The Incredible Shrinking Deficit

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The Incredible Shrinking Deficit

It has long been argued in the popular press that tax cuts create bigger government deficits and that the only sure way to eliminate budget deficits is eliminating so-called tax cuts for the rich. But, if that’s the case, how could the Office of Management and Budget announce that the budget deficit is just 1.5 percent of GDP, or around $205 billion for the fiscal year ending September 30?1

That is half what was expected by the administration a year ago and $43 billion less than the deficit last year. And, why are we on track to a deficit of around $35 billion next year and a surplus beginning in 2012, despite substantial tax cuts beginning in 2002?

It turns out that, contrary to popular belief in some circles, lower marginal tax rates, particularly on investment, work through market mechanisms to raise tax revenues. President Kennedy instituted a tax cut in 1963, which led to a budget surplus and a strong economy through 1969. President Reagan did much the same thing, bringing the economy out of a deep recession, holding down inflation, and winding up with the budget surplus of the 1990s. President Bush’s tax cuts likewise pulled the economy out of the doldrums after the 9/11 terrorists attacks, and despite the housing crisis the Trends editors anticipated, we are now enjoying an economic boom — with low unemployment and low inflation — as we once again head for budget surplus territory.2

Low tax rates give people an incentive to invest and more money to spend. As a result, we can look forward to at least 3 percent real GDP growth over the next four years.

The reason tax revenues are up — and will soon result in a surplus — is that more people are employed and are paying taxes. At the same time, corporate profits are at a historic high, which are driving strong capital gains. And, with a smaller tax bite, investors are more willing to take profits than in previous bull markets that show up as capital gains tax revenues for the government. All of this is leading to strong tax revenues that more than offset the rate cuts that stimulated the growth in the first place.

Unfortunately, that logic is difficult for some people to comprehend. How can the government make money by giving it away? The first answer is that it’s not a give-away. It’s a matter of letting people keep more of the money they’ve earned. The second answer is that we live in a free-market economy. When the marginal tax rates on capital formation go down, the supply of “easy money” goes up, holding down interest rates and expanding corporate liquidity...

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