Romney’s Formula of Defense Increases + Tax Cuts Puts Supply-Side Economics to the Test

Posted by Jason Van Steenwyk

Romney military budgetAccording to reporting by Military Times, Governor Mitt Romney would act to set the base Defense Department budget to the level recommended by Secretary Robert Gates in 2012. Romney’s would effectively raise the current spending level for defense from 3.2 percent of GDP to 4 percent, according to the report by Times staff writer Marcus Weisgerber.

Congress slashed that baseline by some $259 billion. Full story is here.

Romney’s planned level of defense expenditure rivals the level of defense spending during the Cold War, as a percentage of the gross domestic product – a statistic that measures the total value of goods and services produced within the United States during one year.

At the same time, the Romney campaign is advocating a reduction in a variety of tax rates – including both income tax rates, tax rates on dividends and on capital gains. He is also advocating a cap on federal spending of 20 percent of GDP.

Combining both measures, the Defense Department would effectively comprise 25 percent of the overall federal budget under Romney’s proposal.

At the heart of Romney’s argument is a belief in supply side economics – and with it the assumption that revenue streams to the Treasury react dynamically to reductions in the tax rate. The idea is that if you lower the tax rate, then the additional revenue retained by the private sector would be reinvested in the economy, allowing economic growth to compound exponentially – hopefully at a rate that will outpace the interest rate on treasury debt.

In other words, Romney – and conservatives in general – argue that reductions in tax rates actually have the effect of increasing net revenues to the government, thanks to economic growth. They sometimes point to the Reagan Administration. Ronald Reagan lowered tax rates substantially, but also presided over the longest period of sustained economic growth at that time. Revenues to the treasury doubled during the Reagan Administration as the economy grew substantially.

But Democrats also point out that despite the growth, deficits increased substantially as well. The increases in tax revenue were not sufficient to overcome Reagan’s substantial increases in defense spending – plus the effects of a sharp recession in 1981-82 thanks to the Volker Fed raising interest rates and restricting the money supply to clamp down on the runaway inflation of the 70s.

Nevertheless, the argument that lower tax rates can stimulate economic growth and result in a net increase in revenue to the government is not unheard of on the Democrat side of the aisle. President John F. Kennedy raised precisely this argument in a 1962 speech.

But at the time, the top marginal income tax rate was 91 percent – the same as it was during World War Two. According to Kennedy’s close associate, Robert Schlesinger, who knew Kennedy well, the late president was advocating a reduction in the marginal income tax rate for those in the highest bracket to 65 percent.

It is now 35 percent, as is the maximum tax rate on short-term capital gains.

Schlesinger argues that Kennedy was not advocating a blanket argument that tax reductions paid for themselves in economic stimulus, but was discussing a specific circumstance: The desirability of taking the tax code off of the war footing, when the U.S. economy was essentially fully mobilized to defeat Nazi Germany and Imperial Japan.

During WWII, the U.S. was spending its full production capacity – and all the credit it could obtain and bonds it could sell – on war. It was not concerned with reinvesting private sector proceeds back into the economy to grow to fund future consumption. This was a fundamental difference between the WWII era and Kennedy’s term, as it is for Obama and, if he wins the election, for Romney.

Will Romney’s supply-side economics bear out? That depends on which side of the Laffer Curve you think we’re on right now: If you set the tax rate at zero, revenues to the government will be zero. If you set the rate at 100 percent, that would also likely drive Treasury revenues to close to nil, since there is no incentive for production. All profitable activity would be driven underground, out of reach of the tax man. The economy would contract, not grow.

It follows then, if you believe in the Laffer Curve, that the sweet spot is somewhere in between: There is a point on the curve that maximizes federal revenue.

If Romney is right as a supply sider, the increase in the defense budget is probably sustainable – if he has the political courage and political capital to get cuts in other areas of the government.

If he is wrong, or if he cannot get his other cuts in spending passed – just as Reagan failed to get his proposed spending cuts through Congress when his budget was declared “dead on arrival” on Capitol Hill – then Romney’s proposed defense spending will be a budget buster.

 

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