The Public Policy

How to Balance the Budget

 It can't be done by constantly chasing lower than expected revenues.

By From the July 2010 - August 2010 issue

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President Obama's budget proposes all-time record federal spending of $3.834 trillion for fiscal 2011, up 29 percent from fiscal 2008 and 40 percent from fiscal 2007, which was the last budget adopted by Republican congressional majorities. The deficit for the current fiscal year 2010 is estimated in the president's own budget documents to reach nearly $1.6 trillion, the largest government deficit in world history, up from $161 billion for fiscal 2007. This is what moved Rep. Jeb Hensarling (R-TX) to say to President Obama at the Republican Retreat in Baltimore last January, "What were the old annual deficits under Republicans became the monthly deficits under Democrats."

Moreover, the outlook doesn't improve in the medium term. Over the next 10 years federal deficits under President Obama's budget will total almost $10 trillion ($9.761). The annual deficit by 2020 would still be well over $1 trillion ($1.253) and rising.

As a result, the national debt under President Obama's budget would almost quadruple from $5.8 trillion at the end of 2008 to $20.9 trillion by 2020. Indeed, it would virtually double in just four years from the end of 2008, to $11.6 trillion in 2012.

While campaigning in New Hampshire in September 2008, Obama pledged to the American people:

I can make a firm pledge. Under my plan, no family making less than $250,000 a year will see any form of tax increase. Not your income tax, not your payroll tax, not your capital gains taxes, not any of your taxes. [emphasis added.]

This was not a one-time promise. It was the centerpiece of his campaign, repeated over and over, including during the presidential debates.

But today, after proposing his second budget with record-shattering federal spending, deficits, and debt, Obama is explicitly abandoning this no tax increase campaign pledge, in connection with his appointment of a presidential deficit commission. In an interview with BusinessWeek on February 9, Obama was asked, "If your deficit commission comes back and says we would recommend raising taxes on households earning less than $250,000 a year, would you accept that as part of a larger deal?" He responded,

I don't want to prejudge the commission because the whole point of it is to make sure that all ideas are on the table, and let's see what folks can come up with. What I want to do is to be completely agnostic in terms of solutions.

Obama further revealed the tax increase intent behind the commission in saying, as quoted by the New York Post on February 12, "The notion that somehow we can just cut our way out of this problem is not true."

But the president's budgets with the above deficits and debt already presume $2 trillion in tax increases, mostly focused on those despised "rich" making more than $250,000 a year. Moreover, as the Tax Foundation has carefully documented, before those tax increases even go into effect, the top 1 percent of income earners already pay more federal income taxes than the bottom 95 percent! So we are not going to get still more out of those taxpayers, in any event. Indeed, the presently planned tax increases on those evil "rich" will not raise nearly the revenue expected, which means currently projected federal deficits and debts will be even higher.

This is why Obama, Nancy Pelosi, and the Washington establishment are now talking about massive new tax increases on working people to pay for their spending explosion.

The traditional Washington establishment approach to balancing the budget is to negotiate an agreement on a package of spending cuts and tax increases. This is what Obama's deficit commission seems prepared to do. But this approach never works and has no prayer of ever working. The tax increases are permanently adopted into law. But the spending cuts are never adopted, or if they are they are soon swept away in the next liberal budget.

Then the tax increases don't raise the revenue expected, because, as no one in establishment Washington seems to be able to imagine, tax increases have negative incentive effects that reduce the expected revenue increases. So the deficit reappears, and persists until the voters can be fooled by the whole charade again. We have seen this over and over at the state level as well as at the federal level.

The federal experience goes back to the 1982 budget deal, when congressional Democrats promised President Reagan $3 in spending cuts for every $1 in tax increases. Reagan went to his grave still waiting for those spending cuts.

Then there was the 1990 budget deal, when President Bush agreed to violate his famous 1988 campaign pledge, "Read my lips, no new taxes," in order to get a balanced budget. The budget deficit increased from $221 billion in 1990, to $269 billion in 1991, to $290 billion in 1992, when the voters booted him out office for violating the no tax increase pledge that got him elected.

In 1993, President Clinton tried again, with a Democratic Congress voting through a tax increase as part of another budget deal. By 1995, the new Republican Congress, elected to replace the tax-increasing Democratic Congress, was greeted with a Clinton budget projecting continued $200 billion deficits indefinitely.

House Speaker Newt Gingrich led Congress to try a different approach, the one tried-and-true way to balance the budget, which has worked every time it has been tried. It is a simple two-step process. One, cut tax rates to improve incentives for savings, investment, job creation, business creation, business expansion, entrepreneurship, and economic growth, to get the economy booming. You can't balance the budget by constantly chasing lower than expected revenues. With the economy booming, revenue surges consistently. Step two, cut spending growth, and let revenues surge past it.

The new Republican Congress cut the capital gains tax rate by 40 percent and reduced other tax burdens on capital investment. It also cut total federal discretionary spending, including non-defense discretionary spending, with both actually declining from 1995 to 1996 in nominal dollars. In constant dollars, the decline was 5.4 percent. By 2000, total federal discretionary spending was still about the same as in 1995 in constant dollars. As a percentage of GDP, federal discretionary spending was slashed by 17.5 percent in just four years, from 1995 to 1999. Total federal spending relative to GDP declined from 1995 to 2000 by 12.5 percent, reducing federal spending relative to the economy by one-eighth in five years. The House-passed budget in 1995 actually cut federal spending by a trillion dollars over 10 years, when a trillion dollars was still real money.

As a result, $200 billion annual federal deficits, which had prevailed for more than 15 years, were transformed into surpluses by 1998, peaking at $236 billion by 2000.

This is the approach we should adopt now to balance the federal budget again. We should start with tax reform that will maximize long-term economic growth. The current federal corporate tax rate is 35 percent, approaching 40 percent counting state corporate income taxes. This is the second-highest corporate tax rate in the industrialized world, which leaves American companies uncompetitive in the global marketplace. The EU has slashed its corporate tax rate over the last decade from an average of 38 percent to 24 percent. Germany and Canada are slated to go below 20 percent. Our emerging competitors India, China, and Brazil have lower business taxes as well.

We should cut the federal corporate tax rate from 35 percent to 15 percent to restore international competitiveness for American companies, and adopt an optional flat tax for individuals of 15 percent as well. To offset those cuts, we could close both individual and corporate loopholes, including credits, special deductions, and exemptions. We should follow the Steve Forbes/Dick Armey flat tax model of providing a generous personal exemption of $10,000 per person, exempting the first $40,000 in income for a family of four, so the tax burden would not increase on low --  and moderate -- income workers.
We should keep the capital gains and dividends tax rates also at 15 percent, and abolish completely the counterproductive and unfair estate tax and Alternative Minimum Tax, as multiple taxation of capital is never a good idea.

These measures would establish the revenue base we have to work with, and the government could simply match long-term spending to it. We can save a trillion dollars just by terminating unspent stimulus funding, and ending, rather than refunding, TARP bailouts. For everything else, other than Social Security, Medicare, and Medicaid, we should return to the spending levels of 2007. That was just three years ago, and America was doing fine then. Apply that to national defense as well; 2007 was the height of the Iraq surge, an adequate funding base going forward. This would have the added benefit of demonstrating to everyone the real source of current budget deficits. The budget documents show that this would save an additional $670 billion in annual spending to start, growing over time as the long-term baseline would be lower.

For entitlements, what we need is fundamental structural reforms, not trying to just "cut our way out of this problem." We can start by allowing young workers the freedom to choose to save a portion of their Social Security payroll taxes in their own personal accounts, with the accounts taking responsibility for an equivalent proportion of future Social Security benefits. Because long-run market investment returns are so much higher than what Social Security even promises, let alone what it can pay, workers would actually get higher rather than lower benefits through this option. Consequently, we can back up the accounts with a federal safety net guarantee that workers with the accounts would get at least as much as promised by Social Security.

We can start small and then expand the accounts over time until they finance all the benefits currently financed by the payroll tax, replacing survivors' benefits with life insurance, disability benefits with disability insurance, and even Medicare with health insurance. The payroll tax can consequently be phased out over time as well. These personal accounts dramatically reduce federal spending over the long run by shifting the payment of all these benefits from the public sector to the private sector. There would consequently be no need to cut these promised benefits. They would be replaced over time with better benefits from the private sector.

The general revenues now financing so much of Medicare could be used to provide means-tested vouchers for health insurance for seniors who could not otherwise afford such coverage, with such general revenue expenditures limited to grow no faster than the rate of economic growth. Medicare Advantage should be updated and expanded so that all seniors would be free to choose private coverage for Medicare, including Health Savings Accounts (HSAs).

We should also expand the enormously successful 1996 welfare reforms to the other 85 federal means-tested welfare programs, sending the federal financing for those programs back to the states in the form of finite block grants that do not vary by matching state spending. This includes Medicaid, food stamps, and housing programs. The states would then redesign their entire welfare systems based on work by the able-bodied, with states that succeeded in reducing costs rewarded by keeping the savings, and states that ran up costs paying for that themselves. The 1996 reforms succeeded in reducing the rolls of the old AFDC program by nearly 60 percent nationwide, portending enormous potential savings from expanding these reforms to the entire welfare system.

Medicaid in particular could be reformed by providing vouchers for the purchase of private insurance for the poor, including HSAs, allowing them to escape the poor health care provided through the Medicaid ghetto, and enjoy the same health care as the middle class.

Bringing back the Freedom to Farm policies of the 1990s would phase out agricultural subsidies entirely. We should extend that to eliminating all other corporate welfare as well, exactly contrary to Obama's crony capitalism.

House Republican budget chief Paul Ryan has already shown how similar reforms, including the tax reforms, would permanently balance the federal budget over the long run, as officially scored by CBO, with federal taxes and spending at their postwar average of 18.6 percent of GDP, in addition to achieving full solvency for Social Security and Medicare. Ryan's plan, which he calls "A Roadmap for America's Future," includes financing the transition to personal accounts entirely through the savings from the entitlement and spending reforms. The full reform plan outlined in this article would reduce federal spending by more even than the Ryan Roadmap.

Tragically, however, President Obama's Washington establishment deficit commission won't consider any of these innovative reforms. It is likely instead to demand more taxes from working people through a Value Added Tax, as in socialist Europe, which House Speaker Nancy Pelosi has already endorsed.

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About the Author
Peter Ferrara is Director of Entitlement and Budget Policy at the Heartland Institute, General Counsel of the American Civil Rights Union, Senior Fellow at the National Center for Policy Analysis, and Senior Policy Advisor on Entitlements and Budget Policy at the National Tax Limitation Foundation. He served in the White House Office of Policy Development under President Reagan, and as Associate Deputy Attorney General of the United States under President George H.W. Bush.