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Testimony Before the Committee on the Budget U.S “The Budget and the Economy” Testimony before the Committee on the Budget U.S. Senate Peter R. Orszag1 Joseph A. Pechman Senior Fellow in Tax and Fiscal Policy The Brookings Institution January 29, 2002 Mr. Chairman and Members of the Committee, it is an honor to appear before you to discuss the interactions between the budget and the economy. The focus of my testimony is the economic and budgetary effects of the tax cuts that were passed as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), but that have not yet been implemented. An appendix table to this testimony presents the major provisions in EGTRRA by the year in which they take effect. Assuming that all the sunsets in the legislation are removed, the long-term cost of the tax bill as a whole is roughly 1.6 percent of GDP.2 About half of that long- term cost reflects provisions that are already in effect, and the other half reflects provisions that take effect after 2002. The tax cuts that have already taken effect have supported aggregate demand in the economy at a time when such stimulus was beneficial. For example, the rebates sent out in August and September provided timely stimulus to the economy by helping to boost consumer spending in a weak economy. The early evidence, however, suggests the beneficial impact was likely to have been quite modest. The evidence suggests that most households saved, rather than spent, the rebates. 3 The focus of my testimony, however, is the tax cuts that are scheduled for future years, not the ones already in place. Although the future scheduled tax cuts have some benefits, their economic costs outweigh their economic benefits in both the short run and the long run. To summarize my results: · The tax cuts scheduled for the future raise long-term interest rates and therefore impede economic activity today. The important linkage between future fiscal policy and long-term 1 The views expressed in this testimony are those of the author and should not be attributed to the staff, officers or trustees of the Brookings Institution. I thank Robert Cumby, William Gale, Robert Greenstein, Richard Kogan, and Gene Sperling for helpful discussions, and David Gunter and Jennifer Derstine for excellent research assistance. For further discussion of many of these issues, see Peter Orszag and Robert Greenstein, “Future Tax Cuts and the Economy in the Short Run,” Center on Budget and Policy Priorities, January 28, 2002. 2 This figure reflects the present value of the tax cut relative to the present value of GDP over the next 75 years, using the same discount rate as applied by the Social Security actuaries under their intermediate cost estimates for that period and assuming that all sunsets in EGTRRA are removed. 3 See Matthew Shapiro and Joel Slemrod, “Consumer Response to Tax Rebates,” NBER Working Paper 8672, December 2001. It should be noted that the tax cuts already in effect have contributed to higher long-term interest rates (as have the tax cuts not yet in effect), so the net impact on the economy in the short run from the already implemented cuts is unclear and may not be positive. 1 interest rates is recognized in all major macroeconomic models (such as that of the Federal Reserve), as well as in analyses by such noted policy-makers and economists as Chairman Greenspan, former Secretary Rubin, the Council of Economic Advisers under the Reagan Administration and the (first) Bush Administration, Professor Martin Feldstein of Harvard, and Professor John Taylor (the current Undersecretary of the Treasury for International Affairs). · Any short-run benefit from the scheduled future tax cuts -- which could arise if the tax cuts induced households to spend today based on the expectation of lower taxes in the future -- is likely to be minimal. Evidence, including from the phase-in of the 1981 Reagan tax cuts, strongly suggests that households do not respond to tax cuts until they take effect. In any case, any potential positive effect in the short run from future tax cuts is likely to be dominated by the negative effect from higher interest rates. · The long-run benefits of the tax cuts scheduled for the future are similarly minimal because any positive incentive effects from lower tax rates in the long run are offset by the adverse effects from lower national saving. The overall effect of the yet-to-be-implemented tax cuts on economic activity in the long run may, if anything, be negative. · The nation faces severe budgetary pressures as the baby boomers begin to retire. The tax cuts scheduled for the future make these budgetary pressures more severe. For example, the tax cuts not yet implemented cost about 0.8 percent of GDP in present value over the next 75 years, which is slightly larger than the projected deficit in Social Security over the same period. In addition, the future tax cuts disproportionately benefit high-income households, raising the issue of whether proceeding with the scheduled reductions will benefit high- income families (who will disproportionately enjoy the tax reductions) at the expense of low- and moderate-income families (who may disproportionately bear the burden of any spending reductions necessitated by the future tax cuts and the desire to avoid excessive debt levels). · In light of the long-term budgetary pressures facing the nation, as well as the confusion created by the sunsets in EGTRRA, a possible compromise would freeze the tax cuts that have not yet taken effect while also removing the sunset on the tax cuts already in effect. More precisely, the compromise would freeze the tax cuts that have not yet been implemented until the projected 10-year surplus outside Social Security is as large as it was immediately following passage of the tax cut. But to clarify budget accounting and eliminate any ambiguity about whether the tax cuts already in effect will be continued, the compromise would also remove the sunsets on the tax cuts that have already been implemented. Short-run economic effects of scheduled future tax cuts The scheduled future tax cuts adversely affect the economy in the short run because financial markets are forward-looking, and the fiscal deterioration caused by the future tax cuts therefore raises long-term interest rates today. The increase in long-term interest rates, in turn, increases the cost of business investment and home mortgages – and restrains economic activity. 2 There are two ways to see how the scheduled tax cuts affect shorter-term interest rates in the future, and therefore affect longer-term interest rates immediately: · First, one effect of the future tax cuts is that the government will be saving less than it otherwise would (i.e., it will be running smaller surpluses). As a consequence, the pool of saving available for investment will be reduced. Firms competing for this smaller pool of investment funds will push up the price of borrowing funds -- that is, raise future interest rates. · An alternative, but fundamentally equivalent, way of grasping the relationship between the tax cut and interest rates recognizes that the amount of debt the government is projected to pay down in the future will be smaller (and the national debt will consequently be larger) as a result of the tax cut. The amount of Treasury bonds held by the public will therefore be higher in the future than it would be without the tax cut. To persuade investors to hold more bonds, the government will have to offer a higher interest rate. The scheduled tax cuts thus exert upward pressure on future interest rates. Since financial markets determine long-term interest rates today largely on the basis of what they expect shorter-term interest rates to be in the future, the expected increase in shorter-term interest rates in the future drives up long-term interest rates now. By raising long-term interest rates now, tax cuts scheduled for the future discourage investment and interest-sensitive consumption, thereby impeding economic activity today. Recent interest rate movements It is perhaps instructive to review what has happened to interest rates recently. Over the past year, as the Federal Reserve has moved aggressively to bolster a weakening economy, short- term interest rates have declined sharply. Between the beginning of 2001 and the beginning of 2002, for example, the interest rate on 3-month Treasury bills fell from 5.5 percent to 1.7 percent. Normally, when short-term rates decline, long-term interest rates tend to do so as well. Over the past year, however, long-term rates have remained fairly flat despite the steep decline in short-term rates. The interest rate on 10-year Treasury bonds actually increased slightly during 2001, from 5.0 percent to 5.2 percent. In other words, short-term interest rates have declined substantially but long-term rates have not. Although the precise relationship may depend on many factors and fluctuates over time, long-term rates have tended to move by about half as much as short-term rates, on average, over the past two decades.4 Based on this historical relationship, the 3.8 percentage point decline in short-term rates during 2001 should have corresponded to a decline in long-term rates of a bit 4 A regression of the annual change in the 10-year constant maturity yield on the annual change in the 3-month constant maturity yield from 1982 to 2001 yields a coefficient on the change in the 3-month yield of 0.52 (using the Prais-Winston transformed regression estimator to address serial correlation in the errors).
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