Kevin A. Hassett
If you listen to Clinton, the restoration of "fiscal sanity" and resumption of higher tax rates will have a profound positive impact on every corner of the economy.
Clinton and her Democratic competitors have a big problem. The facts don't support their negative characterization of the Bush tax cuts. Indeed, everything Bush's opponents said would happen after taxes were reduced didn't happen.
GDP growth during the past year has been 2.6 percent, compared with 0.8 percent in 2001.
Recall that supporters of marginal-tax-rate reductions argued that the lower rates would induce individuals and firms to work more and take more risks. This heightened activity would lift the economy and, over time, even help the Treasury recapture a good bit of the revenue lost when the rates were initially cut.
Opponents warned that increased deficits would limit or even overpower the effects of the tax cuts by driving up interest rates.
Both schools of thought could, in theory, be correct. If individuals don't respond much to reduced tax rates, but debt markets respond a good deal to growing deficits, then tax cuts would provide little benefit.
Back in 2001, when the first Bush tax cuts were being debated, these arguments were laid out by numerous economists on both sides of the issue. One meme making its way through Washington was the assertion that a sustained increase in the deficit relative to gross domestic product of 1 percent would lift long-term interest rates by 50 to 100 basis points. That, the story went, would offset any positive stimulus from lower marginal rates.
Looking back at more than six years of economic history since the Bush tax cuts, two observations stand out. First, the deficit increased much more than was expected at the time Bush took office.
Even after accounting for the tax cuts, for example, the Congressional Budget Office forecast that there would be a cumulative surplus between 2001 and 2010 of $564 billion. Instead, including current projections, there was a deficit over that period of $3.7 trillion.
Rates Never Rose
Second, interest rates never rose. Even though the change in the fiscal situation was at least twice as large as the anticipated 1 percent of GDP, interest rates have been lower than they were in 2001 for almost Bush's entire presidency. Bush took office on Jan. 20, 2001, a time when the 10-year Treasury bond yielded 5.17 percent. Today, it yields about 4.28 percent and has been well below 5.17 percent on average every year in between.
Fine, a skeptic might say, but other things changed. True, but they also changed in a direction that would suggest interest rates should be higher. Inflation has surprised on the upside because of high energy prices. GDP growth during the past year has been 2.6 percent, compared with 0.8 percent in 2001.
Interest rates in the U.S. are low, of course, because rates everywhere else are, too. Government debt from the U.S. is a close substitute for debt from many other countries, and their rates move in tandem. A global savings glut and a flight to safety are far more important determinants of U.S. interest rates than the Bush deficits.
One can only conclude from such evidence that the link between swings in the U.S. fiscal situation and interest rates, never very strong to begin with, has become impossible to detect. As Harvard economist Kenneth Rogoff recently wrote in the Financial Times, "Explosive financial globalization has made U.S. federal budget policy far less important as a determinant of global real interest rates."
But if we accept that global markets have mostly severed the tie between deficits and interest rates, another question emerges. Exactly how is it that the Bush tax cuts have harmed the economy?
John Edwards seems to be the first of the Democratic candidates to look at the data and accept that deficits might not be so bad. Edwards's policy director, James Kvaal, recently commented, "Investments in health care, energy and education... are more important for our economy, even if that means sustaining the deficit for a while." It shouldn't be long before Clinton and Barack Obama come to the same conclusions.
Up, Up, Up
This means if Democrats win, despite the utterances of the presidential candidates, the deficit is going to go up as tax dollars are steered toward health care and other Democratic favorites. Taxes will go up, too, as the Bush tax cuts expire, and the economy will suffer.
If, on the other hand, Republicans win, then they will extend the Bush tax cuts, and the deficit will go up. The extension of the low marginal tax rates will provide continued economic benefits.
Either way, you can be sure that the Bill Clinton-era dogma about deficits and interest rates will be a thing of the past.Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.