Part VIII

I have written a lot about raising taxes to increase revenue but there is another school of thought on the topic of raising revenue and it is best explained by talking about pie.

Governments like revenue and people like pie. If you want to get your hands on more pie your options are very similar to the options a government has to get more revenue. You either have to cut bigger slices (like cutting the pie into fourths as opposed to eights), or bake a bigger pie (each of the eight slices are bigger). Some politicians and economists argue that the best way to raise more revenue is not to tax people more (take a bigger slice), but rather to help people make more money. The government is still taking the same percentage but it is getting more because people have more money (bake a bigger pie so your share is bigger).

So how does the government “bake a bigger pie?” To do this the government has to encourage economic growth. This is a tricky business for our government because we live in a capitalist nation were the government has limited control over the economy. A good way to think about it is like doctor who is treating a patient with medication. The doctor knows that the medication will most likely help but the doctor cannot say exactly how effective the medication will be or how long it will take to be effective because not all patients respond the same way. So doctors will often try different medications at different doses to get the desired effect with the least amount of side affects. This is very similar to how a government would try to boost its national economy. The government knows that certain actions will encourage economic growth, for example lowering taxes, but there is no formula that shows if the government lowers taxes by "X" than it will grow the economy by "Y".*

But assuming that the government could consistently grow the economy could it balance the budget by doing it? Lets look at couple of factors to determine what is realistically possible.

So how fast can we grow the economy?

It is hard to say but we can use some historical benchmarks. From 1993 to 2000 the US experienced huge financial growth with only minimal inflation. The economy was booming and unemployment steadily dropped and the federal government was able to have a huge increase in tax revenue and balanced the budget for the first time in decades. From 1993 to 2000 there was a 56.9% increase in tax revenue. That is an average of 7.1% a year. When you factor in inflation the Federal government’s revenue was increased by 4.5% on average a year. Given that the 1990’s were considered a boom time, lets use this rate as yard stick for excellent economic growth.

So how does this growth balance the budget?

If we keep making more money and do not spend any more, eventually we will balance the budget. So it is not a matter of if it would work how long would it take?

So can we do it? Can we “out grow” the deficit?

Sadly no. Assuming that starting in 2011 the American economy starter growing at the rates comparable to the 1990’s (4.5% a year) it would take 11 years to balance the budget. That is 7 years longer than the actual 90’s boom (which was the longest period of economic expansion in US history) and that is not to pay off the debt, that is simply to start paying down the debt. To make matters worse this figure assumes that the government would never raise spending levels for 11 years. If the government continues to increase spending at the same rates that it has from 2000 to 2010 (an average of 19.3% per year) we would never balance the budget, even if the economy grew at 90’s boom levels forever.

But what if we freeze spending completely and did not adjust it for inflation?

In a way this be the equivalent to a 2.6% decrease in the federal budget each year and it would take 7 years to balance the budget, all the while, the deficit would be growing. Also keep in mind that the 7 year period of growth was the largest in history and would be difficult to reproduce.

So what is the verdict?

By the numbers:

How many years would we need of 1990’s level economic expansion to balance the budget:

Freezing the budget at 2010 and adjusting for inflation: 11 years
Freezing the budget at 2010 and not adjusting for inflation: 7 years
Budget increasing at the average rate from 2000 to 2010: Never

The verdict

If we could maintain 11 years of 1990’s level economic expansion and Congress limited all spending increases keeping up with inflation, along with some reductions in spending to counter balance an increase in the interest rates from the national debt, it could be done in 11 years. Is this possible? I would argue no because even if we could manage an unprecedented 11year economic boom we could not freeze spending for that long. Congress’s financial restraint aside we would need a major cuts to Social Security to keep spending from increasing because the first of the baby boomers will be 65 in 2012 and will be eligible for full Social Security retirement.

*Welcome to the bonus topic!

There are probably dozens if not hundreds of theories on how to grow the economy but for simplicity's sake let's just look at one of the most popular theories, cutting taxes. Can cutting taxes increase tax revenue? Lets look at the numbers.

Let's pretend we are looking a fictional country so that we are dealing with smaller round numbers. Let’s imagine there is a nation called Taxcutistan whose citizens and businesses have $100 in taxable income and a government that collects 20% of that income in taxes giving the government $20 in revenue. Now let's say that Taxcutistan elected a new president who wants in increase revenue to $21 by cutting taxes, so he proposes reducing over all rates from 20% to 19% in the hopes of growing the economy. To collect the extra $1 in revenue by reducing taxes the taxable incomes would need to grow to $110.6 or by 10.6% annually (remember that 4% to 5% is considered really good). If the president was really ambitious and was wanted to increase revenue by $5 by reducing taxes to 18% taxable incomes would need to grow to $138.8 or by 38.8% annually.

Whether you are dealing with Taxcutistan or the US these same ratios hold true. So could you have balanced the budget in 2010 by cutting taxes? No, and the reason is that we would need to increase tax revenue by 67.2%. That means that a tax cut of 5% would need to grow the economy by 524% and based on how fast the economy has historically grown this is impossible (remember that 4% to 5% is considered really good).

Now this does not mean that tax cuts cannot be used to increase revenue it just means that it is not a short-term solution. For example, it would it may be unlikely that the US economy could grow 10.6% in a year, but it could do it in two or three good years. Based on these numbers I would say that tax cuts are not a good way to deal with the deficit, but after the budget is balanced they could potentially be a good way to pay down long-term debt.