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Busch: The Salient Issue on Deficits

Yes, they need to be cut. It’s how to do it. In Newsweek, Fareed Zakaria states, “Raise My Taxes, Mr. President!” and the NYT Sunday Op-Ed had something similar entitled, “What They’re Not Telling You.”Both articles are worth reading to understand the US fiscal deficit and how it became $1.4 trillion.

Zakaria states, “The Bush administration inherited budget surpluses from the Clinton administration. What turned these into deficits, even before the recession? There were three fundamental new costs—the tax cuts, the prescription-drug bill, and post-9/11 security spending (including the Iraq and Afghanistan wars). Of these the tax cuts were by far the largest, adding up to $2.3 trillion over 10 years. According to the Congressional Budget Office, nearly half the cost of all legislation enacted from 2001 to 2007 can be attributed to the tax cuts.”

True, but what of the recent spending from 2008-2010?

The NYT says, “And because the budget was already in bad shape when the financial crisis hit in late 2008, the necessary spending to rescue the system only deepened an already deep deficit. Unchastened, Republicans — joined by a few Democrats — are now determined to dig the hole even deeper by calling for all of the Bush tax cuts to be extended beyond their scheduled expiration at the end of this year.”

When the problem is posed as a funding issue, the solution is to raise revenue or receipts. But is this the correct path?

Writing in the WSJ this weekend, Art Lafferexplains why raising taxes on the rich may not generate the expected funds or dollars that Keynesian models say it would. “When President Kennedy cut the highest income tax rate to 70% from 91%, revenues also rose. Income tax receipts from the top 1% of income earners rose to 1.9% of GDP in 1968 from 1.3% in 1960. Even when Presidents Harding and Coolidge cut tax rates in the 1920s, tax receipts from the rich rose. Between 1921 and 1928 the highest marginal personal income tax rate was lowered to 25% from 73% and tax receipts from the top 1% of income earners went to 1.1% of GDP from 0.6% of GDP.”

“Or perhaps you'd like to see how the rich paid less in taxes under the bipartisan tax rate increases of Presidents Johnson, Nixon, Ford and Carter? Between 1968 and 1981 the top 1% of income earners reduced their total income tax payments to 1.5% of GDP from 1.9% of GDP.”

"When the problem is posed as a funding issue, the solution is to raise revenue or receipts. But is this the correct path?" -BMO Capital Markets, Andrew Busch

In other words, you can raise taxes to generate Treasury receipts, but they will likely be much less than anticipated. It’s not as simple as politicians think or as simple as Keynesian modelsshow.

It comes back to the question of how we got here. Like James Carvillesaid, “It’s the spending, stupid.” US government spending as a percentage of GDP has exploded while tax receipts have fallen. As the economy recovers, this gap will narrow slightly as tax receipts recover to their pre-crisis levels. Spending will not.

The driving force behind fiscal policy can not be just to make the US Treasury whole for past spending decisions. Like Canada in the 1990s, the US has to answer the question of what it wants to do for its citizens and what it can afford.

So far, the US hasn’t even got to the question yet, let alone the answer.

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Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.