as published by National Review Online, June 24, 2004

The Demand for Tax Cuts
There’s a lot of confusion about tax-rate reductions and deficits.

A recent Wall Street Journal editorial excoriated four Republican senators for opposing President Bush's proposal to cut taxes permanently. While these four Republicans — Susan Collins and Olympia Snowe of Maine, John Chafee of Rhode Island, and John McCain of Arizona — oppose the new tax-cut proposal, the Journal reported that they also voted in favor of a Democratic proposition that would increase educational entitlement spending over the next six years by $35 billion. The Journal's editorial concludes: "These votes show that their real motive in obstructing future tax cuts is to keep the money in Washington so they'll have more to spend."


The Journal and the senators all seem to miss the economic principle of "aggregate demand." Even with ultra-low interest rates for a number of years, the president's two tax-cut initiatives, and what many consider to be runaway spending by Congress, there is still substantial excess domestic manufacturing capacity (currently at 77.7 percent), a low percentage of workforce participation, and a recent downturn in commodity and energy prices. Even the latest core consumer price index for May (0.2 percent) and core producer price index increase of 0.3 percent provide precious little evidence of inflation caused by excess demand. 

What the senators and media don't get is the basic equation that defines the role of government deficits in the economy: The federal government deficit = non-government savings (of net financial assets). That's fact, not theory, a.k.a. an "accounting identity." Non-government savings include that of both residents of the U.S. and foreigners. If the federal budget deficit of $450 billion about equals the current account deficit, it means that all the net financial assets added by the deficit are being saved by foreigners, who desire to hold all those dollar-denominated U.S. financial assets and are willing to net export to us in order to get them.

This data indicates is that the federal deficit is too small for the U.S. domestic sector to save anything! Domestic savings are low because the budget deficit is too low. Low and unobtainable savings means low demand, excess capacity, and low levels of employment. In other words, to get adequate demand from a healthy economy, a much larger federal budget deficit is needed. Unfortunately neither political party sees the light on this one, and both proclaim a sincerity to balance the budget — which would totally choke off what growth we do have, as it would actually drain domestic income and savings and further reduce demand.

Some tax cutters are in the right for the short-term but mistaken for the long term. They explain how tax cuts are "good" now, even though we initially get "bad" deficits, because we get "good" revenue increases and lower deficits later. Note how many commentators during the extensive coverage of Ronald Reagan's funeral pointed out that the Reagan tax-rate cuts stimulated economic activity during the 1980s and thereby contributed to a doubling of tax revenues for the federal government, along with proportional increases to state and local governments. Even the proposed estate-tax cut is justified by the promise of future tax revenues from a stronger resultant economy.

Again, they miss the principle of aggregate demand. Tax cuts today (budget deficits) add to income and savings of the private sector, thereby increasing output and employment. Tax-rate cuts also increase incentives to work, adding further to output and employment tomorrow. But if the resultant strong economic growth produces a lower deficit in the future, that would mean an offsetting reduction in the growth of private sector income and savings in the future. That's what happened in the Reagan years. The combination of Reagan's tax-rate cuts and congressional spending contributed to huge budget deficits that increased aggregate demand, which in turn drove an expanding economy. The stronger economy produced an increase in tax revenues that reduced deficits, capped by the Bush I tax increases. This shrinkage of the budget deficit aborted the expansion, resulting in a Clinton victory.

The Clinton years began with a large deficit that added to savings and income, propelling us out of the recession and providing the financial equity for the coming "Goldilocks" years. Unfortunately the strong economy and the Clinton tax-rate increases drove the budget into surplus, devastating private-sector savings, and handing Bush II a struggling, savings-starved economy. Clinton economic policies could be called "Calvin Coolidge Economics," as the surplus years of the late 1920s led to the Great Depression of the 1930s. Note, too, what recently happened to Japan after it allowed the budget to go into surplus from 1987 to 1992.

Politicians and investors who fear budget deficits don't understand the interaction of a floating exchange rate and a central bank like the Federal Reserve. When the federal government spends, it writes checks that subsequently create deposits in banks and corresponding bank reserves at the Fed. It's a "ledger entry." No gold coins are crammed into some wire.

This process is not operationally a revenue-dependent process. It is independent of taxing and borrowing. Solvency is never an issue. To the extent that the government sells bonds, they only do so to soak up excess liquidity in the system (called "offsetting operating factors" by insiders) and thereby support the Fed's interest-rate targets. As a result, whether or not tax revenues go up or down, the government's spending will only be constrained by the willingness of politicians to authorize the writing of the checks.

To the contrary, for example, state governments along with the rest of us are constrained by revenues, since we don't have our own currency and central bank like the federal government does. We must either acquire money or borrow to be able to spend without bouncing checks.

The deficit mongers, however, think of the deficit in this micro-framework — in the way that a family deficit can limit our ability to spend. The government doesn't have such a constraint — it can't run out of money because it creates it. As long as government deficits do not infringe on the private sector's demand for goods and services, and in the process instigate inflation, the government deficit promotes economic growth and the related benefits to the private sector.

The bottom line today is that we need more tax cuts because demand is low, not because we will get more tax revenues later to pay off the budget deficit. The worst scenario would be that a new administration would opt for demand-killing tax increases and spending cuts in the name of fiscal solvency that would get us into a Japan-style deflationary quagmire. Government policies of taxing and spending should be structured to encourage demand not truncate it.

Let me suggest one obvious target: the payroll tax. By reducing this tax, both for employers and employees, incomes and savings will directly rise, employment will become less costly for employers (especially small businesses), economic growth will accelerate, and the lower costs to business will help hold down prices. To cut taxes at the lowest levels also makes the most sense politically as both parties compete for the votes of the working constituency.

The outlook would be a lot brighter if policymakers realized that we need more demand now, to get a better economy now, and not to increase growth for the purpose of raising more revenue in the future.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.


posted July 1, 2004