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Greenspan Endorses Tax Cuts but Calls for Fiscal Discipline and Continued Debt Reduction

Monday, January 29, 2001

Deloitte & Touche OnLine

A portion of projected federal budget surpluses should be used to reduce taxes, Federal Reserve Board Chairman Alan Greenspan told a Senate Budget Committee hearing January 25. According to Greenspan, projected resources are now sufficient to repay the publicly held debt and cut taxes.

"The most recent data significantly raise the probability that sufficient resources will be available to undertake both debt reduction and surplus-lowering policy initiative. . . . In general, as I have testified previously, if long-term fiscal stability is the criterion, it is far better, in my judgment, that surpluses be lowered by tax reductions than by spending increases," Greenspan said.

Greenspan emphasized that his call for tax cuts is prompted by new fiscal realities and that he was not backing away from testimony in previous years in which he encouraged Congress to devote all surpluses to debt reduction. Although he would not be pinned down as to the size of the tax cut, Greenspan said it should be phased in over a period of years to ensure Congress maintains fiscal discipline and a policy of sustained debt reduction, as well as to avoid overheating the economy.

Tax Cut not Likely to Forestall Economic Slowdown -- Responding to questions from several senators, Greenspan said that retroactive tax cuts designed to stave off an economic slowdown would have little impact because fiscal policy is "too blunt an instrument" to affect short-term economic outcomes. In other words, it is extremely difficult to time a tax cut, and reductions often take effect just when the economy is rebounding.

This would be an inopportune moment for a tax cut to take root because it could be inflationary, Greenspan said. If the current slowdown were to be prolonged, however, a tax cut could do "noticeable good." Greenspan said policymakers should not worry about the downside risk of cutting taxes just when the economy is beginning to pick up steam because he believes tax cuts are necessary in any case.

Appeal to Tax Cut in Context of Fiscal Discipline Should Pacify Wall Street Worries

Greenspan's call for tax reductions within a framework of fiscal discipline should calm Wall Street fears that the government could return to large budget deficits. Over the past several years, the economy has benefited from lower long-term interest rates brought about by debt reduction. Investors may worry that a large tax cut could prevent further debt reduction or, worse, cause the debt to accumulate, which would create a spike in interest rates and harm long-term economic growth.

Wall Street may have much to gain if Greenspan's recommendations are implemented. A continued reduction in long-term interest rates through sustained debt reduction could now be accompanied by tax reductions that could help build capital stock and spur further economic growth. A tax cut phased in over several years adopted in the context of maintaining fiscal discipline could also be slowed or abandoned if the government does not meet debt reduction targets.

My Point Exactly -- Both sides were to quick to use Greenspan's testimony to bolster their own position on tax cuts. President Bush said he was gratified that Greenspan endorsed tax reductions, even though the Fed chairman stopped short of recommending a specific tax-cutting strategy. "He recognizes that we need good monetary policy and sound fiscal policy to make sure that the economy grows," Bush said. "I know he wasn't going to the Hill to say, 'well, President Bush has got the right plan.' I felt like he was speaking about policy in general," Bush added.

Members of the Senate Budget Committee appeared divided along partly lines about the scope and form of any reductions. Members from both parties, however, seemed to agree a tax cut would be prudent policy. Committee Republicans hailed Greenspan's testimony and expressed their enthusiastic support for President Bush's 10-year, $1.6 trillion cut ($1.3 trillion over nine years). For their part, Democrats urged caution -- reminding colleagues of Greenspan's appeal for fiscal discipline -- and claimed such a large cut would leave no resources for competing priorities.

Republicans Support Bush Plan -- The estimated surpluses are "as real as the deficits we used to predict," said Senate Budget Committee Chairman Pete Domenici, R-N.M., at the beginning of the hearing. There is "sufficient money to take care of all the priorities everyone has spoken of," including tax relief, increased defense spending, and a prescription drug benefit for Medicare recipients. "You will have enough money left over to give President Bush his $1.3 trillion tax cut," he added.

Republican senators, including Charles Grassley, R-Iowa, and Phil Gramm, R-Texas, also stressed the need to ensure that spending increases do not dissipate surpluses.

Democrats Cautious -- Budget Committee ranking Democrat Kent Conrad, D-N.D., argued that although he could support "a substantial tax cut," the country cannot afford the Bush plan. Only $2 trillion of the anticipated surplus is left over after resources are expended to increase defense spending, add a prescription drug benefit, and extend expiring tax provisions, Conrad said. The Bush plan, he argued, would cost $2.2 trillion over 10 years due to a modification needed to make it neutral with respect to the alternative minimum tax on individuals and reduced interest payments on the national debt.

Importantly, in calculating his projection of the available surplus, Conrad, unlike Republicans, did not include an estimated $400 billion in excess Medicare revenue as available for tax reductions or spending increases, suggesting instead that they be used to bring the program into long-term fiscal balance. Had Conrad included these funds, the available surplus would be $2.4 trillion over 10 years.

Several Democrats urged extreme caution regarding tax reductions. Although Sen. Robert Byrd, D-W. Va., claimed he would support reducing the marriage penalty, as well as a few other unspecified initiatives, he said his constituents "aren't clamoring for a tax cut." He also warned colleagues that it is much easier to vote for tax reductions than subsequent increases.

Sen. Bill Nelson, D-Fla., agreed and recalled supporting President Reagan's Economic Recovery Tax Act of 1981 before subsequently voting to raise taxes three times to close growing deficits.

Lower interest rates brought about by debt reduction will help all Americans, Sen. Debbie Stabenow, D-Mich., said. A tax cut, however, may only benefit a few individuals and cause the economy to overheat, which would lead to higher interest rates, she added.

Changes in Attitude -- For most of last year, Greenspan advocated using all budget surpluses to repay the publicly held debt. If policymakers were unable to exercise enough fiscal restraint to allocate surpluses to debt reduction, Greenspan urged tax reductions ahead of spending increases. But thanks largely to sustained increases in labor productivity, Greenspan said, the previously unimaginable has come to pass: there are now enough resources to both reduce taxes and the debt.

Thanks largely to sustained increases in labor productivity, Greenspan said, the previously unimaginable has come to pass: there are now enough resources to both reduce taxes and the debt.

Although Greenspan acknowledged an economic slowdown, he claimed this has little bearing on his call for tax cuts.

"Recent projections make clear that the goal of paying off the debt can be achieved before the end of the decade," Greenspan said. It would, however, be inadvisable to allocate all funds to debt reduction, he added. While a large portion of the publicly held debt is in the form of liquid marketable securities, a substantial portion takes the form of nonmarketable securities, such as savings bonds and instruments that pay a fixed rate of return held by foreigners.

Although Greenspan advocates using surpluses to immediately buy back debt held in the form of liquid securities, he said it would be prohibitively expensive to repurchase savings bonds and other illiquid securities before they mature. Foreigners who now earn an essentially risk-free rate of return on their holdings of government debt would be unlikely to return their bonds early in the absence of a substantial payment that Greenspan says would dwarf the securities' value. Repaying the debt slowly as illiquid assets mature would be the prudent course, he argued.

Spreading repayment of the publicly held debt over a longer period frees up surplus revenues, which can be used for tax reductions, spending increases, or the purchase of private sector assets, such as home mortgages. Greenspan cautioned policymakers against spending increases or buying privately held assets. Buying private sector assets, he argued, would make the government subject to political influences and distort economically rational decision making.

Timing and Substance -- Greenspan argued that policymakers should cut taxes sooner rather than later, so the reductions can take effect gradually instead of appearing in a lump sum at an inopportune time. In other words, Greenspan favors a tax cut phased in over several years in conjunction with debt reduction, rather than a massive cut adopted after several years of debt reduction. A large cut could be inflationary and necessitate interest rate increases, Greenspan said. An added benefit of a phased-in tax cut is that it could be tied to spending and debt reduction targets, which would encourage policymakers to maintain fiscal discipline.

In response to a question from Gramm, Greenspan indicated his preference for marginal rate reductions or across-the-board tax relief over targeted tax breaks. Rate reductions, he said, are more efficient and likely to produce long-term growth. Greenspan indicated, however, this was a political decision, as the income tax regime, since its inception in 1913, has often been used to redistribute resources.

Responding to a question from Sen. Kit Bond, R-Mo., Greenspan also expressed his support for capital gains rate reductions, especially since productivity gains in the informational technology sector have played a primary role in promoting economic growth.

Tax News & Views is produced by the Legislative & Regulatory Services Group at Deloitte & Touche LLP.

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