Evaluating Economic Stimulus Packages

Testimony Before the House Small Business Committee Subcommittee on Tax, Finance, and Exports

Thank you very much, Chairman Toomey for the opportunity to address the Small Business Committee on the issue of policies to promote economic growth. In compliance with the Truth in Testimony Act, I will note that the Cato Institute receives no federal grants, loans, or subsidies--nor do we want any.

With the economy officially slipping into recession in 2001, it is crucial to concentrate public policy in Washington on getting back on the high growth rate path of the previous expansion. From 1982-2000 the economy grew at an annual average rate of 3.5%. Over this period, family incomes increased by 15% in real terms, poverty rates fell--particularly for black Americans--and real assets owned by Americans increased in value by some $15 trillion. This was not just a period where the rich got richer and others got left behind. The average family that was poor in the late 1970s was more likely to be in the highest income group by the 1990s than to still be poor. Twice as many middle-income families rose up the income ladder into the high income group than fell down into the low-income group.

In this testimony I wish to address two issues. First: why is economic growth important? And second, what are the fiscal policy changes that are likely to expand economic growth and opportunity.

The answer to the first question of why economic growth is important may seem self-evident. Growth leads to higher living standards, more jobs at higher wages, and the production of more goods and services that people want.

But growth has two often under appreciated benefits that I wish to emphasize to this committee. First, economic growth is strongly correlated with other social improvement. A recent Cato Institute study entitled Economic Freedom of the World, 2000, rates 120 nations on the degree of economic freedom. Countries receiving an A grade, such as the U.S. and Hong Kong, have relatively low taxes, small centralized government, low tariffs, protection of private property rights, the rule of law, and so on. Countries receiving an F grade are those nations like Afghanistan and African nations that have high taxes, big centralized government, a heavy load of regulation, protectionist trade policies, and so on.

The study found, not too surprisingly, that nations with a high level of economic freedom have much higher standards of living than the unfree countries. The per capita income is 10 times higher in economically free ($18,000) than economically unfree nations ($1,600). See chart.

But what was much more surprising is that wealth leads to health. The free and prosperous nations had a life expectancy that was 20 years longer than in the centrally planned unfree economies. This means that economic growth leads to more income and better health. Wealthier nations are healthier nations.

The second under appreciated dividend from economic growth is that growth is what balances the budget. And the absence of growth is what leads to budget deficits.

Growth drives the entire process when it comes to revenues, deficits, and debt. Take this past year as a textbook case study. Economic growth has fallen from 3.5% to about 0.5% for the year. What was the revenue and deficit impact? The revenue growth from FY 1999 to FY2000 was 9 percent. The revenue growth from FY2000 to FY20001 was 0.5% (after subtracting out the $35 billion tax rebate).

No amount of fiscal root canal budget surgery and no amount of tax increases can make up for that kind of Niagara Falls impact on revenues. We lost $100 to $150 billion of expected revenues this year because of the growth anemia this year.

In the late 1990s we averaged 4% real economic growth. Federal tax receipts soared by about 8 per year. This growth dividend converted a $200 billion deficit in 1994 into a $200 billion surplus by 2000. Ronald Reagan and Jack Kemp had it right all along: we grew our way out of deficits.

Now, let's gaze forward. Let us assume 3 growth path scenarios. Slow growth, modest growth, and rapid 1980s-90s style growth. We assume a revised growth path of expenditures that has federal spending growing more rapidly than is assumed by the latest CBO forecast. We assume a federal spending baseline of 5% nominal growth per year, which is the average pace of federal spending since 1980. We assume a $50 billion a year higher annual baseline for national defense spending, as a result of the war on terrorism.

The slow growth scenario is 2% from 2002-2011. Under this scenario we get federal tax receipts of $27 trillion over the 10-year period. Assuming spending grows at 5% per year, which was the average over the past 20 years and that defense is increased by $50 billion a year above the baseline, this 2% real growth rate would yield a deficit of just under $1 trillion over ten years. Trying to balance the balance budget with a 2% growth rate is about as eating chicken broth with a fork. It can't be done.

The medium growth path is 3% for 2002-2011. This gives Congress $29 trillion in revenues. That's about $1.75 trillion more money into the federal coffers over the next decade just by elevating growth by 1 percentage point. Under this economic growth scenario, keeping the budget balanced is a piece of cake. We'd run surpluses of about $75 billion a year with a 3% real growth rate.

The high growth path is 4% for 2002-11. This is achievable. We had 4% growth with no inflation from 1996 through 2000. What does that give us in revenue streams? More than $30.5 trillion in tax receipts. That's about $3.5 trillion more revenues from high growth than from low growth. JFK had it right when he said in 1963, "high tax rates will never produce enough revenues to balance the budget." Congress would have budget surpluses equaling $2.5 trillion even with the higher spending baseline we assume. Congress would almost have to cut taxes.

By the way, the difference between a 2 and 4% growth path means a world of difference in terms of the size of the U.S. economy ten years from now. A 4% growth path nearly doubles GDP in 10 years time. A 2% growth path increases GDP by a little less than 60%.

What we have at play here is the impact of what Albert Einstein once called "the most powerful force in the universe." He was referring to compound interest. Two percent growth gets you an annual struggle to keep the budget in balance. Four percent growth gets you revenue riches that would create mountainous surpluses. So, growth is everything when it comes to fiscal health.

Now one problem is that many economists and politicians regard fiscal policy (particularly tax policy) as an exogenous variable having no effect on the economic growth rate. These economists regard growth as akin to the weather: you can complain about it but you can't do much to change it. The Congressional Budget Office, for one, believes that tax changes have no impact on growth rates. This is why the CBO truly casts a curse on the U.S. economy with its interminable "static revenue analysis." Tax rate changes under this model impact the economy not at all.

We respectfully disagree. Our analysis indicates that the profound tax rate reductions of the 1960s and 80s had a giant impact on economic growth and revenues, as shown in the graphs below.

So this is why the balanced budget hawks in both parties are wrong when they say that we cannot afford to cut taxes now or that tax cuts would be fiscally irresponsible. The truth is the opposite: in this no-growth economic environment, Congress cannot afford not to cut taxes in ways that enhance the growth potential of the U.S. economy.

This brings me to the second question: what tax policies will stimulate growth? A number of prestigious economists, including Professor Dale Jorgenson, Chairman of the Economics Department at Harvard University have found that a single flat rate consumption tax system is the model that would optimize potential economic growth. The two key components of this ideal tax system are: 1) it does not double tax savings and investment, and 2) it applies just one low uniform tax rate to all economic activity. Jorgenson finds that a single rate flat tax system would increase annual production by as much as 10% over the long term trend. A flat tax or sales tax would be like rocket fuel for the economy. This is the model we should strive toward. We may not get there soon or in one grand tax reform action.

Herein lies the critical point for Congress as it addresses tax changes to enhance economic growth. The standard of measurement should be as follows: Does this tax change under congressional consideration move us closer toward or further away from a single rate consumption tax model? If the tax change does move in the direction of a flat rate tax system, then the tax change promotes economic growth. If the tax change moves us in the opposite direction, it should probably be rejected.

Tax changes such as the elimination or lowering of the capital gains and death tax are advisable, because under a flat consumption tax model there would be no capital gains or death tax at all. Tax changes that increase tax-free savings keep the faith of tax reform, because savers should not pay a tax on income that has already been taxed. A lowering of tax rates is consistent with tax reform, because lower tax rates leads to a low uniform tax rate system. Allowing businesses to write off business investment expenses is consistent with a reformed tax system. Under the ideal tax system, businesses would be permitted to write off all capital expenses in the year the expenses were incurred.

Tax rebates, tax credits, and temporary tax cuts generally do not move the IRS tax code in the direction of growth and simplicity and generally should be avoided.

Given this guideline, I finally will review some of the short-term anti-recession economic stimulus options that Congress is now considering. The best research on this issue was conducted earlier this year in a study for the Institute for Policy Innovation. Two former Treasury tax experts, Gary Robbins and Aldona Robbins, ranked the various tax policy options on the basis of which would provide the greatest bang for the buck. Below, I reprint a table prepared by these two scholars. Clearly, you can see that a capital gains tax cut, accelerated income tax rate reductions, and business tax cuts for investment purposes are the options on the table that provide us with the greatest bang for the buck.

In sum, an economic stimulus plan that cuts income tax rates, cuts the capital gains tax rate in half, and spurs business investment would provide a real and quick stimulus to the economy. Whether these tax policy changes would be enough on their own to pull the U.S. economy out of recession is not clear, but they are far more likely to succeed than the alternatives.

I've always been interested in finding out more about this National Sales Tax idea.

What should be the tax rate be?

Should services be taxed?

If you have to pay a large percentage as a tax on the purchase of item that you wish to invest in (e.g., real estate, a painting, an item of jewelry or stock shares, won't the item have to appreciate in value by the amount of the tax rate before you even begin to break even?

To find out more about the Fair Tax Act, try www.fairtax.org.

That legislation, which is HR 2525, calls for a sales tax rate of 23% inclusive, meaning 23% of each dollar spent on the purchase price of a taxable item is tax.

The Fair Tax Act would use those taxes to replace all federal income tax (both personal and corporate), capital gains tax, estate and gift tax, and all payroll taxes. So you get your entire paycheck, and you pay no taxes on investment returns or when you make a gift or when you die.

The Fair Tax would apply to services sold at retail, meaning for final consumption. This has been a particular concern to me, since I do not want a loophole for taxing all labor with the sales tax. However, I understand this will apply only to services such as legal, dental, medical, plumbing, etc., sold for final consumption.

Sales of used items would not be taxed.

When the painting you mention is first sold as a new item, it would be subject to tax. The labor expended in making the painting would not be taxed (unlike the existing system). The purchaser would have 100% of his earnings with which to make the purchase, rather than earnings less income and payroll taxes. Figure out for yourself which way you would come out ahead.

As to sales of real estate, the sale of a new house would be subject to tax. Again the cost would be cheaper because labor expended in building the house would not be subject to income or payroll taxes. Upon resale, only the amount of increase in the sales price over the original sales price would be subject to the Fair Tax. And the amount of tax on the purchase of the home could be paid over the life of the mortgage loan, as I recall.

I would oppose the sales tax with every fiber in my body. I'm serious! I don't want the government to be in control over every thing I buy. I want to write one check to the government and that's it. I don't want the government to say "hmm well we don't people to overindulge in certain things so we'll tax them more". State sales taxes do that all the time

I don't want the government to be in control over every thing I buy.

That is one of the great strengths of the Fair Tax Act. Now the Internal Revenue Code regulates every decision with provisions to favor or disfavor every investment or personal decision, even charity. In contrast, the Fair Tax would apply equally to all purchases of new goods and services for consumption. You would make your own choice of what to purchase. The Fair Tax Act applies broadly so that special carve-outs of favored products or industries do not exist. Take a closer look, and I think you may be persuaded.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.