Tax Cuts and Deficits
January 20, 2003
Some oppose President Bush's tax plan because of its impact on the deficit. Economists are divided on the impact of budget deficits on interest rates.
- A Brookings Institution paper by scholars Bill Gale and Peter Orszag concluded there is a large and close relationship between federal budget deficits and interest rates. They say that a sustained increase in the deficit of $100 billion will raise long-term interest rates by 50 basis points (half a percentage point) right away, rising to a full percentage point in 10 years.
- In another paper, Gale estimated that the Bush tax plan will raise interest rates by 20 basis points immediately and 40 basis points later on. This suggests that higher interest rates could offset much of the stimulative effect of a tax cut.
- The impact will be much less, according to on the work of economists N. Gregory Mankiw of Harvard University and Douglas Elemendorf of the Federal Reserve (http://www.federalreserve.gov/pubs/feds/1998/199809/199809abs.html). Their research indicates that a $100 billion increase in the deficit -- the first year impact of the Bush plan -- would raise rates by just 1 or 2 basis points.
Former Clinton economist Brad DeLong recently called for the resignation of Council of Economic Advisers Chairman R. Glenn Hubbard for supposedly saying that a higher deficit will have no impact on interest rates whatsoever, in contrast to what he wrote in his own textbook .
- In fact, Hubbard has pointed out that many older textbook analyses of the impact of deficits on interest rates failed to account for world capital flows, which have more of an effect. (http://www.whitehouse.gov/cea/taxnotes30th_anniversaryspeech_dec10_2002.pdf)
- Finally, an article published by the Federal Reserve Bank of St. Louis concludes "the linkage between budget deficits/surpluses and interest rates is weak." (http://research.stlouisfed.org/publications/net/20021201/cover.pdf)
That probably comes close to telling us what economists really know on the subject.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, January 20, 2003.
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