Peter Ferrara: Beware the Balanced Budget Deal

ACRU General Counsel Peter Ferrara wrote this column appearing July 29, 2010, on Wall Street Journal Online.

Washington’s traditional approach to balancing the budget is to negotiate an agreement on a package of benefit cuts and tax increases. President Obama’s deficit commission seems likely to recommend just this strategy in December. The problem is that it never works.

What happens is the tax increases get permanently adopted into law. But the spending cuts are almost never fully adopted and, even if they are, they are soon swept away in the next spendthrift budget. Then–because taxes weaken incentives to produce–the tax increases don’t raise the revenue that Congress initially projected and budgeted to spend. So the deficit reappears.

In 1982, congressional Democrats promised President Ronald Reagan $3 in spending cuts for every dollar in tax increases. Reagan went to his grave waiting for those spending cuts.

Then there was the budget deal in 1990, when President George H.W. Bush agreed to violate his famous campaign pledge–“Read my lips, no new taxes,” he had said in 1988–in pursuit of a balanced budget. But after the deal, the deficit increased substantially: to $290 billion in 1992 from $221 billion in 1990. Voters booted Mr. Bush from office for violating the pledge that had gotten him elected.

In 1993, President Bill Clinton tried again as the Democrat-controlled Congress passed a tax increase as part of another budget deal. By 1995, however, Mr. Clinton greeted the new Republican-controlled Congress with a budget that projected $200 billion deficits indefinitely into the future.

At that point, House Speaker Newt Gingrich led Congress to try a different, two-step approach. First, cut tax rates to improve incentives for economic growth. A strong economy provides the government with consistently surging tax revenue. The second step: Cut spending growth so that revenues come to exceed outflows.

During the Gingrich years, the Republican-controlled Congress cut the capital gains tax rate by 40% and reduced other tax burdens on capital investment. Congress also cut federal discretionary spending by 5.4%, measured in constant dollars. By 2000, discretionary spending was about where it had been in 1995. As a percent of GDP, discretionary spending dropped 17.5% between 1995 and 1999. Total federal spending relative to GDP declined by 12.5% from 1995 to 2000.

As a result, although annual federal deficits of $200 billion had lasted for over 15 years, by 1998 the government was running surpluses. In 2000, the surplus peaked at $236 billion.

This is the approach that Congress should now adopt to balance the budget again. Start with the tax reforms necessary to maximize long-term growth and shoehorn spending into that revenue base.

Cut the federal corporate tax rate to 15% from 35%–which would restore international competitiveness for American companies–and adopt a 15% flat tax for individuals. Close loopholes for both individuals and corporations. Keep capital gains and dividends taxes at 15% while abolishing the death tax and the Alternative Minimum Tax.

On spending, terminate all unspent stimulus funding, which still totals roughly $400 billion, and end the TARP program. For everything besides Social Security, Medicare and Medicaid, return federal spending to 2007 levels, which would save $670 billion a year. Save close to $100 billion by slashing corporate welfare–including Mr. Obama’s handouts to “green energy” businesses–and phasing out farm subsidies. And repeal ObamaCare, which alone would save $2 trillion to $3 trillion over 20 years.

Unfortunately, such slashing won’t solve the enormous problems posed by federal entitlements. For that, Congress must adopt fundamental structural reforms that maintain the social goals of Social Security and Medicare while costing the government far less.

In 1996, new work requirements and finite block grants reformed the Aid to Families with Dependent Children (AFDC) program and reduced its rolls by 67%. Congress should similarly reform its remaining 184 means-tested welfare programs, including Medicaid. Secondly, it should phase in personal savings, investment and insurance accounts to finance all benefits currently financed by the payroll tax (ultimately displacing that tax entirely). Shifting all of those benefit payments to the private sector and off federal taxpayers would reduce federal spending by over 20%. This would be an unprecedented reduction in government spending.

Enacting such an expansive reform agenda would be a political challenge, but similar proposals are being advanced already by Wisconsin Rep. Paul Ryan, Mr. Gingrich, and prominent tea party campaigns across America. These are the only feasible means for balancing the budget while restoring economic growth.