August 30, 2001

Where did that surplus go that seemed so large when the Congress was cutting taxes earlier this year?

More than $2.5 trillion in estimated decade surpluses appear to have vanished in less than three months. We know that part of that reduction was the $1.35 trillion in tax reductions. We also are learning that government borrowing will be higher than otherwise would be the case because of the tax reduction. Therefore, interest payments will be higher.

A third problem is the actual spending relative to assumed spending by the administration when they made their surplus estimates. The administration thought that all their initiatives for defense and education could be achieved without allowing spending to grow more than 4 percent. To reach that spending level with the administration initiatives, pork barrel spending would need to be reduced by 75 percent.

A fourth problem is the reality that the economy will underperform its capabilities for a longer period of time than initially expected. The second half rebound in economic activity is nowhere to be seen.

A fifth problem is the result of lower productivity gains than originally expected. As mentioned in previous columns, the downward revisions in GDP during the past three years took 0.3 percentage points out of productivity estimates per year. Instead of being able to grow more than 3.5 percent per year based upon recent conditions, growth capability probably is somewhere between 3 and 3.25 percent unless productivity accelerates.

With the dramatic reductions in fixed investment and the collapse of new enterprise development, the likelihood that productivity will accelerate any time soon is almost nil.

Finally, the administration over-estimated the normal yield that a percentage point increase in nominal GDP will generate. This occurred because they failed to return profits to a more realistic long term relationship to GDP than existed in the past five years. Also, they did not realize how much of the high tax yield per dollar earned was caused by capital gains (rather than the excessive taxing of a rapacious government as some overweight talk show hosts would have us believe).

There has been very little capital gains lately. So tax yields have returned to historically more normal relationships relative to income creation.

Some people argue that the tax reductions will create enough incentives to build the tax base by as much as the tax yield per dollar in that base is shrinking. This is wishful thinking.

Most of the tax reductions are for tax deferred savings accounts, a new 10 percent bracket, the removal of a "marriage penalty" and the ultimate elimination of estate taxes. The actual changes in marginal tax rates are so small relative to the percentage changes of the Kennedy or the Reagan tax reductions that incentive comparisons to those changes are not applicable.

Of course, the Congress could recognize that revenues will not be as much as they originally thought and cut back that pork barrel spending. As some members of Congress like to say, one member's pork is another's development catalyst (or something like that).

President Reagan tried to restrain Congress by taking away revenue through tax cuts. As economists know, Congress knew that the federal government can borrow. Instead of restraining government, the reduced revenues caused mountains of debt.

Perhaps President Bush is different and will veto spending that exceeds his spending assumptions. Reagan did not do so because he wanted growing defense spending to spend the Soviet empire into the ground. He succeeded in that objective, but this allowed the Congress to say that defense spending will grow only if other spending objectives also could expand.

President Bush also wants more defense. Will he fall victim to the same Congressional horse trading as Reagan, or will he jeopardize defense to defeat other spending initiatives.

All of this discussion does not mean that tax cuts were economically unsound. However, the more recent surplus estimates (which fall short of cash surpluses generated by the medicare and social security trust funds in the next few years) are more realistic than those used to support the tax cut.

If our representatives were told the truth, would they have passed the same tax bill?

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