Analysis: Cut spending, or raise taxes: Neither answer's easy

Should Congress let any of President Bush's tax cuts expire? Increasing taxes is not the best policy while the economy is still struggling to recover. However, these tax cuts are also the primary reason for the structural federal budget deficit.

Between 1981 and 1992, the U.S. federal government had a chronic budget deficit, but in 1993 the top marginal tax rate was increased, albeit to a level much less than the top rate before 1981. This caused some predictions of economic catastrophe, and Democrats experienced a political catastrophe, but the economy actually grew faster than usual, partly because of improved investor confidence.

Between 1993 and 2000, federal revenues rose from 18 percent of GDP to 21 percent, while total federal expenditures fell from 23 percent to 19 percent. The budget was in surplus! While the Federal Reserve chair worried that we might actually pay down our national debt too much, and Democrats suggested making Social Security solvent for the long-term, President Bush called for dramatic tax cuts. By 2003, federal revenues were down to 17 percent of GDP, helped somewhat by a recession, and federal spending rose back to 20 percent, due largely to two wars. We were in deficit again, but Vice-President Cheney told the Treasury Secretary, "Deficits don't matter."

To make the projected long-run fiscal deficit seem less intimidating, the Bush administration put a

10-year expiration date on the tax cuts, but they expected the cuts would renewed because politicians like getting re-elected. As a country, we are now looking at the milk bottle, deciding whether we should pour it out.

The housing bubble popped in 2006, and the value of financial assets started to tank. The damage done to the assets of financial firms led them to the brink of collapse by 2008. President Bush pushed us to lend these financial institutions up to $700 billion, about 5 percent of GDP, to keep them afloat. As much as doing so made us grit our teeth, it helped keep our economy from being flushed down the toilet.

Of course the deficit grew. Taxpayers don't pay as much when their incomes are down, and the government has to spend more on things like unemployment and Medicaid. But in 2009, the Obama Administration pushed for a stimulus plan that totaled about 6 percent of our annual GDP, though it was spread out over a couple of years. Roughly a third of it was in the form of more tax cuts, and another third was in the form of bailouts for the states, to help stabilize public education without making states dramatically raise their own taxes. The first part was marginally effective, but the second really helped. The remainder was budgeted for new spending on mostly energy and healthcare infrastructure, and to help states with Medicaid and unemployment.

Surprise! Federal expenditures rose to 25 percent of GDP (partly because GDP had fallen), and revenues dropped to 16 percent. Those who dismissed the Bush deficits now worry about the Obama deficits. Clearly, deficits of this magnitude are not sustainable over the long term. What should we do?

We could wait, for some of this deficit is temporary. The stimulus plan will expire in another year. The money lent to banks is already being repaid, and some of the spending on unemployment benefits will be repaid by the states. Tax revenues will recover when the economy finally starts growing again. But even if we wait, we still have a structural deficit, and our debt will likely keep growing faster than our economy.

Can we cut federal spending? If we subtract out Social Security, Medicare, national defense, interest on the national debt, and the monies transferred to the states, we have a remainder of 1-2 percent of GDP. That is, we can cut everything else the federal government does to zero, and fire every employee outside the Pentagon, and it won't make a big dent in the deficit.

The lion's share of the federal budget goes for Social Security and Medicare, but these programs also have their own revenue streams from payroll taxes. Until just a few years ago, these funds had an annual surplus that we used to reduce the deficit. We certainly need to restrain the future spending growth of these programs, but I don't hear many people suggesting dramatic cuts to current benefits.

At 5 percent of GDP, defense spending is the majority of the remainder. We could dramatically cut this spending, but somehow I doubt any politician running for office would win election if they propose it.

We spend about 2-3 percent of GDP for interest on the national debt. This will rise if and when the interest rate on government bonds recovers, but if we stop paying this interest then you should expect the world financial system, which relies on our government bonds as the safest of all assets, to experience a collapse that will make this recession seem like a fond memory.

The federal government transfers about 3 percent of GDP to the states, mostly in matching funds. If we eliminate this spending, what will the states do? Will they raise their taxes to replace those revenues, or will they merely stop paying for roads, bridges, schools, and Medicaid for poor people?

What about raising revenue? President Obama has proposed extending the Bush tax cuts for all but the wealthiest Americans. Now is probably not the best time to raise taxes for any group, since we need more private spending in a recession, not less. But if we want to get the deficit down, what choice do we have?

In fact, one tax cut we might want to consider keeping is the reduced tax on dividends, but we ought to change how we do it. Unlike most developed countries, we tax corporate profits, and then we tax them again when they are paid out in dividends. A more sensible approach might be to allow corporations to deduct dividend payments, and then tax those dividends as regular income for the recipient.

Voters need to make an informed choice, and we need those running for office to be honest. If any politician says we can eliminate the deficit by cutting spending, then they need to say exactly what we should cut, instead of pretending that there is a free lunch hiding somewhere in the federal budget numbers. And when they won't say what we could cut to reach the required amount of savings, then we need to decide whether we prefer keeping tax cuts or eliminating deficits. As much as political candidates and ideologues might say otherwise, we can't have it both ways.

• Elliott Parker is professor and chair of the UNR Economics Department.