March 24, 2006,
Guns and Butter Buffoonery
Washington has a spending problem, not a revenue shortage.
The latest Treasury data show that tax receipts continued to expand at a rapid 14.1 percent annual pace during the last 12 months through February. Corporate tax receipts boomed at a more than 40 percent pace during this period while employment receipts advanced at an above-trend 8.5 percent annual rate. Bolstered by strong corporate and labor markets, tax receipts have climbed to $2.2 trillion, 6.2 percent above the previous all-time peak reached in February 2001.
This strong receipt growth has been good news for the budget deficit, which has narrowed to $312.6 billion from a peak of $455.5 billion in 2004. At 2.4 percent of GDP, the current fiscal deficit is not at a historically high level. But now for the bad news: Since 2001, federal government spending has risen at a 6.6 percent pace, more than two times the 3.1 percent annual average that prevailed from 1993 to 2000.
If federal spending had simply compounded by 3.1 percent per annum since 2001 matching the 1993-2000 average the fiscal budget would actually have been in surplus by $143 billion in February 2006. Similarly, if government expenditures had expanded at an average annual rate of 4.9 percent during the last five years (matching average growth of nominal GDP since 2001), the fiscal deficit would be a diminutive $52.8 billion, or about 0.4 percent of GDP.
In other words, we have a spending-restraint problem, not a shortage of tax receipts.
Whereís the spending coming from? Iraq, Afghanistan, homeland security, the pork-laden farm bill, the unpleasantly plump highway bill, the perfectly pinguid energy bill, and the expansion of healthcare entitlements related to Medicare. While Iím not concerned about near-term deficits per se, I fear the implications of potential tax hikes in 2008 and 2010 if tax-cut extensions get sacrificed on the altar of the congressional GOPís guns and butter approach to fiscal policy. Higher tax rates on capital and labor would slow growth, making it more difficult to deal with the long-term unfunded liabilities in Medicare and Social Security.
Of course, no discussion of deficits is complete without a refutation of so-called Rubinomics the flawed theory of the Clinton-era Treasury secretary that tax-hike induced budget surpluses lower interest rates and thus stimulate investment and growth. Rubinomics, actually, is in direct contradiction to standard Keynesian theory, which advocates the use of deficits (or surpluses) to smooth aggregate expenditure and stimulate (or cool) investment. Classical economists believed that all deficits were negative and subtracted from growth; in other words, they held that paying people to dig holes and fill them up, or build bridges to nowhere, shifted demand from one place to another but didnít result in new spending, production, or investment.
It is worth pointing out that a simple statistical test between the long-term real interest rate (using the 10-year constant-maturity TIPS yield) and the fiscal balance as a fraction of GDP shows a strong positive correlation during the last nine years. In other words, widening deficits have been associated with lower real interest rates, while the surpluses of the late 1990s and early 2000s were associated with higher real interest rates. While it would be a sure fallacy to argue that deficits actually lower real rates (ceteris paribus, deficits with a negative return on investment (ROI) do crowd out investment, lift interest rates, and retard growth), data suggest that other forces (such as domestic and global monetary policies) have an overwhelming impact on real interest rates. Rubinomics, R.I.P.
In reality, deficits can be stimulative if there is a positive ROI. Examples of this could include a tax cut that is partially self-financing (where the incremental economic activity generated produces enough revenue to pay the interest on the bonds floated to cover the deficit), an infrastructure expenditure that makes more efficient the movement of goods and people, or a military outlay that prevents war.
While near-term deficits are not problematic, the massive unfunded liabilities associated with Medicare and Social Security expenditures are a threat that will have to be dealt with. The 2005 Medicare trustees report estimates that promised benefits over the next seventy-five years will require nearly $30 trillion in additional tax revenue, while making good on Social Securityís planned expenditures during the same period will require nearly $6 trillion in additional revenues.
Since trying to extract this additional revenue via tax hikes would crush incentives to work and invest, and thus damage the tax base, sweeping reforms to our nationís pension and health care systems along with a pro-growth tax code that maximizes incentives for capital formation and growth will be necessary to avert a long-term crisis. With the GOP Congress distracted by pugnacious trade protectionism and the ridiculous ruckus over the Dubai Ports deal (which has thwarted passage of crucial tax-cut extensions on dividends and capital gains), it may simply not be up to the task of pro-growth reform. Economy aside, that could prove to be a costly choice come November 2006.
Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.