Deconstructing Rubinomics

Just in time for the presidential campaign, former Clinton Treasury Secretary Robert Rubin has published a new book, In an Uncertain World, in which he contends that the Clinton tax increase on middle-income Americans was “tiny.” Rubin writes that he encouraged the tax hike because he thought it would “give us credibility in the markets.” Here we have the essence of “Rubinonomics,” a kind of New-Age social science premised more on feel-good psychology and business/consumer confidence than economic fundamentals. On the presidential campaign trail, Democrats, and particularly front-runner Howard Dean, are embracing Rubinonomics, blaming the Bush tax cuts for the escalating deficit projections and proposing tax hikes. Dean, for example, has put forward a tax plan that would reinstate the marriage penalty, resurrect the death tax and increase taxes on a typical middle-class family of four by almost $2,500 a year, according to Steve Moore of the Club for Growth. Moreover, the governor has the audacity to call himself pro-business while pushing for raising the tax rates on capital gains and dividends, increasing the cost of capital, which is decidedly anti-business. The fact is, with the economy growing at rates not seen in 20 years, governments at all levels will soon see a substantial rise in tax revenues. The real cause of short-term deficits is a witch’s brew of recession and out-of-control federal spending. The real cause of the long-term fiscal imbalance is not insufficient revenues but ill-conceived tax-and-transfer entitlement programs that will collapse of their own weight unless they are reformed to allow workers to invest while they are young to build up annuities to pay for their retirement needs. “Rubinomics,” ironically, has its roots in the old conservative canard that government borrowing crowds out private investment. The so-called “crowding-out” hypothesis holds that when the government borrows money to finance spending it competes with private companies that are also seeking to borrow money, thus increasing demand for credit and causing interest rates to rise. Higher interest rates increase the cost of doing business and therefore reduce economic growth. If the government raises taxes to reduce deficits or run surpluses, then, the conjecture holds, interest rates will decline, the cost of business will fall and economic growth will rise. The problem with Rubinomics is that the empirical evidence contradicts its predictions. Both sound economic theory and the historical record demonstrate that it is government consumption of private resources – i.e., government spending whether tax-financed or debt-financed – that crowds out private investment and retards economic growth. Using the 1990s as a case study, we find that just the opposite happened from what Rubinomics predicts: Interest rates actually began to rise as the deficit declined, and as the economy began to grow in the late 1990s and deficits turned to surpluses, interest rates continued upward. Then, after the economy stagnated in the latter half of 2000 continuing through mid-2003 and surpluses turned to deficits, interest rates sank to historically low levels. A recent Congressional Budget Office report illustrates the real dynamics behind deficits. Under current tax law, revenues will continue to grow and provide adequate revenues to finance a government growing at the same pace as the economy. It’s when politicians use good economic times to enlarge government at the private sector’s expense that revenues appear to “lag.” This is precisely what the Democratic candidates intend to do by repealing the Bush tax cuts. If the administration’s tax rate reductions are allowed to expire, by 2050 the combined effect of economic growth and a progressive tax system will increase revenues to approximately 25 percent of GDP, the highest level of taxation in American history – including World War II – and fully one-third higher than the historical average. On the other hand, if the president’s tax cuts are made permanent, federal tax receipts would level off around their historic average of 18.4 percent of GDP. Clearly, the “structural deficits” complained about in the press and among left-wing economists stem from too much spending, not insufficient tax revenue. Recent press reports on the president’s budget proposals for fiscal year 2005 suggest he is on the right track by reining in discretionary spending. I hope President Bush will campaign on the proposition that government spending should not grow faster than the economy and that he will pledge to veto any legislation inconsistent with this goal. But to successfully ward off tax-and-spend liberals, as well as tax-happy Republican deficit hawks, Bush must provide bold leadership on entitlement reform. As my supply-side guru Irving Kristol always used to say, the best way to reduce the growth of government is by enacting policies that allow the economy to grow faster and enabling people to build wealth. To that end, I hope the president will announce in his State of the Union address a reform agenda including Social Security reform premised upon large personal retirement accounts available to all taxpayers with a guaranteed minimum benefit equal to that promised under the current system. That way, he can exorcise the New-Age mythology of Rubinomics and get us back to fundamentals.


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