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.]

Why do so many countries so often wander far off the path of fiscal responsibility? Concern about budget deficits has become a burning political issue in the United States, has helped persuade the United Kingdom to enact stringent cuts despite a weak economy, and is the proximate cause of the Greek sovereign-debt crisis, which has grown to engulf the entire eurozone. Indeed, among industrialized countries, hardly a one is immune from fiscal woes.

Clearly, part of the blame lies with voters who don’t want to hear that budget discipline means cutting programs that matter to them, and with politicians who tell voters only what they want to hear. But another factor has attracted insufficient notice: systematically over-optimistic official forecasts.

Such forecasts underlie governments’ failure to take advantage of boom periods to strengthen their finances, including running budget surpluses. During the expansion of 2001-2007, for example, the US government made optimistic budget forecasts at each stage.  These forecasts supported enacting big long-term tax cuts and accelerating growth in spending (both military and domestic).  European countries behaved similarly, running up ever-higher debts.  Predictably, when global recession hit in 2008, most countries had little or no “fiscal space” to implement countercyclical policy.

In most cases, the problems have long been plain for objective observers to see, but public officials kept their heads buried in the sand.  Over the period 1986-2009, the bias in official U.S. deficit forecasts averaged 0.4 % of GDP at the one-year horizon, 1% at two years, and 3.1% at three years.  Forecasting errors were particularly damaging during the past decade.  The U.S. government in 2001-03, for example, was able to enact large tax cuts and accelerated spending measures by forecasting that budget surpluses would remain strong.   The Office of Management and Budget long turned out optimistic budget forecasts, no matter how many times it was proven wrong.   For eight years, it never stopped forecasting that the budget would return to surplus by 2011, even though virtually every independent forecast showed that deficits would continue into the new decade unabated.

How were American officials in the last decade able to make forecasts that departed so far from subsequent reality?   In three sorts of ways.  The first comes in the form of optimistic baseline macroeconomic assumptions such as a high and everlasting growth rate.  OMB forecasts of economic growth were biased upward:  by a huge 3.8% at the three-year horizon.

Second, some politicians argued that tax cuts were consistent with fiscal discipline by appealing to two fanciful theories:   the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit but that this will put downward pressure on federal spending. 

Sanguine macroeconomic assumptions will do the job in the context of OMB forecasts and fanciful theories about the effects of tax cuts can deliver the rosy scenarios of presidential speeches.  But to get optimistic fiscal forecasts out of the Congressional Budget Office a third, more extreme, strategy was required.  (In 2003, when some Lafferite congressmen tried to get CBO to say that “dynamic scoring” of the effects of  tax rate cuts would show higher revenue, the estimates from the independent agency did not give the answer they wanted.) 

To understand the third strategy, begin with the requirement that CBO’s baseline forecasts must take their tax and spending assumptions from current law.   Elected officials in the last decade therefore hard-wired over-optimistic budget forecasts from CBO by excising from current law expensive policies that they had every intention of pursuing in the future.  Often they were explicit about the difference between their intended future policies and the legislation that they wrote down. 

Four examples: (i) the continuation of wars in Afghanistan and Iraq (which were paid for with “supplemental” budget requests when the time came, as if they were an unpredictable surprise); (ii) annual revocation of purported cuts in payments to doctors that would have driven them out of Medicare if ever allowed to go into effect; (iii) annual patches for the Alternative Minimum Tax (which otherwise threatened to expose millions of middle class families to taxes that had never been intended to apply to them); and (iv) the intended extension in 2011 of the income tax cuts and estate tax abolition that were legislated in 2001 with a sunset provision for 2010, which most lawmakers knew would be difficult to sustain.    All four are examples of expensive policy measures that Congress fully intended would take place, but that it excluded from legislation so that the official forecasts would misleadingly appear to show smaller deficits and a return to surplus after 2010.

Unrealistic macroeconomic assumptions, fanciful theories about tax cuts, and legislation that deliberately misrepresented policy plans all worked as intended, yielding over-optimistic forecasts.  These in turn help to explain excessive budget deficits. In particular, they explain the failure to run surpluses during the economic expansion from 2002-2007: if growth is projected to last indefinitely, retrenchment is regarded as unnecessary.

Many have suggested that budget woes can best be held in check through fiscal-policy rules such as deficit or debt caps. Some countries have already enacted laws along these lines.  The most important and well-known example is the eurozone’s fiscal rules, which supposedly limit budget deficits to 3% of GDP and public debt to 60% of GDP for countries to join.  The European Union’s Stability and Growth Pact (SGP) dictated that member countries must continue to meet the criteria.   We have now seen how well that worked out.

Other countries have also adopted fiscal rules, most of which fail.  Switzerland’s structural budget rule (”debt brake”) is well-designed to allow higher deficits in recessions automatically, counterbalanced by surpluses in expansion periods. But the success of any budget rule depends on accurate forecasts of government spending and revenues. Getting those forecasts right has proven to be difficult for most countries.

Part of the problem is that governments that are subject to budget rules, such as Europe’s SGP, put out official forecasts that are even more biased than the US or other countries.  The Greek government, for example, in 2000 projected that its fiscal deficit would shrink below 2% of GDP one year in the future and below 1% of GDP two years into the future, and that the fiscal balance would swing to surplus three years into the future. The actual balance was a deficit of 4-5% of GDP - well above the EU’s 3%-of-GDP ceiling.

In almost all industrialized countries, official forecasts have an upward bias, which is stronger at longer horizons. On average, the gap between the projected budget balance and the realized balance among a set of 33 countries is 0.2% of GDP at the one-year horizon, 0.8 % at the two-year horizon, and 1.5 % at the three-year horizon.  So, how can governments’ tendency to satisfy fiscal targets by wishful thinking be overcome? In 2000, Chile created structural budget institutions that may have solved the problem. Independent expert panels, insulated from political pressures, are responsible for estimating the long-run trends that determine whether a given deficit is deemed structural or cyclical.

The result is that, unlike in most industrialized countries, Chile’s official forecasts of growth and fiscal performance have not been overly optimistic, even in booms. The ultimate demonstration of the success of the country’s fiscal institutions:  unlike many countries in the North, Chile took advantage of the 2002-2007 expansion to run substantial budget surpluses, which enabled it to loosen fiscal policy in the 2008-2009 recession. Perhaps other countries should follow its lead.

[A shorter version of this op-ed was published by Project Syndicate.   It draws on several recent academic publications of mine, especially "Over-optimism in Forecasts by Official Budget Agencies and Its Implications,"  Oxford Review of Economic Policy  27, no.4, 2011, 536-562.]  

In my earlier post, I catalogued some quotes from high Bush Administration officials asserting the Laffer claim that a cut in US tax rates stimulates income so much that the Treasury ends up taking in more revenue than before. I didn’t then quote in detail the extensive statements made by the Director of Office of Management and Budget, Joshua Bolten, in July 2005.

Director Bolton’s statements are of particular interest for several reasons. First, by 2005 it had become obvious to any objective observer that (1) the record budget surplus inherited by the Bush Administration had been quickly converted into a record budget deficit, and that (2) the aggressive Bush tax cuts were a major cause of that swing (as was the sharp acceleration in federal spending, both domestic and international, relative to the 1990s). Second, while the utterings of President Bush himself can in general perhaps be dismissed as not to be taken seriously, Bolten was the professional whose job is to be responsible for the integrity of the budget process. (Indeed, he is a higher-quality civil servant than some in the Bush Administration who have been quick to “bolt on” crazy ideological propositions to what should be serious positions.)

Here is what the OMB director had to say about the Laffer proposition:

“And with all those economic gains, we are also seeing more revenues coming into the Federal Treasury. We have arrived at this point largely because of this President’s and this Congress’ pro-growth policies, especially tax relief. Those policies have strengthened the economy, which is now producing better-than-expected revenues.” — Testimony of Joshua B. Bolten, Mid Session Reivioew of the President’s FY 2006 Budget Requst, Committee on the Budget, U.S. House of Representatives, page 1, para. 3.

And lots more:
“The tax cuts proposed by the President and enacted by Congress are not the [budget] problem. They are, and will be, part of the solution…Had Congress not enacted the President’s three tax relief packages, moreover, the economy would be substantially weaker than it is…The most effective way to lower future deficits is to grow the economy. And the President’s tax packages have been well designed to do precisely that.”

“…all economists, I think will agree very strongly that when you reduce taxes, put more money back into the economy, that has a feedback effect in the economy that causes growth and in turn increases receipts. And being able to measure those receipts, to see how much better the government’s fiscal situation is as a result of the tax cuts would be something I’d very much like to include in the numbers….We think we’ve done the right things by making the tax cuts to restore the economy to growth, because what got us into the difficulty deficit situation in the first place is the flagging growth, flagging receipts in the economy. We think the best way back is to restore the economy to growth, and restore receipts that correspond to it…. ”

Q: “…you’ve got a substantial drop in the deficit [forecasted] in 2005…”
A: “…there are other factors involved, and one of them is the ‘03 tax cut.”

– Press Briefing by OMB Director Josh Bolton, The White House, July 15, 2003.

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.