During the past few weeks, numerous politicians stated that the recent passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extends all of the Bush-era tax cuts for the next two years, will cause the U.S. federal budget deficit to rise by more than $700 billion during the next 10 years.
Yet, in usual fashion, none of the persons that made such a claim provided any sound arguments to support their forecast. That’s because, as I discussed in my Moneynews.com blog on Dec. 14, there isn’t any data showing that reductions in tax rates cause budget deficits to rise.
Quite the contrary, much of the tax data going back to the year 1913 – the year in which the 16th Amendment was passed into law – through the end of 2009 show that reductions in tax rates have often been followed by reductions in the size of the federal budget deficit or by eliminations of deficits and the creation of federal budget surpluses.
Meanwhile, that same data show that increases in tax rates have often been followed by increases in the size of the federal budget deficit.
For example, when the U.S. Congress lowered marginal tax rates during 1919, a federal budget deficit of $13.3 billion evaporated during 1920, and the U.S. government operated with a budget surplus during each of the following 10 years.
However, when Congress raised tax rates five times from 1932 to 1945, the large budget surpluses that existed during the 1920s became a thing of the past and the government operated with budget deficits during that 15-year span. Yet, a federal budget deficit of $47.6 billion that existed during 1946 shrank to $15.9 billion during 1946 after Congress lowered marginal tax rates during that year for the first time since 1925.
A similar situation occurred during 1965, after Congress reduced marginal tax rates during the prior year for the first time since 1946, with the budget deficit declining to $1.4 billion from $5.9 billion during 1964.
Lastly, after marginal tax rates were substantially reduced during 1991, the large budget deficits that existed during much of the 1980s, as a result of substantial expenditures on the U.S. military, declined to $21.9 billion during 1997, from $269.2 billion during 1991, and the U.S. economy experienced its most robust decade since the 1920s.
So, how do certain persons get away with claiming that the federal budget deficit will increase substantially during the coming year as a result of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010? The answer is by relying on static forecasting methods – forecasting a specific outcome of an event without considering the effects that such an event might have on other variables. In contrast, persons who use dynamic forecasting methods assume (properly) that any given event will affect numerous variables, rather than only one given variable, and that those variables will often produce interacting effects.
For example, someone using a static forecasting method would assume that a 10 percent reduction in income tax rates would lead to a 10 percent reduction in tax revenues.
Specifically, persons who claim that the U.S. federal budget deficit will rise by approximately $700 billion during the next 10 years assume that anyone who generates more than $250,000 in annual taxable earnings during the next 10 years will pay approximately $700 billion less in income taxes during that period because of the two-year extension of the Bush-era tax cuts.
The problem with that assumption is that a vast amount of empirical data show that households and businesses tend to spend more money when their tax rates are reduced, and that those spending increases, in turn, often lead to increases in tax revenues. Hence, there is no reason to assume that the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 will cause the U.S. federal budget deficit to rise during the years ahead.
Unfortunately, many politicians have chosen to use only certain statistics to bolster their claims about the potential outcome of the recently passed tax bill and to disparage statistics that don’t support their positions.
As many of you know, Mark Twain referred to the usage of such demagoguery as "Lies, damned lies, and statistics."
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