The deficit distraction

Alan Reynolds
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Posted: Jul 24, 2003 12:00 AM

The government's new estimate that the budget deficit may hit $455 billion this year was quickly greeted with pompous media comments that managed to evade the main point. The Washington Post weighed in with a self-assured editorial listing four reasons "Why Deficits Matter." The first point was that deficits result in, as Alan Greenspan put it, "draining savings from the private sector," which supposedly reduces investment and growth.

That theory has been thoroughly tested over the past decade and failed spectacularly. From 1998 to 2001, while the budget was in surplus, national savings amounted to 18 percent of GDP. From 1981 to 1989, when deficits averaged 3.8 percent of GDP, national savings was 18.2 percent of GDP. Fixing the government's budget at the expense of taxpayers' budgets does not add up to a net gain for the economy as a whole.

Since national savings is about 18 percent of GDP regardless of the government's budget, the only sure way to increase savings is to increase GDP. But higher tax rates have the opposite effect, draining both the resources and incentives needed to boost economic growth. Besides, profitable investment opportunities do not really rely on the fraction of income set aside each year. Good investments can be financed from the accumulated assets of the whole world.

Savings can indeed gradually increase our collective wealth. But wealth rose far more swiftly thanks to the increased market value of stocks after the recent tax cut. Ironically, critics of the tax cut (those who now feign concern about deficits "draining" savings) argued that too much of the tax cut might be saved. The pundits' solution is always the same -- higher taxes -- only the problem changes.

The Washington Post's second complaint cites Economics 101 (as far as they got with the subject) to the effect that the alleged reduction in national savings allegedly raises interest rates. In reality, as opposed to elementary theory, there is no evidence that changes in either deficits or savings rates affect national interest rates. Interest rates reflect the real return on capital and inflation, and they are largely determined in global rather than national markets.

The third complaint is that "increased borrowing means the government has to spend even more on interest costs. . . . That's made even worse by the deficit-driven increase in interest rates." This is another theory without any facts. Interest expense has fallen to only 8.5 percent of federal spending this year -- down from 12.5 percent in 2000. That is because the "deficit-driven increase in interest rates" is a myth. As anyone who has refinanced a mortgage knows, interest rates fell dramatically after the budget swung from surplus to deficit. The government is paying lower rates, too.

The editorial's final complaint is that "we ought to be socking money away (or at least paying down the existing debt) to pay for the soon-to-explode costs of Social Security and Medicare." That is, we should pay high income taxes right now because the government may (or may not) keep handing out increasingly generous age-based benefits many years from now.

This pay-in-advance scheme seems based on three fallacies. The first fallacy is to pretend that more taxes today would (by reducing deficits) result in more savings and therefore more investment. This is just an accounting fraud, which amounts to defining an increase in taxes as an increase in savings. In reality, of course, people who pay higher taxes have less left over to save. And prospective investments look worse, not better, if companies and their investors are heavily taxed.

A second fallacy is hidden in the veiled hint that income taxes will have to be increased to pay whatever the baby boomers hope to receive in retirement and health benefits. Using income taxes to bail out Social Security or Medicare would be completely illegal. Legislating such a total destruction of any link between payroll taxes and benefits would undo the career of any politician who dared to attempt it.

The third fallacy behind proposing high taxes today to support baby boomers in the future is the naive assumption that today's projections about deficits 10 or more years into the future are remotely accurate. In August 1994 -- one year after a big tax increase -- the Congressional Budget Office's estimated deficit for 2000 was exaggerated, we now know, by 5.3 percent of GDP. That amounted to overestimating the actual deficit by $520 billion for just one year. Today's estimates of deficits in the distant future could easily be just as wildly inaccurate.

Federal spending is indeed a problem for private producers, but federal spending would be a problem almost regardless of whether the bills were paid by borrowing, taxing or printing money. There are more or less efficient ways of financing federal spending. But allowing government spending to grow faster than incomes of private households and firms is always dangerous. To focus on deficits and taxes is to miss the point.

Alex Berenson of The New York Times thus noted that the budget swung from a $237 billion surplus three years ago to an estimated $455 billion deficit this year. Ostensibly trying to explain "that swing, of $692 billion," Berenson predictably quoted several critics of the Bush tax cut. Yet this year's tax cut is responsible for only $35.6 billion of this year's deficit -- merely 5.1 percent of Berenson's $692 billion fiscal swing. The big story is the other side of the budget.

In the past three years, federal spending jumped to 20.6 percent of GDP -- up from 18.4 percent in 2000. That increase is responsible for more than half of the current deficit, $235 billion. Nearly 80 percent of that spending increase was not for defense, which just rose from 3 percent of GDP to 3.5 percent.

The spending side of the budget is where genuine and serious problems exist and where genuine and serious solutions must be found. Editorial writers who have been busily recycling old fairy tales about budget deficits draining savings pools and raising interest rates are just using blue smoke and mirrors to conceal what really matters.