New Year Finds United States Between a Rock and the Budget Deficit

The new year is a time to take stock and resolve to do better. Let us take a look at budget policy to see what we’ve accomplished, both good and bad.

The growth of government spending, increasingly strident regulation and rising marginal tax rates in the 1960s and 1970s had the United States careening toward becoming a European-style welfare state. By the mid-1970s, the federal government was spending more on transfer payments to individuals than on purchases of goods and services. Rather than providing goods and services to the population, the budget was primarily redistributing income. Around the same time, inflationary bracket creep, combined with our then-unindexed tax system, quadrupled the fraction of American families subject to high marginal tax rates--those on additional dollars of income.

Economic policy in the 1980s--heavily influenced by President Reagan’s priorities but also reflecting Federal Reserve monetary policy and congressional budget policies and priorities--helped achieve some impressive results. Double-digit inflation was reduced to about 4% at much less lost output than expected. Budget priorities were reordered from domestic non-defense spending to defense in the first half of the 1980s.

Since then, the defense buildup has been brought to an abrupt halt. Entitlement programs based on need grew more slowly. While the funds were targeted much more closely on the poor, the share of the funds going to those below the poverty line increased by about one-third. Federal government grants to state and local governments were reduced and consolidated into bloc grants to give greater flexibility to state and local officials. This was done at a time when the federal government’s large budget deficits were partially offset by substantial surpluses in the state and local sector.

We had an astounding reduction in marginal tax rates. The top personal income tax rates fell from 70% on investment income and 50% on earnings in 1980 to 28% this year, without reducing the share of GNP collected in taxes . Taxes are now 19% of GNP and projected to remain there; in 1979 they were 18.9%. The “tax cuts” offset projected tax increases.

These achievements, taken together, have at least temporarily halted the trend toward welfare statism and will help reserve the dynamism and flexibility of the economy.

But serious problems remain. We are spending too much and doing so inefficiently. We did not achieve much simplification in the tax code. The budget deficit remains stubbornly large, despite budget summits and Gramm-Rudman targets. We will not be able to grow or inflate our way out of our budget deficit.

These large budget deficits in prosperous times cause two potentially dangerous problems. First, with large deficits, a downturn in the economy must be dealt with primarily by monetary policy. Worse yet, if mechanical rules to reduce the deficit are not temporarily set aside, attempting to reduce the budget deficit in a slack economy will worsen a recession or slow an already-sluggish growth rate.

Enter monetary policy. The Federal Reserve acted promptly to increase liquidity immediately after the stock market crash of Oct. 19. Since then, it has reverted to a relatively tight money policy, explainable only by an overly cautious attitude toward resurgent inflation. The rise in inflation in the past year was primarily because of the falling dollar and to the relative stability (until recently) of oil prices. Inflation is hardly licked, but no one expects it to explode soon.

Large Deficits

The Fed appears to be waiting for actual signs of a serious slowdown in the economy before acting to expand the money supply. I believe that it is being overly cautious, and this is just one example of why we need to get our budget deficits under control: Too much pressure is placed on the Federal Reserve, which has other objectives besides high employment in mind. These include price stability and concern about exchange rates.

Second, continued large deficits, unless offset by a corresponding rise in private saving--a dubious proposition at best--cause a shortfall of national saving relative to investment, requiring us to import foreign capital. Our already-low private saving and investment rates, combined with the continued influx of foreign capital, commit us to a stream of future interest dividend and rent payments to foreigners. The growth of our external debt--toward $1 trillion by the end of the decade--will eventually necessitate a huge swing in our trade picture, from large deficit to substantial surplus. It may also generate the temptation, or fear of one, to reinflate.

These problems are part of the explanation for recent uncertainty in financial markets.

It is not obvious how to partition the blame for the budget deficits. Relative to the level of government spending and tax revenue projected before the Reagan Administration, tax cuts were the major source of the deficit. But the level and composition of spending and projected tax increases were inappropriate in 1980. We needed a defense buildup and were spending large amounts on ineffective or poorly targeted programs. Despite the rhetoric that President Reagan has totally refused to increase taxes, the fact is that taxes were raised in 1982, 1983 and 1984--and almost again in 1985 as part of a compromise that fell through at the last moment.

Serious budget problems remain, aside from the current deficits. Future problem areas include the potential growth of mandated private activity as a substitute for spending and taxes--that is, requiring businesses to provide things, especially health care and pensions, that the government might have provided if Congress could raise the taxes and spend the money.

There is a substantial pent-up demand from constituencies that have experienced cuts or slowdowns or even privatization in their programs in the past seven years. The abrupt halt to the defense buildup the past two years places great urgency on improving the efficiency of defense spending. A serious move toward improved defense procurement could save $10 billion to $20 billion a year.

Running Surpluses

Revenue also may be a problem. Most people now agree that the 1986 tax reform will lose revenue in the 1990s, as about one-third of the $120 billion corporate tax increase was an accounting rule shifting taxes forward from the early 1990s into the 1987-91 period.

If tax revenue is ultimately required as a last resort, as part of a compromise budget plan, it should be raised from taxes on consumption, not private saving and investment, so long as the economy is robust. And we should not have a tax increase if the economy is sluggish.

Thus, we have placed ourselves in something of a bind in order to change budget priorities and reduce the role of government and marginal tax rates.

Even if we do not use fiscal policy--tax cuts or spending increases--to try to offset any downturn in the economy, we should be running surpluses in good times to offset the automatic deficits that occur in slack times. We are so far from this idea now that just reducing the deficit while maintaining flexibility in the event of a downturn should be the immediate goal.

Whoever is elected President next November had better have a program that hits the deck running before many weeks have passed in a new Administration, or the dangers noted above will continue indefinitely.