1 Surplus Tax Policy? Surplus Tax Policy? Abstract - The emergence of large and apparently growing budget surpluses represents a paradigm shift for tax policy. This speech examines and dismisses some contrarian views about the effect of surpluses on fiscal well being, and then addresses three questions: (1) Is the surplus real? (2) Do surpluses or deficits matter? (3) Should surpluses change the rules of tax policy? The speech concludes that the Administration s fiscal year (FY) 2000 budget framework, if enacted, would advance fundamental tax policy principles of fairness, simplicity, and economic growth without abandoning the fiscal discipline that brought us a strong economy and budget surpluses. Leonard E. Burman Department of the Treasury, Washington, D.C National Tax Journal Vol. LII, No. 3 INTRODUCTION I want to start by thanking Diane Rogers and the symposium committee for putting together such a great and timely conference. The theme of the conference Tax Policy in a Time of Surplus suggests some important questions. Should tax and budget policy change because we have budget surpluses? Are the old tax policy principles of fairness, efficiency, and simplicity somehow outdated because fiscal discipline is no longer a dire imperative? The answer to the first question is that a surplus creates opportunities to deal with serious long-run policy concerns, but that a radical shift in policy in particular, spending a large part of the projected surplus either directly or through tax cuts is unwarranted. The answer to the second question is that there is no reason to surplus our tax policy principles. Any change in tax and budget policy should be guided by those principles. My talk will discuss the new paradigm of tax policy in a time of surplus, some amusing but largely irrelevant concerns that have been raised about persistent budget surpluses, and the implications for tax and budget policy of the projected surpluses. I will conclude by discussing how the program the President announced in the State of the Union address fits the new tax policy opportunities and constraints. A NEW PARADIGM When I started my career, people were preoccupied with soaring budget deficits, rampant inflation, and stubbornly persistent unemployment. Inflation and unemployment diminished in the 1980s, but deficits exploded. In part, deficits 405
2 grew because of supply-side economics the idea that taxes suppress the economy so much that tax cuts are effectively free. This created a very undisciplined environment both for tax cuts and government spending, and deficits ballooned as a result. Despite some corrective efforts such as the Deficit Reduction Act of 1982 and the Gramm Rudman Hollings Act of 1985, the national debt grew from 26 percent of gross domestic product (GDP) in 1980 to 50 percent by At the end of 1993, the national debt stood at $3.2 trillion. Now, after three painful deficit reduction bills (in 1990, 1993, and 1997), nearly a decade of fiscal discipline, and what will soon be the longest economic expansion in history, we are running surpluses ($69 billion in 1998). Surpluses in the unified budget are forecast to persist for nearly 50 years. Great news, right? Well, don t fall prey to irrational exuberance. Policy observers could not let the end of deficits happen without sounding the alarm. SURPLUS MANIA (AND OTHER NEUROLOGICAL DYSFUNCTIONS) 406 NATIONAL TAX JOURNAL So what could be wrong with moving from budget deficit to surplus? First, the paradigm shift is confusing. The Congressional Budget Office ceased publication of its perennial best seller Options for Reducing the Deficit while they tried to come up with a new title to reflect a deficitless reality. (After a year s hiatus, the series reemerged with a new name, Maintaining Budget Discipline: Spending and Revenue Options.) Second, some policy analysts have predicted dire consequences of persistent surpluses. Davidson and Galbraith (1999), in The Dangers of Debt Reduction, warn that debt reduction is basically impossible. If the government tried to save the surplus, the contractionary government policy would depress the economy, which would in turn reduce or eliminate the surplus. These authors also argue that persistent deficits have served a valuable purpose by creating an ample supply of safe and liquid assets Treasury bills (Tbills) which are essential for the proper functioning of financial markets. An even more hysterical article, Surplus Mania: A Reality Check, by Wray (1999), argues that debt is good for the economy. The government has been in debt every year except one since 1776 and our economy has outpaced the entire world, so debt must not be bad. Moreover, every period of significant debt reduction has been followed by a depression and every depression has been preceded by surpluses. This, Wray concludes, represents clear and convincing evidence of the folly of debt reduction. Sometimes economics lives up to its reputation as the dismal science. There are serious problems with the doom and gloom scenarios. First, even under the best of circumstances, we have several decades before we have exhausted the national debt and the associated supply of Treasury securities. Although financial markets currently find T-bills extremely useful as a basis for their hedging and arbitrage operations, it is hard to imagine that they would be unable to develop an alternative over the next 20 years. Besides, balanced budgets do not preclude the government from issuing securities. Many state governments are required by their constitutions to balance their budgets, but they still issue tax-exempt bonds to finance capital investments. Thus, if financial markets need T-bills to run efficiently, the federal government could continue to produce them, even while maintaining fiscal responsibility. I am not advocating such a policy, for a variety of reasons, but the point is that the need for a safe and liquid asset should not be the rationale for failing to pay down the debt. That would be an extreme case of the tail wagging the dog. The surpluses-cause-depressions hypothesis would make a fine test question
3 Surplus Tax Policy? for an undergraduate econometrics course, but should not be taken seriously as a matter of policy. The reason that surpluses have preceded economic downturns is simple. It is called the business cycle: expansions are followed by contractions. The correlation between debt reduction and depression is testament to the fact that we haven t run a substantial surplus in a very long time since the days when the nation was incompetent at managing its monetary and fiscal policy. Expansions, except in periods of extreme fiscal profligacy, tend to improve the budget situation that is, lead to surpluses and contractions worsen the budget create deficits. That doesn t mean that surpluses cause deficits or vice versa. Put differently, correlation does not imply causality. End of econometrics lesson. WHAT ARE THE IMPLICATIONS FOR TAX POLICY OF SURPLUSES? So, as a matter of tax policy, what should we make of budget surpluses? In this paper, I ll break down the question into three parts: Is the surplus real? Do surpluses or deficits matter? Should surpluses change the rules of tax policy? Is the Surplus Real? 407 A fundamental question is whether we are getting carried away with all this talk about surpluses. So far, we have experienced a surplus for exactly one year compared with two decades of deficits. The paradigm shift might be premature for at least two reasons: (1) the extraordinary economic conditions that led to the surplus may not persist; and (2) surpluses in a political environment may tend to be self-correcting. Auerbach and Gale (1999) argue the first point. A key reason that the deficit situation has reversed itself with such startling speed is that the economy is doing extraordinarily well. Real GDP is growing at an annual rate in excess of four percent after decades of lackluster growth. The unemployment rate most recently is about 4.3 percent and inflation nearly nonexistent. (Traditional macroeconomic theory suggests that this coincidence is impossible, given that the NAIRU the nonaccelerating inflation rate of unemployment is around 5.3 percent.) Individual income tax receipts are near a historic high as a percentage of GDP despite the fact that most families face lower tax burdens than they have in decades. Federal income tax rates on a typical family are lower now than at any time since A family at half the median income faces no income tax liability at all due to the earned income tax credit and the child credit. Even a family at twice the median income faces lower income tax rates now than at any time since Thus, the entire rise in income tax revenue is coming from the top of the income tax distribution, which has experienced explosive growth in almost all sources of income, but especially earnings and capital gains. Both of these factors are driven in large part by the extraordinary growth in the stock market. So, under the unlikely event that the stock market tanks and the economy goes into a tailspin, the surpluses will get smaller. It s worth noting, however, that the Administration s forecast for the surplus is not a rosy scenario. The macroeconomic forecast for the past several years has anticipated a return to modest growth rates, and those expectations have always been surpassed. The revenue forecast assumes that the share of taxes paid by people with high incomes will move back toward its historical norms also an unfulfilled expectation. In consequence, the seemingly optimistic forecasts have repeatedly proven to be too cautious in recent years. That trend might reverse itself at any time, but there is no evidence that it is happening yet.
4 The current political debate may determine if surpluses are self-correcting in a political environment. Can politicians resist the urge to spend the surplus or cut taxes? If they can t, then we may have a problem. If deficits are hard to solve, as the experience of the past two decades suggests, and surpluses are self-correcting, then serious debt reduction is never going to happen. The right answer is to adjust to surpluses as slowly as to deficits, which means that most of surpluses should be saved rather than spent or rebated in the form of lower taxes. I find the general agreement that a significant portion of the projected surpluses should be reserved for Social Security and Medicare a very positive signal in this regard. Thus, on both economic and political grounds, there is reason to think that the surplus is real and will not be dissipated immediately. Do Surpluses or Deficits Matter? Theoretical dynamic macroeconomic models have a peculiar kind of government budget constraint called a transversality condition. The transversality condition requires that tax and spending policy allow the budget to be balanced over an infinite horizon. The government could run growing deficits for a million or a billion or a trillion years, just so long as it retains the ability to pay off the debt. The practical implication is that deficit policies that cause GDP to grow more than the debt are optimal... forever. The chimerical theory that such policies exist and that the government can find and implement them underlies supplyside economics. That theory was tested in the early 1980s in an experiment sometimes called Reagonomics. Comparing the 1980s, when the debt exploded while the economy grew at a healthy pace, with the 1990s, when the debt fell as a share of GDP and the economy grew at an amazing pace, I d vote for fiscal responsibility. 408 NATIONAL TAX JOURNAL In the wacky theory department, one called Ricardian equivalence says that deficits don t matter because people will adjust their saving to offset government borrowing. Possibly, the disappearance of personal savings might be a response to an increase in government saving, but that doesn t explain why national saving plummeted in the 1980s at the same time that the debt was mounting. In fact, with personal saving vanishing, the need for government saving (or, at least, to rein in government borrowing) is especially acute. National saving is the sum of private saving (done by individuals and businesses) and government saving (debt reduction). Increased saving from either source reduces our reliance on foreign capital and thus improves our trade balance. It also means that the capital stock is growing to help offset the declining labor supply that will occur when the baby boom ages. Finally, the existence of surpluses matters because it creates opportunities that do not exist when there are deficits. Should Surpluses Change the Rules of Tax Policy? How should we choose the right policy? We should apply the basic principles of tax policy: fairness, simplicity, and economic growth. Tax policy in a time of surplus presents a real opportunity to make the tax system fairer and simpler and to strengthen the economy. A fundamental question that arises when we have surpluses is, should we abandon or modify the Budget Enforcement Act (BEA) rules? The BEA limits spending and requires that tax revenues pay for mandatory programs, such as Medicare and Social Security. In particular, tax increases can t be used to pay for more discretionary spending, even if taxes more than cover mandatory spending. The BEA has been effective at reducing the deficit, which is good. One way it has
5 Surplus Tax Policy? done this is by severely limiting discretionary government spending, but those limits also restrain policy choices in possibly undesirable ways. For example, the budget rules create a strong incentive to channel new spending through the tax side of the budget. Sometimes, it might be fairer, simpler, and more economically efficient to replace a tax expenditure with a direct expenditure program, but that choice is not available. But if we scrapped the budget rules, we might ironically find ourselves back in the supply-side world that launched the explosion of public debt. If not in a balanced budget context, how should new tax cuts or expenditures be evaluated? THE ADMINISTRATION S APPROACH The President approached this problem in his budget by establishing a new set of budget guidelines. First, not a penny of the surplus would be touched until Social Security is reformed. Second, a major part of Social Security and Medicare reform would be accomplished through debt reduction. As a result, 77 percent of predicted surpluses over the next 15 years would actually be saved. In fact, under the President s plan, the national debt would be eliminated by As compared with tax cuts, debt reduction benefits everyone, because future taxes will be lower, the economy will be stronger, and the Social Security and Medicare guarantees that are so important to working people would be absolutely secured. With personal saving at a zero rate, the economic argument for the government to bolster public saving is extremely persuasive. Thus, debt reduction is efficient and fair. It is also prudent given the uncertainty of the long-run surplus projections. The budget would also set aside ten percent of the surplus for new Universal Savings Accounts (USAs), a program designed to increase national retirement savings. This progressive tax credit is the rare 409 tax expenditure in which the distributional objectives and the efficiency objectives are in sync with each other. To be efficient, the savings created must be new savings not savings financed by withdrawals from other accounts or increased borrowing. Fairness requires targeting the tax incentive at lower-income people. Because they are the least likely to have other forms of savings, their contributions to USAs would be almost all new savings rather than asset shifting. Universal Savings Accounts Here is how the new USAs would work. Eligible workers and their spouses would receive an automatic government contribution of $300 in the form of a refundable tax credit deposited directly into their USAs. The automatic credit would be phased out between $40,000 and $80,000 of adjusted gross income (AGI) for joint filers ($20,000 to $40,000 for single filers; $30,000 to $50,000 for head of household filers). Individuals could also make voluntary contributions to their USAs. An individual s voluntary contributions to a USA would be matched in the form of a refundable tax credit deposited directly into the USAs. Lower- and moderate-income individuals would receive a dollar-for-dollar match. The match rate would phase down to 50 percent over the same income ranges as the phaseout for the automatic contribution. Highincome people covered by pensions would be ineligible. Total USA voluntary and government contributions (including the credits) to a USA would be capped at $1,000 per year. Workers are eligible if they are not the dependents of other taxpayers, have at least $5,000 of earnings (combined earnings on a joint return), and are between the ages of 18 and 70. Withdrawals are not permitted until age 65, and contributions are not permitted after withdrawals have commenced.
6 NATIONAL TAX JOURNAL Special provisions encourage workers with contributory employer pension plans, such as 401(k) and 403(b) plans, to participate in those plans. They can use their contributions to those plans as the basis for USA tax credits. There are no employer mandates of any sort, but employers who wish to set up payroll deduction options to allow workers to make periodic contributions to a USA would be able to do that. Workers could also designate contributions to their USA on their tax returns, for example, by channeling a portion of their refund into the account. Workers would also have the option of making direct contributions to USAs, against which they could claim a refundable tax credit on their tax return. Individuals would have a choice of investment options for their USA contributions, just as federal employees do under the Thrift Savings Plan, including a stock index fund, a bond fund, and an interest bearing account. Seventy-three million people without access to pensions would have access to USAs. The ability to channel refunds into the accounts combined with the large match rate would provide a very strong incentive for lower- and moderate-income people to save for retirement, and designating saving on a tax return would be very simple. Moreover, the accounts would provide a significant supplement to Social Security for millions of people who rely on it entirely. An individual who contributed only the automatic $300 per year could have $38,000 in today s dollars after a 40- year working career. That is enough to produce an after-tax annuity of $250 per month. Someone who contributed the maximum of $1,000 per year, including automatic and matching tax credits, would have $126,000 in the account at retirement. A couple would have a retirement nest egg of over a quarter of a million dollars. Compared with other proposals for tax cuts, the President s proposal for USAs would be much fairer. The proposed 10 percent across the board tax cut, for example, would bestow 66 percent of its benefits on the top 20 percent of taxpayers. The proposal for USAs would provide only 20 percent of the benefits to that group. The USA proposal would help the economy, especially in the long run, by increasing private saving. This increased saving will help increase the capital stock that will be vital to continued prosperity once the baby boomers retire. Other tax cut proposals would stimulate consumption, arguably bad policy for both the short and long run. And the proposal would provide the easiest way to save for retirement available for the 73 million people not covered by employer pension plans, and it would also encourage workers who have access to employer plans to participate in those plans. CONCLUSIONS After two decades of struggling with deficits, the economy now faces the prospect of surpluses for the foreseeable future. Those surpluses reflect extraordinarily good news about the economy and a reward for the fiscal discipline of the 1990s. The surpluses present challenges and opportunities. The main challenge is how to take advantage of the opportunities while advancing the basic tax policy principles of fairness, simplicity, and economic growth, and without abandoning fiscal discipline. The President s proposal for Social Security reform and USAs meets that challenge. Acknowledgments I thank without implication Joel Platt, Marti Thomas, and David Wilcox for 410
7 Surplus Tax Policy? helpful comments. Norma Coe provided invaluable research assistance. REFERENCES Auerbach, Alan J., and William G. Gale. The Case Against Tax Cuts. Brookings Policy Brief. Washington D.C.: The Brookings Institution, March Davidson, Paul, and James K. Galbraith. The Dangers of Dept Reduction. The Wall Street Journal (March 3, 1999): A16. Wray, L. Randall. Surplus Mania: A Reality Check. Levy Institute Policy Notes. Annandale-on-Hudson, NY: Jerome Levy Economics Institute of Bard College, 1999/3. 411
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3 Macroeconomics LESSON 8 Fiscal Policy Introduction and Description Fiscal policy is one of the two demand management policies available to policy makers. Government expenditures and the level and type