Taxes, the Deficit and the Size of Government

National Center for Policy Analysis

Taxes, the Deficit and the Size of Government
The Heritage Foundation
National Taxpayers' Union
Citizens Against Government Waste
Dirksen Senate Office Building, Washington, D.C.

John Berthoud

Good afternoon. I am John Berthoud, President of the National Taxpayers' Union. I'm very pleased that you could all join us today. This is the second in a series of four sessions being hosted by NTU and Heritage and Citizens Against Government Waste.

Last week, we had a session over on the House side. We talked a lot about recent trends in spending, what the implications of all that spending are going to be for the economy for tax cuts, et cetera. The topic today is a little different. We are going to now move into more into economics. Certainly with the President's tax cuts in the last couple of years, there have been a lot of debates: What is the effect of tax cuts, the effect of the President's tax cuts on the economy? With the re?emergence of deficits, a lot of discussion about what the deficits mean for the economy, a lot of conflicting claims. So, hopefully, today we have a terrific panel of speakers who are going to help us sort through some of these questions. We've basically tried to divide the speaking into spending, taxes, and deficits, and looking at the relationship between those three variables and economics. And all three of our speakers [unintelligible] to only speak for about twelve minutes or so, so we have some time for Q&A.

Our very first speaker is Dan Mitchell, and Dan is Heritage's long?time chief expert on tax policy. Dan has worked for other policy organizations and is a Senate alumni, and also worked for the Senate Finance Committee. Dan is going to talk a little bit about – particularly focusing on the relationship of spending and economic growth. So, with no further ado, Dan Mitchell.

Dan Mitchell

Well, thank you very much, John. The main thing I want to get across in my comments is to get a better understanding of what is it that really matters. Is it the size of government? Is it the tax system? Is it the deficit? And the specific chunk of that debate that I want to touch on is the size of government, because a lot of what we argue at the Heritage Foundation is that it's the size of government that matters, not necessarily as much as how it's financed. So when some people talk about we have a deficit, therefore we have to raise taxes, and they're leaving the size of government unchanged, at the very best, all that's happening is you're jumping from one frying pan to another, and in all likelihood, since taxes tend to have more adverse impact, depending on the type of tax raised, you're probably actually jumping from the frying pan into the fire. Now, I know other people on the panel will probably comment on some of the tax issues; I want to focus specifically on the government spending issue, and touch on several of the economic aspects of about why we should be concerned about the size of government, the growth of government spending, and the particular adverse impacts of different government programs.

The first thing I want to do is just start with a little bit of empirical evidence that I think helps to make the point that we should be concerned about the size of government. In the United States, our government's too big. If you include state and local governments, government spending consumes more than – well, maybe not quite, but about one?third of our economy, over 30 percent of GDP certainly, and it might even be over one?third of GDP, depending on how you measure it. Now, that's bad, but that's actually pretty good compared to Europe, where government spending, in many nations, consumes more than 50 percent of GDP, and the average is certainly way up in the 40s.

The question we have to ask ourselves is, well, might that perhaps have some relationship with the fact that in Europe the average GDP is the equivalent of being from the state of Arkansas, or Mississippi or something – or one of the poorest states in the U.S.? Might the high growth of government and the size in Europe have something to do with the fact that their unemployment rates average nearly double ours? Or the fact that people in Europe, when they do get unemployed, the average person who's unemployed can be unemployed for as much as a year, whereas in the U.S. it's only about 8 percent of the unemployed are ever unemployed for that long? In other words, is there a reason why the economic performance of countries with big governments tends to be so mediocre, whereas countries that have smaller governments enjoy faster economic growth? And again, I want to tie this back into the issue of, well, isn't the deficit what's important? I would argue no. You have several countries in Europe, including many in Scandinavia, that have balanced budgets, and yet their governments are consuming more than 50 percent of GDP. Their economies are in the tank, unemployment rates are rising, per capita incomes are falling, there's no private sector job creation, so there's no nirvana in a balanced budget.

Milton Friedman said, many, many years ago, he would rather have a $500 billion budget with a $200 billion deficit than a $1 trillion budget that was balanced. Now, our budget numbers have gotten a lot bigger since the 1970s when he said that, but the point is that we are better off with a smaller government with a deficit than with a bigger government where the budget is balanced. Why? Because government spending is associated with worse economic performance. But let's go into that statement I just made a little bit and try to get an understanding of why this is true. The first thing we should understand is not all government programs are created equal. Every single government program has a rate of return, and we have to compare that rate of return of that government program to the rate of return that those resources would generate if they were left to the private sector. In other words, government can't create wealth out of nowhere. When government spends money, it has to extract that money from the productive sector of the economy. Sometimes they tax the money out of the economy, sometimes they borrow the money out of the economy, but in either case, every time the government spends a dollar, there's a dollar left in the private sector.

Now, we can argue – and I think we would probably all agree – that some government programs meet that test, they provide a very valuable need, so it's worth it to take a dollar out of the private sector to fund those programs, the "classic public goods," as economists called them, of national defense, of the legal system. These are things that actually help the economy by creating certainty and creating a structural and a legal framework in which people can operate. But how many government programs in today's budget meet that test? Now, we know that there's a long?term rate of return to capital in the private sector, adjusted for inflation, of anywhere between 5 and 10 percent, depending on the measurement. Of course, economists love to disagree about these things, but we know that capital in the private sector generates a rate of return. In other words, it makes us all better off in the long run because it's increasing our ability to enjoy more income in the future.

Now, if we take the dollars out of the private sector and give them the Department of Housing and Urban Development, do we think that we're getting a better rate of return than what we would get if those dollars were left in the private sector? What about the Department of Transportation? What about the Department of Education? For that matter, even though we're big supporters of a strong defense at Heritage, we should apply the same test to the defense department. Is the money being spent in such a way that we know we're actually getting some bang for the buck to justify the taking away of those resources from the private sector? And we would argue that those strict cost/benefit tests should be applied very rigorously to all government programs. We don't think we're getting that cost/benefit test today. When you're looking at a budge of well over $2 trillion, I would strongly suspect that an awful lot, a very high percentage, of that federal budget does not meet a cost/benefit test. In other words, we are sacrificing economic growth and prosperity and living standards for our children and grandchildren in order to fund government programs today that either have very low rates of return or, in many cases, have negative rates of return.

Now, I mentioned before that every time the government spends a dollar, it's taking a dollar out of the private sector. Now, when it takes the dollars out in the form of taxes, we're probably pretty familiar with those debates. And Bruce is going to talk more about that. And when government takes money out in the form of borrowing, we're obviously taking money out of private credit markets, and that's less money that's available to be loaned to private businesses and to other private users. Now, I would strongly argue, and maybe other people on this panel will argue, that you don't have a big interest rate effect from that.

Sometimes you hear people on the left say we need to raise taxes and balance the budget, because otherwise interest rates will be high and the economy will grind to a halt. Well, the first thing I would point out is that higher interest rates tend to be found in periods of economic growth, whereas you tend to find very low interest rates when the economy is weak. In other words, the deficit doesn't drive interest rates, and interest rates don't drive the economy. The better way to think about it is that the economy drives interest rates. When there is no possibility of making a profit with an investment, nobody wants to borrow money, and interest rates are very low. They've been very low in Japan for a long time. Why? If you invest your money, you may as well be throwing it away. You'd rather just consume it. So interest rates are low, whereas, say, during the 1980s, when the economy boomed, interest rates rose. Why? Because people saw chances to make money. They were willing to go out and borrow that money so they could invest it. In other words, there was a greater demand for credit because there was more prosperity in the economy.

If we look at the effect of deficits on interest rates, we see that it's very, very tiny. And the way to think about this logically is: if you go over to the Potomac River and you dump a pitcher of water into the river, theoretically you're raising the water level in the river. Can you measure it with the human eye? No. Can you measure it even with very fine instruments? Well, I suppose, depending on how fine those instruments are, you might be able to. Well, that's the same way that deficits affect interest rates in the modern global economy. We have a global economy where $2 trillion changes hands every day, and the argument that even a tiny change in government, or even a big change in government deficits, is going to have some big effect on interest rates that are set in global markets where trillions of dollars changes hands every day just doesn't wash. That's one of the reasons why we've seen – or it's not one of the reasons why we've seen interest rates fall when we went from surplus to deficit, but the very fact that we saw interest rates fall as we went from surpluses to deficits should make people a little bit suspicious of the argument.

But let me get back to the spending side of things and make a few other points, and then move on to other people on the panel. To the extent that we do allow spending to go up and go up and go up, it will create pressure for higher taxes. It will put at risk the tax cuts that Congress has approved in the last couple of years, and those tax cuts, I would argue, are exactly the kinds of tax cuts we need: lower tax rates on individual income, lower tax rates on dividends and capital gains, reductions in the death tax, elimination of the death tax for people who plan ahead and die in 2010. These are things that reduce the tax burden on productive economic behavior. They're among the reasons why our economy is growing faster now, and certainly they're among the reasons why we're outperforming the high tax welfare states in Western Europe.

So above and beyond just the specific arguments about government spending having a very low rate of return, to the extent that we let government spending continue to grow out of control, we are sowing the seeds for the Europeanization of America, which is certainly something I hope we would all agree we don't want. If we become like France, we have to train our army to surrender, we have to not use deodorant, all sorts of problems in our economy. Government is all about resource allocation. Where do we want the resources in our society? Do we want them left in the private sector, where they're going to create growth and opportunity, or do we want them transferred, via either taxes or borrowing, to Washington? Or for that matter, even to local and state governments, where they tend not to be used as well?

I want to close by saying it's not just the resource allocation impact of government spending we should be concerned about. It's also the impact of that individual behavior of government programs. We have a lot of people that periodically will write in the financial magazines and journals about, oh, Americans are so irresponsible; they don't save enough; we have a national crisis of not enough savings. Why do people save? People save – at least they used to save – because they want to buy a house, they want to prepare for retirement, they want to send their kids to college. We have government programs in all these areas that in effect are displacing and undermining the initiative of people to save. When government, in effect, becomes your mommy and your daddy, and it takes care of you and wipes your nose and makes your bed and feeds you dinner, why are you going to take any individual responsibility for yourself? So when you have all these government programs that in effect take over what used to be the individual initiative and responsibility to save and prepare to deal with these costs in life, why would people want to save? And then, of course, you add the fact that our tax code routinely discriminates and double taxes people who save as opposed to people who consume; I'm surprised we have any saving in our economy whatsoever.

But it's not just saving is undermined. When you have welfare programs, one of the most adverse impacts of – at least the old type of welfare system we had – is that government literally paid you not to work, paid you to have babies out of wedlock and things like that, that were very counterproductive, especially for the people that the programs were designed to help. So it's not just that welfare spending was less productive than how those dollars would have been spent if they were left in the private sector of the economy; it's the fact that you sort of get this double negative effect of not only are you taking the resources out of the productive sector, but then you're spending them in such a way that you're actually encouraging social pathologies and you're encouraging people not to work.

So whether it's encouraging people not to save, whether it's encouraging people not to work, or not to invest, or whether it's things like Fannie Mae and Freddie Mac, that misallocate the capital of the economy, government spending is the problem. We need to get back to what Ronald Reagan used to talk about, which is that government is the problem, not the solution. Thank you very much.

John Berthoud

Our next speaker is Bruce Bartlett, who is a Senior Fellow with the National Center for Policy Analysis. Bruce has held a number of positions prior to that, including Deputy Assistant Secretary of Economic Policy at the Department of Treasury. Bruce is a very prolific writer, and also an alumni of Capitol Hill, and also an alumni of the Heritage Foundation. There has been a lot of discussion – Dan talked about some of it – about taxes and the impact on the economy. Bruce is going to explore the relationship between taxes, tax cuts, and the economy. Bruce is also, I think, going to look a little bit about the idea of – some have suggested that, with the era of deficits, all we need to do is cut taxes to close the budget deficit, and I think Bruce is going to talk a little bit about that idea as well. So I give you Bruce Bartlett.

Bruce Bartlett

Thank you, John. In the spirit of the way Dan started his talk, what is it about taxes that matter? I mean, why do we care? Well, there's a moral question. Some Libertarians would argue that taxation is per se theft, that there's no difference between the IRS and the mugger on the street. If you take that position, then there's clearly no level of taxation above zero that is moral or justified. Now, since I presume everybody here works in Congress or has some interest in government and is not an anarchist, we can sort of dismiss that position. Some other people might implicitly argue that the government owns everything. That's the socialist idea: everybody works for the government, the government, in effect, owns everything. I presume that nobody shares that position either. So the question is – somewhere between 100 percent socialism and zero percent anarchism, there's a level of taxation that the government is going to take and is appropriate, given its responsibilities, and the question is, what is that rate, and how do we measure it and how do we achieve it?

Historically – that is, in the post?war era, the federal government has taken about 18.5 to 19 percent of GDP – that is, the total output of the economy, in the form of taxation. Right now it's about 16 percent. It's been as high as 22 percent during the Clinton years. There was a widespread feeling in the latter part, certainly, of the Clinton years that 22 percent was too high. It's not often remembered, but Bill Clinton signed a rather large tax cut in 1997 that, among other things, cut the capital gains tax. So clearly, even Democrats have – there's a limit to how much taxation they want to raise.

I think there's a rather widespread feeling, among at least budget experts, that 16 percent is not sustainable, that revenues as a share of GDP will need to rise to some degree. Some of this will come about automatically as a result of an expanding economy, which causes profits to rise and aggregate wages to rise and things of that sort, but there's still a question of is there a need to address the structural deficit that appears to exist in our economy? And even if you believe, and I'm certainly no deficit hawk, that we can probably run modestly?sized deficits forever, the fact that we have a retiring baby boom generation, the first of whom will retire in the year 2008, aged 62, born in 1946, and the fact that Congress and the White House, in its wisdom, has larded on a multi?trillion dollar Medicare drug benefit on top of massive amounts of pork barrel spending, we have to ask a serious question about the extent to which and how we're going to finance government.

Now, you can't really say, based on empirical data, that 20 percent of GDP is just right and 19 percent is too low and 21 is too high. There's just no data that tells us that. There is a lot of data that tells us about the structure of the tax system and what is the best way to raise the revenue that is needed to be raised. One of the things I think has become clear is we want to have the lowest marginal tax rates. And the marginal tax rate, just to emphasize this point, is not the total amount of taxes you pay; it's only the tax you pay on the last dollar you earn. Now, many people think that this corresponds to the rates in the statutory rates schedule, of which, I think, 35 – what is it right now, 35 – 35 this year is the top rate you can pay, but that's not really correct, because the effective marginal tax rate can be a lot higher, depending on how the tax base is defined. For example, we double tax corporate profits. We tax them at the corporate level at 30?something percent – I forget, 35 percent, I think. Then when the profits of the corporation are paid out to the shareholders, they're taxed again. So the effective marginal tax rate on capital earned in the corporate sector is far higher than the top statutory tax rate on either corporations or on individuals.

Another way you can have very high rates, much higher than the statutory rates, is in the area of capital gains, where gains are treated as if – are not adjusted for inflation, so that all gains are treated as if they are real. And especially in the 1970s, this was a very, very severe problem. People were paying really confiscatory tax rates on relatively modest amounts of capital gains because they were entirely fictitious as a result of inflation. So we've had a lot of debate about these things, a lot of experience, and I think there's probably now a consensus among economists that we want to have the lowest possible marginal tax rates and the broadest possible tax base that is consistent with approximating a consumption tax base.

Now, what do I mean by tax and consumption? Whenever I bring this up, people think that this means that we have to have a sales tax, like the states have. So when you go to the checkout, you're going to pay 10 or 15 percent or whatever on everything you buy, or you're going to have a European style value?added tax, or something like that. That's just simply not the case. It's very important to understand that there are only two things you can do with income, however defined, and only two things: you can either save it, or you can spend it. There are no other options. So if you have a tax base, a tax system, that excludes all saving, and by that, I mean investment as well – all saving from the tax base, all that is left is spending.

So if we were to have a tax system, let us say – suppose we had a system whereby you could open an IRA?type account and put in as much as you wanted to put into it and take out as much as you wanted to put into it, and anything you put in is a – you can deduct from your income, and anything you take out you would pay taxes on as if it was income, and any income generated within the account through interest and dividends and capital gains, would similarly remain untaxed until you took the money out – if you had a simple thing like that, then all taxation would fall on spending, because all saving would have been removed from the tax base, unless someone was foolish enough to save outside of that account, in which case they deserve to be penalized. My point is that you can have a consumption tax base without ever having to worry about collecting taxes at the checkout counter or putting in a value?add tax or doing any of these other kinds of direct forms of taxation.

All we have to do is adjust our tax base. And we've already done quite a lot of that. We've reduced the tax rate on capital gains. In theory, you would want no tax on capital gains in a consumption?based system. We've lowered the tax rate on dividends. In theory, you would want to have at least – not a double tax, at least, on corporate dividends. You'd tax them either at the corporate level or at the individual level, but you wouldn't tax both. And we've substantially reduced that tax penalty. We've lowered the top rate of taxation, which is, by the way, a very important thing for people outside the wealthy, because this is always painted as, well, how many people pay the top rate? Well, not very many. But the top rate is like a cap on the tax, the top rate that anybody could pay. A very good example of how we put in taxes to soak the rich and then everybody else ends up paying them is with the alternative minimum tax, which you're probably familiar with. It was a tax that was put on to force the wealthy to pay their fair share even if they had a lot of deductions and credits and exclusions and things, and now the vast majority who pay the alternative minimum tax are middle?class people. So my point is that you don't ever want to soak the rich, because eventually, whatever you do to soak the rich soaks the middle?class. That's, I think, an argument that the vast majority of people understand and have no trouble with, which explains why middle?class people vote for reducing the top tax rate whenever they get the opportunity.

Now, let me just say one final thing. John wanted me to mention something about the [unintelligible], because I think that this is an argument that has gotten a little bit carried away with. I often hear people on the radio and read people who write letters to the editors say, "We don't have to worry about the revenue effects of tax policy, because whenever we cut taxes, the revenues go up, and I'll point to the fact that revenues rose in the 1980s." Well, one reason revenues rose in the 1980s is because Ronald Reagan signed a lot of tax increases into law. We had a huge tax increase in 1982. The TEFRA bill was over 1 percent of GDP. It was a big tax increase in 1984, 1985, 1986, 1987. Fortunately, there wasn't one in 1988. I calculated that in nominal terms, the tax increases took back 50 percent of all of the 1981 tax cut. Now, there still was a big net tax cut, and the research by Larry Lindsey suggests that that tax cut only lost about two?thirds of the revenue that the Joint Committee on Taxation and Treasury said it would lose. So there is a [unintelligible] curve effect in the sense that you don't ever lose as much revenue from cutting taxes – or tax rates, I should say – as the static revenues estimates would suggest, but the idea that we're going to magically balance the budget by cutting taxes is just ludicrous.

So we have to be responsible, and we need to concern ourselves more with the tax base and with the tax rates structure, and get away from gimmicky stuff that is just spending disguised as tax cuts. I think we should have no refundable credits for any reason whatsoever. In fact, we should have no tax credits for any reason whatsoever. We need to clean up the tax code and get away from having the government telling people how to spend their money, and how to live, and how to behave. I'll go on from there. Thanks.

John Berthoud

Our last speaker today is Scott Hodge, who is Executive Director of the Tax Foundation. Like Bruce and Dan, he is a prolific writer, and he also has the Heritage Foundation on his resume. I'm the only person up here who somehow didn't make it through the Heritage Foundation at one time or another. Scott is going to look, finally, at mostly the relationship between deficits and economics. For decades, there has been a debate, with charges going back and forth about the effects of deficits on the economy, interest rates, inflation. And he's also going to talk a little bit, I think, about the research that the Tax Foundation – which has some really terrific research on a variety of tax issues. They, of course, are most famous, I think, for their calculation of Tax Freedom Day. But Scott is going to talk a little bit about some other research, looking at the impact of appealing the Bush tax cuts.

On the other side, while some have happily talked about the idea that we can cut taxes to resolve the deficits, you have yet others who say we need to raise taxes, and Scott and the Tax Foundation have done some research looking at the question of whether repealing part or all of the Bush tax cuts – what will that do for resolving our deficit situation? So, Scott Hodge.

Scott Hodge

Thank you, John. Now, as Dan alluded to, the conventional wisdom here in Washington, whether it's on Capitol Hill, the media, among pundits, talk radio, and so forth, is that the deficit and deficits in general, or the national debt, are bad for the economy. As Dan said, this conventional wisdom says that when government goes out and borrows money, it crowds out private investment, drives up interest rates. The long?term effect of those higher interest rates, of course, are to slow the economy, and the domino effect falls through and the economy grinds to a halt. Now, I'm a little puzzled on why we're still talking about this conventional wisdom and why so many people buy into it when we are witness – and have been witnessed over the last four years – to perhaps the greatest refutation of this proposition that's ever been, and that is the most phenomenal run of home mortgage refinancing that we've probably ever seen in America today. And that's because interest rates are at an all?time low

Now, I passed along, on your chair, a fancy little graphic showing a lot of squiggly lines between the negative – actually, the non?relationship, or in some cases negative relationship, between deficits and interest rates. Now, let's just throw away all of this economic gobbledy?gook, and all these regression analyses, and so forth and talk about what's been going on in front of this. In fact, I got a call from – just last week from a journalist at some big newspaper, and she had just talked to a well?known economist at a liberal think tank, and she wanted the – about the deficit and the long?term economic impact to the deficit, and of course he was saying this is going to have all these terrible effects, and she wanted my side of the story. I said, "Well, it's very simple. Call back that well?known economist and ask him how many times he's refinanced his home over the last four years." She said, "What do you mean?" I said, "Well, all of us who own a home -" how many people own a home here? How many of you have refinanced at least once in the last few years? How many twice? How many three times? Why? Because as the deficit has been growing by leaps and bounds – in fact, we've gone from having record surpluses to, quote?unquote, record deficits, interest rates are, and especially home mortgage interest rates, are now at their all?time lowest level.

I was kind of messing around on the mortgage bankers website, trying to just play around with some numbers here. In the year 2000, when the federal government was running a surplus of $236 billion, the 30?year fixed mortgage was going for 8.26 percent. That year, the mortgage bankers originated about $302 billion in loans. About 16 percent of that was refinancing. In the year 2001, the federal government – the surplus shrank down to a level of $127 billion. The 30?year fixed mortgage was 7.13 percent. The mortgage bankers wrote $552 billion in mortgages. That was the second quarter of that year. And refinancing went up to 53 percent of all mortgages originated. The year 2002. Oh, my God, disaster happened. The deficits came back. We had $153 billion deficit that year. Thirty?year fixed mortgages came down to 6.53 percent. Refinancings were about the same level, about 50 percent. 2003, the deficit soared to $357 billion that year. Thirty?year fixed mortgages in the second quarter of that year were 5.1 percent. Damn, I missed that one. Mine was about 5.6 that year. That quarter, $1.2 billion worth of home mortgages were originated, and refinancings went up to 73 percent. This year, similar statistics. The deficit is an estimated $477 billion. The interest rate is somewhere back up a little bit to 5.8 percent. Mortgage originations are at an all?time high, and refinancings are at an all?time high.

So it seems rather ironic to me that while the deficit has soared in recent years, millions of Americans have not only enjoyed lower taxes, but they've enjoyed the lower interest rates and the savings on refinancing their home mortgages and the ability to pay down high interest credit card debt, and yet there's this army of conventional wisdom thinkers in Washington wringing their hands over the fact that the government is refinancing the national debt at about 2 percent interest rates on long?term T bills – or short?term T bills, a little bit higher on long?term. So what's all the hand?wringing about? I don't get it. I think what we ought to worry about are the calls to repeal the Bush tax cuts, in particular, the tax cuts on the wealthiest of Americans. I'll defend the wealthy here for a second, because I think the economic effects of raising taxes, especially on the highest income Americans, will have a far greater effect than any perceived or real effects of deficits on interest rates in the economy.

We performed a little thought experiment earlier this year, which I've got on your chair, on a little fiscal fact we call "Don't repeal tax cuts for the rich. Cut the spending, stupid." Using a static tax model similar to the one used by the Joint Committee on taxation, we systematically repealed various portions of the Bush tax cut to see how much, quote?unquote, new revenue would be generated from the result of that appeal. Or, in another way or looking at it, how much revenue would be generated by raising those taxes again, and what effect that would have on the deficit. Our first step was to repeal all the tax cuts for the so?called rich, returning the top two tax brackets to 36 percent and 39.6 percent, and applying those higher rates to dividend income. We estimated that would raise about $27 billion, about 5 percent of the overall deficit, lowering the deficit from $477 billion to $450 billion. We then restored the higher tax rates on dividend and capital gains income for all other taxpayers. That would raise another $20 billion, lowering the deficit to $430 billion. Still a long way to go towards balance. Then we restored all the other tax rates to their 2000 levels, the Bill Clinton year levels, and repealed the 10 percent tax bracket for lower income Americans, and that raised $70 billion, the bulk of the tax cuts, lowering the deficit to $360 billion. Still a long way to go. We restored the marriage penalty, eliminated the ITC, and adjustments to the AMT. Raised another $26 billion, but we still had $334 billion left remaining in the deficit. We returned the value of the child tax credits, or lowered it, from $1,000 back down to $500. Raised another $21 billion, and lowered the deficit to $313 billion.

The moral of the story was that repealing all the Bush tax cuts would cut the deficit by only one?third. But what does that mean? That means that spending is the problem, even on this static basis, which assumes that people won't change their behavior if you whack them with higher taxes. But we do know that people do change their behavior when you raise their taxes, especially at the highest marginal rates. There's kind of a misperception about the rich, and we're beginning to explore that, using not only our tax model, but some databases that we have, and looking at the composition of income of high income taxpayers. There is this presumption that they're all the Michael Jordans and they're the entertainers and so forth that are getting rich and they're not going to change their spending behavior if you tax them a little bit more.

We find out that's not true, that the highest income tax rates – or those affected by the highest income tax rates are principally entrepreneurs and business owners. In fact, three?quarters of all of those taxpayers hit by now the 35 percent tax rate had business income in one form or another, either as a sole proprietor, as a partner in an LLC or an S Corporation, or from farm income. These are the entrepreneurs of America. And while those on the left, especially those at the Brookings Institution, will say, well, only about 3 percent of all small businesses are even up in those top brackets – no, the real point is, of those people who are hit by the highest marginal tax rates, three?quarters have business income. That tells you a lot about who and what they are. In fact, as incomes rise, so too does the incidence of business activity. While the average at that level is about 75 percent having business activity, if you go up to $1 million in income, about 84 percent of those folks have business income. That tells us an awful lot about who they are.

And they are not passive investors. These are not your gentlemen investors sitting back and just chipping in on someone else's investment, trying to reap some benefit. They're in very active business enterprises. We did a little demographic analysis on the type of industries in which we tend to find these people, and while most of us, when we think of LLCs and partnerships and S Corporations – we tend to think of doctors, and lawyers, and stockbrokers, and those kinds of guys. We find out that those are well in the minority. In fact, folks in the securities, brokerages, and investment companies comprise of only about 4 percent of those high income taxpayers. Doctors and lawyers and dentists combine to less than 15 percent of those high income taxpayers. What you do find, these people tend to categorize themselves as being in – 2.5 percent are in agriculture. We've got some rich farmers out there. Construction manufacturing, about 5 percent. Non?durable goods, 3.2 percent are in the manufacture of those. Transportation industries, 2.6 percent. That's your truckers and so forth. So these people are all in very, very active enterprises.

Our current CBO Director, Doug Holtz?Eakin, was part of a study that was performed looking at the effects on entrepreneurs of the 1986 tax cuts, which lowered the tax rates on high income individuals as well, and what he found was that a 10 percent rate cut would increase the likelihood that an individual in a firm would hire new workers by about 12 percent, increase the median wages paid by those entrepreneurs by 3 to 4 percent, or increase the firm's receipts by about 8.5 percent. What that means is those people do respond to cuts in their highest marginal rates.

Let me just kind of conclude by saying that I think we all need to take a page from the movie Dr. Strangelove, which the subtitle of which was How I Learned to Stop Worrying and Love the Bomb. Now we don't need to love the deficit, but I think that we can certainly live with it until the economy begins to generate more and more tax revenues, which will bring the deficit down naturally. And, of course, that is unless Congress spends it before it hits the Treasury door. Thank you very much.

Question and Answer Session

JB = John Berthoud

DM = Dan Mitchell

BB = Bruce Bartlett

SH = Scott Hodge

JB: We have time, about ten minutes, for questions, so, for any of our panelists, please go ahead. Yes?

Q: [Inaudible]

SH: The question is, can I explain the correlation, or lack thereof, between deficits and interest rates? Really, as I think the chart sort of shows, it's – for those of you who are not familiar with looking at those, it is typical, but what you're seeing is actually either a lack of correlation, meaning as deficits go up, interest rates go down, or conversely, as we saw in 2000, when the surplus goes up, interest rates go up. Why is that? As Dan mentioned, it's really driven by economic activity in a private market, not by government activity. By the way, we're looking at – right now, I think that the private – the worldwide bond market is about $35 billion this year, somewhere, give or take. So today's current deficit of $450 billion is less than 1 percent – trillion, excuse me. Thank you. Three zeroes. It's around $35 trillion, and it's running 24 hours a day all around the world. Our $450 billion deficit is a drop in the bucket. What is driving it is that economic activity, as Dan mentioned. As economic activity climbs during a recession, for instance, there are people out there that are going to have [inaudible] borrowing or interest rates, because there isn't much private activity. So when the government borrows a lot during a recession, we're certainly not crowding out any private activity.

DM: I want to add one thing to Scott's comments, which I think are right on the mark. As an economist – or those of us who took Economics 101 and suffered through it, you remember your supply and demand curves. I'm an economist; I do believe in supply and demand curves. So why doesn't that make me think that deficits have a big impact on interest rates? It's not that they have zero impact; it's just that other things are so much more important, they completely swamp the impact of deficits on interest rates.

A good example is, let's say I decide [unintelligible] 30 days. Let's say I want to be that person. I'm going to eat the cows every day, every meal for the rest of my life. I'm increasing the demand for McDonald's. Now, in theory, that's going to bid up the price of McDonald's cheeseburgers and stuff like that. But what if everyone else is reading a report that eating McDonald's is bad for you or something, and everyone else in the room decides that you're not going to eat at McDonald's? Well, it doesn't matter the fact that I'll be eating that McDonald's more if there are other factors in the market that are causing the overall demand for McDonald's to go down. That's just the downward pressure on that, making McDonald's cheaper.

So it's not that deficits have no effect; it's just that the empirical research indicates the effect is very, very small, for exactly the reasons Scott was talking about. You have a global capital market, with all this money trading hands, and lots of other things, like inflationary expectations, demand for credit. These are the things that are very important in terms of effecting interest rates, not whether the U.S. budget deficit is $100 million higher or lower.

JB: Yes?

Q: [Inaudible]

BB: The question was, are we misstating the relationship or are we looking – by talking about deficits, isn't it the debt that is the issue? Of course, the deficit is merely the annual increment to the debt, and actually, that's an interesting way to look at it. If we have a $3 trillion debt and we run $100 billion deficit, that's only a 3 percent net addition to the debt. So it should be the stock of debt that affects interest rates anyway, not the annual increment to it. It's like the price of gold. The price is not set by the amount of gold that's mined each year, because it's a trivial portion of the existing stock of gold. Almost all the gold that's ever been mined in the history of man is sitting in a bank vault somewhere. So the net increment to that stock is what would affect the price of gold, not the annual production. It's the same thing with the debt. And also, we mis?measure all these things.

DM: If I can add one thing about the debt that I think is very interesting and also I think would be instructive, let's look at Japan and Ireland, because in some way, they're the opposite over the last 10 to 15 years. Ireland used to have a government debt of well over 100 percent of GDP, and now it's way down to under 50 percent of GDP. That happened at a point in time when Ireland was radically cutting tax rates. As a matter of fact, their corporate tax rate has gone all the way from 50 percent down to 12 and a half percent. They've gone from being the sick man of Europe to being the Celtic tiger.

What's the moral of the story? The moral of the story is if you have a prosperous growing economy – and Ireland has boomed with all these tax rate reductions – your existing stock of debt begins to shrink relative to the growth in your economy, whereas Japan is exactly the opposite. Japan has been mired in economic stagnation for about 10, 12 years. What's happened? Their government debt used to be under 50 percent of GDP. It's now well over 100 percent of GDP. Now, in part, that's because they've been running big deficits as they try to reinvigorate the silly idea of Keynesian economics, but also it's because if your economy is flat, your debt's going to outgrow your economy. That's why economic growth is so important.

Now, as we've talked about, it's probably not enough. Bruce raised very important questions about the Social Security liabilities and the even bigger Medicare liabilities, which you all have made worse last year. But the point is if we can get the economy growing faster and we can control government programs, both today and tomorrow, that debt is going to fall as a burden of our economy.

JB: Let me just quickly add to that. Dan mentioned some lessons from Economics 101. I think another really important – also, Dan was talking about deficits as a share of GDP. I think whenever you're talking about deficits or debt as a share of GDP, it's a much better way to look at it than just talk about the aggregate numbers. A $500 billion deficit, as Dan said and others have said, in the global scheme of things, or in the scheme of the U.S. economy, 3 or 4 percent of GDP is just not that significant. If we were Guatemala and had a $500 billion deficit, that would be a very different situation. That goes to the point that Bruce and Dan have talked about. Long?term, while the deficits, where they are now as a share of GDP, aren't very economically significant, all bets are off once the baby boomers start retiring and we have these $75 [trillion], $80 trillion, depending on how you're counting, unfunded liabilities, long?term numbers there, then we're going to have – one way or another, you're going to have some significant economic impact.