Home > News & Policies > July 2001

For Immediate Release
Office of the Press Secretary
July 19, 2001

Remarks by Dr. Lawrence B. Lindsey at the Federal Reserve Bank of Philadelphia
Philadelphia, Pa

Thank you. It is a pleasure to be here in Philadelphia today to discuss our nation's economy, the recently passed tax reductions, and the federal budget. Frankly, it's a pleasure to be anywhere but Washington D.C. And it's not the weather. Let's face it, Philly in late July is not a noticeable improvement over D.C. But, how do I put it nicely? The term hot air takes on a whole new meaning in our nation's capital.

     On a serious note, there are few topics of more importance to our country and its economic health than the government's fiscal situation.  It is a natural topic of political disagreement.  But there is also a non-political  element to the conduct of fiscal policy, one that centers on fundamental economic principles that transcend partisan differences.  Today I would like to separate out some of these economic principles from the more partisan comments now being made.

     For example, the new Chairman of the Senate Budget committee has alleged that the recent tax cuts are driving the country "right into the fiscal ditch."  His colleague, Senator Fritz Hollings proposed legislation to take back the recently enacted tax cut.  Similar ideas have appeared on the editorial pages of some of the nation's newspapers.

     These views reflect one side of the political debate, one that ultimately favors allocating more of our nation's resources to government. By contrast, the Administration takes the view that more of our nation's resources should be controlled by those who produce them by their work, saving, and risk taking.  This political and philosophical difference has gotten most of the attention.

     But, contemporary economic thought also bears directly on the conduct of fiscal policy.  The criticisms of the tax cut and comments on the budget made by Senators Conrad and Hollings hearken back to views widely held in the 1920s and 1930s.  History has shown that if adopted, they are likely to cause adverse consequences for the American economy and are being advanced at a delicate time for the entire global economy.  As a student of economic history, I find the popularity of these positions disturbing.

     Back when I took freshman economics, my text, the classic by Paul Samuelson, assured me that we would never make the same mistakes again, that we had learned our lesson.  The particular mistake I am referring to is the Revenue Act of 1932.  Faced with falling tax revenue from the economic slowdown of 1930 and 1931, President Hoover and a bipartisan majority in Congress focused first and foremost on the fiscal health of the country.  As Hoover said in May 1932, "Nothing is more necessary at this time than balancing the budget."  Their solution was to raise taxes.  The top income tax rate was raised from 24 percent to 63 percent.  The result, of course, was economic disaster.

     Today, we are experiencing an economic slowdown, but nothing approaching the magnitude of the 1930-31 slowdown.  But qualitatively the same prescription holds.  Proper macroeconomic management requires that the government "lean against the wind," or act as a shock absorber.  That is what the recently enacted tax bill does, and it is vitally important that we resist the efforts by those in Congress to change course and raise taxes.

     Fortunately, the overwhelming majority of economic commentators share the President's view that the recently enacted tax cuts were not only economically sensible, they were necessary.        For example, the highly respected Blue Chip Economic Indicators, which polls some 50 of the nation's leading forecasters, stated in its last report, "The tax cut effects could not have come at a better time given the expectation of continued deterioration in labor market conditions."  Bruce Steinberg of Merrill Lynch advised the firm's clients, "For once Congress managed to implement a contra-cyclical fiscal policy that should boost economic growth exactly when the economy needs it."  Chris Varvares of Macroeconomic Advisers described the tax package as "a remarkably well-timed application of counter-cyclical fiscal policy."

     The timing of this tax cut was not a matter of accident.  Economic history makes clear that the political process is not usually attuned to timing its actions at the right point in the business cycle.   Perhaps we have James Madison to thank for that.  214 years ago, long before the idea of counter-cyclical fiscal policy was thought of, he designed a process that requires an extended process in making any changes in tax or spending policies.  We do not have the British system where the Chancellor of the Exchequer can, in effect, change tax rates with a speech in Parliament, confident of being sustained by a parliamentary majority.

     The American political process requires that a President expend enormous amounts of political capital in order to obtain a more-rapid-than-usual change in tax law.  This political capital is most obviously available in a new President's first year in office, particularly when the President-elect had run on such a platform.  That certainly helped President Reagan enact his sweeping tax change in 1981.

     A similar principle also helped a just-recently-sworn-in President Johnson enact the Kennedy tax cut just a few months after President Kennedy was assassinated.  The martyred President, in his last State of the Union speech had stated, "I am convinced that the enactment this year of tax reduction and tax reform overshadows all other domestic problems in this Congress."  Furthermore, the speeches Kennedy was to have given in Texas included appeals for his tax cut proposal.

     These lessons in American political economy were very much on then-Governor Bush's mind back in December 1999 when he originally proposed the tax cut.  That is why, despite widespread partisan criticism, he stuck to his tax cut proposal throughout both the 2000 Presidential primaries and the general election.  The tax cut was very much a central part of the compassionate conservative philosophy on which he campaigned.

     For example, the President was very concerned about the demoralizing level of tax rates on single parents with modest incomes.  He noted repeatedly the case of a hypothetical waitress struggling to support two children on $25,000 per year.  Due to the complexities of the tax code and particularly the phase-out of the Earned Income Credit, she faced a combined federal and state tax rate of nearly 50 percent on any additional income that she earned.  Such a disincentive to earning more and making it into the middle class was clearly bad social policy and represented bad economic policy as well.  The President's tax reform program was carefully crafted to end this situation by eliminating income taxes for that waitress and six million other families with children on modest incomes.

     We conservatives have long argued that high marginal tax rates have adverse incentive effects.  In general we have pointed to high tax rates on entrepreneurs and other businesses.  President Bush pointed out that high tax rates are bad for all Americans: waitress and entrepreneur alike and thus are bad for America.  Compassionate conservatism meant tackling this problem for all Americans.

     A second, very much related factor was also on the President's mind back in December 1999: the state of the economy.  At that time the economy was booming.  The fourth quarter of 1999 saw real GDP expand at an 8.3 percent annual rate.  In hindsight, we know for a fact such a pace was unsustainable.  But that view was not unanimous at the time.  Some of those who are most critical of the tax cut today were arguing in 1999 that the business cycle had somehow been repealed and, "it would be different this time."  They argued it was foolish to propose a tax cut when the economy was booming -- conveniently forgetting the long lags in the process of fiscal policy implementation just discussed.

     President Bush had a different view.  His background was not consumed by politics.  He was an entrepreneur with the experience of having to meet a payroll in good times and bad.  He knew what booms were all about.  He also knew first-hand that booms end, and what the problems are when they do come to an end.  So, he said in his speech in Des Moines, where he proposed the tax cut that the economy needs an "insurance policy."

     The tax proposal was designed to be sound, incentive-oriented tax policy regardless of economic circumstances.  It was designed to be phased-in to protect the government surplus.  It was also left flexible enough that, if the economy did need an insurance policy, its timing could be modified to provide the needed fiscal stimulus as well as to provide the incentive-oriented reforms needed for sustained long-term growth.

     It turned out the economy did need an insurance policy.  In March of 2000 the equity markets peaked.  By the end of the year the NASDAQ composite had been cut almost in half.  In July of 2000 manufacturing employment peaked.  By the time the tax bill was signed in May of this year, manufacturing jobs had fallen back to levels not seen since the early 1990s.  Industrial production peaked in September 2000 and has been continuously falling ever since.

     During this entire period, those same people now most critical of the tax bill were insisting that nothing was wrong with the economy.  Even as the boom was ending and manufacturing jobs were being lost, they were opposing the tax cut as being 'too stimulative' for the economy.  They were wrong then and they are wrong again today.

     Today the economy clearly needs the stimulus.  Thanks to the President's perseverance it was signed in record time.  Admittedly, compromise was necessary.  The legislation that was enacted is somewhat smaller overall than what the President asked for.  But, it was designed to have a maximum effect on consumer behavior.

     Economic studies and experience with past tax cuts show that a one-time rebate which is not a part of an overall increase in consumers? take home pay is ineffective.  The current tax cut is designed to have maximum effect by signaling to consumers that their taxes will be permanently lower; that they will be receiving a series of tax cuts well into the future.  In this way they can plan on receiving ever-increasing paychecks into the indefinite future.  Such planning is key to the stimulative effects of a tax cut.

     Over the next 9 months taxpayers will get four separate boosts to their finances.  First, withholding rates were cut for taxpayers in the 28 percent and higher tax brackets on July 1.  A single worker making $75,000 per year will get a $16 increase in his or her biweekly paycheck as a result, or over $400 annually.  Second, starting next week, most taxpayers will get an advance refund on their 2001 federal income taxes due to the establishment of a new, lower 10 percent bracket.  This tax change will mean a check from Uncle Sam of $600 for most married taxpayers and $300 for most single taxpayers.   There is a third withholding change in January of next year.  This will allow the 10 percent bracket to boost every taxpayer's paycheck on a regular basis.  A married taxpayer will receive a pay increase of $24 in his or her biweekly paycheck.  Finally, taxpayers with children will receive a larger than expected refund next April equal to $100 for every child in the household as the child credit was increased and made refundable, retroactive to January of 2001.

     Of course, more tax cuts will come as the tax bill is phased in throughout the next 10 years.  But, over the next four quarters, when the economy needs the most help from increased spending, a typical family of four making $50,000 per year will receive $1100 from Uncle Sam.  To some of the President's critics that $1100 doesn't seem like much.  But, let's put it in perspective.  Over the last 10 years for which we have data, 1989-1999, the median family saw its real income rise by an average of $298 per year.  In effect, this tax cut is worth the equivalent of almost four years of real income increase over just the next 12 months.

     What should this do to the economy?  The Blue Chip consensus view on average was that the tax cuts may add about 0.5 percent to the growth of personal consumption expenditures in the third quarter of this year.  New York Federal Reserve Bank President William McDonough believes that the tax cut could increase real GDP by 0.4 percent this calendar year (or roughly twice that rate in the second half of the year) and by 0.7 percent in 2002. Morgan Stanley Dean Witter told its clients that, "The tax bill delivers fiscal stimulus sooner than we've been expecting and it packs a punch: we estimate that it will boost second half growth by about 1 1/4 points." Credit Suisse First Boston's Neal Soss said, "We expect it to add roughly 1 percentage point to consumer spending growth from what it otherwise would have been and 0.75 percent to GDP growth over the next 18 months."

     It is important to recall the issue of timing for this stimulus.  In the last six quarters real GDP growth has decelerated from an 8 percent annual rate to a virtual standstill.  The tax cut therefore is necessary to put a floor under this drop in real GDP growth; sustaining growth until the demand for investment goods resumes.  This investment turnaround may take a couple more quarters.  The economic evidence is conclusive that investment spending depends crucially on the level of final demand in the market.  So, sustaining final demand with the tax cut in the interim is vital to the ultimate successful turnaround in investment and the economy.

     There are a wide variety of reasons to expect growth to resume in a robust fashion next year.  First, as already mentioned is the tax cut.  The second reason is monetary policy.  Prompt Federal Reserve action beginning in January of this year will help stimulate final demand next year.  The usual lag in monetary policy is 12 to 18 months.  Thus, the interest rate cuts in the early portion of this year should have their maximum impact on the economy during 2002.

     The third reason is energy.  The run up in energy prices since they bottomed in 1999 has acted like a significant tax increase on the economy. Nominal energy expenditures by households rose from 4.1 percent to 5.0 percent of personal consumption expenditures.  Stated differently, the energy price increases acted like a tax increase of 0.9 percent of income on U.S. households.   Energy prices have backed away substantially from their peak, and at the very least they have stopped rising.  Even if energy prices do not fall from current levels, the added negative effect they caused will disappear from the economic calculus.  If they drop, this will actually help provide an economic stimulus.

     Thus, there is every reason to expect that as long as the tax cut is able to sustain final demand for the balance of this year, that significantly faster economic growth will resume next year. Some members of Congress are interpreting the resumption of growth as a reason to go ahead and raise taxes.  In recent hearings conducted by Senator Conrad at which Budget Director Daniels testified, the Senator agreed that raising taxes this year might not be a good idea given the economy.  But, he went on to be clear that next year might be different.  He hinted at a tax increase in 2002, just as the economy is recovering.

     Of course, such a tax increase -- or a repeal of a portion of the scheduled tax cut -- would hit the economy at precisely the wrong time.  It is important to recall that great effort was made to stress the PERMANANCE of the tax cut.  That is how households are provided the confidence by which they can maintain their spending habits.  Senator Conrad's implied threat of a tax increase next year thus directly undermines the potential for this year's tax cut to act as a stabilizing force.

     Indeed, one does not have to look back to the 1930s to understand the folly of raising taxes just as the economy is beginning to recover.  One need only look at Japan.  In 1997, just as the Japanese economy was well on the way to recovery, a tax increase was begun.  Like Senator Conrad, the Japanese government was primarily concerned with its fiscal situation, in effect placing the fiscal position of one portion of the economy ahead of the macroeconomic fundamentals on which overall economic growth depended. The result of the tax increase was to put the economy into an immediate tailspin and prolong Japan's decade long economic slump.  We must not allow the same mistake to happen here.

     What is most curious about the charges now being levied by the President's critics is their failure to accept that fiscal policy is quite tight.  Senator Conrad asserted that we were driving into a fiscal ditch. But, the facts show that we will be running a budget surplus this year of $160 billion to $200 billion, or between 1.5 percent and 1.9 percent of GDP.  This is the second largest budget surplus in post-war American history, both in absolute terms and as a share of GDP.  This should be a cause for both economic and political celebration.  It is a major achievement for our economy and for our government.

     Furthermore, the good news continues.  Every credible estimate of the federal budget for the rest of the decade forecasts record surpluses as far as the eye can see.  The federal government will be retiring more than $2 trillion in debt over the next 10 years.  That is the maximum debt retireable over that period without incurring unjustified premium expenses. The ratio of federal debt to GDP will be reduced to levels not seen since before World War I.  This is an unprecedented reduction in our national debt level.

     President Bush is committed to protecting the Social Security surplus and, in so doing, providing more funds than are needed to assure retirement of the national debt.  President Bush also strongly supports reforming Social Security using personal retirement accounts to put our federal government sponsored retirement system on sound financial footing.  Social Security must ultimately come to rely on real financial assets to provide benefits, not just political promises.

     We must also keep in mind that the Social Security surplus is different from other trust funds.  Unlike Medicare or many of the other 100-plus trust funds, Social Security is in true surplus for the moment, taking in more than the program costs. Some have alleged that there is a "Medicare surplus."  In fact, every dollar of Medicare taxes paid by workers and every dollar of Medicare premiums paid by beneficiaries is spent on Medicare. The President's budget protects this commitment.  In addition, Medicare receives $50 billion in extra money from the rest of the federal budget.

     Some in Congress are beginning to pick and choose their definition of budget surplus.  As the renowned economic columnist Robert Samuelson recently pointed out in an outstanding explanation of the subject, "What masquerades as a technical budget redefinition is really a subtle effort to confuse the public and suppress political debate.  Though clever it deserves our contempt."

     Samuelson reminds us that it was President Johnson who created a special intergovernmental commission to try and make sense of the federal budget.  The stated aim was to "advance public understanding of the budget by avoiding complicated and confused -- definitions that only accountants or other specialists can understand."  What they recommended was a "unified budget" concept.  That concept has been in use ever sense and is the basis of the numbers I just cited.

     But part of the effort at budgetary redefinition is an effort to confuse the public on the appropriateness of fiscal policy.  Paying off the national debt should not be an end in itself, but should be weighted against other economic priorities.  The Democratic Senators who are now most vociferous about redefining the government's accounts to produce ever- increasing surpluses, even as the economy slows down, should seek the advice of leading Democratic economists.

     Alan Blinder, advisor to Vice President Gore in last year's campaign who with William Baumol, wrote in their economic text, "Arguments that the public debt will burden future generations, who will have to make huge payments of interest and principal, are based on false analogies.  In fact, most of these payments are simply transfers from some Americans to other Americans--The bogus argument that a large national debt can bankrupt a country like the United States ignores the fact that our national debt consists of obligations to pay U.S. dollars -- a currency the government can raise by taxation or create by printing money."

     MIT professors Fischer, Dornbusch and Schmalensee all say of the national debt, "At this level there is nothing to worry about.  The national debt is mostly a debt that we owe ourselves."  Paul Samuelson, one of President Kennedy's economic advisers wrote, "A panel of economic experts, in this country or anywhere else in the Western world, will usually put the public debt toward the bottom of any such list of worries."

     It is not that paying down the national debt is not a good idea.  It is.  President Bush is committed to retiring that debt in a prudent fashion.  What is essential to keep in mind is that paying off the national debt should not be the sole priority of government.  The government must first and foremost be concerned with economic conditions.

     The most effective statement of the context between debt reduction and the economy was given by President Franklin Roosevelt as part of his fiscal 1946 budget message, delivered in early 1945.  FDR said, "The management of the public debt is bound to have a profound influence on the economy for a long time to come.   Retaining high taxes on the masses of consumers for general reduction of debt held by financial institutions may destroy purchasing power and create unemployment? I favor a policy of orderly but steady debt reduction, consistent with the objectives of long-run economic policy."

     Roosevelt got to the heart of the issue.  The important point to keep in mind is the relation between economic performance and public finances. When the economy does well tax revenues surge and the budget situation looks fabulous.  When the economy declines, the budget situation looks less rosy.  Uncle Sam has a very important claim on economic performance.  When the economy expands one percent in real terms government revenues rise roughly 1.4 percent.  That means that 30 percent growth over a decade will increase real federal revenues by over 40 percent.

     One need only look at the 1990s to see this.  In 1990 individual income taxes took $467 billion out of total personal income of $4.9 trillion.  In 2000, taxes took more than $1 trillion out of personal income of about $8.3 trillion.  Income rose 70 percent, taxes rose 115 percent. When the private economy does well, Uncle Sam does very well.

     It does not necessarily follow that when Uncle Sam raises taxes that the economy does well.  One need only recall the experience of the 1930s with the increased taxes from the 1932 act.  That tax act passed that year increased marginal tax rates by 150 percent across the board and cut the exemption level to bring more taxpayers into tax paying status.  But, this massive increase in rates, which would have produced a tripling of revenues under constant economic circumstances, crushed the economy.  Economic conditions deteriorated so rapidly that revenues rose only 52 percent. Sure, in the short run the deficit was smaller than it otherwise might have been, but the effect on the economy led to a decade of lower output and, in the long run, lower tax revenue.

     Thus, a wise and prudent government will manage its finances in a way to maximize economic growth.  It is growth that produced the current surplus.  It is growth that will allow us to pay down the national debt. The focus of our economic policy should therefore be based on the three principles that underpinned the tax cut that President Bush campaigned on.

     First, we need common-sense tax reductions and tax reform that maximize economic incentives.  Lower marginal tax rates provide the incentives that the economy needs for sustained long-term growth.

     Second, tax reductions should be implemented in a way which preserves government surpluses assuming normal economic growth.  We need to preserve the Social Security surplus to help fulfill our commitment to America's seniors and provide for the long-term stability of that system.

     Third, if economic growth slips into recession, government fiscal policy should act as an insurance policy to maintain aggregate demand.  At the very least, government should absorb any temporary shortfall in revenue, not raise taxes to try and recoup any revenue loss.  This is known in the economics profession as maintaining the automatic stabilizers of the fiscal process. If the economic slowdown is more severe, a discretionary reduction in taxes should also be contemplated.

     This is common-sense economics.  It is the economics you will find in just about every textbook now used.  This is not Republican economics or Democratic economics; it represents the broad consensus of the economics profession.  This is the recipe for sound fiscal policy that comes from the lessons of economic history, not from some temporary political advantage.

     President Bush promised to change the tone in Washington.  He believes, as do I, that sound fiscal management should not be a Republican objective or a Democrat objective, it should be a shared goal of us all. That is why he stands by his budget.  It is why he stands by the tax cut he proposed more than 20 months ago.  He will keep our solemn obligations to our nation's seniors by using every dollar of Social Security revenue to protect and strengthen that system.  He will use every dollar of Medicare revenue for Medicare, and will add to that money from the rest of the budget to meet the medical needs of those who depend on it.  But he will also make sure that the American people get to keep the money that is rightfully theirs through their hard work, savings, and risk taking.

     Most important, he will place the nation's economic health at the top of his agenda.  When it comes to sound tax and budget policy, President Bush's approach shows that our nation has learned the lessons of history and will not be doomed to repeat them. ###