Wednesday, September 3, 2014
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Four Magic Tricks for Fiscal Conservatives

CAMBRIDGE – The United States is famous for its ability to innovate. Aspiring fiscal conservatives around the world thus might be interested in learning four tricks that American politicians commonly use when promising to cut taxes while simultaneously reducing budget deficits.

These are hard promises to keep, for the simple reason that a budget deficit equals government spending minus tax revenue. But, each of the four tricks has been refined over three decades. Indeed, they first acquired their colorful names in the early years of Ronald Reagan’s presidency: the “magic asterisk,” the “rosy scenario,” the Laffer hypothesis, and the “starve the beast” scenario. As shop-worn as these tricks are, voters and journalists still fall for them, so they remain useful tools for anyone posing as a fiscal conservative.

The first term was coined by Reagan’s budget director, David Stockman. Originally, it was an act of desperation, because the numbers in the 1981 budget plan did not add up. “We invented the ‘magic asterisk,’” Stockman wrote in The Triumph of Politics in 1986. “If we couldn’t find the savings in time – and we couldn’t – we would issue an IOU. We would call it ‘Future savings to be identified.’”

Ever since, the magic asterisk has become a familiar American device. Recent examples include the recommendation of the Simpson-Bowles commission – tasked in 2010 with charting a fiscal-consolidation path – to cut real spending growth by precise amounts, without saying where the cuts would be made. US presidential candidate Mitt Romney’s spending plans contain the same conjuring trick. So, too, his plan to eliminate enough tax expenditures to offset the $5 trillion in revenue lost from cutting marginal tax rates by 20%, while refusing to say which tax loopholes he would close.

As Election Day nears, the pressure on a candidate to be more specific grows. The conjurer thus resorts to the rosy scenario: since he cannot find enough tax loopholes to eliminate, he must claim that what he meant by closing the revenue gap was that stronger economic growth will bring in the additional revenue.

Here, Murray Weidenbaum, the chairman of Reagan’s first Council of Economic Advisers, deserves the credit for inventing what he called “perhaps my most lasting legacy.” In its early years, the Reagan administration forecast 5% income growth (twice the long-run average), in order to imply in its projections a boost to revenues big enough to make up for its many tax cuts. Since then, candidates of both major US political parties have relied on rosy scenarios.

Indeed, overly buoyant official growth forecasts are a fact of life in almost all of a sample of 33 countries, contributing to overly optimistic budget forecasts. European governments are particularly biased. From 1991 to 2010, for example, Italy forecast growth rates at the three-year horizon that were, on average, 2.3 percentage points above what was actually achieved.

In the Republican primaries last year, candidate Tim Pawlenty assumed a 5% growth rate to make his own plan work. He was all but laughed out of the race. Romney probably cannot get away with this sleight-of-hand, either. The press asks, “Why should we believe that the growth rate will magically accelerate just because you become president? Where will this GDP come from? It sounds like pulling a rabbit out of a hat.”

Right on cue, it is time for the famous Laffer hypothesis – the proposition, identified with the economist Arthur Laffer and “supply-side economics,” that reductions in tax rates are like magic beans: they so stimulate economic growth that total tax revenue (the tax rate times income) goes up rather than down.

One might think that the Romney campaign would not resurrect so discredited a trick. After all, two of his main economic advisers, Glenn Hubbard and Greg Mankiw, have both authored textbooks in which they argue that the Laffer hypothesis is incorrect as a description of US tax rates. Mankiw’s book, in its first edition, even called proponents of the hypothesis “charlatans.”

Each Republican presidential candidate since Reagan has had good economic advisers who disavow the Laffer hypothesis. Yet, time and again, the president (or candidate), his vice president (or running mate), and his political aides eventually rely on Laffer’s flawed argument. And they, not academic economists, formulate policy. Hubbard and Mankiw advised former President George W. Bush in his first term, when he cut taxes and transformed a record surplus into a record deficit.

The final trick, “starve the beast,” typically comes later, if and when the president has enacted his tax cuts and discovers that smoke and mirrors do not trump reality. He cannot find enough spending to cut (the magic asterisk has disappeared up the conjurer’s sleeve); the acceleration in GDP is nowhere to be seen (the rosy scenario having vanished); and tax revenues have not grown (no rabbit in the Laffer hat).

The audience is now told that losing tax revenue and widening the budget deficit was the plan all along. The performer explains that the deficit is all the fault of congress for not cutting spending and that the only way to tame the beast is to raise the budget deficit because “Congress can’t spend money it doesn’t have.” This trick never works either, of course. Congress can, in fact, spend money it doesn’t have, especially if the president has been quietly sending it budgets that call for just that.

By the time the crowd realizes that it has been conned, the magician has already pulled off the greatest trick of all: yet another audience that came to see the deficit shrink leaves the theater with the deficit bigger than before.

Read more from our "Fiscal Cliff Notes" Focal Point.

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  1. CommentedWayne Barker

    Ah, Mr. Frankel just because you say we are not on the down-side of the Laffer curve (where higher tax rates bring in less tax revenue) doesn't mean it is so.

    Recent (last 20 to 30 years) evidence points to the contrary--American tax revenues have consistently risen after tax-rate cuts.

      Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Wayne Barker:
      Of course tax revenues are always on a long-term upward trend, just like most economic quantities, due to inflation and real growth in the economy. Is that what you mean? Federal tax receipts fell from 19.6 % of GDP to 17.5 after President Reagan cut tax rates in 1981 and from 20.9% to 15.7 after George W. Bush cut tax rates in 2001. If you think you have seen good econometric evidence that reductions in tax rates have led to an increase in tax revenue, I wonder what it is. I reviewed the literature in my "Snake Oil Tax Cuts" paper, and the evidence was pretty clear the other way. The failure of the Laffer hypothesis is a big part of why the Reagan and Bush tax cuts were each followed by record increases in the budget deficit as a share of GDP. Reagan and Bush should have listened to their Council of Economic Adviser Chairs -- Feldstein, Hubbard, and Mankiw -- all of whom have consistently written and said that the Laffer proposition does not hold. So it's not just me who is saying we are not on the downside of the Laffer Curve, as you suggest.

      Jeff Frankel

  2. CommentedCarol Maczinsky

    Unresolved federalism balance and a lack of ethnic cohesion of the United States which leads to a lack of solidarity in society. I mean, it is outrageous that the US is even unable to get full public support for a universal health insurance because their "people" do not feel as a community. Because there is a tendency of fragmentation and a lack of cohesion. Ironically the US population backs military keynesianism. The laffer curve is just a tool. The substance is that the population has no allegeance to the state. Ideally the US should create a new level of regional governments between states and Washington.

  3. CommentedKodjo Adadevoh

    The recent increase in spending by the government in the face of a 1 in 80 year economic event is clearly the right thing to have done. I cannot imagine what the state of the economy would be without the necessary intervention. When the economy goes into free fall, the short term remedy is government spending, since the private sector is in no position to remedy the situation.

    The issue with debt and deficits has everything to do with the growth in the economy (slow at the moment) and what the US decides to spend the tax receipts on. If the US continues to fulfill the role of world police, maintaining over 150 bases all over the world and spending money on arms that are outdated (borrowing money to do this), then where on earth is the fiscal restraint. Isn’t it obvious that the remedies for overcoming structural problems are to rework the system to stimulate a resurgence of manufacturing in the US and increase the wealth of the middle and lower class? The path is a long one but necessary one. The US has to first start with a national consciousness and decides on what things are in the national interest. Education is paramount and the type of education is even more important. Job mobility, retraining, and appropriate government incentives are the engines for progress. Make no mistake, tax rates can be a negative or positive engine for growth, the argument always is what levels are appropriate. I have always favored the idea of a flat tax rate; it removes all of the mystery and contention from the picture. Clearly tax reform is absolutely necessary; it is really hard to fathom how millionaires can be paying 14% in taxes. This is not an issue of tax warfare, it is simply an issue of overcome the debt and deficit, every citizen has to contribute their share to moving the country off of life support. It is a fact that the US started this unending period of deficits and debt during the Reagan administration, so it is worth a further examination to determine how to get the country back on track, even if it requires more taxes by the rich. There is ample room on the linear portion of the Laffer curve, from zero to close to the peak without disincentivising the rich!

  4. CommentedJoshua Ioji Konov

    It will be very truthful if China's economic policies are included into the consideration in context of this article, even when China is an emerging market, in recession and post recession times of an export oriented economy China's flexibly used the complete variety of economic tools in a random "as it comes; as it goes" approach. From tax-breaks, subsidies, security loans to raising individual income, and building up an equity headed monetary policy. The division between politics and economics is beyond comprehension. whereas the first is regressive but the second adequate and progressive. In context with the Laffer hypothesis, in a globalizing open market and rising productivity it is not actual to comprehend market processes. Proper counter-cyclical and raising market security approach close to the Chinese one but with political freedoms is the name of the game.

  5. Portrait of Jeffrey Frankel

    CommentedJeffrey Frankel

    To Mark Pitts:
    Please show where I say anything good about the fiscal policies of Greece and the other countries you mention. I have many times written that the problem is that they failed to address their budget problems during the expansionary phase in the world economy, which is precisely the failure of Reagan in the 1980 and Bush in the 2000s, and is precisely what Clinton got right in the 1990s.
    You ask what I suggest for taming the deficit. I have written on this many many times, including during the period when VP Cheney said that "Reagan showed that deficits don't matter." I have given lots and lots of specifics (all of them very unpopular politically of course). In the event that you are actually interested, you could start with these very specific blog posts:
    http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/12/01/ten-ways-to-move-the-budget-back-toward-a-sustainable-path/ ; http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2010/02/08/limit-tax-expenditures/ ; http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2010/06/27/time-to-grab-the-third-rail-address-the-fiscal-problem-by-social-security-reform/ .
    Jeff Frankel

  6. CommentedMark Pitts

    Don't trust anyone over 35.

    Krugman says the government should borrow as much as possible today because interest rates are low. But that is exactly what Greece, Portugal, Ireland, Italy, etc. did when their rates were low. How’s that working out for them?

    Many Dems apparently believe we are the chosen country that can somehow defy the laws of economics. But if we borrow like madmen today, what happens if rates go up in the future when it is time to roll over that debt? What if growth does not pickup, even after all the spending? Where will the money come from to pay the interest and principal? From education? Social Security? Medicare? From higher inflation that crushes savers? From higher taxes on those who are still working?

    Certainly, we cannot be sure that the fiscal conservative argument will yield the desired result. But look at the suggested alternatives.

    If you’re under 35, think ahead!

  7. CommentedMark Pitts

    Easy to see problems. Much harder to solve them.

    So what does the genius Prof. Frankel suggest for taming the deficit? Nothing. He too is silent on specifics.

  8. CommentedMichael Griffin

    Is the Laffer Curve's problem with non-existence or is it with ideologues who assume (or pretend) that society is on the descending side of the peak?

      CommentedMark Pitts

      Laffer Curve has to exist: Start at zero revenue (when tax rates are zero), and end at zero revenue (when tax rates are 100%), and you are pretty much guaranteed that you get an upward sloping curve that turns and then goes back downward.
      The disagreement is where we are on the curve.
      Reagan and Bush II used tax breaks to combat recessions. The question is whether or not the same strategy would work today.

  9. CommentedColin Wiles

    I much rather live in Singapore, Australia, Canada or the US than live in Greece, France, Italy, or Spain. Feel free to move to one of those countries Jeffrey Frankel if you believe in their fiscal policies so much.

      CommentedColin Wiles

      @Jeffrey Frankel - It seems that all our comments were directed to you but relating to another article. I agree with much of what you argue in this post - but this was not what I was commenting on 2 months ago.
      Read more at http://www.project-syndicate.org/commentary/fiscal-conservatives--four-tricks-by-jeffrey-frankel#O1OEXRd6Myq1BdJp.99

      Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Colin Wiles,
      Your comment is very puzzling. I have written repeatedly about the problem of politicians who follow procyclical fiscal policy (failing to take advantage of boom periods to run surpluses) which includes Greece and the other Mediterranean countries you name -- and which also describes the behavior of Republican leaders in the US over the last three decades or more. May I suggest that you read either "The First World's Fiscal Follies," at Project Syndicate; or "The Procyclicalists" at VoxEU (at http://www.voxeu.org/article/procyclicalists-fiscal-austerity-vs-stimulus); or my blogpost "Procyclalists Across the Atlantic Too" (at http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2012/07/30/procyclicalists-across-the-atlantic-too/). When I say that we should try to follow the fiscal policies of countries like Singapore, rather than those of Greece and Italy, how can you tell me that I should move to Greece or Italy if I believe their fiscal policies so much. Perhaps you meant to comment on somebody else's column and it ended up here by mistake?
      Jeff Frankel

  10. CommentedDave Thomas

    I love the fictions of liberal professors of government. According to them FDR's New Deal is the best thing since sliced bread as long as you ignore the fact that all that taxing and spending never reduced unemployment below 14%. LBJ's Great Society and the liberal Democrats that controlled Congress throughout the 1970's produced the stagflation decade with their policies, but you need catch liberal professors of government owning up to that failure of Statism. Finally the Obama stimulus, cash for clunkers, the General Motors bailout and Obamacare were supposed to spur a dramatic recovery until they didn't and then the excuses flowed.

    Excuse me Dr. Frankel, but you are trying to put lipstick on the liberal Statist economic pig when you start attacking fiscal conservatism.

    All Americans have to do is look at France, Spain, Greece, Portugal, Ireland, and Italy to get a smell of what you are shoveling.

    Are you professors of government supposed to know what works?

      CommentedColin Wiles

      @Jeffrey Frankel - It seems that all our comments were directed to you but relating to another article. I agree with much of what you argue in this post - but this was not what I was commenting on 2 months ago.

      Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Dave Thomas: Again with the fiscal policies of Italy and Greece! Are you all commenting on some column by some other Jeff Frankel? And also please show me where I have ever said that FDR's New Deal was the greatest thing since sliced bread, or anything along those lines. But at least one of your wild guesses about what I must believe is correct: I do think that the Obama fiscal stimulus quickly helped turn around the economic freefall in the economy. In the millisecond before you scoff, please pause and look at the graphs I used in my Project Syndicate column or blog in February (at: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2012/02/20/did-obama-turn-around-the-economy/). Obviously it wasn't big enough to rapidly restore full employment, which is precisely what we "liberals" said at the time.

      Jeff Frankel
      Jeff Frankel

  11. CommentedProcyon Mukherjee

    Martin Feldstein in his seminal analysis ‘Effects of taxes on economic behavior' has come out with the two basic issues that politicians (and their economic advisers) fail to consider; their bias towards certain specific denouements make evidence a prisoner of their firm belief.

    First of all the assumption of constant GDP while estimating revenue effect from tax changes under various scenario of marginal tax rates is wrong. Secondly behavioral responses and elasticity could be very different amongst the target people and needs to be ascertained.

    Finally if monetary policy is loose and it is hanging at the lower bound, loose fiscal policy simultaneously would need to be directed towards specific earmarks that generate economic gains aimed at employment boosting.

    Procyon Mukherjee

  12. CommentedThomas Haynie

    Man I can’t say enough good things about this site/publication.

    Excellent article. My own search into the validity of Laffer Curve AT BEST lead to a blog that suggested that IF it exists the curve is multi-peaked. I tried to articulate it with econometric methods and quickly learned that I’m not up to the task. . . later I’d learn that the issue is that it likely does not exist.

    What gets me is how organizations like CATO, Freedom Works, and Heritage Foundation can continue to promote these ideas and get away with it.

    Is this not a serrious problem in our society and political process?

      Portrait of Jeffrey Frankel

      CommentedJeffrey Frankel

      To Thomas Hayne: Thank you !

      To Mark Pitts: You are right, of course. As I think everyone recognizes, the tax revenue curve does eventually turn down at sufficiently high tax rates. I think this idea appeared in standard public finance textbooks long before Jude Wanniski ever assigned Arthur Laffer's name to it. I give three examples of contexts in which governments do end up -- in practice, not just in theory -- on the wrong side of the curve in an article titled "Snake Oil Tax Cuts (at http://www.hks.harvard.edu/fs/jfrankel/TaxCutSnakeOilSept16-08.pdf ; it is Box I on page 6-7) But the question, as you say, is whether this applies with respect to the US income tax rate in modern times. And the answer is "no."
      Jeff Frankel

      CommentedMark Pitts

      The Laffer Curve has to exist: Start at zero revenue (when tax rates are zero), and end at zero revenue (when tax rates are 100%), and you are pretty much guaranteed that you get an upward sloping curve that turns and then goes back downward.
      The disagreement is where we are on the curve.

      Commentedlee kus

      We have found the silver-tongued devil and it is us. We will get the government we deserve.

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