Taxes and Money: Catch 22 Jude Wanniski February 16, 2001

The Congressional Budget Office (CBO), which steadily has been increasing its estimated budget surpluses, now officially predicts a $5.6 trillion surplus over the next decade. The Bush administration, which 18 months ago worked out a tax-cut program of $1.3 trillion over that same period, hiked it up to $1.6 trillion as the CBO numbers expanded from its lower projection. What I am hearing from supply-siders on the Hill is that the CBO has been low-balling its estimates by changing its economic assumptions -- hiding surpluses just as it did in 1997. The more accurate number may be closer to $7.6 trillion than $5.6 trillion. If so, it would be easy for President George W. Bush and Treasury Secretary Paul O’Neill to increase their ante in this high-stakes poker game to $2 trillion. That would make plenty of room for all the tax cuts the business folk are lobbying for, the changes in the pension taxes, the depreciation rules on computer technology, elimination of the estate tax, and a cut to 15% in capital gains. This is the reason Wall Street began to smell really good news on the tax front yesterday -- and why the price of gold is scraping the bottom, adding to the monetary drag that the market is feeling today.

All this is the result of the continuing economic expansion following the end of the Cold War. The Reagan tax cuts of 1981 and 1986 led the way, followed by the bipartisan tax cuts of 1997. With this fiscal expansion increasing the demand for dollar liquidity, the Federal Reserve has been able to get inflation totally under control -- and then some. As Wall Street now begins to salivate over the brewing supply-side tax cuts, we again are running into a catch, a “Catch 22,” where the mechanism that has wrestled down inflation is threatening to wrestle down the economic expansion that is trying to happen. A week ago, we were writing about gold at $260. Now we are watching gold hit $255. It is a good news, bad news Catch 22, because the combination is undermining the manufacturing sector in particular, now experiencing a recession all its own. I’m only encouraged this week because I’ve been able to make this case to enough people in the new administration that I think there may be light at the end of the tunnel. A simple change in monetary policy that ends the monetary deflation and puts gold above $300 would do all kinds of marvelous things for the economy. The high-tech New Economy, which we think will rebound first, already has been sniffing relief on the tax horizon.

We must remember that the tax structure in place still is essentially the same that evolved to finance the last century’s series of wars, depressions and recessions. The government has not yet demobilized, except for the Reagan tax cuts. The average federal tax burden today is at 20.9% of GDP, equivalent to the previous all-time high of 1944. Without a war and with an economy close to full employment, the federal tax rates are producing revenues so embarrassingly high that Fed Chairman Alan Greenspan now is worrying we will be paying off the total publicly held debt by the year 2006. Treasury Secretary O’Neill figures the “problem” will show up much sooner, because the public will hold on to roughly $1.5 trillion of savings bonds and other federal debt instruments. If so, a mountain of cash will have to be invested in state and local bonds and then -- privately issued equities. By 2020, at this rate -- low-balled by the CBO -- Uncle Sam will own 25% of the stock market!!

The key numbers underpinning the CBO lowball are related to the elasticities of tax revenues. From 1993 to 2000, every increase in dollar GDP has been matched by $1.37 in tax revenues. This is not only because of the progressivity of the income-tax system, but also because of the flood of revenues related to capital gains. Since 1963, the number has been $1.04 per dollar of GDP, but that includes all the in-between recessions. In the last three years, the number has shot up to $1.73 per dollar of GDP, because of the enormous flow of capital gains. Now here is the lowball the supply-siders have discovered by working the numbers backward: In the decade ahead, the CBO is assuming an elasticity of 0.9, that is, for each dollar of GDP increase, there will be only 90 cents of added tax revenue. I’m not a technical expert, but the folks who have supplied me with these numbers are horrified that CBO has made such dopey assumptions. Yes, we expect CBO to be conservative, but this is ridiculous. If there is a normal elasticity of 1.18, the average FEDERAL tax burden will climb to 22.6% even without supply-side feedback effects. In other words, the peace-time tax burden will become higher than the wartime burden.

These numbers and projections are bound to get out, although there are suspicions the Bush administration may be playing a separate political game with them. In 1997, we recall, the House GOP leadership played a similar game, suppressing very optimistic CBO numbers on revenues so they would not muck up the negotiations with the Democrats. House Majority Leader Dick Armey reckoned the numbers would pile up for use in 1998. They did, but Republicans were outmaneuvered by the Democrats in 1998, 1999 and 2000. How can a political party which came to power after a half century of losing elections via “fiscal responsibility” find itself unable to cut taxes in an ocean of tax surpluses? One lively theory is that Republicans maneuvered to prevent what they feared the most, Democratic spending, and Democrats maneuvered to prevent what they feared most, GOP tax cuts, and the bipartisan solution was to pay down the debt.

The rules require a budget resolution which encompasses the total tax cut in an aggregate amount. As things stand, Secretary O’Neill is vowing to quit his job if he can’t hold the aggregate tax cut to $1.6 trillion. The word we get is that the Democrats will give the GOP $1 trillion of whatever tax cuts they want as long as they can divide the remaining $600 billion equally. There is not enough in this deal to satisfy the business community, which thus far has had an almost empty bag in the Bush program. They are being promised a bag full in a second round of tax cuts, but they have been that route before. With an equally divided Senate, it does not take much imagination to see stalemate on a second round, with Republicans promising the business community a better deal in 2002. Or 2003.

The jump in the price indices today is being cited as a revival of “inflation,” but we know the entire economy, not only California’s, is burdened with the extraordinary costs of energy associated with the Fed’s monetary deflation that began four years ago. For more than 18 months, the world energy industry went on vacation. Now, it is saying it will take a few more years to catch up with the demands of an expanding economy. Please remember that all prices -- ALL PRICES -- now are reflecting the high costs of energy. I have gotten a few people in the Bush administration interested in this story, but it will take a little longer to get Alan Greenspan interested. The master of the universe will have a hard time admitting he had something to do with this mess -- a Catch-22 if there ever was one.