second reason for opposing tax cuts is a manifestation of envy and a “class-warfare” mindset. It is predicated on the belief that financial success in the United States is the result of mere fortune rather than hard work, risk-taking, innovation, or business creation. In fact, over two thirds of the richest Americans on the Forbes 400 made their money rather than inheriting it. It is ironic that many of the leading class warriors in Congress are the beneficiaries of inherited wealth and have little idea of what is necessary to create wealth.

Beyond this, since the rich pay more in taxes than the poor, it should be obvious that any tax reduction will benefit the former directly more than the latter. Why should this be a source of concern, especially in light of the distribution of taxes vs. share of national income? For instance, the richest one percent of US households receives 17 percent of national income, but pays 32 percent of total federal income taxes. The top five percent receives 31 percent of national income but pays 51 percent of federal incomes taxes. The bottom 75 percent receives 35 percent of national income but only pays 19 percent of federal income taxes, the bottom 50 percent 14 and four percent respectively.

In a liberal capitalist democracy like the United States, tax reduction can enhance the important function that the rich fulfill. For it is the rich that possess the greatest capacity to expand saving and investment, the necessary engines of economic growth. Insofar as tax reduction increases saving and investment, it indirectly benefits the middle class and the poor by increasing their employment opportunities and incomes.

Finally, reduction in taxes cannot lead to inflation unless it is “ratified” by an increase in the money supply. Under Federal Reserve Chairman Alan Greenspan, this is unlikely. And an examination of the historical record indicates that there is no causal relation between deficits and surpluses on the one hand and interest rates on the other.

The problem with the current Republican plan is not that it is too large, but that it is too timid. Larger tax cuts than those contained in the current congressional proposal are necessary if the maximum economic benefits are to be realized. The cornerstone of this view is that tax cuts should focus on reducing marginal income tax rates, the tax paid on each additional dollar of income. High marginal tax rates discourage saving and thus reduce funds for capital formation, the source of economic growth. Advocates of this view contend that the current economic boom can be traced to the 25 percent reduction in marginal tax rates (over three years) that Ronald Reagan signed into law 18 years ago this month.

The best that can be said in favor of the current Republican plan is that it will preempt the additional government spending the president and his allies want. Recent research conducted by the Joint Economic Committee of the Congress indicates that sixty percent of a budget surplus will be spent within one year. This confirms the finding of two Ohio University economists who discovered that over the past 50 years, 74 cents of every surplus dollar has gone for new spending, 21 cents for debt reduction, and 5 cents for tax cuts.

This dynamic led Federal Reserve Chairman Greenspan to testify before Congress that the use of the surplus to increase federal outlays would be “the worst of all possible worlds from a fiscal policy point of view, and under all conditions, should be avoided.” Accordingly, he continued, “I have great sympathy for those who wish to cut taxes now to preempt that process.”

If unanticipated revenues are to be automatically spent on new programs, government will continue to grow and gradually undermine the source of America’s economic growth and prosperity. Do we really wants to return to the Carter years?

Mackubin Thomas Owens is professor of strategy and force planning at the Naval War College in Newport, RI, and an adjunct fellow of the Ashbrook Center. The views expressed here are his own and do not reflect the position of the War College, Navy Department, or Department of Defense.