Politicians who advertise themselves as “fiscal conservatives” sometimes campaign on crowd-pleasing pledges to cut taxes and simultaneously reduce budget deficits.  These are difficult promises to deliver on in practice, since the budget deficit equals government spending minus tax revenue.

Aspiring fiscal conservatives may be interested in learning four innovative tricks that are commonly used by American politicians who like to promise what seems impossible.   Each of these feats has been perfected over three decades or more.  Indeed they first acquired their colorful names in the early years of the Ronald Reagan presidency:

1. The “Magic Asterisk”
2. “Rosy Scenario”
3. The Laffer hypothesis
4. The “Starve the Beast” hypothesis.

As shop-worn as these four conjuring tricks are, voters and journalists continue to fall for them. Thus they remain useful equipment in the repertoire of the 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 didn’t add up.  “We invented the ‘magic asterisk’:  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.’” [p.124]   Since that time the Magic Asterisk has become a familiar device in the American policy arena.   Recent examples include the recommendation of the Simpson-Bowles commission to cut real spending growth by precise amounts, without saying where.   US Presidential candidate Mitt Romney has done the same in his spending plan.    Another current application of the Magic Asterisk is Romney’s plan to eliminate enough tax expenditures to make up the revenue lost by cutting marginal tax rates by 20% (which is $5 trillion in revenue), while steadfastly refusing to say what tax expenditures he would eliminate.

As Election Day nears, the pressure on a candidate to get more specific grows.  The conjurer is thus forced to go to Trick Two:  since he can’t 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 added revenue.   The most popular magician’s assistant of all time makes her encore on the stage.  Murray Weidenbaum, Reagan’s first Council of Economic Advisers Chairman, deserves the credit for originally dreaming up Ms. Rosy Scenario, “perhaps my most lasting legacy” [p.57].  The Reagan Administration in its early years 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 cut measures [p.93-97].   Since then candidates of every party have made use of Rosy’s talents.

Indeed official growth forecasts are systematically overly optimistic in almost all of a sample of 33 countries, contributing to overly optimistic budget forecasts.   European governments are particularly biased.

In the Republican primaries last year, candidate Tim Pawlenty assumed a 5 per cent growth rate to make his own plan work.   He was all but laughed out of the race.  Mitt Romney probably can’t 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 Trick 3.

Trick 3 is the famous Laffer Hypothesis.   This is the proposition, identified with “supply side economics,” that reductions in tax rates are like magic beans:  they stimulate economic growth a lot — so much so that total tax revenue (the tax rate times income) goes up rather than down.   One might think that the Romney campaign would never resurrect such a hoary and discredited trick.  After all, two of his main economic advisers, Glenn Hubbard and Greg Mankiw, both have textbooks in which they say that the Laffer Hypothesis is incorrect as a description of US tax rates.  Mankiw’s book, in its first edition, even called its proponents “charlatans.”  But the historical record is that each Republican presidential candidate since Reagan has had good economic advisers who disavow the Laffer Hypothesis.  Yet time and again the president (or candidate), and his vice president (or running mate) and his political aides read from a script that relies on the Laffer logic (Appendix I). They are the ones who make the policy if the candidate wins, not the academic economist.   George W. Bush had these same two top economic advisers in his first term, Hubbard and Mankiw, when he cut taxes and transmogrified a record surplus into a record deficit.

Trick 4, “Starve the Beast,” typically comes later, if and when the president is elected, has enacted his tax cuts, and discovers that smoke and mirrors don’t work against hard fiscal reality. He can’t find enough spending to cut (Magic Asterisk has disappeared up the conjurer’s sleeve); the acceleration in GDP is nowhere to be seen (Rosy Scenario has vanished in thin air); 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 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 “conservative” president has been quietly sending it budgets every year that call for that.   “Starve the Beast” as a budget strategy, like the other three, dates back to the first Reagan Administration. (Bartlett, 2007, p.6-7.)

By the time the crowd realizes it has been had, the confidence man has pulled off the greatest trick of all:  yet another audience who came to see the deficit shrunk instead leaves the theater with the deficit bigger than when it came in.

References
Bruce Bartlett, 2007, “‘Starve the Beast’ Origins and Development of a Budgetary Metaphor,”The Independent Review, XII, 1, summer, 5-26.
Jeffrey Frankel, 2008, “Snake-Oil Tax Cuts,” Economic Policy Institute, Briefing Paper 221, September.
–2011, “Over-optimism in Forecasts by Official Budget Agencies and Its Implications,” Oxford Review of Economic Policy vol.27, no. 4, 536-562. NBER WP 17239; Summary in NBER Digest.
David Stockman, 1986, The Triumph of Politics: Why the Reagan Revolution Failed (Harper & Row).
Murray Weidenbaum, 2005, Advising Reagan: Making Economic Policy, 1981-82 (Washington Univ., St.Louis).

[A version of this column appeared earlier at Project Syndicate, which has the copyright.  Comments can be posted there.]

President Obama proposes allowing the Bush tax cuts to expire next year — as they are scheduled to do if nothing is changed — for those earning more than $250,000, but changing the law so as to extend the tax cuts for those earning less than that amount.   Republican politicians are opposing the proposal.    I don’t understand what they are thinking.  Their position doesn’t make sense to me, regardless whether they are thinking about short-term stimulus, long-term fiscal conservatism, good economics, or even pure politics.   

Start with the pure politics.   What is the end-game?   Are congressional Republicans prepared to block the Obama proposal extending the tax cuts for those making less than $250,000 and to let them expire as in the original legislation proposed by President Bush and passed by the Congress in 2001-03?   More than 95 % of Americans make less than $250,000.   Their taxes will go up on January 1 as a direct result if Republicans block the Obama proposal.  How are they going to explain their position to the voters when the current law takes effect?    Will it be: “To address budget deficits we need to let taxes go up on most Americans”?   That doesn’t sound like them.   Or: “Minimizing taxes for the rich is so important that we are willing to let taxes go up on everyone else”?     When it comes down to the wire, surely they would have to back down.  So why aren’t they thinking ahead?  

The same goes for the estate tax, which under the original Bush legislation is scheduled in January 2011 to bounce back from oblivion (beneficiaries of any rich people who die in 2010 don’t have to pay a dime of tax) to the old system of taxing estates worth over a million dollars at 45%.  The White House proposal is to exempt in future years all estates under $ 3 ½ million, $7 million for couples, and to tax only the largest estates.  If the Republicans are going to continue to oppose Obama, how are they going to explain this to the electorate?   That the only benefits that matter are those for the tiny minority of super-rich?

Now let’s move to economics.  If you were going after stimulus because the recovery is still weak, and if you believed that only tax cuts created stimulus, the priority should be in other areas like extending the Making Work Pay provisions for low-income workers, which are also set to expire.   This proposition holds regardless whether
(i) your idea of stimulus is Keynesian demand expansion (the lower-income workers have a higher marginal propensity to consume), OR even if
(ii) your idea of stimulus is purely enhanced incentives to work.  (Lower income workers face overall effective marginal tax rates that are often higher than the rich face, when one factors in payroll taxes, etc.)    Alec Phillips of GS US Global ECS Research points out that the amount of revenue (and stimulus) that is at stake in the expiration of Making Work Pay is greater than in the expiration of tax cuts for those over $250,000, and yet the latter question is getting all the attention and the former question is getting no attention.

Fixing the Alternative Minimum Tax is another sensible policy that qualifies as a tax cut relative to existing legislation, and should be part of any fiscal package.

If we want to achieve short-term fiscal stimulus from the viewpoint of good economics, then we should realize that well-chosen spending programs give far more bang-for-the-buck than most tax cuts.   (”Bang for the buck” means a high ratio of short-term fiscal stimulus to long-term damage to the national debt.  It’s the opposite of how the Bush fiscal program was designed in 2001-03.)    Examples of well-chosen spending programs include aid to the states (which Republican congressmen have been voting down) so that the hard-pressed states don’t have to lay off firemen, policemen, bus drivers, teachers and road workers.     Examples of tax cuts with much less bang for the buck include not just those for the rich (e.g., the abolition of the estate tax), but even garden-variety income tax cuts, because they are partly saved.    Don’t take my word for it.   Martin Feldstein (whose work on taxes and incentives led to the supply side revolution, and who was the Chairman of Reagan’s Council of Economic Advisers) argues that almost all of the income tax cut that was passed n response to the recession in 2008 was saved by households rather than spent, and predictably so, and that government spending would bring more short-term stimulus.

Of course good economics would mean not just short-term fiscal stimulus, but equal emphasis on measures to bring the budget deficit under control in the long run.   The best proposals are the least popular, as so often.   Fixing social security would be a huge step toward long-term fiscal responsibility, without endangering the current recovery.   A good package would combine all these measures. 

Personal saving rose again in the second quarter. “Does this mean the stimulus tax cut has failed, as the 2008 tax cut stimulus did?”, asks The National Journal.

My answer:

Martin Feldstein and others predicted that the tax-cut component of the 2009 fiscal stimulus package would have substantially less expansionary bang-for-the-buck than the spending component of the package, because much of the tax cut would be saved, as had been the case with the 2008 tax cut.  (“Bang for the buck” in this case could be defined as demand stimulus divided by budget cost.)   We knew this from Milton Friedman’s permanent income hypothesis, or even from good old Keynesian multiplier theory.

But in February President Obama had to get those last three (Republican) votes to pass the stimulus bill in the Senate, and those three Senators insisted on raising the tax cut component of the stimulus package a bit and lowering the spending component. Their motivation presumably was to mollify their fellow Republicans, many of whom still claim that ONLY tax cuts provide stimulus, and that spending does not (and perhaps even has a negative effect) — which is even more extreme than the claim that a tax cut creates stimulus equal to spending. After the failures of the Bush tax cuts (and Reagan’s before him), I don’t know if any economists still cling to such “supply sider” notions — or indeed if these congressmen would be able to state their logic. Regardless, I think the Feldstein prediction has been borne out since then.   Talk about irony!   The Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03 were both explicitly designed to boost saving — hence their focus on capital income and higher income brackets — and yet in both cases private saving fell in their aftermath.   The tax cuts of January 2008 and February 2009 were both explicitly designed to boost consumption; yet private saving rose in their aftermath !   

Fortunately, the majority of the Obama stimulus package took the form of increased spending, much of which has yet to come.

None of this is to deny that efficiency is an important consideration, and cost-benefit calculations should always enter into the choice of both what kind of tax cuts to adopt and what kind of spending increases to adopt. But if it is short-term demand stimulus we are after, and we are, then government spending gives more bang for the buck than tax cuts.

[Any readers wishing to post a comment are encouraged to go to the versions on Seeking Alpha or RGE Monitor.]

Over the past month, I , citing Feldstein, have said that if one looks at available information on monthly GDP, available from estimates of MacroAdvisers, that output declined within the first quarter of the year, even though as standardly reported GDP was higher in QI overall than it had been in the last quarter of 2007. But, as it turns out, there is some ambiguity to the question.

The estimates do show GDP falling in February, by a hefty 10.1% anualized. But the numbers for January and March are up. To net out the three months, one must split hairs. The positive numbers for January plus March are just slightly greater in absolute value than February’s negative 0.9 (monthly). So the net is up? Not necessarily.

We are trying to figure out the change within the quarter, from beginning to end. Technically, that means from January 1 to March 30. But of course even Macroadvisors doesn’t report daily or weekly estimates. Estimated total real GDP in the month of March was just slightly above total real GDP in the month of December. So again the net is up? The most precise measure of the change between January 1 to March 30 is the change between the December-January average and the March-April average. That is a tiny negative number: GDP fell by an estimated $28 billion within the first quarter (in year-2000 $). And April is so flat as to be essentially zero.

I think I am sorry I brought the subject up.

It would in any case be a mistake to make much of these numbers. The reason the Commerce Department’s Bureau of Economic Analysis doesn’t report monthly numbers is that the data are so unreliable, and subject to revision. For anyone who needs some sort of estimate of monthly GDP, as we do on the NBER Business Cycle Dating Committee as an input into our thinking, this is what we have to go on. But one sees here yet another illustration as to why the BCDC waits a long time, until all the data are in, before declaring a recession.

*** Comments can be posted at http://www.rgemonitor.com/us-monitor/bio/660/jeffrey_frankel . ***

Following up on my preceding post, I will here document who has said what.

High officials in the Reagan Administration apparently did subscribe to the Laffer Hypothesis:
• Reagan himself: “…our kind of tax cut will so stimulate the economy that we will actually increase government revenues…” July 7, 1981 speech 1/
• His Secretary of the Treasury, Don Regan, even after events had falsified the proposition to the satisfaction of most observers, wrote of his “very strong opinion that a tax cut would produce more revenue than a tax increase.”2/
Also: “The increase in revenues should be financed not by new and higher taxes, but by lower tax rates that would produce more money for the government by stimulating higher earnings by corporations and workers…” (p.173).

Similarly, high officials during the Bush era have also have been quoted saying that tax cuts, via faster growth, lead to higher tax revenues:
• President George W. Bush : “The best way to get more revenues in the Treasury is not raise taxes, slowing down the economy, it’s cut taxes to create more economic growth. That’s how you get more money into the U.S. Treasury.” — July 24, 2003.
• OMB Director Joshua Bolten, press conference July 2003; & WSJ, Dec. 10, 2003
• Majority Leader Tom DeLay: “We, as a matter of philosophy, understand that when you cut taxes the economy grows, and revenues to the government grow.” NYT, 3/31/04.
• Treasury Secretary John Snow, Congressional testimony, Feb. 7, 2006: “Lower tax rates are good for the economy and a growing economy is good for Treasury receipts.”
• CEA Chair Ed Lazear, press conference 2/12/07, “revenues have come in…higher than we predicted…because the economy has grown at a rate higher than we predicted…[T]he tax cuts…[were] at least in part responsible for making the economy grow.”

Most leading Republican economists who served as chief economic advisers to Presidents Reagan and Bush during their tax cutting frenzies, however, do not subscribe to the Laffer Hypothesis, and did not compromise their beliefs while in office. Three examples:

• Martin Feldstein: “I objected therefore to those supply-siders like Arthur Laffer who argued that a 30 percent across-the-board tax cut would also be self-financing because of the resulting increase in incentives to work.”3/
• Glenn Hubbard: “Although the economy grows in response to tax reductions… it is unlikely to grow so much that lost tax revenue is completely recovered by the higher level of economic activity.”4/
• Greg Mankiw: “Subsequent history failed to confirm Laffer’s conjecture that lower tax rates would raise tax revenue. When Reagan cut taxes after he was elected, the result was less tax revenue, not more.” 5/

1/ Feldstein, American Economic Policy in the 1980s (U. Chicago Press) 1994, p.21.
2/ Regan, For the Record (St. Martin’s Press: New York) 1988, (p.214).
3/ American Economic Policy in the 1980s ( U. Chicago Press) 1994, p.24 .
4/ Economic Report of the President (Government Printing Office) 2003, p.57-58.
5/ Principles of Economics (Dryden) 1998, p. 166.

I thought it would be useful to get all this into the record, since some observers have claimed that Reagan and Bush never subscribed to the Laffer hypothesis, while others have inaccurately accused Feldstein, Hubbard and Mankiw of selling out on this score.

So Arthur Laffer — still arguing the improbable “supply side” proposition that cutting income tax rates generally raises total tax revenue — is apparently now a special adviser to John McCain. And McCain has taken on a big consignment of the snake oil, to Greg Mankiw’s dismay. The political temptation for a Republican candidate to promise both lower tax rates and higher revenues is irresistible. The policy-makers who cut taxes when Ronald Reagan and George W. Bush, respectively, came to power subscribed to this claim. Remarkably, at the same time, the economists who were the chief economic advisers to Reagan and Bush during these tax cuts disavow the proposition that they increase revenue (Murray Weidenbaum, Martin Feldstein, Glenn Hubbard, Mankiw…) . Almost all serious economists – let us say Ph.D. economists – disagree with this proposition, with only a microscopic handful of exceptions like Laffer. Indeed some of the advisers who defend the Reagan and Bush economic policies claim that this formulation of supply side economics is a caricature, and was not the true rationale of the tax cuts. This wishful thinking is directly at odds with quotes from the presidents themselves and their Treasury secretaries and other economic officials, to the effect that tax cuts stimulate income so much as to produce more tax revenue. Laffer is not a straw man. (See my next post.)

Even more interesting, the academic defenders of the Republican tax cuts often offer a proposition that is diametrically opposed to the defense offered by their political masters. This is the famous “starve the beast” hypothesis: the claim that if you deprive the government of tax revenue, it will reduce government spending, which is of course viewed as a worthy objective. If this proposition were true, and the supply side hypothesis were also true, it would lead to the nonsensical proposition that Republican presidents should raise tax rates in order to reduce tax revenue (Laffer) and thereby reduce government spending (Starve the Beast). I challenge some candidate to run on that platform !

As it happens, there is abundant empirical evidence against both the Lafferite hypothesis and the Starve the Beast hypothesis. In other words, just because two propositions are diametrically opposed doesn’t mean they are not both wrong. I hope that in this election campaign, the media do something they have failed to do in the past. If McCain proposes extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense, which tends to be driven more by political expediency, and the “Starve the Beast” defense, which has more support among at least some reputable Republican economists. Only then can the rest of us know which of the two propositions to refute.