Cocktail-bar calculations

The budget deficit

Aug 18th 2005 WASHINGTON, DC
From The Economist print edition

Are George Bush's tax cuts paying for themselves?

NOT many economists find fame in a cocktail lounge. But it was in just such a venue that Arthur Laffer in 1974 drew the “Laffer curve” on the back of a convenient napkin. The sketch, still more popular with politicians than economists, illustrated how lower tax rates, by spurring growth, might leave tax revenues undiminished. Tax cuts might pay for themselves.

None of the weighty studies produced by the Congressional Budget Office (CBO) would fit on the back of a napkin. But the latest projections from the legislature's non-partisan budget-watcher have excited a few of Mr Laffer's fans. The federal budget deficit, the CBO reckons, will narrow to $331 billion this fiscal year (which ends on September 30th), from $412 billion the year before. Tom DeLay, the Republican majority leader in the House of Representatives, was quick to offer a Laffer-like explanation: “Lower taxes and spending discipline spur economic growth, which in turn cuts the deficit,” he opined.

In fact, spending discipline is still rather lacking. Government outlays will increase by $181 billion (or 8%) this year, a figure that does not include the cost of the pork-stuffed highway bill, signed by the president on August 10th. The fall in the deficit owes rather more to the other side of the ledger: tax revenues are set to grow by $262 billion, or 14% this year. They will increase as a share of GDP for the first time under this tax-cutting president.

Income taxes withheld from pay cheques account for some of the new revenues, but many of the gains are in more exotic areas. The government's take from such things as capital gains, payouts from pension funds, and “sole proprietorships” (one-man companies) should increase by 28% this year, the CBO reckons. Corporations are also making a strikingly handsome contribution to the state's coffers, paying $80 billion (or fully 42%) more than the year before. A third of this bounty seems to be due to the demise of a corporate tax break, which allowed firms to deduct up to half their investment costs from their taxable profits last year. But some $53 billion of it caught the CBO unawares, and remains unexplained.

Is Mr DeLay right to attribute any of these gains to the seductive curves of supply-side economics? In December, Gregory Mankiw, who used to be chairman of Mr Bush's Council of Economic Advisers, and Matthew Weinzierl, a colleague at Harvard University, published a “back-of-the-envelope guide” to tax rates and revenues. Given the relatively low tax rates prevailing in America, they thought that tax cuts could not be entirely self-financing. But by their reckoning cutting taxes on labour would generate enough growth to recoup about 17 cents on the dollar, and a tax cut on capital could pay for more than half of itself. The government would take a thinner slice of a bigger pie.

Left out of these calculations is any guide to what happens when taxes are cut but spending is not. The budget deficits that ensue will tend to “crowd out” investment, slowing growth. The CBO calculates that every extra dollar of federal borrowing reduces investment in the economy by 36 cents.

The White House, according to its latest forecast in July, now expects to leave a deficit of $162 billion by the time the president leaves office in 2009. But it assumes (absurdly) that Congress will not add a single dollar to its discretionary spending on anything except defence and homeland security from 2006 to 2010. It also leaves out of its projections any extra money for Iraq, Afghanistan or the war on terror.

The CBO makes the opposite assumption. It assumes that by 2009, all of these missions will remain far from accomplished, costing the American taxpayer the same amount, in real terms, as they do today. Partly as a result, the CBO shows Mr Bush bequeathing a deficit of $321 billion to his successor.

Though the CBO's outlook is substantially worse than the White House's over a five-year horizon, it improves dramatically over ten years. This is not because of some long-run Laffer curve; but because the CBO assumes that Mr Bush's tax cuts will expire, as scheduled (the bulk of them in December 2010). That looks extremely unlikely: no politician would allow it and Mr Bush is already trying to make them permanent. If that happens, it would add $349 billion to the deficit in 2015, plus an extra $83 billion in debt service costs.

The CBO's job, says Douglas Holtz-Eakin, its director, is to forecast the economy and the budget, not Congress. It is required by law to assume that Congress will carry on doing what it currently does, adjusted only for inflation. “Everything we have presented today is going to be wrong,” he confidently predicted as he unveiled his report. The same, of course, could be said of Mr Bush's projections.

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