The incredible shrinking deficit

Posted: Jul 19, 2004 12:00 AM

Liberals are beside themselves. The so-called "structural" deficits that Paul Krugman and other left-wing economists have been fretting about are evaporating before their very eyes as a result of the Bush tax-rate reductions, which have ushered in a robust economic expansion. According to new data, the 2004 deficit will be slightly more than $400 billion this year, nearly $100 billion below estimates from earlier this year. That's what happens when you plug into the supply side of the economy.

Around the world there has been considerable hand-wringing over burgeoning budget deficits, especially during the last few years of slow economic growth. I have always maintained that we can grow our way out of deficits if we simply slow the growth of spending and lower tax rates to get the economy moving again. What is surprising is how quickly we forget the lessons of history, personal experience and common sense.

When Ronald Reagan passed across-the-board tax-rate reductions in 1981, Keynesian economists, including a few notable Nobel laureates, predicted "the engines of economic growth have shut down here, and they are likely to stay that way for years to come." These same economists, including many who were advising President Reagan, predicted rising deficits would lead to runaway inflation. They either forgot or never learned that inflation is here and everywhere a monetary phenomenon.

As a result of sound monetary policy and incentive-based tax-rate reductions, the engines of growth surged forward: Inflation dropped into the low single digits, unemployment dropped continuously, GDP doubled and tax revenues skyrocketed. We are seeing it happen again in the United States.

It can happen in Japan, as well, where there was a decade of lost economic growth due to "tax and spend" politicians trying to "stimulate" the economy with a host of stop-gap measures and public works projects. These fiscal policy errors were compounded by the equally dubious monetary policy of interest rate targeting, which had the perverse effect of lowering the interest rate to virtually zero without adding much needed liquidity. After a decade of malaise and poor economic policies, Japan is left with debt to GDP approaching 160 percent.

Today, Japan's economy has begun a nascent economic recovery, growing faster than 6 percent over the last two quarters. Yet in the face of this success, Keynesian witch doctors prescribe a 5 percent consumption tax to "solve the problem" of rising interests, a normal consequence of revived growth.

In Europe, the European Court of Justice ruled recently in favor of the European Union finance ministers who allowed Germany and France to break the E.U. deficit rules. Hopefully that ruling will spark a more serious debate over the real question: how to grow the euro zone and restrain government spending. Despite the European Union's stability pact, which seeks to control the size of government's deficits, government expenditures as a percentage of GDP in the euro zone remain near 50 percent of GDP. In other words, as the economy grows, so does the size of the government, usually resulting in an ever larger tax burden.

This was not always the case. In both Japan and Germany post World War II, the economic "miracles" were produced on the back of low tax rates, free trade, stable prices and limited regulation. The United States fell behind many of its competitors in the '60s and '70s because we forgot these simple rules. It took Margaret Thatcher and Ronald Reagan to reinvigorate the U.S. and British economies, forcing other to follow or fall behind.

Despite a prolonged period of economic expansion due to the "incredible tax machine" that is progressive taxation, if governments are not constantly cutting taxes, as the economy grows government revenues as a percentage of GDP will grow faster than the private sector. And because Germany, Japan and the United States are graying rapidly, if entitlement programs and government spending are not seriously addressed, simultaneously future generations will be consigned to higher taxes, slower economic growth, less job opportunity and lower standards of living.

Empower America chief economist Lawrence Hunter points out in a recent report published by the Institute for Policy Innovation that the real "deficit" problem is out-of-control spending growth that is slated to drive federal spending from just below 20 percent of GDP to over 30 percent in the coming decades, well outside any historic boundaries in the United States.

Time is running out on being able to solve the twin problems of government spending growth and entitlement reform in the United States without resorting to Draconian measures, but we can do it if we demand commitments from candidates in this election year. We can also show the rest of the world that a free-market growth agenda is the solution to their problems, as well.