Prepared Testimony By
James Gwartney

JEC Hearing on Tax Cuts and the Budget Surplus
September 13, 1999

Congress has passed a $792 billion reduction in taxes spread over the next ten years. The bill would
reduce marginal tax rates by 1 percentage point, cut the capital gains tax rates from 20% and 10% to 18%
and 8%, widen both the standard deduction and tax brackets in order to reduce the marriage penalty, and
provide additional incentives for savings, investment, and research. The President has called the legislation
"reckless and risky," and promises to veto it. I would like to make four points with regard to this debate.

Point 1: There is a negative relationship between size of government and economic growth.
The debate over the tax bill is primarily about spending rather than taxes. The President wants to use the
projected on-budget surpluses to increase spending. Congress wants them returned to taxpayers. Given
the nature of the debate, it is important to consider the relationship between size of government and
economic growth. Small differences in growth when sustained over a lengthy time period can make a big
difference in living standards.

Governments play a key role in establishing an economic environment conducive for individuals to use
their skills and knowledge productively and where markets can operate smoothly. The key elements of
that environment are: (a) a sound legal structure that enforces contracts and provides for secure property
rights, (b) competitive markets, (c) price stability, (d) freedom of international trade, and (e) small
government expenditures. The recent policies of the U.S.-- particularly those in the areas of monetary and
trade policy--have been fairly consistent with long-term growth.
Given the size of government in high-income industrial countries, the level of government spending is
inversely related to economic growth. Countries with large government spending as a share of the
economy and more rapid growth of government experience lower levels of economic growth. Figures 1
and 2 illustrate this point.

Exhibit 1 looks at the relationship between the size of government and the growth of OECD countries
during each of the last four decades. Size of government at the beginning of a decade is measured on the
x- axis and growth of real GDP during that decade is measured on the y- axis. The graph contains four
dots for each of the 21 OECD members on which data were available. Thus, the total number of dots is
84. Each dot represents a country's total government spending at the beginning of the decade and its
accompanying growth of real GDP during that decade. As the plot illustrates, there is a clearly observable
negative relationship--larger government expenditures are associated with slower growth. The
accompanying regression equation also includes dummy variables for the data points in the 1960s and
1970s in order to adjust for the fact that the overall growth rate during these decades was significantly
different than during other decades. The size of government variable is highly significant (at the 99
percent level) and it indicates that a 10 percentage point increase in size of government as a share of GDP
reduces the long-term annual growth rate of real GDP by seven-tenths of a percent. The R2 indicates that
size of government and the decade dummy variables "explain" 62 percent of the variation in growth
across these high-income nations.

During the last four decades, the size of government has expanded in every OECD country. At the same
time, the growth rates of these countries--with the exception of Ireland--have fallen. However, there has
been considerable variation in the magnitude of government expansion. If big government retards
long-term growth, as Figure 1 implies, then there should be a relationship between increases in the size of
government and reductions in economic growth. The countries with the largest increases in government
should experience the sharpest reductions in growth.

Since 1960, the size of government as a share of GDP has increased 20 percentage points or more in six
OECD countries--Denmark, Finland, Greece, Portugal, Spain, and Sweden. On the other hand, the
growth of government has been 10 percent or less in four OECD countries-- Iceland, Ireland, United
Kingdom, and United States. Figure 2 presents data on the growth rates of these two groups, along with
the average for OECD countries (bottom line of the table). Among the "rapid expansion in government"
group, the growth rate of real GDP fell from 6.4 percent in 1960-1965 to 1.9 percent in the 1990s, a
reduction of 4.5 percentage points. In contrast, the average growth rate of the countries with less
expansion in the size of government fell from 4.1 percent during 19601965 to 3.5 percent in the 1990s, a
drop of only 0.6 percent. In every case, the reduction in growth of those countries in the "rapid expansion
in government" group was greater than for any of those in the "slower expansion in government" group.
It is interesting to note that in 1960, government expenditures as a share of GDP for every country in the
top part of Figure 2 exceeded the OECD average (bottom line of table) of 27.3 percent. At the same time,
their average GDP growth rate of 4.1 percent was below the OECD average of 5.6 percent during the
1960s. The situation was exactly the opposite for this same set of countries in the 1990s. After their ratios
of government expenditures to GDP dropped below the OECD average, their GDP growth rate rose
above the average.

Just the reverse happened to the nations in the bottom part of Figure 2. In 1960 their government
expenditures as a share of GDP were below the OECD average, and their GDP growth rates were higher
than the OECD average. By 1998 their mean size of government had risen above the OECD average and
their growth rates had fallen below it. Because these figures are for the same countries (and country
groupings), they are particularly revealing.

Point 2: The $792 billion tax cut spread over ten years is small.
The tax cut bill passed by Congress is small compared to the size of the economy, total federal revenues,
the surpluses that will remain after the tax cut, or any other sensible measure. Only $156 billion is
scheduled to take affect during the first five years. The remaining $636 billion will not be phased in until
after 2004. As Figure 3 shows, it is approximately .7 of a percent of GDP--0.4% during the first 5 years
and 1.0% during the last five. The tax cut amounts to only 3.5 percent of the projected federal revenue
during the ten-year period.

Even with the tax cut, huge surpluses will be present during the next ten years (see Figure 4). To a large
degree, these projected surpluses are a reflection of favorable demographics--the large share of the U.S.
population currently in their prime-earning years of life. If the tax cut is instituted, the surpluses are
projected to average approximately $200 billion per year during the next five years and more than $300
billion per year during the years 2005-2009. This is a highly restrictive fiscal policy. Sizeable tax cuts are
needed to smooth the transition of financial markets to large budget surpluses of the next decade.
Both Congress and the Administration are on record as favoring use of the $1.9 billion projected Social
Security surplus to retire outstanding debt during the next ten years.

Figure 5 shows the path of the net privately-held debt if (a) the Social Security surplus is used for this
purpose and (b) the Fed holdings of debt increase at the same rate as during the last decade. If this is the
case, the net privately-held debt will fall from the current $3.3 trillion to only $826 billion in 2009. This
will push it to less than 10 percent of GDP, the lowest level since prior to World War

Point 3: The CBO projections grossly underestimate the size of the future surpluses.
The CBO's methodological assumptions understate federal revenues by at least $1.35 trillion dollars over
the next ten years. There are two reasons for this underestimation:

1. The CBO assumes that federal tax revenues will increase less rapidly than nominal income. According
to their projections, a 53.1% increase in nominal GDP between 2000 and 2009 will lead to only a 49.6%
increase in federal revenue. Thus, their implied tax revenue- income elasticity is 0.94. This is substantially
too low. We have a progressive tax structure. While the tax brackets are indexed for inflation, a larger and
larger share of income will be taxed at higher rates as real income grows. In addition, the current system is
not fully indexed for inflation. Most notably, as inflation increases nominal capital gains, the rate of
taxation on the gains will rise. Clearly, the tax revenue-income elasticity is greater than 1.0.
During the last four years (1995-1998), there have been only minor changes in the tax law. The 1994
revenues would reflect the implementation of the 1993 Clinton tax increase. Even though the tax system
was basically unchanged, federal tax revenue rose 8.1% annually during 1995-1998 compared to a 5.2 %
annual growth rate of nominal GDP. This would imply a tax revenue-income elasticity of 1.56. Most
public finance economists would place the long-term tax revenue-income elasticity of the U.S. tax
structure between 1.1 and 1.3. Thus, we re- calculated the CBO revenue projections for the next ten
years using these more realistic elasticity figures. As Figure 6 shows, this adjustment indicates that the
CBO's projections understate tax revenues and therefore the size of the budget surplus by between $257
billion and $528 billion during the next five years. During the five years after that (2005-2009), the CBO
understatement of the tax revenue elasticity results in an understatement of revenue between $709 billion
and $1,621 billion. Clearly, these understatements of tax revenues are far greater than the Congressional
tax cut.

2. In addition, the CBO assumes a 2.5 percent growth rate during the next decade. During the last ten
years, the annual real growth rate was 2.6%; it was 2.7% during the 1980s and 3.2% during the 1970s.
During the last five years, real GDP grew at an annual rate of 3.4%. During the last 15 years, real GDP
growth has averaged 3.1% annually. During the last 44 years for which it is possible to construct a 10-
year moving average with the current GDP series, the 1 O-year average annual growth rate fell to 2.5% or
lower on only 4 occasions. Given the highly favorable demographics--a high percentage of the work force
in prime earning years--the 2.5% projected growth rate of the CBO is too low. As Figure 7 shows, even if
real GDP growth is only 2.8%, just three-tenths higher than the CBO projection, $89 billion will be added
to federal revenues during the next five years and an additional $296 billion would be added during years
2005-2009. A still more realistic annual growth rate of 3.0 percent during the next decade will increase
federal revenues by $150 billion during the next five years and $495 billion during 2005-2009.
The tax cut looks puny when compared with the CBO's underestimation of revenue during the next ten
years.

Point 4: If we do not reduce government spending as a share of GDP during the next
decade, we will become Euro-ized when the baby-boomers retire.
Persons age 65 and over currently account for approximately 12 percent of the U.S. population.
Expenditures on health care, social security and other entitlements targeted toward the elderly account for
about 12 percent of the total federal budget. When the baby boomers retire between 2010 and 2025, the
elderly population will increase to 18 percent of the total. Under current law, this will push federal
spending up by 6 to 8 percentage points as a share of GDP during this period. If new programs are added
and government spending is maintained at approximately the current share of GDP during the next
decade, the retirement of the baby boomers during the following decade (2010-2020) will push total
government spending (including federal, state, and local) up to 40 percent of GDP. No country has been
able to sustain real growth above 2 percent with government spending of this magnitude. If we go this
route, we can expect European-type growth-- one percent to 1.5 percent--when the baby boomers begin
to retire.

Conclusion
We are at a crossroads. As a healthy economy provides substantial revenue, it will be tempting to expand
spending in the years ahead. This tax legislation will be the first of several conflicts between those who
want rapid growth versus those who want more spending, which will retard growth. The tax cut debate is
about spending, not taxes. As Figure 8 shows, the President wants to use the on-budget surpluses to
increase spending. The funds will be there to do so during the next decade. But such spending will plant
the seeds of destruction for the following decade. Clearly, the American people are not under-taxed. As
Figure 9 shows, federal taxes as a percent of national income are currently at an all-time high.
Furthermore, they are projected to remain at or near this high level during the next decade. Even with the
Congressional tax cut, there are only a few prior years with higher taxes as a share of national income
than will be the case during the next decade. This suggests that, far from being "reckless," the tax cut is--if
anything--too modest. Nonetheless, it is a step in the right direction.

Let me close with this question. Suppose that the non-social security budget was balanced and that Social
Security was projected to generate a $1.9 trillion surplus during the next ten years. Would you vote for a
$792 billion tax increase? If your answer is no, you should support the tax bill. If the bill is vetoed, this
will in fact be the result. Under very cautious growth assumptions ones that are well below what is likely
to be achieved--the non-social security portion of the budget will not only be balanced, it will run a
surplus. The government does not need more revenue. These funds belong to American taxpayers and
they should be returned to them. This is precisely what the tax bill will do.