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Eye on the News

Josh Barro
Pawlenty’s Fuzzy Budget Math
Some good ideas can’t compensate for overly optimistic projections.
9 June 2011

On Monday, presidential candidate Tim Pawlenty gave a major speech on economic policy in which he laid out his plan to get America’s fiscal house back in order. The proposal, which includes huge cuts in personal income-tax rates and ambitious spending restraints, centers on a fundamentally problematic assumption: that we can achieve an annual rate of 5 percent real GDP growth for the next decade.

Rapid growth would solve a lot of our fiscal problems. Unfortunately, there’s no reason to believe we can reach the sustained growth levels Pawlenty believes his reforms will ignite. The last time America saw real annual GDP growth exceeding 5 percent over a 10-year period was from 1941 to 1950, an era that included World War II, recovery from the Great Depression, and massive exports for European postwar rebuilding efforts.

Only special circumstances got us to a sustained 5 percent in the past, in other words. The situation is much more challenging today, because economic growth has slowed throughout the developed world since 1970—in countries pursuing all kinds of economic policies. In the United States, real annual GDP growth from 1970 to 2010 averaged 2.9 percent. Our strongest decade within that timeframe ended in 2001, when we saw annual growth of 3.5 percent, and that figure was inflated by the tech bubble.

Pawlenty’s fiscal proposals wouldn’t work, however, even if we reached his sky-high growth target. As outlined in his speech, his plan resembles the one that Paul Ryan laid out as part of his Roadmap for America’s Future. Its centerpiece is the replacement of the current individual income-tax structure with a two-bracket system: taxpayers would pay 10 percent tax on the first $50,000 of taxable income ($100,000 for couples) and then 25 percent on income above that. Capital income would not be taxed. Pawlenty’s plan differs from Ryan’s in one key respect: while Ryan proposed an 8.5 percent value-added tax in lieu of a corporate-income tax, Pawlenty retains a 15 percent corporate-income tax and does not include a VAT.

After Ryan released his Roadmap, the Brookings-Urban Tax Policy Center estimated that it would raise revenues equivalent to 16.8 percent of GDP in 2020*—but the VAT would bring in a significant portion of that total (4.25 percent of GDP). A 15 percent corporate-income tax, by contrast, would typically raise just shy of 1 percent of GDP using the current corporate tax base, or perhaps close to 1.5 percent if Pawlenty can significantly widen the base.

Using a back-of-the-envelope analysis, then, Pawlenty’s plan could be expected to raise federal tax revenues of somewhere between 13.5 and 14 percent of GDP in a non-recession year. This assumes, moreover, that Pawlenty, like Ryan, is prepared to broaden considerably the personal income-tax base by doing things like abolishing the home-mortgage interest deduction, which he hasn’t explicitly endorsed. Otherwise, revenues would be even lower.

As for federal spending, Pawlenty has set an ambitious target of capping it at 18 percent of GDP (the current CBO baseline would put us closer to 24 percent in 2020; the Ryan budget backed by most House Republicans is over 20 percent for that year). Even if we managed to hit that number, Pawlenty’s tax plan would leave us with an unacceptably large structural budget gap—over 3 percent a year. It’s hard to imagine any situation where a federal tax code that collects less than 15 percent of GDP is sustainable.

There were praiseworthy aspects to Pawlenty’s speech. Its structural hallmarks of lower rates, broader bases, and favorable tax treatment of capital are sound, and would favor growth—just not nearly enough to solve the deficit crisis. Businesses, in particular, need a simpler, fairer tax structure, and Pawlenty’s willingness to cut ethanol subsidies and other special tax breaks in favor of lower business taxes overall is a good sign. Pawlenty’s idea of giving the president impoundment power—allowing him to decline to spend money appropriated by Congress—borrows a tool that has been useful for managing the growth of state budgets. He should also be commended for calling for restraint in the defense budget; taking on defense and ethanol are both politically difficult choices in Republican presidential primaries.

But overall, Pawlenty’s speech reflects what Republican primary voters are demanding: detachment from reality on fiscal issues. In case anybody has forgotten, the federal budget deficit is massive—dangerously, destabilizingly massive. A huge reduction in federal tax revenues overall, the inevitable outcome of Pawlenty’s budget proposal, would obviously not improve our worsening deficit crisis.

We do need economic growth to secure our future, but we shouldn’t overestimate our ability to foster growth through tax and fiscal policy. Ultimately, we need a fiscal policy that involves figuring out what we can’t afford to do or don’t want to do, and levying sufficient taxes to pay for the rest. As part of that process, Republicans must give up the idea that federal tax receipts can fall even farther as a share of the economy. Unfortunately, as Pawlenty’s speech shows, we’re not there yet.

* While Ryan, unlike Pawlenty, proposed to allow taxpayers to continue to file under the old personal income-tax system, the Tax Policy Center’s 16.8 percent figure assumes all taxpayers opt into the new system, in line with the Pawlenty proposal.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute and a regular columnist for RealClearMarkets.

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