Cost of Government Day (COGD)
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Special Focus: Spending and the Federal Budget Deficit

The federal deficit is a completely uninteresting number which is the difference between two meaningful and important numbers – the total level of federal spending and the total level of federal taxes.

The size of government is determined not by the deficit but by the level of spending and taxes.  The deficit is also not a major driver of economic performance, up or down.  Taxes, and the total burden of government spending, are truly major factors affecting the economy, as they determine the incentives for saving, investment, business, entrepreneurship, and work.

Nevertheless, it is noteworthy that despite rapidly growing federal spending, the federal deficit had declined to $162 billion, or just 1.2 percent of GDP, by 2007.  This was down from a high of $412.7 billion, or 3.6 percent of GDP, just 3 years earlier, in 2004. 

This decline was due to the rapid increase in federal revenues resulting from economic growth, which had been stimulated by the Bush tax cuts, particularly the reductions in marginal tax rates on capital income which were part of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) adopted in 2003.  Had federal spending been held to the rate of national income growth since 2000, the deficit would have been eliminated entirely by 2006. 

Federal Budget Would be in Surplus if Spending was in Line with Income Growth

The remaining deficit in 2007 was due entirely to the growth of federal spending in excess of national income growth in prior years.

However, President Bush and Congress joined in passing a so-called economic stimulus package in early 2008.  Because of that stimulus package, the Congressional Budget Office (CBO) now projects the deficit for 2008 to balloon to $357 billion.

The Economic Stimulus Package in Context

That stimulus package was touted as involving a tax cut or tax rebates.  But in reality, it involved primarily one-time cash grants intended to stimulate consumer spending demand based on old-fashioned Keynesian analysis.  Lacking reductions in tax rates or any other permanent change in the incentives for saving, investment, entrepreneurship or work, the stimulus package will not have any permanent or long term effect on economic growth.

In fact, the stimulus package may not have any significant short term effect either.  That is because the federal government simply borrowed the money for the cash grants through a higher deficit.  Borrowing over $100 billion dollars from the economy to give back the same amount in cash grants does not even have any net impact in increasing overall demand.  This flawed logic was the reason why Keynesian economics became discredited and abandoned in favor of tax cutting supply side economics in the 1980s.

A true stimulus package would have focused on areas where the tax system is hurting economic growth and relieved those excessive burdens.  One example is corporate taxation.  The federal corporate income tax rate is set at 35 percent. Adding in state income taxes leaves American corporations shouldering an average corporate tax rate of 40 percent.  By contrast, the average corporate tax rate in the European Union was reduced from 38 percent in 1996 to 24 percent in 2007.

Consequently, America finds itself at a competitive disadvantage not only with these countries, but with the emerging giants of India and China. The corporations bearing this tax burden are the ones expected to provide working people with jobs, better incomes, and long term prosperity.  That is not going to happen with corporate tax rates among the highest in the industrialized world.

In addition, business expenses are deductible for the income tax in the year they are incurred, except for the expenses of capital investment.  These may be deducted generally only over several years under depreciation schedules specified by the IRS.  This discriminates against and discourages investment in the U.S.  Capital investment expenses should be deductible in the year they are incurred, just like all other business expenses.

Moreover, the capital gains tax imposes a second layer of taxation on capital income, in addition to the income tax.  A capital gain represents an increase in the expected future income to a capital asset.  That income will be taxed when it is earned.  To tax the gain as well amounts to effectively taxing the income to the capital asset twice.  That is why the capital gains tax should be abolished, a policy already adopted by some of our major international competitors.  At least, the capital gains tax rate could be further reduced from the present 15 percent to 10 percent. 

Another highly desirable change would be to reduce the top individual tax rate from 35 percent to 25 percent to match the top corporate tax rate.  Many small businesses and partnerships operate under individual tax rates and their rate should be no higher than the corporate rate.

Rather than wasting a $200 billion increase in the deficit on ineffective Keynesian cash rebates, a true economic stimulus package would have included at least some if not all of these components.  Such a package would produce a long-term economic boom similar to the booms of the 1980s and the mid- to late 1990s.  Capital would flow into the United States once again from all over the world, relieving any credit crunch.  Demand for the dollar to invest in the U.S. would soar, reversing the dollar’s decline and giving the Federal Reserve Bank more leeway for an accommodative monetary policy.

Short of comprehensive tax reform, such as the 17 percent optional flat tax advanced by Steve Forbes and the alternative systems proposed by Congressman Paul Ryan (R-Wis.) and Sen. John McCain (R-Ariz.), incremental tax reform based on the above proposals represents a highly desirable agenda for reform.

The booming economy produced by this taxpayer agenda would provide a solid foundation for balancing the federal budget in the short run, for those who consider it important.  If federal spending was merely limited to grow no more than the growth in national income, or that growth minus 1 percent, the current federal budget deficit would be eliminated within a few years.

This combination of tax cuts coupled with spending restraint was precisely the formula used to eliminate the long-standing federal deficits in the 1990s, turning them into large surpluses instead.  Despite the record-setting tax increase of 1993, when the new Republican Congressional majorities came into office in 1995, President Clinton’s budget still projected annual $200 billion budget deficits indefinitely into the future.  The Congressional majorities adopted tax cuts on capital investment accepted by President Clinton, which resulted in booming economic growth.  They also limited federal spending increases to 3.9 percent for 1996, 2.6 percent for 1997, 1.5 percent for 1998, and 3 percent for 1999.  With the new revenues from booming economic growth, this is what turned the $200 billion annual deficits into $200 billion annual surpluses.  Employing this strategy again would be an effective way to eliminate federal deficits.

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