Anyone who has been missing President Bush's optimism and Duke Wayne swagger in his second term got a happy surprise on July 11, when the president announced that the federal budget deficit for fiscal year 2006 would come in $127 billion below the projections made in February. Surging tax revenues, said Bush, had cut an expected $423 billion deficit down to $296 billion. The icing on the cake: The nation is one year ahead of schedule in its goal to cut the budget deficit in half.
The new data announcement was hailed as good news, at least before the catastrophe in Israel and Lebanon punted it off the front page. But appearances can be misleading.
Unfortunately, this deficit reduction cannot be attributed to any spending cuts by the president…or even a modicum of spending restraint. Spending has increased by 45 percent since 2001, with homeland security and defense spending accounting for less than one third of the hike. Rather, the reduction is mainly the result of strong economic growth, which increased tax revenue. In fact, extra revenue makes up 90 percent of the $127 billion reduction. Economists' rosiest predictions about the 2003 supply-side tax cuts turned out to be right on the mark. Lower tax rates increased incentives to work, save and invest, and as a result the economy has grown faster. As the economy grows, tax revenues increase.
Looking closely at these figures, we see one overriding characteristic of this deficit reduction: Americans are sending more money to Washington. Overall nominal tax revenues—$2.4 billion—are up 11.4 percent in 2006 from their 2005 level. And tax revenues in 2006 are projected at 18.3 percent of GDP—instead of 17.5 percent. This is slightly above the 18.1 percent average for the last 50 years. And according to the Congressional Budget Office, in the first nine months of 2006 tax revenue have climbed by $206 billion and "that increase represents the second-highest rate of growth for that nine month period in the past 25 years." In other words, Americans are prospering but they are also paying more taxes.
How can that be? Aren't Americans paying taxes at lower rates? Not necessarily. As Cato Institute budget expert Alan Reynolds recently noted, "reductions in marginal tax rates may induce people to alter their taxable income in many ways: Entrepreneurs may start more businesses, spouses of high-bracket taxpayers may rejoin the labor force, those previously working in the underground cash economy may take jobs that require taxes to be paid, skilled professionals and managers may work harder and retire later, executives may negotiate for cash rather than perks, high-income investors may hold fewer tax-exempt bonds and trade stocks more frequently, taxpayers may not try so hard to maximize tax deductions and adjustments." These taxpayers end up reporting more income, which pushes them into higher tax brackets and exposes them to a greater tax liability—even though the rate in that bracket is lower than it was before the cut.
But there is a problem. The surge in tax revenue is masking the effects of reckless federal spending. At $2.696 trillion, projected outlays for 2006 are at record levels. And with outlays growing about three times the rate of inflation, there is no sign that the profligacy of Bush's first term is dissipating.
The White House tries to provide a positive spin. It argues that outlays are now estimated to be $12 billion lower than February's estimates. According to President Bush, that is a sign of this administration's commitment to fiscal discipline. However, a quick look at the numbers reveals that the lower estimate of 2006 outlays results mainly from reductions in the projected growth rates for Medicare and Medicaid. These aren't much-needed spending cuts in these two programs: they are only slightly slower rates of expansion. Medicare alone is growing at a rate of 15.5 percent in 2006.
Overall federal spending has increased by almost 9.1 percent in 2006. That's not just the steepest increase since George W. Bush moved into the White House. It's the steepest since 1990. And thanks to the GOP majority's prescription drug benefit and inability to reform Social Security, federal spending will grow even faster in the future. Unfortunately, the recent deficit reduction relieves Bush from any pressure he might have had to start cutting his budget.
All things considered, this is why it is a serious mistake to focus our attention on the budget deficit. The size of the deficit is the wrong measure of fiscal responsibility. Congress and the White House should focus on reducing the size of government, not just the share that is financed by borrowing.
If this administration were really serious about fiscal discipline, it would do two things: insist on cutting taxes until we reach the point where Americans are actually sending less money to Washington (in other words, seek the growth-maximizing point on the Laffer Curve, not the revenue-maximizing point), and cut spending to stop that tax revenue from being squandered on pork and bureaucratic bloat. Until then, the GOP will remain the tax-and-spend party. And that should give President Bush some pause before he announces more good news.