On Monday, the Bush administration's budget for fiscal year 2003 will be released. It will show significantly larger revenues in future years than projected by the Congressional Budget Office last week. Inevitably, this will bring forth Democratic charges that the administration is "cooking the books," using "Enron accounting" and employing a "rosy scenario" to make the budget look better.
There is a theory, often put forward in the liberal media, that the budget deficits of the 1980s were caused by Ronald Reagan's foolish belief that his tax cut would actually raise revenue. This was based on something called the "Laffer Curve," which shows, quite correctly, that no revenue is collected at a zero tax rate or at a 100 percent rate. Under the former, there is no taxation; under the latter, there is no taxable income, because no one will work, save or invest for no return.
If one plots these two points on a graph, obviously there is one in between at which federal revenue is maximized. If tax rates are above this point, in theory a rate cut will increase revenue. More importantly, the curve shows that there are always two tax rates that will raise the same revenue: a high rate on a tax base shrunk by slow growth, tax evasion and tax avoidance; and a low rate on a larger base in which growth is higher because of greater incentives for work, saving and investment, which is less reduced by tax evasion and avoidance.
All economists agree that this is the case. Where they disagree is on the actual shape of the curve. This is an empirical question that can only be answered by detailed estimates of the impact of taxes on various forms of income. U.S. taxes have never been so high, in 1981 or any other time, that an across-the-board rate cut would lead to such an outpouring of economic output, and such a diminution of tax evasion and avoidance, that there would be no loss of revenue.
Contrary to popular mythology, the Reagan administration never made any claim that the 1981 tax cut would pay for itself. Every revenue estimate ever put out by the Treasury Department or Office of Management and Budget was based on the same methodology used for years before. They all showed large revenue losses that were in line with independent analyses. For example, the Congressional Budget Office, then under Democratic control, had virtually identical estimates of expected federal revenues, including the tax cut, as did the Reagan administration.
The reason for deficits was two-fold. First, spending rose more rapidly than expected. Second, inflation fell much more rapidly than expected.
The fall of inflation from 12.5 percent in 1980 to 3.8 percent in 1982 through 1985 was considered impossible by most economists in 1981. The prevailing view, based on something called "Okun's Law," was that it would take many, many years to bring inflation down so much. And this was the view of the Reagan administration as well, which projected much higher inflation than was actually the case.
At the same time, most economists thought tax cuts were inflationary. That is because they viewed their principal effect as increasing disposable income, which would stimulate demand for goods and services.
Inflation caused tax revenues to rise because it pushed people up into higher tax brackets. Contemporary estimates said that federal revenues rose about 1.6 times faster than the inflation rate. Thus, even if one did not believe in the Laffer Curve at all, one would still expect revenues to rise due to bracket-creep. Indeed, all the Reagan tax cut really did was keep taxes from rising.
It was the fall of inflation, not some misguided dependence on the Laffer Curve, that caused revenues to come in much lower than expected. But the core of the Laffer Curve turned out to be right. There was higher output and a larger tax base due to lower tax rates. Within a few years, at least a third of the static revenue loss was recouped as a result, according to careful academic studies. At some point, revenues probably were higher than they would have been if tax rates hadn't been cut.
Now liberals are trying to play the same game -- blaming erosion of the surplus on last year's tax cut. And they are attacking the Bush administration's revenue figures for being too rosy, too optimistic, just as they attacked the Reagan figures back in 1981. They are saying that deficits will actually be much larger and surpluses much smaller than Bush claims.
However, I think that the incentive effects of the tax cuts, especially if they are speeded-up as the administration proposes, will actually be much greater than it estimates. I think revenues are more likely to be higher than the administration projects than lower. There are those within the administration who believe so, too.
In any event, there is no evidence that the revenue figures are being manipulated for political gain.