As President Bush presses for passage of his tax plan, it is
clear that it is politically most vulnerable in terms of its impact on the
deficit. That is because there are a number of Republican senators who may
be persuaded to vote against a tax cut -- or at least one as large as the
president is proposing -- for fear that it will increase the deficit too
Given the close margin in the Senate and the likelihood that all
Democrats, with the possible exception of Zell Miller, D-Ga., will oppose
the bill, the White House cannot afford to lose more than one or two
Republicans. Therefore, President Bush must convince wavering members of his
party, such as Sen. George Voinovich, R-Ohio, that the tax plan's impact on
the deficit is not enough to justify voting against it.
Democrats, recognizing the Republican vulnerability, are
hammering the deficit issue as hard as they can. The rhetoric will become
even more heated in a few weeks, when the Office of Management and Budget
and the Congressional Budget Office release their new budget estimates.
Undoubtedly, they will show an increase in deficits from those projected
last summer even without another tax cut.
For now, Democrats are laying the foundation for their attack
and stocking up on intellectual ammunition. This sort of thing is usually
done at think tanks and universities, but eventually will be boiled down
into sound bites that will animate floor debate and press coverage.
The first shot was fired in December by Brookings Institution
scholars Bill Gale and Peter Orszag in a paper with the deceptively bland
title, "The Economic Effects of Long-Term Fiscal Discipline." --
(www.brook.edu/views/papers/gale/20021217.htm). Their purpose is to show
that there is a large and close relationship between federal budget deficits
and interest rates. They conclude that a sustained increase in the deficit
of $100 billion will raise long-term interest rates by 50 basis points (half
a percentage point) right away, rising to a full percentage point in 10
In another paper, Gale looks at the impact of the Bush tax
plan. -- (www.brook.edu/views/papers/gale/20030109.htm). He estimates that
it will raise interest rates by 20 basis points immediately and 40 basis
points later on. This suggests that higher interest rates could offset much
of the stimulative effect of a tax cut.
Bush administration economists do not deny that a larger deficit
will raise interest rates -- all other things being equal -- but think that
the impact is much less than the Brookings economists believe. They base
their estimate on the work of economists N. Gregory Mankiw of Harvard and
Douglas Elemendorf of the Federal Reserve. --
(www.federalreserve.gov/pubs/feds/1998/199809/199809abs.html). This research
indicates that a $100 billion increase in the deficit, which is the first
year impact of the Bush plan, would raise rates by just 1 or 2 basis
points -- a trivial amount.
Some partisan Democrats are trying to say that the Bush
administration believes that a higher deficit will have no impact on
interest rates whatsoever. Former Clinton economist Brad DeLong recently
called for the resignation of Council of Economic Advisers Chairman R. Glenn
Hubbard for supposedly saying so, in contrast to what he wrote in his own
textbook. -- (www.j-bradford-delong.net/movable_type/archives/001351.html).
In fact, Hubbard's views are well within the mainstream of
economists. In a Dec. 10 speech at the American Enterprise Institute, he
pointed out that many older textbook analyses of the impact of deficits on
interest rates failed to take into account world capital flows, which are in
the trillions of dollars per year. "The bottom line," he said, "is that real
interest rates are not dictated by country-specific short-term deficits." --
Of course, one can always find economists to support whatever
position is taken, no matter how extreme. But serious economists look at
what is published in the top economic journals as the best indication of
what economic science knows. The latest review of the literature on this
subject is by economist John Seater of North Carolina State University,
published in the Journal of Economic Literature, an official journal of the
American Economic Association. He found that there is no statistically
significant impact of deficits or debt on interest rates.
The problem with making a final determination is that there are
always lots of other things going on in the economy that make it difficult
for economists to isolate the effect of any one variable. For example, in an
economic expansion, one would expect interest rates to rise because the
return to capital is rising. This suggests that interest rates will rise
this year regardless of whether the Bush tax plan is enacted. But if it is,
some people will say that rates rise because of the tax plan, not because of
normal economic forces.
A December report from the Federal Reserve Bank of St. Louis
concluded, "The linkage between budget deficits/surpluses and interest rates
is weak." --(research.stlouisfed.org/publications/net/2002/cover12.pdf).
That probably comes close to telling us what economists really know on the