Assessing President Bush's fiscal policies Mark M. Zandi July 2004

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Recently, Economy.com's chief economist, Mark Zandi wrote a study that evaluated the effects of President Bush's policy of tax cuts and other measures to energize the economy. Although he believes the President shortened the recession and boosted the economy, Zandi also argues that the tax cuts cost far too much compared to the economic growth they stimulated. Zandi argues that other, more temporary moves could have provided much stronger growth without incurring what he sees as long-term problems stemming from the administration's actions.

Zandi will appear on the July 30, 2004 broadcast of Wall $treet Week with FORTUNE as part of a roundtable talking about Democratic and Republican economic claims.

» The complete study (PDF reader required) » Policy stimulus » Bang for the buck » Counterfactual scenario » Deficits » Conclusions

The economy has struggled during the Bush Presidency. Real GDP has expanded, but only slowly, growing at a 2.5 percent per annum rate. This is one of the weakest performances during any Presidential term since World War II. Indeed, this is the slowest topline growth aside from that experienced during the second Eisenhower term in the late 1950s and Bush senior's term in the early 1990s (see Table 1). The growth in real GDP has not been sufficient to forestall substantial job losses. There are some 1.1 million fewer payroll jobs today than when President Bush took office. No other President since World War II has suffered out-right job declines during their term. Those befallen by unemployment continue to have a difficult time finding new jobs. The average duration of unemployment remains at close to five months, which save for a brief period in the depths of the severe early 1980s recessions when unemployment soared to over 10 percent, is the longest unemployed workers have had to look for work before finding a new job since the Great Depression. An extraordinarily high still more than one-fifth of unemployed workers have been without a job for 27 weeks or more when workers. standard unemployment insurance benefits expire. The unemployment rate has remained low during the President's term, averaging only 5.5 percent. This is near the average unemployment rate experienced throughout the past World War II period.

This belies the health of the job market in recent years, however, due to an unprecedented decline in labor force participation. Since peaking in early 2001, the participation rate has declined by well over a percentage point. While a number of factors have driven participation lower, a key factor is potential workers. reticence to even look for a job given their belief that there are few viable job opportunities. If the participation rate had simply held steady since its peak, then the unemployment rate would have averaged over 6.5 percent during President Bush's term.

The struggling job market has been a millstone on household finances. Average real household income has remained largely unchanged and real median household income has fallen during President Bush's term. Weighing on incomes has been weak labor compensation growth. Total labor compensation as a share of national income is currently as low as it has been since the mid-1960s and wages and salaries as a share of income has never been lower.

Households are also less wealthy, as rising housing values have not been able to offset the impact of still lower stock values and rapidly rising household debt loads. Real household net worth is lower today than at the start of the President's term. It has risen in every other Presidential term.

A weak job market and incomes combined with a weaker balance sheet have resulted in a substantial increase in household credit problems. Personal bankruptcy filings, mortgage foreclosure rates, auto repossession rates, and delinquency rates on manufactured housing loans and credit cards are all at or just off record highs.

The economy has performed well with respect to inflation so far during the Bush Presidency, with consumer price inflation averaging just over 2 percent per annum. This is the lowest rate of inflation since the Kennedy Presidency and compares very favorably with the over 10 percent inflation that raged during the Carter term. Homeownership has also steadily increased during the Bush Presidency, a trend that began during Clinton's first term, with the sharp decline in mortgage interest rates.

It is important to note that President Bush's term extends through the end of this year and with the currently improving economy the previously cited economic statistics will likely also improve. Current job growth if sustained in coming months, for example, may be sufficient to return employment back to where it was at the start of the Bush Presidency. Incomes are also rising and credit problems are past their worst. Despite the improving economic statistics, it is likely that the economy's performance during President Bush's term will end up being as poor as during any other Presidential term since World War II.

It is also important to consider that measuring the economy's performance during Presidential terms depends in part on the stage of the business cycle when the term begins. President Bush had the misfortune to begin his term just prior to the March 2001 start date of the last recession. A recession that his Presidency had nothing to do with. President Clinton, in contrast, began his first term nearly two years after the end of the early 1990s recession. Conclusions regarding the economy's recent performance do not change, however, when comparing it to its performance during the same stage of past business cycles. The average of per annum real GDP growth in past cycles since World War II, for example, has been 3 percent.

There is an argument to be made that the economy has suffered through a series of massive shocks during the Bush Administration, severely exacerbating the economy's problems and making comparisons to previous historically periods difficult. These shocks include the collapse in stock prices which began in earnest in late 2000, 9/11, the invasion of Afghanistan in late 2001, the corporate accounts scandals which hit a fever pitch in the summer of 2002, the invasion of Iraq in early 2003, and a series of terror alerts and combat losses that continue until today. The economy has been subject to enormous shocks in the past, however, including free-falling stock prices, debilitating credit crunches, global financial crises, and conventional and cold wars.

Policy stimulus

While the economy has struggled with substantial shocks during the Bush Presidency, it has at the same time been the beneficiary of unprecedented combined monetary and fiscal stimulus. Nearly all of the economic growth experienced since the President took office is due to the aggressive easing in monetary policy and greater federal government largesse.

The magnitude of the monetary stimulus is evident from the sharp decline in the federal funds rate target from 6.5 percent in mid-2000 to a low of 1 percent that prevailed through this June. The real federal funds rate, as measured by the difference between the nominal rate and long-run inflation expectations as implied by Treasury inflation-protected securities, is negative and will likely remain so at least through the end of this year. Given that the real funds rate first turned negative soon after 9/11, this will ultimately be the longest stretch of a negative real funds rate on record. The vehicle and housing markets have been the principal beneficiaries of the extraordinarily low rates. Automakers have been able to offer wildly popular zero percent financing deals given that their own borrowing costs are so low. Generational-low mortgage rates have sparked record-shattering home sales and single family homebuilding, and even more importantly ignited a mortgage borrowing binge. Homeowners have raised an astonishing more than $300 billion in additional cash secured by the equity in their homes since the monetary easing began. The cash has been used to repay other higher costs debt, to finance home improvement and other investments, and to supplement incomes and support broader consumer spending.

The magnitude of the fiscal stimulus is evident in the yawning budget deficit, which is on track to post a record $450 billion during fiscal year 2004 which ends this September. As recently as fiscal year 2000, the year before President Bush took office, the federal government was running a record surplus of just under $250 billion. This is a swing of some $700 billion in just four fiscal years.

Three rounds of tax cuts, including the 2001 Economic Growth and Tax Relief Reconciliation Act, the 2002 Job Creation and Workers Assistance Act, and the 2003 Jobs and Growth Tax Relief Reconciliation Act, have reduced individual taxpayer's collective tax bills by some $300 billion this year compared to what they otherwise would have been. This includes $100 billion of cuts in 2004, on top of the over $100 billion provided last year, and nearly $50 billion in each of the previous two years. Businesses have also received substantial tax benefits. Large businesses that make investments before the end of this year, for example, will benefit from accelerated depreciation schedules and small businesses from larger investment write-offs.

Federal government outlays have also surged, with spending excluding interest payment on the federal debt expanding at close to a double-digit per annum pace during the Bush Presidency. Spending growth has been as strong only in the depths of the Vietnam and Korean Wars, and while current defense and homeland security spending is rising rapidly, the government is also writing much larger checks for almost everything it writes checks for.

The economic impact of the combined monetary and fiscal stimulus has been substantial. Indeed, if monetary and fiscal policy had remained unchanged during the Bush Presidency, the recession that began in early 2001 and ended later in the year, would have likely instead lasted through much of 2003. The economy would still be shedding jobs. Over the entirety of the Bush Presidency, monetary and fiscal stimulus have added an estimated 2.5 percentage points to per annum real GDP growth. Of that, 1.5 percentage points is due to an easier monetary policy and 1 percentage point to fiscal policy. Of the contribution to growth from the fiscal stimulus, the bulk has been from surging defense spending and income tax cuts to lower and middle income households. At the peak of the stimulus in early 2002, combined policy stimulus provided a whopping 4 percentage points to real year-over-year GDP growth. Even during the first quarter of this year, nearly one-half of the close to 4 percent annualized real GDP growth in the quarter was due to the policy stimulus.

Bang for the Buck

The economy has benefited from the fiscal policies implemented during the Bush Presidency, but only because of their sheer magnitude. The economic bang for the buck from these policies, or economic stimulus provided for a given dollar of lost tax revenue or increased spending, has been substantially lacking. This is evident from the massive swing from fiscal surplus to deficit in the past four fiscal years. While this nearly $700 billion swing amounts to nearly two percentage points of per annum real GDP growth, it has generated economic gains of only just over one-half that.

Mitigating the economic efficacy of the President's fiscal policies is that a majority of the benefits going to taxpayers have gone to high income and high net worth households. More than one-half of the tax benefits under the 2001 tax cut, for example, have accrued to the no more than 3 percent of taxpayers earning over $200,000 in annual taxable income. These households have benefited substantially from subsequent cuts in marginal personal income tax rates, reduced dividend income and capital gains tax rates, and the phasing-out of the estate tax. These tax cuts however have a particularly low economic bang for the buck. The near-term economic bang for the buck of reducing personal marginal tax rates, the most significant part of the President's fiscal policies, is only 59 cents. That is, the one-year increase in GDP is only 59 cents for every dollar of lost tax revenue. Reducing the economic potency of lower income tax rates for higher income households is the high rates of saving and other financial resources of these households. They are substantially less likely to spend any tax savings quickly than lower and middle income households. An estimated less than one-half of any tax benefit to households with incomes above the median are spent within one-year of receiving the benefit. This compares to nearly 90 percent for households with incomes below the median. As such, the creation of a new 10 percent income tax bracket and the child tax credit rebate as part of the President's tax policies has provided a significant economic boost. The near-term economic bang for the buck of both is over a dollar. The reduction in tax rates on dividend income and realized capital gains, a policy vigorously advocated by the President, also has only a small nearterm economic bang for the buck.

While the long-term economic benefits are potentially significant, due to the inequities in the taxation of corporate income, the impact on the economy's near-term performance is largely through higher stock values. Stock values should rise by an amount equal to the present value of the stream of future tax savings. Although this calculation depends on a number of assumptions, the boost to stock values is estimated to have been no more than 5 percent. While this should support economic activity through positive wealth effects, these effects are small. Also diluting the near-term economic punch of eliminating dividend taxation is the resulting increase in interest rates on tax-free bonds, including Treasurys and municipal bonds, which compete for investable funds against the stocks of dividend paying companies.

Other aspects of the fiscal policies adopted during the President's term have been more economically efficacious. The provision of emergency federal unemployment insurance benefits and larger grants-in-aid to state governments have been particularly potent policies as they put cash in the hands of financially-pressed households who likely immediately spent it. These were only minor parts of the adopted policies, however. The accelerated depreciation benefits for businesses have also supported previously moribund business investment. An estimated one-fourth of the increase in investment in equipment and software since late 2001 is due to this tax benefit.

Counterfactual scenario

The economic effectiveness of the fiscal policies adopted during the Bush Presidency can be further assessed by considering how the economy would have performed if alternative policy choices had been made. This is done by quantifying the economic impact of a counterfactual scenario through an historical simulation of Economy.com's macroeconomic model system.

The counterfactual scenario assumes that a package of policies designed to stimulate the economy is debated in the immediate wake of 9/11 and signed into law at the start of fiscal year 2002. The scenario includes a combination of policies designed to provide the most significant and timely boost to the economy. The total cost of the package is designed to be some $300 billion, approximately equal to the estimated cost of the President's tax cuts through fiscal year 2004. The policies included were either actually adopted at some point during the President's term, although more sparingly, or were debated but never became law.

Emergency unemployment insurance benefits were included as part of the 2002 tax bill, for example, but these benefits were limited and allowed to expire at the end of 2003. In the counterfactual scenario, the emergency UI program is substantially expanded, as no other policy considered by policymakers to stimulate the economy provides as large an economic bang for the buck. UI benefits support hard-pressed households that spend it as quickly as it is received.

The counterfactual scenario also includes accelerated depreciation benefits for businesses. These benefits are similar to those actually adopted except that they expire at the end of 2002. The current depreciation allowances are still in effect, expiring at the end of this year. Businesses have substantially greater incentive to increase investment more quickly if they only have a temporary window of opportunity to do so. Most of the economic boost provided by the President's accelerated depreciation policy, for example, was delayed until this year.

The counterfactual scenario includes a one-time family tax cut providing $300 for each adult in a family and $300 for the first two children. A family of four thus receives a tax cut of $1,200. It is generally held that a permanent cut in personal taxes will induce a larger increase in consumer spending than will a temporary tax cut. This view is based on theories of consumer spending that conclude that consumers not only consider their current income but also their expected income over a long period when making spending and saving decisions. A temporary tax cut, so the argument goes, does little to raise lifetime income and thus weighs on consumers. willingness to spend their tax saving.

This view is less compelling than it appears, however. The majority of households likely have very short-term horizons when making assessments of their income. Indeed, many households save little, and have little or no net worth. Their horizon is not much further than their next paycheck. Any tax benefit they receive will almost certainly be spent immediately. It is only households near the top of the income distribution who have horizons that effectively extend much beyond several years. The economic benefit of a permanent tax cut is also mitigated by the impact such a cut may have on long-term interest rates. Bond investors holding government debt with maturities that extend for decades are highly sensitive to policy changes that will have long-run implications for the federal fiscal situation.

The counterfactual scenario also includes a large $50 billion one-time grant to state governments scrambling to fill in the very large budget holes that were developing in early 2002. As most state governments are required by their constitutions to quickly eliminate their deficits, they were forced to be particularly aggressive in cutting payrolls, reducing funding for programs ranging from healthcare to education, and even raising taxes. All of this was a substantial drag on the economy that could have been ameliorated with more support from the federal government. The most costly policy included in the counterfactual scenario is a payroll tax holiday. The nearly $150 billion price tag pays for a six-month holiday beginning in November 2001 when tax rates are cut in half for both workers and their employers.

Cutting payroll taxes is a particularly efficacious way of stimulating a struggling economy given that they can be quickly implemented, as they are under the control of federal policymakers, and any benefits show up immediately in paychecks and checking accounts. In 2002, annual earnings up to nearly $85,000 were subject to a 6.25 percent tax earmarked for Social Security and an additional 1.45 percent for Medicare. Employers match the taxes withheld from their employees.

A cut in payroll taxes benefits the nation's least advantaged workers, with less in the way of savings and other assets. This is particularly true since the cut is designed to begin at the end of the calendar year when higher income taxpayers have already surpassed the annual maximum contribution subject to the Social Security portion of the payroll taxes. Indeed, a number of lower income workers who don.t earn enough taxable income to qualify for the family tax cut get some benefit from lower payroll taxes. The timing is also propitious as it coincides with Christmas shopping, when consumers are most obliged to spend. This would have been particularly important to very nervous retailers during Christmas 2001. Cutting payroll taxes paid by employers also provides a bit of extra cash to struggling small business owners, many of whom were having increasing financial difficulty. Cutting payroll taxes even temporarily also lowers the cost of labor, reducing their incentive to shed workers as many businesses did in the wake of 9/11.

Any concern that cutting payroll taxes would somehow undermine the financial viability of Social Security or Medicare would be misplaced. Both programs are funded out of general revenues, of which personal income, corporate income and payroll taxes are all part. It does not matter how Social Security and Medicare are funded; all that matters is that they are.

The 2001 recession can not be avoided in the counterfactual scenario as it is already history when the stimulus package is passed into law. The ensuing recovery in the counterfactual scenario is substantially stronger, however. Instead of actual real GDP growth of only 2.2 percent in 2002, which while substantially better than if no fiscal stimulus was provided at all, the economy would have expanded by a whopping 4.3 percent. Growth would have slowed in 2003 and 2004 as the stimulus ended, but the expansion would have become self-sustaining long before it actually did. Substantive job growth would have resumed by year's end 2002 instead of at the start of 2004. There would have been some 2 million more jobs today if the policies in the counterfactual scenario had been implemented. The unemployment rate would have thus peaked well below 6 percent instead of well over 6 percent.

Given that all of the policy steps taken in the counterfactual scenario are temporary, this assuages worries among bond investors that they would undermine the government's long-term fiscal health. As such, long-term interest rates do not appreciably rise as even as the economy improves. This point is crucial because if long-term rates were to rise, they would offset the economic benefits of the stimulus package. Indeed, while the federal government's fiscal situation erodes substantially in fiscal year 2002 when the stimulus provided in the counterfactual scenario is at its peak, it improves quickly. By FY 2004 the deficit is less than one-half that currently expected.

Broadly speaking, if a package of fiscal policy steps were taken soon after 9/11 that were substantial, but temporary, and designed to get the most significant bang for the buck, the economy would not have avoided the 2001 recession, but the ensuing recovery would have been significantly more robust.

Large persistent deficits

The President's fiscal policies have not been very efficacious in stimulating the economy, and moreover, any near-term benefits will be eventually overwhelmed by the impact of the persistently large federal budget deficits expected to result from those policies. Even under sanguine economic assumptions, cumulative budget deficits over the next decade appear headed into the trillions of dollars.

An improving economy will ensure that coming deficits will narrow from this year's record shortfall, but they will remain large as the erosion in the budget situation in recent years has largely not been due to the heretofore weak economy. Indeed, the previously struggling economy is responsible for only an estimated one-fifth of the swing from surplus to deficit between fiscal year 2000 and this fiscal year. Another one-seventh is due to what are arguably unavoidable increases in defense outlays. The remainder is the result of the President's tax cuts and increased non-defense spending. The most optimistic 10-year deficit outlook is available from the Congressional Budget Office. Assuming no change in current fiscal policies, and that discretionary spending rises at the rate of overall inflation, the budget deficit is projected to vanish a decade from now. Most of the improvement in the fiscal situation occurs after FY 2010, however, when the President's tax cuts are legislated to expire. Currently lower personal income, dividend and capital gain rates revert back to the rates prior to the tax cuts. Estate taxes are also re-instituted. The cumulative 10-year deficit in the CBO outlook is just under $2 trillion, equal to approximately 1.5 percent of GDP.

A more pessimistic, yet perhaps more realistic, fiscal outlook begins with the CBO's projection, takes its underlying economic assumptions as given, and makes several popular and reasonable changes to fiscal policy. Most significantly, the President's tax cuts are assumed to be made permanent. The President has made such a proposal the economic centerpiece of his re-election bid. This would add some $1.5 trillion to the cumulative 10-year budget deficit taking the cumulative deficit to $3.5 trillion or nearly 2.5 percent of GDP.

The alternative minimum tax is also assumed to be indexed to inflation to forestall what will soon be a rapidly growing number of middle-income taxpayers who are forced to begin paying this more onerous tax. If a change is not made, then the number of taxpayers falling under the AMT will rise from approximately 3 million today to 33 million a decade from now.11 Adjusting the AMT will add an additional almost $400 billion to the 10-year cumulative deficit.

Defense spending under the CBO outlook also appears unreasonably low, particularly in light of the nation's growing overseas and homeland security obligations. Simply holding defense outlays to 4 percent of GDP, still very low by post World War II standards, would add another $1 trillion to the cumulative deficit. Non-defense discretionary spending expectations in the CBO outlook also appear at odds with political realities. The 10-year cumulative deficit would increase by another more than $500 billion if the real annual growth in such spending were held to just 2 percent.

Together, these tax and spending changes would result in an expected cumulative 10-year budget deficit of well over an astounding $5 trillion, equal to almost 4 percent of GDP. Fiscal prospects seem set to erode even more substantively after the 10-year budget horizon with the aging of the population and the stresses this will place on Social Security, Medicare and Medicaid.

Optimism that if the President's tax cuts are made permanent that they would create powerful incentives for more investment and harder work and thus ultimately more tax revenues and an improving long-term fiscal situation is misplaced. This supply side argument is vastly overstated. There is no empirical evidence to suggest that lower top marginal tax rates, that have already been cut in half during the past quarter century, would provide anywhere near the necessary supply-side boost to the economy needed to right the fiscal situation. Deficits of the size that would ensue if the tax cuts are made permanent will have serious negative long-term economic implications. Empirical evidence strongly suggests that deficits result in higher longer-term interest rates and crowd out private more productive investment. Indeed, econometric analysis shows that persistent federal budget deficits equal to 1 percent of GDP add approximately 25 basis points to 10-year Treasury yields. The relationship between deficits and interest rates is so strong it can be seen graphically.

Deficits equal to 4 percent of GDP, as would be the case under the previously described pessimistic fiscal outlook, will raise long-term rates by approximately a percentage point over what they would be with a balanced budget. The negative long-term consequences on the economy would be substantial. Average annual real GDP growth over the next decade would be reduced by approximately 30 basis points, resulting in some 3 million fewer jobs a decade from now than would be the ease if the CBO's most optimistic scenario of no change in current fiscal policies came to pass. Investment, productivity growth, and ultimately the nation's living standards would all be measurably weaker, and a more substantive fiscal crisis would eventually ensue.

Conclusions

The economy has struggled during President Bush's first term. The expansion has gained momentum during the past year, but by many measures has yet to fully rebound from the 2001 recession and weak ensuing recovery. Employment, real median household incomes, and real household net worth are lower today than at the start of the President's term. The recession was not of the President's doing and the economy has suffered through a series of substantial shocks. Moreover, the economy would have been substantially more troubled in recent years without the benefit of the stimulus of the fiscal policies implemented during the President's term. The year-long 2001 recession would likely have continued well into 2003 without the three rounds of tax cuts and surging government spending.

The economic efficacy of the President's fiscal policies has been particularly poor, however. The cuts in marginal personal tax rates and dividend income and capital gain tax rates provide a notably small economic bang for the buck. It is not difficult to construct a package of alternative fiscal policies that would have lifted the moribund economy much more quickly and powerfully.

Moreover, the magnitude of the stimulus has resulted in a ballooning budget deficit. While this year's $450 billion deficit will be the largest ever, as a share of GDP at 4 percent, it will fall short of the deficits recorded in 1983 and 1992. The current fiscal outlook appears much darker than in the early 1980s and 1990s, however. Unlike those years, which were the first years of expansion following more serious recessions, this is the third year of expansion. Moreover, the current policy debate is centered on more tax cuts, not tax increases, as it was in the early 1990s. The demographic pressures posed by the aging boomers are also obviously much more intense today.

The economic import of the bleak fiscal outlook has yet to be felt. Bond investors have yet to incorporate any of this into long-term interest rates. This will soon change, however, once corporate credit needs revive and bump up against the Treasury's ever-increasing funding needs. Unprecedented foreign buying of U.S. debt will also eventually weaken. Measurably higher long-term interest rates will have a pernicious impact on the nation's long-term growth prospects.

A focused debate regarding the darkening fiscal situation and its economic implications must thus occur and be resolved. The next President may very well have the last opportunity to do this is a measured and thoughtful way. After that, the debate will be conducted in the heat of a fiscal crisis and resolved to no one's satisfaction.