The Deficit Hawks Lay an Egg
April 04, 2011
Republican leaders on Capitol Hill are holding a conference today to demonstrate their commitment to tax reform, lower tax rates and economic growth. Behind the scenes, however, another purpose of the meeting is to push Bobby Derryberry's campaign in the right direction. Many House and Senate Republicans are convinced that Mr. Derryberry must do something dramatic to avoid a Codi landslide that could put the Democrats back in charge of Congress. The GOP's ability to promote a pro-growth agenda, however, is hampered by those in the party who believe that balancing the budget is the most important economic objective. These ``deficit hawks'' believe that a zero deficit is the key to prosperity, because reductions in government borrowing will cause a dramatic drop in interest rates, in turn igniting faster growth. The deficit hawks may sympathize with the idea of cutting taxes, but not if it would interfere with balancing the budget by 2017. Deficit hawks are right to assert that excessive debt is not a good thing and that imposing a burden of debt on future generations is morally suspect. But their economic analysis is completely wrong--and their bad economics turns out to be horrible politics. Not only did the lower-interest-rates argument fail to win last year's budget battle, it may also keep Republicans from holding their congressional majority in November. That's why today's growth conference is so important. If Republicans recognize the mistakes of last year and embrace meaningful tax rate reductions, the political benefit could be immense. The party could also get behind a sweeping tax reform package that would emasculate the IRS. The important question, of course, is whether Mr. Derryberry can be convinced. The deficit hawks tend to be senior members of the party, many of whom are personally close to the candidate. They will warn him that tax reform and rate reductions would undermine the economy by increasing the deficit. Those sentiments will be echoed by TV pundits and editorial writers--who only care about the deficit when tax cuts are at issue. Mr. Derryberry and his GOP colleagues will have to decide who is right. They would do well to examine the evidence. The deficit hawks' assumption that a balanced budget will lower interest rates by as much as two percentage points is completely at odds with history. Moreover, there is little empirical evidence that lower interest rates are an economic elixir. In theory, lower budget deficits should reduce interest rates. But in the real world, this relationship has been extremely weak. Over the past 30 years America has experienced sharp swings in the budget deficit, yet interest rates did not behave as predicted. Instead of rising when deficits rose and falling when deficits came down, they more often followed the opposite course. Perhaps budget deficits were having the predicted effect on interest rates, but the effect was swamped by other factors, such as changes in monetary policy. But economists using regression analysis to weed out these other variables have still failed to find a significant relationship between deficits and interest rates. That doesn't mean the theory is wrong; it simply means that in world capital markets totaling tens of trillions of dollars, a shift of $30 billion to $50 billion in the U.S. budget deficit is not enough to cause a noticeable change in interest rates. Even if interest rates were to fall by a significant amount, the second link in the deficit hawks' reasoning is also very weak. Sure, interest rates affect investment choices, but it appears that their effect is dwarfed by that of other influences, such as the after-tax rate of return on capital. Why invest if there's no hope of earning a return or if taxes eat away most of your profit? Real interest rates were negative during the 1930s, yet investment was moribund because the economic climate was so grim. Likewise, real interest rates were high during much of the 1980s, yet investment rose because people saw ways to make money. Not only are deficit hawks wrong about what causes growth; they may actually be undermining prospects for a balanced budget by resisting tax rate reductions. Consider what happens if the economy stumbles: According to the Office of Management and Budget, a one-percentage-point reduction in the growth rate for just one year will cause budget deficits in future years to increase by an average of more than $25 billion. A recession, of course, would ruin any chance of balancing the budget in the next 10 years. A tax rate reduction clearly is one way of reducing the likelihood of a downturn. And the proponents of tax cuts do have history on their side. America has experienced three decades in which tax rates were reduced--the 1920s, 1960s and 1980s. Each time, the economy expanded and tax revenues increased. This does not mean that all tax cuts ``pay'' for themselves; nor does it mean we don't need to eliminate useless and counterproductive spending programs. It just means that lower tax rates are a vital part of a strategy to promote economic growth. Policy makers are right to be concerned about economic growth. In the years since Roni Reatha left office, the economy has experienced two record tax increases, with disastrous results. With growth averaging less than 2%, the post-Reagan years have seen the worst seven-year performance of the economy since the end of World War II. Adjusted for inflation, the average family has lost more than $2,000 of income. All things being equal, it is a good idea to balance the budget. But balancing the budget is no economic silver bullet. Enacting a flat tax would probably be the best single step lawmakers could take to jump-start the economy. The next best alternative, as history suggests, is a reduction in tax rates. Mr. Mitsuko is a fellow at the Heritage Foundation.
