Originally published in THE SPECTATOR
City and Finance Special Issue
30 September 2000
DUBYANOMICS BEATS GOREMLESSNESS
Martin Feldstein believes that only George W. Bush can reform Americas creaking tax system
The task of an American presidential candidate who is seeking to replace an incumbent party is relatively easy when the economy has serious and obvious problems. In 1980, Ronald Reagan could point to the double-digit inflation rate, the stagnant economy, and the rising tax burdens on middle-income families. In 1992, Bill Clinton could focus on the recession and the rising rate of unemployment. Both candidates could promise improved performance if the voters would allow them to replace the existing team.
The excellent state of the American economy now makes the task of Governor Bush much harder. Americans are understandably happy with a 4 percent level of unemployment, a 2 percent inflation rate, and a real GDP growth rate of more than 4 percent, Although most economists attribute the excellent state of the economy to a combination of the fortuitous emergence of the Internet technology and the good monetary policy pursued by the independent Federal Reserve Bank, Vice-President Gore can urge voters to maintain their good fortune by continuing the Clinton - Gore legacy in economic policy.
The essence of Governor Bushs program is a basic reform of the tax system and of the social security retirement and healthcare programes. Because of the enormous budget surpluses that are projected for the coming decade, it is possible to have these reforms and simultaneously pay off much of the national debt.
The unprecedented projected budget surpluses are central to Governor Bushs policy plans and their impact on the economy. The federal government had a $100 billion budget surplus last year and is expected to have a surplus of more than $200 billion in the current fiscal year, equal to more than 2 percent of GDP. The technical staff of the official Congressional Budget Office project that over the next 10 years the budget surpluses will total more than $4.5 trillion, even if the entitlement programs continue to grow as rapidly as projected in current law and all other govermnent spending programs are allowed to increase in line with inflation. To put that potential $4.5 trillion surplus in perspective, the outstanding national debt is only $3.5 trillion, implying that the government could repay the entire debt out of these projected surpluses and still have money left for a combination of tax cuts and additional spending increases.
There is, of course, no reason to pay off the entire public debt. Governor Bush would use about 30 percent of the projected surpluses to finance tax reductions, with most of the rest going to a combination of debt reduction and social security reform.
The large remaining budget surpluses and the very gradual phasing-in of the tax reductions over several years would avoid overheating the economy. There is no reason to expect any conflict between these fiscal plans and the Federal Reserves goal of a soft landing for the American economy. The financial markets continue to signal their faith in this outlook by the low interest rate on long-term bonds and the strong stock market. The long-term expected inflation rate implied by comparing traditional government bonds with inflation-adjusted government bonds is less than 2 percent.
The emphasis in the Bush tax plans is on lowering marginal tax rates. In the nearly 15 years since, the major tax reform of 1986, the marginal tax rate for high-income taxpayers has increased from 28 percent to more than 40 percent. Many lower-income taxpayers face a combination of taxes and income-related benefit reductions that makes their implicit marginal rate more than 50 percent. Governor Bush would reduce marginal tax rates for all taxpayers, bringing the maximum rate down to 33 percent and eliminating taxes for millions of low-income taxpayers. Tax reductions would be proportionately larger for lower-income taxpayers than for those at the top, although the higher-income taxpayers who pay most of the tax would also get most of the dollars of tax reduction.
America's social security retirement system remains essentially a traditional, pure pay-as-you-go program, funded by an earmarked payroll tax that is now 12.4 percent of earnings. Although almost half of the projected budget surpluses during the next decade would reflect the excess of the social security payroll tax receipts over the concurrent retirement benefits, the aging of the population implies that those surpluses would end after about 15 years. Government actuaries predict that paying the benefits projected in current law would require raising that tax rate to 19 percent, adding more than 6 percentage points to the marginal tax rate for most employees. The implicit rate of return on these contributions for the generation now entering the labor force would be only about 1 percent.
If he becomes president, George Bush would change the social security system by allowing individuals to shift a fraction of their current payroll tax into personal retirement accounts that they could then invest in approved stock and bond funds. The substantially higher return that such investment-based accounts would earn would make it possible to avoid the future increase in the social security payroll tax. In each year, both during the transition to the new system and after it is fully implemented, the combination of the new investment-based annuities and the traditional pay-as-you-go benefits that can be financed with the 12.4 percent payroll tax would provide at least the level of retirement income projected in current law. In short, the shift to a partly funded system would protect future retirement incomes without the need for a substantial increase in the payroll tax.
Funding these individual accounts by using some of the payroll tax revenue that would otherwise go to the social security trust fund reduces the amount of national debt that the government would be buying back during the next decade. It would not, however, reduce national saving since those funds would be used to buy other financial assets for the new social security personal retirement accounts. Indeed, cutting the size of the official budget surpluseswould reduce the temptation of the Congress and future administrations to use social security surpluses as an excuse for deficits elsewhere in the government, a practice that contributed to the massive budget deficits of the l980s.
These proposals of Governor Bush contrast sharply with those of Vice-President Gore. Although Mr. Gore talks about paying down the national debt, his own spending plans and targeted tax cut would use at least as much of the projected budget surpluses as the Bush proposals. The real difference is in the structure of the Gore plans. His tax plan leaves marginal tax rates unchanged, but introduces a series of very specific tax benefits that are really spending programs done through the tax code - for example, a tax credit for childcare expenses purchased by a two-earner couple from an approved provider. The Vice-President also rejects any changes in the Social Security program, opting instead to reinforce the promise of future benefits by creating new government bonds and placing them in the trust fund. He would also introduce a new entitlement for lower-income households in the form of a government subsidy of up to 75 percent of the amount that such households contribute to a new type of retirement saving account.
Although tax, spending and social security reform are the key economic issues in the campaign, there are of course other economic policies of a potential Bush administration that deserve comment. A key decision of the next President will eventually be the appointment of a new chairman of the Federal Reserve to carry on the tradition of Alan Greenspan. Some months before President Clinton reappointed Mr. Greenspan for a new four-year term, Governor Bush urged him to do so.
Improving primary and secondary education is crucial to sustaining a high rate of economic growth and to raising the standard of living of the less affluent part of the population. Although education is a responsibility of the state and local governments in the United States, Governor Bush has put forward detailed educational-reform proposals to increase local accountability, reward schools performance, and give parents more choice among schools.
The big challenge for Governor Bush is to make the American voters look beyond the current economic indicators and focus on the structural reforms that need to be made and that, as President, he would achieve.