[Senate Hearing 109-]
[From the U.S. Government Publishing Office]


                                                    
                                                     S. 109-695
 
                    STATE OF THE ECONOMY AND BUDGET

=======================================================================

                                HEARINGS

                               before the

                        COMMITTEE ON THE BUDGET
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               ----------                           


        September 28, 2006--THE STATE OF THE ECONOMY AND BUDGET




           Printed for the use of the Committee on the Budget
                  THE STATE OF THE ECONOMY AND BUDGET



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                        COMMITTEE ON THE BUDGET

                  JUDD GREGG, New Hampshire, Chairman

PETE V. DOMENICI, New Mexico         KENT CONRAD, North Dakota
CHARLES E. GRASSLEY, Iowa            PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               PATTY MURRAY, Washington
MICHAEL ENZI, Wyoming                RON WYDEN, Oregon
JEFF SESSIONS, Alabama               RUSSELL D. FEINGOLD, Wisconsin
JIM BUNNING, Kentucky                TIM JOHNSON, South Dakota
MIKE CRAPO, Idaho                    ROBERT C. BYRD, West Virginia
JOHN ENSIGN, Nevada                  BILL NELSON, Florida
JOHN CORNYN, Texas                   DEBBIE STABENOW, Michigan
LAMAR ALEXANDER, Tennessee           ROBERT MENEDEZ, New Jersey
LINDSEY O. GRAHAM, South Carolina

                  Scott Gudes, Majority Staff Director

                      Mary Naylor, Staff Director

                                  (ii)


                           C O N T E N T S

                               __________

                                HEARINGS

                                                                   Page
September 28, 2006--The State of the Economy and Budget.......... 1, 71

                    STATEMENTS BY COMMITTEE MEMBERS

Chairman Judd Gregg..............................................  1, 8
Ranking Member Kent Conrad....................................... 9, 23

                               WITNESSES

Edwards, Chris, Director of Tax Policy Studies, CATO Institute...72, 75
Hassett, Kevin, Director of Economic Policy Studies, American 
  Enterprise Institute...........................................59, 62
Lazear, Edward, Chairman, Council of Economic Advisor............25, 32
Orszag, Peter, Deputy Director of Economic Studies, Brookins 
  Institute......................................................83, 86


               HEARING ON STATE OF THE ECONOMY AND BUDGET

                              ----------                              


                      THURSDAY, SEPTEMBER 28, 2006

                                       U.S. Senate,
                                   Committee on the Budget,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 9:58 a.m., in 
room SD-608, Dirksen Senate Office Building, Hon. Judd Gregg 
(Chairman of the Committee) presiding.
    Present: Senators Gregg, Alexander, Grassley, Allard, 
Conrad, Sarbanes, and Murray.

              OPENING STATEMENT OF CHAIRMAN GREGG

    Senator Gregg. I believe we are going to get started even 
though it is a few minutes early, if that is agreeable to 
Senator Conrad.
    We appreciate Dr. Lazear coming today and we appreciate the 
other witnesses who are on our second panel joining us. I would 
at the opening make the point that, unfortunately, we did not 
receive Dr. Lazear's statement until just a few minutes ago. 
That is unfortunate, because the Democratic membership has a 
right to the statement 24 hours before the hearing, and the 
Administration really doesn't do itself any good by not getting 
those statements up here in a timely manner. It is really 
unfair to the minority not to get them.
    So I would hope that this would not be a recurring event, 
and on behalf of at least the majority of the Senate, we 
apologize to the minority for not having the statement.
    Senator Conrad. Mr. Chairman, might I inquire? What is the 
rule of the Committee with respect to testimony before the 
Committee?
    Senator Gregg. I believe it has to be filed 24 hours before 
the testimony is presented. Is that correct? You probably know 
more than I do.
    Senator Conrad. I think that is the rule, and what is the 
consequence for a failure to adhere to the rule?
    Senator Gregg. I have no idea.
    Dr. Lazear. The consequence is the dissolution of the 
hearing, if I am not mistaken.
    Senator Gregg. The problem would be then we would never get 
anybody to testify. They would never send in their testimony.
    Senator Conrad. It may be a valuable lesson to send if we 
are going to have these hearings and they are going to be 
meaningful. I have not had a chance to read three paragraphs of 
the testimony before we hear it here, which makes it difficult 
to prepare questions, makes it difficult to prepare a response. 
I am not going to insist on imposing the rule here, but I would 
send a message that I may not always be so tolerant.
    I think we have the rule for a reason and it is a good 
reason. So we will go forward. I thank the chairman for his 
explanation of the situation as well.
    Senator Gregg. I appreciate it and I appreciate the Senator 
allowing us to go forward, because I think it would be within 
his rights to state that the hearing shouldn't go, and that 
would mean we wouldn't be able to give opening statements, 
which would mean we would miss potentially thousands of charts. 
We do appreciate the minority's allowing us to move forward and 
waiving that right.
    I want to start my opening statement and talk a little bit 
about what this hearing is about, which is the state of the 
economy, specifically the effect on the economy of the tax cuts 
which were put in place by this Administration. There has 
obviously been a lot of representations of what these tax cuts 
have and have not done, and I am sure the Senator from North 
Dakota will have a differing view than I do, but if we look at 
the facts on the ground, and maybe we can put the first chart 
up, the economic growth, we have seen now 18 consecutive 
quarters of economic growth, significant economic growth. This 
came in light of a period when this Administration came into 
power, came into office, that was extremely disruptive for our 
economy. We have had the internet bubble, which burst which was 
a dramatic event economically in and of itself and should have 
led to a severe recession. We had the attack of 9-11, which was 
a hugely disruptive event to our culture and to our economy. 
And those two things coupled together, basically in a regular 
economic cycle would have led, I believe, to a very dramatic 
and significant decline in the economy and recessionary event 
of significant proportions.

[GRAPHIC] [TIFF OMITTED] 30816.064


    What happened, however, was that because we put tax cuts 
into place, actually at the right time, which was right at the 
beginning of this Administration and before 9-11, some of them 
anyway and some right after, that we were positioned to give 
the economy some lift through tax incentives and create an 
atmosphere for more entrepreneurship and more investment, and 
as a result, it created more jobs. In fact, over that period, 
we have created 5.7 million jobs just in the last 36 months. 
That is pretty significant, 5.7 jobs as this chart would show. 
That is a pretty significant increase in the number of jobs.

[GRAPHIC] [TIFF OMITTED] 30816.065


    The practical effect of that, however, is even more 
important, because not only does it give people jobs, what the 
practical effect of making these tax cuts has been has been 
that revenues have jumped radically over the last 2 years, 
especially as the economy has recovered. We have seen the two 
largest increases in years of revenue increase in our history, 
and the effect of that revenue increase has been that the 
deficit has dropped significantly, down from an estimated 450 
billion, approximately, to about 270 billion, depending on 
where we end up this year. That is because the economy is 
moving aggressively forward. People are working and people are 
investing and there is a tax atmosphere out here which 
encourages that.

[GRAPHIC] [TIFF OMITTED] 30816.094


    Now, some have said that during this period, there has been 
less of a wage growth. Actually, real compensation under this 
timeframe has exceeded the same type of period under President 
Clinton's timeframe. Real compensation is a function not only 
of actual wages, but it is a function of benefit structure.

[GRAPHIC] [TIFF OMITTED] 30816.095


    In addition, some have said that these tax cuts have 
inordinately benefited the wealthy. Well, the numbers don't 
support that either. In fact, these tax cuts have benefited 
dramatically all Americans by generating more economic activity 
and more revenue to the Federal Government, and the wealthy in 
this country are now bearing a higher percentage of the tax 
burden, income tax burden, than those people bore during the 
years of the Clinton years. People in the high income brackets 
are paying almost 85 percent of the tax burden today, 85 
percent.

[GRAPHIC] [TIFF OMITTED] 30816.076


    Do you have the comparison of the Clinton years?
    During the Clinton years, the people in the high income 
brackets bore about 81 percent of the tax burden. Today, people 
in high income tax brackets are bearing 85 percent of the tax 
burden.
    Why is that? It is very simple. When you make taxes fair, 
people invest in activity that is taxable. When taxes are 
excessively high, people avoid taxes. High income people know 
how to avoid taxes. They invest in shelters, basically, in 
various vehicles that will keep them from having to bear a tax 
burden that they consider to be too high. When you make the tax 
burden reasonable, they are willing to take the cost of that 
tax burden as a cost of doing whatever their investment is.
    So the Federal Government receives more revenue. It is a 
very simple function of human nature, and it is reflected 
dramatically in these figures, which show that under the 
President's tax cuts, we actually now have high income 
taxpayers in this country bearing a larger percentage of the 
cost of income taxes than they did under the Clinton 
Administration.
    In addition, another interesting fact is that under the 
Bush tax cuts, low income taxpayers, and that was the chart 
that was up there before, are actually receiving--low income 
taxpayers, the people in the bottom 20 percent, don't actually 
pay taxes on the whole, income taxes. They receive earned 
income tax credits, basically, which is a payment to them, and 
then actually that has increased also under this Presidency. So 
the people in the lowest quadrant of income are receiving more 
back in benefit than they did in the Clinton years. People in 
the highest quadrant of income are paying more as a percentage 
of the burden of taxes than they did in the Clinton years.

[GRAPHIC] [TIFF OMITTED] 30816.074


    So we have actually, by cutting tax rates and making them 
fair and getting people to do more economic activity and 
generate more revenue for the Federal Government and at the 
same time generating more taxes being borne by high income 
people because they are not avoiding taxes, we have actually 
made the tax laws in this country significantly more 
progressive than they were under the Clinton Administration. 
Now, that is counterintuitive to the ``New York Times'', but it 
is the fact. The simple fact is that by reducing taxes and 
making them fair, we have created an atmosphere where high 
income people are picking up more of the tax burden, low income 
people are getting more back out of the Federal Government, and 
we have created more jobs, more revenue, and more economic 
activity than any time in our history.
    That is all pretty good news, and I know my colleague from 
North Dakota will have a different take on this, but those are 
the facts and they are pretty good facts. So I will yield at 
this time to my colleague for his perception.
    [The prepared statement of Senator Gregg follows:]

    [GRAPHIC] [TIFF OMITTED] 30816.063
    

        OPENING STATEMENT OF RANKING MEMBER KENT CONRAD

    Senator Conrad. Well, I enjoyed this presentation very 
much. They are facts, but I would say highly selective and 
leave out a lot of things, and now for the rest of the story.
    First of all, I always enjoy these hearings and I 
appreciate the chairman calling this one, because this really 
is an important discussion for us to have. Let us go back in 
history and recall what occurred. It was not the case in 2001 
that you were for tax cuts and we were against tax cuts. In 
fact, the proposal that I put before our colleagues was for 900 
billion of tax cuts. The President proposed about twice as 
much.
    So the question was, first of all, the size of the tax cuts 
and what kind of tax cuts should there be. The tax cuts the 
President advocated were much larger in amount, and the 
President's tax cuts were much more heavily skewed to the 
wealthiest among us. The tax cuts that we proposed on our side 
were more affordable, and certainly in light of history, that 
is clearly the case, and they were also geared to the middle 
class. I would argue that is where we get the biggest bang for 
the buck.
    The second question is the revenue chart that the chairman 
put up, talking about revenues I don't know if you put up a 
chart or just talked about revenues going up, but the rest of 
the story here is what happened to real revenues adjusted for 
inflation since 2000: The fact is we are just now getting back 
to the real revenues that we had in 2000. There hasn't been 
some giant run-up in revenue. Please. The last few years, 
revenue has gone up, but from a very low base, much lower than 
the revenue that we had in 2000.

[GRAPHIC] [TIFF OMITTED] 30816.081


    So this talk about a dramatic rise in revenues, please. The 
fact is we are just now getting back to the real revenues we 
had 7 years ago.
    Let us go to the question of deficits. The chairman talked 
about big improvements in deficits; well, yes, a big 
improvement from the worst deficits we have ever had. You know, 
2 years ago, the deficits were higher than they are now. They 
were the highest they have ever been, but compared to 6 years 
ago when we had surpluses, these deficits are terrible, and the 
deficits understate the seriousness of the situation.

[GRAPHIC] [TIFF OMITTED] 30816.082


    Well, just to make the point, the first year of this 
Administration where they inherited the fiscal policies of the 
previous Administration, we had a surplus. Now with the fiscal 
policies of this Administration, we have run up four of the 
largest deficits in the country's history, and the deficit 
substantially understates the red ink, because while the 
deficit is projected to go up by 260 billion dollars this year, 
the debt is going to increase by $560 billion dollars. When you 
measure that against GDP, we find that we are over 4 percent of 
GDP, debt increasing by over 4 percent of GDP.

[GRAPHIC] [TIFF OMITTED] 30816.083


    Let us go to the next chart. Just visually, here is what is 
happening to the debt of the country under the policies of our 
colleagues on the other side under this Administration: The 
debt at the end of the President's first year--we don't hold 
him responsible for the first year--was 5.8 trillion dollars; 
at the end of this year, eight and a half trillion dollars, and 
if we follow the President's plan, 11.6 trillion dollars 5 
years from now. That is about a doubling of the debt of the 
country and at the worst possible time, right before the baby-
boomers retire.

[GRAPHIC] [TIFF OMITTED] 30816.084


    Let us go to the next slide if we could. I asked my staff 
to go out and look and find out how much borrowing this country 
is doing in comparison to other countries, and here is what we 
found: In the last year, according to the International 
Monetary Fund, we borrowed 65 percent of all the money that was 
borrowed by countries in world, 65 percent. That is utterly 
unsustainable. That is what the Controller General of the 
United States is telling us, this is an unsustainable path, and 
indeed it is. The next biggest country, by the way, in terms of 
borrowing was Spain at 6.8 percent, one-tenth of the borrowing 
that we are doing.

[GRAPHIC] [TIFF OMITTED] 30816.085


    Now let us go to the next one. The ``Wall Street Journal'' 
of yesterday had this warning from the Economic Forum: ``The 
Economic Forum warns that the U.S. has budget deficits that 
will bring ill effects.'' And it reads: ``The U.S.'s huge 
budget deficit threatens to make the country's economy less 
competitive according to the study by the World Economic Forum. 
The institute's annual study of global competitiveness says the 
U.S. economy is the sixth most competitive in the world, 
slipping from first place last year.'' So we slipped five 
places in a year. ``Slipping from first place to last in last 
year's ranking, a result of mediocre scores from its public 
financing.''
    They went on to say: ``Serial budget deficits in the U.S. 
have lead to rising public debt, which means an increasing 
portion of government spending goes toward debt service. That 
means less money available for spending on infrastructure, 
schools, or other investments that could boost productivity. 
Heavy government borrowing, which means competing for money in 
financial markets with the private sector, also tends to drive 
up businesses' borrowing costs.''

[GRAPHIC] [TIFF OMITTED] 30816.086


    Let us go to the question of jobs, the jobs chart if we 
could. There is a lot of talk about jobs and how the economy is 
improving. The fact is 74 percent of people in this country 
believe that jobs are not plentiful or are hard to get. Only 26 
believe that jobs are plentiful. That is according to the 
Conference Board.

[GRAPHIC] [TIFF OMITTED] 30816.087


    Let us go to the next. Consumer confidence has never 
recovered under President Bush. In January 2001 when he took 
over, consumer confidence was 115.7, again according to the 
Conference Board. Now in September of this year, it is 104.5. 
That is almost a 10 percent decline. If we compare job creation 
under this Administration to the previous Administration for 
the first 67 months, we see under the Clinton Administration, 
16.6 million jobs were created. Under this Administration for 
that same period, 67 months, three million jobs have been 
created, about one-fifth of the jobs created, actually less 
than one-fifth of the jobs created under the Clinton 
Administration in its first 67 months.

[GRAPHIC] [TIFF OMITTED] 30816.088


[GRAPHIC] [TIFF OMITTED] 30816.089


    What is most interesting, of course there have been jobs 
created now that we are in an economic recovery. That always 
happens. What is the real test is how does this recovery 
compare to previous recoveries, and by that standard, what we 
see is job creation is lagging far behind the average of all of 
the major recoveries since World War II. We have had nine major 
recoveries since World War II. The pattern of average job 
creation is the red line. The black line is job creation in 
this recovery, and this recovery is running 6.7 million private 
sector jobs short of a typical recovery. Something is wrong.

[GRAPHIC] [TIFF OMITTED] 30816.090


    Let us go to the next. Business investment, again looking 
at the typical recovery, the average of the nine previous 
recoveries since World War II is the dotted red line. This 
recovery is the black line. On business investment, we are 
running 72 percent behind the typical recovery since World War 
II. Something is wrong.

[GRAPHIC] [TIFF OMITTED] 30816.091


    Real GDP growth lags behind the typical recovery as well. 
The average in the nine recoveries since World War II, GDP 
growth of 3.2 percent; this recovery, 2.8 percent.

[GRAPHIC] [TIFF OMITTED] 30816.092


    Let us go to median household income. Median household 
income in 2000 was $47,599; this year, $46,326. So real median 
household income has declined by almost $1300.

[GRAPHIC] [TIFF OMITTED] 30816.093


    Look, this recovery--the facts I think are very clear--is 
not performing as previous recoveries have, No. 1. No. 2, we 
are running up debt at an alarming rate. It took 42 Presidents 
224 years to run up a trillion dollars of debt held by 
foreigners, U.S. debt held by foreigners. This President has 
more than doubled that amount in just 5 years. This is an 
utterly unsustainable course, and the question is what are we 
going to do about it.
    I would suggest to my colleagues neither party can do this 
job alone. What we really require is a bipartisan comprehensive 
plan to get this country back on track, and I know my 
colleague, the chairman, is interested in that approach. I 
certainly am, and I hope we can get to it.
    I thank the chairman.
    [The prepared statement of Senator Conrad follows.]

    [GRAPHIC] [TIFF OMITTED] 30816.078
    

    [GRAPHIC] [TIFF OMITTED] 30816.079
    

    [GRAPHIC] [TIFF OMITTED] 30816.080
    

    We will go to Dr. Lazear.

 STATEMENT OF EDWARD P. LAZEAR, CHAIRMAN, COUNCIL OF ECONOMIC 
                            ADVISERS

    Mr. Lazear. Thank you very much, Chairman Gregg, Ranking 
Member Conrad, and Members of the Senate Budget Committee. Good 
morning and thank you for giving me the opportunity to speak 
with you about the economy and its relation to tax revenues and 
the budget.
    I would like to begin by summarizing the economy, where we 
are right now and where I believe that we are headed. The 
economy is strong, in part as a reflection of pro-growth tax 
policies. Revenues are up and the deficit is shrinking at a 
rapid rate.
    Some specifics: Real growth of GDP was 3.1 percent over the 
three quarters of 2005. Although it now appears that GDP growth 
in the current quarter will be significantly slower than in the 
first half of the year, the current forecast indicates that 
growth in 2006 will remain about the same as it was last year 
and the economy should continue to grow at a robust pace in 
2007 and beyond.
    Job growth has been strong. The economy has been producing 
roughly one and a half to two million jobs per year for a total 
of 5.7 million additional payroll jobs since August of 2003. We 
expect that trend to continue with some slight moderation.
    The unemployment rate, which was 5.1 percent in 2005, is 
expected to average 4.7 percent for 2006. The most recently 
released jobs report shows that the unemployment rate declined 
to 4.7. Additionally, it revealed an increase of 128,000 
payroll jobs in August. The continued increase in payroll jobs, 
even in an environment with low unemployment rates, suggest 
that the labor market continues to be strong and that its 
tightness will be reflected in more wage growth as we move into 
the coming months.
    Nominal wage growth has accelerated over the past year, and 
at an annualized rate, it has been 4.1 percent since January of 
2006. As I will discuss shortly, this follows the typical 
business cycle pattern of productivity increasing, leading to 
wage increases with a lag. What distinguishes this period from 
the past is that recent large and unanticipated increases in 
energy prices have consumed much of the strong nominal wage 
growth. Workers' paychecks have gone up, but they have had to 
use a portion of that increase for higher energy costs, such as 
gasoline and heating fuel.
    The increase in the price of gasoline and oil products has 
been one of the most notable changes in our economy during the 
past year. Since the beginning of August, we have experienced 
substantial declines in the price of gasoline and crude oil. 
Declines in energy prices are already apparent in the latest 
inflation data. Markets are expecting inflation rates going 
forward to moderate to around 2.5 percent. This coupled with 
continuation of high wage growth should translate into 
increased real earnings for the typical worker next year.
    The President's goal of cutting the deficit in half by 
2009, which drew the scoffs of many, is now likely to be 
reached before that date.
    One soft spot in the economy is the housing market. It is 
important to note, however, that the weakness in the housing 
sector does not seem to be spreading to other sectors of the 
economy, and recent consumer surveys indicate improving 
expectations.
    In sum, we expect the average growth rate for this year 
will be similar to that for last year. The economy continues to 
be robust and healthy.
    Underlying these strong numbers is high productivity growth 
that has made our economy the strongest and most robust in the 
world. It is the common thread that ties together all of the 
positive economic news. Productivity growth is closely 
associated with economic growth and results in higher worker 
compensation and improved living standards. It moderates 
inflationary pressure and has proved to be a defining 
characteristic of our economy.

[GRAPHIC] [TIFF OMITTED] 30816.055


    Figure 1 puts out recent productivity growth in a 
historical perspective. The BLS reports that U.S. productivity 
growth since the end of 2000 has been 3 percent per year, 
outpacing the 2.7 percent average from 1996 to 2000. The 
current growth rate in productivity is substantially above that 
for the 22-year period that preceded 1995 when productivity 
growth averaged only 1.5 percent per year.
    Productivity growth is important because it is the basis 
for the growth in hourly worker compensation. Figure 2 shows 
the relationship. The chart demonstrates the very strong 
correlation between productivity increases and improvements in 
real hourly compensation. The red line and blue line move 
together over any reasonable period of time.

[GRAPHIC] [TIFF OMITTED] 30816.056


    A number of observers have pointed out that profits have 
grown at a very high rate during this recovery, which is 
reflected in Figure 3. The red line is showing that profits 
grew at a high rate over the past 3 years. There is a distinct 
pattern of profits and employee compensation over the business 
cycle. After the recession in the early nineties, corporate 
profits rose dramatically and employee compensation lagged 
behind. At the same time, productivity grew faster than 
compensation.

[GRAPHIC] [TIFF OMITTED] 30816.057


    Profit growth outpaced compensation growth until the latter 
part of the nineties when corporate profits fell dramatically. 
Note that corporate profits actually declined during most of 
the period between early 1998 and late 2001.
    Just as in the 1990's, the mild recession in 2001 was 
followed by productivity growth in 2002, and profit growth was 
again very high while employee compensation growth was 
relatively low. The pattern that we observed in the past two 
recessions and recoveries is evident in earlier recessions as 
well going back at least 40 years. The pattern typically works 
in the following way: After a recession, productivity growth 
increases and hourly compensation tends to remain flat. As a 
result, costs stay low and profits rise. As the labor market 
gets tight, unemployment rates fall, hourly compensation 
increases faster than productivity growth, and so total costs 
rise faster than earnings. The result is that labor costs go up 
faster than the profit rate, and then the profit rate declines 
to more normal levels.
    Profits are important because they provide the incentive 
for investment in physical capital, and physical capital growth 
contributes to productivity growth. With rising compensation, 
we forecast that profit rates will decline in the future, but 
that this decline will bring them back to normal levels, and so 
profit rates will be sufficient to motivate the high levels of 
investment necessary to grow our economy.
    Whether real growth compensation growth will rise to the 
highest levels that we have seen over the previous expansions 
remains to be seen, but early indications are that we are on a 
similar path.
    Tax cuts passed by President Bush and the Congress have 
helped the economy grow. Probably most significant was the cut 
in dividend and capital gains taxes enacted in 2003. However, 
the lowering of marginal tax rates on earned or labor income 
was also an important contributor to economic growth.
    As budget directors and members of any budget committee 
surely know, government revenues tend to move directly with the 
state of the economy. When the economy is good, revenues come 
in at high rates, and when the economy declines, revenues 
decline correspondingly. The period since 2003, which has seen 
a growing economy, has also been one which during which 
government revenue have increased at high rates. Since 2003, 
government revenues are up 34.6 percent and the projected 
growth of revenues from 2005 to 2006 is around 11 percent. 
Because of this rapid economic growth-together with the 
continued efforts of Congress and the President to effect 
discretionary spending restraint, the budget deficit is 
declining at rates much faster than was anticipated, and we are 
on the path to meeting the President's deficit goals ahead of 
schedule.
    To determine the effect of tax cuts on revenue, we need to 
ask what revenues would have been absent these tax cuts. This 
question can be answered by providing estimates of what the 
revenue would have been had we not had cut taxes. An exercise 
of this sort can be done in a number of different ways, and we 
recognize the inherent uncertainty associated with the 
calculations.

[GRAPHIC] [TIFF OMITTED] 30816.058


    In Figure 4, we provide a simple comparison using 
historical data showing the path of revenue growth in this 
business cycle compared to previous cycles. The solid red line 
shows what happens during the current cycle's recovery, 
similarly indexed, by way, with a trough in 2002, compared with 
previous patterns. With the tax cuts that were enacted in 2003, 
receipts were below the average of previous recoveries. These 
lower revenues persisted through 2005. But more important than 
the level is the growth rate.
    Because of the growing economy, which we believe was 
stimulated at least in part by the tax cuts and growing taxable 
income, preliminary data suggests that revenues grew between 
2004 and 2006 at rates higher than were experienced in earlier 
recoveries. More refined estimates will be possible when the 
tax return information for 2006 is available.
    Will the tax cuts pay for themselves? As a general rule, we 
do not think that tax cuts pay for themselves. Certainly, the 
data presented above do not support this claim. Tax revenues in 
2006 appear to have recovered to the level seen at this point 
in previous business cycles, but this does not make up for the 
lost revenue during 2003, 2004, and 2005. The tax cuts were a 
positive step and they have contributed to the enhanced 
economic growth, additional jobs, higher real disposable 
income, and low unemployment rates that we currently see today.
    Our goal is not to maximize the size of government by 
generating as much tax revenue as possible, but instead to 
provide the revenues necessary to make sure that we can operate 
those programs that society deems necessary while at the same 
time allowing the private sector to take full advantage of its 
growth potential.

[GRAPHIC] [TIFF OMITTED] 30816.059


    It is also worth noting that because our revenues are 
growing at such high rates now relative to spending, the ratio 
of public debt to GDP, which most economists view as the best 
indication of our long-run budget situation, is expected to 
decline this year. Not only is our debt-to-GDP ratio improving 
as a result of our high economic growth and enhanced revenues, 
but it is also very close to our 40-year historical average and 
lower than at any point in the 1990's.
    As a result, our debt situation is favorable relative both 
to its past and to the debt situation of other industrialized 
countries. This should not be taken as a reason to be 
complacent. Indeed, the opposite is true. If we cannot control 
our spending both on the discretionary and entitlement sides of 
the budget, the pattern we are seeing in the current year could 
easily reverse and we could find ourselves in a debt situation 
that requires higher and higher interest rate payments relative 
to our GDP in the future. This is not a burden that we want to 
pass on to our children and grandchildren.
    Where do we go from here? I believe it is important to 
maintain a positive economic climate so that the labor market 
will remain strong, workers can find jobs quickly, and so that, 
coupled with declining energy prices, the typical worker's 
paycheck will buy more and more goods and services. The best 
way to do this is to keep our taxes low, to adopt more pro-
growth tax policies, and to remain open to international trade 
and capital flows as well as keeping our economy among the most 
flexible in the world.
    Thank you for giving me the opportunity to speak to you 
today, and I welcome your questions.
    [The prepared statement of Mr. Lazear follows:]

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    Senator Gregg. Thank you, Doctor.
    I am going to reserve my time until the end of the 
questioning period, because we have a number of Senators here. 
I want them to get their points in.
    So let us start with Senator Alexander for the first 
questions.
    Senator Alexander. Thank you, Mr. Chairman, for your 
courtesy.
    Senator Gregg. Thank you for coming.
    Senator Alexander. In the President's State of the Union 
Address, he proposed the American competitive initiative, which 
included a proposal to double the Federal investment of basic 
research over 10 years and to improve the teaching in math and 
science structure so we can keep our edge in science and 
technology. A number of Senators, actually 70, 35 Democrats and 
35 Republicans, have sponsored similar legislation this year. 
Last Tuesday, Senator Frist and Senator Reid, the Republican 
leader and the Democratic leader, introduced a comprehensive 
piece of legislation that took the President's proposal, all 
the various Senators' proposals, and worked it through three 
different committees. It was a very remarkable piece, a pretty 
good start on competitiveness.
    I note that in July, the President of China, Mr. Hu, went 
to the Great Hall of the People and assembled the whole 
Government of China, Communist Party leaders, his Academy of 
Sciences and Engineering, and committed that country to a 15-
year plan to make it a nation of innovation, including 
investments in research, remodeling universities, improving 
``K'' through 12, and recruiting outstanding scientists from 
the United States and back to China to help grow jobs.
    So my questions are about this: We talk about pro-growth 
policies and we often talk, at least on our side of the aisle, 
about tax cuts. I agree those are pro-growth policies. Do you 
agree that investments in keeping our edge in science and 
technology are also pro-growth for our economy, and do you 
expect the President and the Administration to get behind the 
Frist-Reid legislation, which can't pass this week, but would 
have a very good opportunity, given its broad support, to pass 
the Senate in November and then a chance to pass the House in 
this Congress?
    Mr. Lazear. Thank you. We certainly agree that investment 
in education, science, education specifically, but education in 
general, is a very high rate of return investment. When we look 
at the kinds of things that an economy can do to grow 
productivity, to grow GDP, to grow wages, investments in human 
capital come in at or near the top. If you look across the 
world and you ask which economies are growing, which ones are 
progressing at the highest rates, which ones are bringing their 
poor into the middle class, they are the economies that have 
the highest levels of education. They are the ones that are 
making the biggest investment in education.
    So I fully subscribe to your view that education and 
investing in skills in general is probably one of, if not the 
most, important things that we can do to grow the economy. It 
certainly has been something that has been on the President's 
mind since he began his Administration. ``No Child Left 
Behind'', of course, was one of his initial endeavors, and I 
think it is a step in the right direction, obviously not the 
only step that one needs to take, but I am completely with you 
in terms of the importance of the investment.
    Senator Alexander. I bring it up this morning because this 
is one of those rare occasions where this is not a Republican 
bill that was offered to the Democrats which they then amended 
or vice versa. This was actually a piece of legislation that 
probably two dozen Senators of both parties worked on together 
with the Administration about which there is unanimous support 
and there is an opportunity for the Administration, if it makes 
it a priority in the next few weeks, to make it happen.
    One other question: I was listening to the Senator from 
North Dakota's comments about the dire straits of the economy. 
I asked the International Monetary Fund to give me some 
information about the United States' position in the world in 
terms of Gross Domestic Product, and they gave this fact: They 
said in 1995, the United States produced about 25 percent of 
all the Gross Domestic Product in the world for about four or 5 
percent of the people, which is our population. Last year, 
2005, the United States produced 28 percent of all the world's 
Gross Domestic Product for about four or 5 percent of the 
people.
    Now we hear all these claims that the economy is bad and 
jobs are going down and things are terrible, but if those 
figures are true, does that not mean that the United States is 
not only remarkably rich in terms of Gross Domestic Product, 
but over the last 10 years, we have gotten richer even at a 
time when China and India and other parts of the world are 
growing and Europe is trying to do better? How would you 
characterize that growth in our share of the Gross Domestic 
Product over the last 10 years?
    Mr. Lazear. Yes, sir. I certainly agree that we have had 
very strong economic growth. If we compare the United States to 
the other G-7 countries, which is usually the comparison that 
we think is probably most appropriate, because then we are 
talking about countries at a similar standard of living, the 
United States is the leading country right now. I always view 
that as particularly remarkable, because it is easier to have 
high growth rates when you are catching up than it is to have 
high growth rates when you are the leader.
    If there are other economies that you can mimic, if there 
are other economies to which you can converge, that is an 
easier task than pushing out the frontier. Our economy has been 
particularly successful at pushing out the frontier. I believe 
that that is attributable in large part to the flexibility of 
the economy, to the fact that we allow for very strong markets, 
for essentially unimpeded capital movements, labor markets are 
flexible, and very strong entrepreneurship, which I think is an 
absolute key to the growth that we see in the United States. We 
have rapid and relatively easy business formation in this 
country, and that is an important component of our economic 
growth.
    So those are all very positive features.
    Senator Alexander. Thank you, Mr. Chairman.
    Senator Gregg. Thank you.
    Senator Conrad.
    Senator Conrad. Mr. Chairman, I wanted to take a moment, if 
we could, because this is going to be Senator Sarbanes' last 
hearing in the Senate Budget Committee, and I think we need to 
take a moment and reflect on his contributions not only to this 
committee, but to the Senate.
    Last night, we had a dinner which we recognized the four 
members who are retiring this year, Senator Sarbanes being one 
of the four. I want to say that I am going to miss Senator 
Sarbanes. There has been a no more valuable member on this 
committee to me than Senator Sarbanes. He is truly a remarkable 
man, not only highly intelligent, but wise and of an 
extraordinary good nature.
    I note that his wife, Christine, is here. Christine, it is 
good to see you as well. The Sarbanes couple are truly a team, 
and I have had a chance to travel with them, to get to know 
their family. They are really an extraordinary couple and we 
deeply appreciate their contribution to this committee and to 
the U.S. Senate and to our country.
    My favorite story about Senator Sarbanes was told last 
night, that he was selected when he was still in high school, 
about to graduate from high school, as an all-star and was to 
play in an all-star game in Baltimore, and he was to be the 
starting shortstop. He went to the game and they had 
preparations before the game, and the coach put him at second 
base. Paul went to the manager and inquired, you know, I had 
been selected for the game as a shortstop, and the coach kind 
of put him off and kept putting him at second base, and he went 
back to the coach and said, You know, again, I was chosen to be 
the shortstop, and the coach finally said to him, Look, 
Sarbanes, you are going to play second base; I am playing 
Kaline at shortstop. Of course, the Kaline was Al Kaline, one 
of the greatest baseball players of all time. You know, 
sometimes you draw the short straw.
    Senator Gregg. I think Senator Bunning struck Al Kaline out 
three times that day.
    Senator Bunning. And he was on my team.
    Senator Conrad. I think Al Kaline went to the Major Leagues 
when he was 18 or 19 years old.
    Senator Bunning. Seventeen.
    Senator Conrad. Seventeen years old.
    So, Paul, you know, maybe you could have had another 
career, a parallel career, one in the Major Leagues. Paul, we 
are truly going to miss you, and I am going to miss you very, 
very much, both as a friend and a colleague.
    Senator Gregg. Let me join you, Senator Conrad, in those 
thoughts and echo them. Obviously, Paul has been an immense 
person in the Senate for many, many years and a brilliant 
contributor to our activities. I am going to miss him too, 
although I am not going to miss his amendments. I used to 
cringe whenever he came to a markup, because I knew his 
amendments were just going to be terrorizing us. He will be 
missed immensely because he has been a force for positive and 
good government, and that is what it is all about.
    Senator Sarbanes. Well, thank you. I very much appreciate 
the very generous comments of the chairman and of my good 
friend, the ranking member. Thank you very much for that.
    Senator Conrad. Christine, thank you so much.
    And I will defer to Senator Sarbanes for any questions he 
may want to ask of the witness.
    Senator Sarbanes. Mr. Chairman, I will be very brief, but 
having heard Senator Conrad say I am good natured, I don't want 
to counter that.
    Mr. Lazear, what is the view down at the Council of 
Economic Advisers? And I understand the chairman and ranking 
member touched on this before I got here, but I was planning to 
raise it myself. What is your view down there about getting 
this testimony to the committee in accordance with our rules 
ahead of time, which of course then gives us a better 
opportunity to prepare substantively for the hearing? This 
isn't the first time this has happened. Is the CEA operating on 
a different premise or assumption than the committee is 
operating on and, if so, we need to know that, and if not, why 
aren't you measuring up to standard?
    Mr. Lazear. I will just simply apologize to you, Senator, 
and say that it is the first time on my watch and we will check 
into it in the future. So you do have my apologies for that 
mishap.
    Senator Sarbanes. I think I am correct in saying, though, 
that it has occurred previously. It now seems to be becoming 
standard operating practice at the CEA.
    Mr. Lazear. If so, as I said, I don't know about that. I am 
relatively new to the CEA, but we will check into it.
    Senator Sarbanes. Well, I wish you would do that. I mean, I 
think it is a good rule and it is there for obvious reasons, 
and most witnesses, at least, comply with it, and I think in 
some respects, there is probably more excuse for someone from 
the private sector who isn't equipped maybe to produce the 
statement the same way as the Council.
    While I have you, let me ask you is the Council still out 
in the hinterlands in terms of its location? You are no longer 
in the Executive Office Building; is that right?
    Mr. Lazear. Most of us are not. We do have an office in the 
Executive Office Building that we retain. As you probably know, 
after 9-11, two-thirds of EEOB was shut down for remodeling, 
most of which was security related, and so most of the people 
in that building were moved out to neighboring offices, and we 
have an office about a block down the street from the EEOB, and 
it requires a bit of commuting between the two, but we have 
managed to do it.
    Senator Sarbanes. Do you have an assurance that you are 
going to go back into that building once the remodeling is 
complete, or has, in effect, the banishment of the CEA from the 
immediate policy confines of the White House been accomplished?
    Mr. Lazear. I expect that we will go back, but, 
unfortunately, it looks like the remodeling will take us at 
least until 2009, probably 2010, possibly 2011. So a promise 
from this Administration, unfortunately, would not be worth a 
whole lot in terms of committing future Administrations to 
moving us back.
    Senator Sarbanes. That is like those promises we got from 
the President about the deficit early on in the first term of 
the Administration. They weren't realized either. Correct?
    Mr. Lazear. Well, as I testified earlier, you know, the 
deficit numbers have been looking much better than we expected, 
and they are moving in the right direction.
    Senator Sarbanes. I will spare you quoting the President's 
statements during the course of his first term about what was 
going to happen to the deficit. Senator Conrad has done a 
first-rate job of outlining that problem.
    The Federal revenues are what share of the GDP now?
    Mr. Lazear. The deficit? I am sorry.
    Senator Sarbanes. No. The revenues.
    Mr. Lazear. The deficit is approximately 2 percent.
    Senator Sarbanes. No. The Federal revenues.
    Mr. Lazear. Revenues are about--it would be about 10 
percent.
    Senator Bunning. No. You have got the wrong question.
    Senator Gregg. I think you said what percent of GDP are the 
Federal revenues. I think they are about 18.1 percent right 
now.
    Mr. Lazear. Oh, I am sorry. Revenues are actually above 
that. I think we are at 18.2 percent right now.
    Senator Gregg. The average?
    Mr. Lazear. I am sorry. I misunderstood your question, 
Senator. The average, depending on which period you look at, is 
about 18.1 percent.
    Senator Sarbanes. The chart you showed had revenues back up 
at the line recovering. You know that chart you put up there?
    Mr. Lazear. This one?
    Senator Sarbanes. Yes. That figure in 2006, that would be 
at 18 percent of GDP; is that correct?
    Mr. Lazear. Actually, that would be using the numbers from 
the mid-session review, which is consistent with a $300 billion 
deficit. So that is what this number is based on.
    Senator Sarbanes. I want to know what percent of GDP is 
Federal revenue.
    Mr. Lazear. I believe that is 18.2 at that point.
    Senator Sarbanes. And back when you started, what it was 
it?
    Mr. Lazear. Which year, sir?
    Senator Sarbanes. 2000.
    Mr. Lazear. In 2000, let us see. Do we have that number 
here? We can get that number for you. Bear with me for a second 
and I will get you the exact number.
    Senator Sarbanes. I don't want to impose on my colleagues. 
Let me ask you this.
    Mr. Lazear. Yes, sir.
    Senator Sarbanes. A 1 percent increase in the share of the 
GDP in Federal revenues would be worth how much money?
    Mr. Lazear. A 1 percent increase of GDP?
    Senator Sarbanes. No. Of revenues as a share of GDP, a one 
point increase. If it was 19 percent instead of 18 percent, how 
much more revenue is that?
    Mr. Lazear. About $130 billion, because GDP is 13 trillion, 
approximately. So you are talking about 1 percent of that 
number, sir.
    Senator Sarbanes. Yes. So if it was 2 percent, we would be 
close to wiping out the deficit; is that correct, if you added 
two points?
    Mr. Lazear. That is right.
    Senator Sarbanes. What was it back in 2000?
    Mr. Lazear. Let me see if I can find that for you. I have 
to get my glasses. Pardon me, sir.
    OK, 2000 was 20.9.
    Senator Sarbanes. So if we were not even at that level, but 
somewhere near that level, we would have eliminated the 
deficit. Correct?
    Mr. Lazear. Well, that assumes that the economy would be 
the same. Your assumption is that GDP would be the same and 
that we would simply take 20.9 percent of the GDP number that 
we have right now. I would not be willing to make that 
assumption.
    Senator Sarbanes. OK. As a calculation, that would be 
correct, would it not?
    Mr. Lazear. Again, sir, if you assume that GDP was the 
same, then that calculation would be correct.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Senator Gregg. Our resident all-star Hall-of-Famer, Senator 
Bunning.
    Senator Bunning. Thank you very much, Mr. Chairman.
    In all the charts and figures that the gentleman from North 
Dakota showed, there was no inclusion of 9-11, no inclusion of 
the Afghan War, no inclusion of the Iraqi War, no inclusion of 
Hurricane Katrina or Rita. The income levels did not include 
any health care and pension benefits that were added on top of 
the income levels. So I want that to be taken into 
consideration when you consider the numbers that were expressed 
by my good friend from North Dakota.
    Earlier this week, the ``Wall Street Journal'' indicated 
that more investors are starting to factor in the Fed Fund rate 
cuts that the Feds have made. Do you believe this is true and 
do you have any comment on the affect on the economy of the Fed 
policies of recent years?
    Mr. Lazear. Well, as you know, the Federal Reserve had 
raised rates for 17 consecutive times and then ceased raising 
rates a couple of periods ago.
    Senator Bunning. I am very familiar with that.
    Mr. Lazear. Inflation now seems to be coming under control. 
I think that the numbers that we have seen for the past----
    Senator Bunning. Do you believe there was inflation in 
those 17 months?
    Mr. Lazear. Well, there is no doubt that measured inflation 
was higher, quite significantly higher.
    Senator Bunning. When they started raising interest rates?
    Mr. Lazear. I don't believe when they----
    Senator Bunning. Maybe in the last 2 months.
    Mr. Lazear. Well, actually no. The last year had higher 
inflation than the previous year, but the question that I think 
most economists argue about has to do with whether this was a 
one-time increase in prices associated with an energy increase 
or whether it would be sustained inflation. I think that is the 
issue that the Fed has been arguing about as well.
    Senator Bunning. Internally?
    Mr. Lazear. Well, you know, right, internally. I don't know 
what they are arguing about internally, but only the statements 
that they have made are statements that I hear. As you know, we 
are an independent body and we have no access to any additional 
information.
    Senator Bunning. You have the minutes of their meetings, 
just like we do, a month later.
    Mr. Lazear. Correct. That is right, sir. When we look at 
what they have been saying, they have had the same kinds of 
arguments that I think other economists have had, which is are 
we more concerned about inflation or are we more concerned 
about making sure that the economy continues to grow at a high 
rate.
    That is a balancing act that the Fed has to engage in. We 
are confident that the Fed attempts to do that the same way 
that we attempt to think about these issues. They have the same 
data that we have, as you pointed out, and I think the recent 
numbers on inflation are encouraging.
    Senator Bunning. I have an even more important question. 
Some economists suggest that the blame for the American deficit 
lies in Asian emerging economies. Asian central banks drive 
their currency down by buying American Treasury bonds, reducing 
interest rates, and allowing Americans to buy even more Asian 
exports. To what degree do you think China's current practices 
have contributed to the growing U.S. deficit?
    Mr. Lazear. There is no doubt that investment in the 
current account surplus to which you refer is the other side of 
the current account deficit that we see in terms of trade. So 
when we are running a current account deficit, it is 
necessarily the case that some other country, at least, is 
running a current account surplus. In fact, we have seen this 
with China investing at very high levels in U.S. Treasuries.
    Senator Bunning. You have to get to the point of my 
question though. The basic point of my question is to what 
degree do you think China's current practices have contributed 
to the growing U.S. deficit, in other words, the undervaluation 
of the Won.
    Mr. Lazear. Well, as you know, Treasury speaks for us in 
terms of the value of the dollar relative to other currencies.
    Senator Bunning. We are trying not to let them do that.
    Mr. Lazear. I would prefer to defer to my colleague, Hank 
Paulson, on speaking about currency.
    Senator Bunning. We will have a bill that will change that.
    Mr. Lazear. All right. I will wait for it.
    Senator Sarbanes. Hasn't he said that it is undervalued?
    Mr. Lazear. I am sorry?
    Senator Bunning. Paulson has said it is undervalued.
    Mr. Lazear. Hank is not shy. I will let him speak for 
himself.
    Senator Sarbanes. He has made public statements to that 
effect.
    Senator Bunning. The thing that he really said was that 
there wasn't manipulation. He didn't say that it was 
undervalued, just to correct the record.
    Mr. Lazear. Again, I would rather let the Secretary speak 
for himself.
    Senator Bunning. All right. I will question him when we see 
him.
    Thank you, Mr. Chairman.
    Senator Gregg. Thank you.
    Senator Conrad.
    Senator Conrad. Thank you, Mr. Chairman. Let me just go to 
a speech that the Controller General of the United States gave, 
General Walker, about the situation that we are in as a 
country. These are remarks from a speech he gave to the 
certified public accounts in August of this year. He said: 
``The U.S. Government is on an imprudent and unsustainable 
fiscal path.'' Let me go to the second statement there. No. Let 
us go to the third one. ``The executive branch is only giving 
5-year projections for their budgets. Why? Because we go in the 
tank after 5 years; the numbers start looking bad after 5 
years.''
    Let us go to the next one. This is General Walker again in 
a speech to the accountants: ``Right now, the miracle of 
compounding is working against us because we are the world's 
largest debtor nation, and if interest rates start going up, 
the effect that that will have could be dramatic because we are 
adding debt at or near record rates, and if interest rates 
start going up, since the duration of our debt is pretty short, 
we will start feeling it pretty quickly.''
    Finally, so the bottom line is, he said, the status quo is 
not acceptable. It is not sustainable. Faster economic growth 
can help, but there is no way we are going to grow our way out 
of this problem. Anybody who tells you we are going to grow our 
way out of this long-range problem, No. 1, hasn't studied 
economic history, and No. 2, would probably flunk basic math. 
The numbers just don't work.``
    I would ask you, Dr. Lazear, are there any of these 
statements that have been made by Controller General of the 
United States that you disagree with?
    Mr. Lazear. I think I fundamentally agree with his 
statements, but I want to make sure that we interpret the 
statements as talking about the long-run situation. It is 
absolutely clear to me that the path that we are on in terms of 
growth and entitlements, Medicare, Medicaid, Social Security, 
cannot be sustainable. We have to think about ways to address 
that problem. I think the President has been clear on that as 
well.
    So I don't think that these statements are at variance with 
the Administration's view on it.
    Senator Conrad. But it is a very different message that he 
is delivering than the message I hear you delivering here 
today. I hear you delivering kind a good news message, 
everything is going great, but I hear the Controller General of 
the United States delivering a very much more sobering message, 
one that we are on a course that is utterly unsustainable where 
we are piling up debt at a rate that is unsustainable and that 
it threatens our future economic strength.
    Mr. Lazear. Again, I would distinguish the short run from 
the long run, Senator. In the short run, I think things are 
getting better, the fact that the deficit has gone down 
significantly greater than anticipated. We are now below what I 
think is the magic number. The magic number at this point is 
about 2.4 percent deficit, which means we are at that number or 
below the deficit--the debt-to-GDP ratio is shrinking. So our 
public debt-to-GDP ratio will actually be shrinking.
    That is true over the short run, but if we allow 
expenditures to grow, if we allow the budget to get out of 
control in the future and if we believe these projections about 
where we are going to go in the future, we will certainly allow 
them to get out of control. That will cause some very serious 
long-run difficulties, and I certainly agree with that. I think 
that that is probably one of the greatest problems that we face 
as a country, and we need to address it.
    Senator Conrad. Let me say that this analysis of the 
deficit as 2.4 percent of GDP to me misses the point. The 
deficit is going to go up 260 billion this year. The debt is 
going to go up 560 billion, and what people seem to miss here 
is that it is the debt that has to be repaid, and this is the 
level of debt increase. The debt of this country, gross debt, 
at the end of this year will be eight dollars and a half 
trillion dollars, and we are going to add 600 billion dollars, 
almost 600 billion dollars, this year, 557 billion dollars. We 
are going to add, according to projections, 600 billion dollars 
or more every year for the next 5 years.
    So we are going be at 11 and a half trillion dollars 5 
years from now just as the baby-boomers start to retire. That 
is what causes so many of us deep concern, and what I hear you 
saying is that that concerns you as well.
    Mr. Lazear. What I am saying is that we encountered some 
unanticipated shocks, some of the ones that Senator Bunning had 
pointed out. The question that every society faces when they 
encounter an unanticipated adverse event is how do we finance 
those over time. No one would ever suggest that you are going 
to finance that at one point in time fully by that particular 
year's worth of income.
    So the question is how do you smooth it over time, and the 
issue is are we smoothing too much or are we smoothing too 
little or are we just about right.
    Senator Conrad. I don't see us smoothing anything. The debt 
this year, and you just described the economy as strong, we are 
going to increase the debt by almost $600 billion.
    Mr. Lazear. That is what it means to smooth. You borrow to 
take care of----
    Senator Conrad. But sir, sir, not only are we going to add 
almost 600 billion dollars to the debt this year, we are going 
to add three trillion dollars over the next 5 years. I don't 
see where the smoothing is coming. The only thing that is 
happening here is we are running on a charge card.
    Mr. Lazear. As I said, the number that I think most 
economists think about is the ratio of the public debt to GDP. 
That is what we think of as the long-term target. Now, we can 
disagree over whether we are too high right now, whether we 
should be much lower. We are at about our historic average, 
slightly about, but pretty close to our historic average. The 
historic average, I showed on the chart.
    Senator Conrad. The historic average includes World War II.
    Mr. Lazear. No, no. Sorry. The 40-year average.
    Senator Conrad. I thought you said the historic average.
    Mr. Lazear. I am sorry. We only went back 40 years. We used 
the same numbers that OMB uses.
    Senator Conrad. I just say to you that we are now running 
up debt at a rate that is by, I think, most objective 
observers' analysis absolutely unsustainable. That is what the 
Controller General is telling us, and we are using an 
accounting system that you know is cash. If we were going on an 
accrual system, the way most of the institutions have to do in 
this society, these deficits would be much, much larger.
    I thank the chairman.
    Senator Gregg. Senator Grassley.
    Senator Grassley. Dr. Lazear, your predecessor at CEA, Dr. 
Mankiw, wrote a paper entitled ''Dynamic Scoring: A Back of the 
Envelope Guide``. That is the name of it. The paper suggested 
the dynamic effects of tax cuts on labor will offset about 17 
percent of the static revenue loss and the dynamic effects of 
the tax cuts on capital will offset about 50 percent of the 
static revenue loss.
    These results are interesting for two reasons, and I want 
you to comment. First, they suggest that while tax cuts do not 
pay for themselves from the perspective of the budget, they do 
have a significant impact on the economy. Second, in order to 
offset 50 percent of the revenue loss, a tax cut on capital 
would have to increase GDP by more than one dollar for each one 
dollar of revenue loss. Are you familiar with the study and 
what are your views, then, on the issue of dynamic scoring?
    Mr. Lazear. Yes, sir, I am familiar with the study, and I 
would say, Senator, that it is actually consistent with the 
numbers that I put up earlier. Actually, if you don't mind, I 
will refer back to that for a second.
    Nick, if you could put up, I think it is Figure 4.
    This makes your point in a slightly different way, but I 
think it is completely consistent with what you are saying. If 
you look at the effect of the tax cuts, which is the difference 
between the red line and the dotted blue line, look at 2003, 
and you will see that there is a decline in revenue there; but 
what you also see is that the revenue growth between 2004 and 
2006 is quite steep. We believe that that revenue growth is at 
least in part attributable to the tax cuts themselves, and that 
is the dynamic aspect of what we are talking about here.
    Now, as a consequence of that, you will also see that the 
revenues in 2006 are back to where they would have been but for 
the tax cuts. In other words, even if we hadn't cut taxes, we 
would be back right at about the same level because of the 
additional growth of the economy. Again, that is the dynamic 
scoring aspect of this issue.
    As you know, we don't do dynamic scoring in most of our 
analyses. Treasury right now is undergoing what they call a 
dynamic analysis to try to incorporate some of these issues. 
CBO is doing the same thing, and a variety of private think 
tanks have been working on this as well. So there are a number 
of different ways to incorporate these kinds of estimates. I 
think, you know, Greg Mankiw's estimates that you mentioned are 
one set of estimates, but I think all of us agree that there 
are dynamic effects. The question is simply how large are they. 
This chart seems to suggest that at least in the short run, 
they are pretty significant and it is certainly something we 
need to take into account.
    Senator Grassley. I yield back the rest of my time.
    Senator Gregg. Thank you, Senator Grassley.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman. I want to pursue 
this idea of the public debt being held by foreign buyers. What 
would happen if the United States prohibited foreign investors 
from purchasing our debt?
    Mr. Lazear. Well, right now, we are running a current 
account deficit, which, again, on the other side of that is the 
capital account surplus. We are bringing in a great deal of 
money from abroad, which is funding our investment. Our 
investment level still happens to be very strong, but that is 
coupled with a pretty high level of personal consumption, as 
you know. What that means is that we rely pretty heavily on 
foreign investment right now as a source of funds. For growth, 
for investment, that capital is extremely important to our 
economy.
    Just to give you a couple of numbers to put this in 
perspective, we estimate that about 45 million American jobs 
are in firms that are engaged in significant international 
trade. We estimate that about one in twenty Americans is 
employed in a foreign-owned firm, and so they are an important 
source of contribution to the American economy. If that were to 
reverse, if that were to come to an abrupt end, obviously it 
would have significant impacts, adverse impacts, on the 
economy.
    Senator Allard. So if you look at, you know, our account 
deficits, it seems as though when our economy is doing better, 
it increases, and when our economy is doing poorer, like during 
the Depression or maybe at the end of the 1970's when we had 
the misery index, the account deficits were in the positive 
range. So would you say, then, in terms that we have an account 
deficit, it can be a sign that our economy is doing great?
    Mr. Lazear. Well, again, I would put it a slightly 
different way. What I would say is when we have a capital 
account surplus which suggests that others are anxious to 
invest in the American economy, that is a good sign, because it 
tells us that not only are we willing to put money in this 
economy, not only do we think that there is a good future, but 
people who have no other inherent stake in this economy also 
agree with us.
    Senator Allard. They will get a greater return on the 
investment than a savings account or whatever?
    Mr. Lazear. Exactly, and they are not in this game for 
charity. They are not in this game for patriotism, but because 
they think it is going to bring a higher rate of return. So I 
would simply view that as evidence that other people in other 
countries agree with our investment sentiments.
    Senator Allard. I want to move on to energy. Right now, we 
are blessed with a drop in the cost of gasoline at the fuel 
pump, but I think that there is still a good deal of 
frustration. When the economy looked like it was good, you 
would explain it to people and they wouldn't believe you 
because every time they would pull up to the gas station to get 
a tank of gas, that impacted them so personally in their 
checkbook, but now we are seeing that dropping down 
dramatically.
    The Organization for Economic Cooperation Development has 
estimated that a $10 decrease in the price of a barrel of oil 
will increase the level of Gross Domestic Product by two-tenths 
percent. Since August, the price of a barrel of West Texas 
intermediate has declined significantly. Would it be reasonable 
to assume that the lower energy prices could provide an 
unexpected boost to our current economic growth in the coming 
months?
    Mr. Lazear. We believe it will be helpful to economic 
growth. Whether the number is 2 percent, I have actually seen 
numbers as high as--sorry--.2 percent. I have actually seen 
numbers as high as .4 percent. You know, I wouldn't want to 
venture an exact number, but it certainly is a positive force. 
I think that one of the good things about the economy is that 
because we have had high productivity growth over the past few 
years, we have been able to withstand what really was quite a 
significant energy price increase, and we did it without seeing 
job loss, without seeing productivity loss, without seeing 
output loss.
    All of those things are good signs, and I think they are a 
testament to the robustness of the economy and the resiliency 
of the economy. So going forward, I think that your point is 
well taken. As we look to these declines that we are now 
seeing, and we are certainly happy that those declines have 
occurred, we do expect that this will have a positive affect on 
the economy, possibly as early as fourth quarter.
    Senator Allard. Yes. I think that the fact that our economy 
did so well during a time of very high gas prices speaks very 
clearly about the strength of the President's economic 
initiative to stimulate the economy and keep it going, because 
I can remember the last time we had high gas prices at the 
pump, it was, again, during the late seventies, and that is 
when it really had an adverse impact.
    So thank you for your comments.
    Mr. Lazear. Thank you, sir.
    Senator Gregg. Thank you.
    I had a set of questions I was going to ask you, but we are 
running into a time issue here. There is going to be a vote, 
and I would like to get the next panel's testimony before we 
have to go into potentially a series of votes. So I want to 
thank you for coming.
    Mr. Lazear. Thank you, Senator.
    Senator Sarbanes. Mr. Chairman, could I just clarify one 
thing?
    Senator Gregg. I would like to move this along, if you 
don't mind.
    Senator Sarbanes. I won't take long. I want to followup on 
what Senator Allard was saying.
    Mr. Lazear. Yes, sir.
    Senator Sarbanes. I was actually taken aback by your 
assertion that other people in other countries are willing to 
hold our debt and that shows that they have confidence and 
strength in the U.S. economy, which you just made. Correct?
    Mr. Lazear. Correct. I am surprised you are taken aback.
    Senator Sarbanes. Well, I am taken aback because, as I 
understand it, more and more of that debt is being held by 
governments, not by individuals, and Senator Bunning made, I 
thought, a very effective point, that they are doing that in 
order to affect the exchange rate and to gain a trade 
advantage. That is why Japan and China have these huge, huge 
holdings, and the shift has been from--it doesn't represent a 
judgment by private individuals. It represents a governmental 
decision in those countries designed, I think, to help them 
gain a trade advantage, which is, I think, the point that 
Senator Bunning was trying to make.
    So they are over there playing a very shrewd game to our 
disadvantage, and you are sitting there as the Chairman of the 
Council of Economic Advisors telling us that everything is 
hunky-dory.
    Senator Gregg. I think we will take that as a rhetorical 
question.
    Senator Sarbanes. OK.
    Senator Gregg. Thank you very much for your input and thank 
you for your time, Dr. Lazear.
    Mr. Lazear. Thank you.
    Senator Gregg. We will now turn to our second panel, which 
is made up of three distinguished scholars from three very 
distinguished policy groups. We have Dr. Kevin Hassett, who is 
Director of Economic Policy at the American Enterprise 
Institute; Mr. Chris Edwards, who is Director of Tax Policy 
from CATO Institute; and Peter Orszag, who is the Deputy 
Director of Economic Studies at Brookings Institute. All three 
have a long track record of substantive and thoughtful input on 
American policy on a variety of different levels, and we 
appreciate these three witnesses taking the time to come here 
today to testify.
    We will start with you, Dr. Hassett.

    STATEMENT OF KEVIN HASSETT, DIRECTOR OF ECONOMIC POLICY 
             STUDIES, AMERICAN ENTERPRISE INSTITUTE

    Mr. Hassett. Thank you very much, Chairman Gregg and 
Ranking Member Conrad. I would also like to take a moment to 
thank Senator Sarbanes for his public service and say that I 
have testified many times over many years and I have always 
found our exchanges to be stimulating and challenging, and he 
really will be missed.
    I am going to abbreviate somewhat my remarks compared to 
what I handed in and try to give you the highlights, and I will 
skip over a good deal of what I have written about the outlook 
as it coincides fairly closely with what Chairman Lazear 
stated. The one thing I would like to add is the final 
concluding point from my overview of the economic outlook, 
which is that right now, it seems like the forecasters that I 
trust the most, like Moody's Economy.com and so on, just non-
political economists, think that we are heading for a 
successful soft landing, and I think that if we do head for 
that, it is just worth mentioning on the record that that is an 
impressive policy accomplishment for the Federal Reserve.
    Indeed, if we look back at last summer, in stopping where 
they did, the Federal Reserve officials took something of a 
calculated risk. Inflation pressures were still present. Growth 
was still strong, and in similar circumstances in the past, the 
Fed has continued to tighten. I think right now, their judgment 
not to do so looks pretty good given the data that we have seen 
since then, and I think a tip of the cap is in order for Mr. 
Bernanke and his colleagues.
    I mentioned in my written testimony that I wanted to bring 
a somewhat different light on the question of the distribution 
of growth. There has been concern in my circles that the 
current economy may somehow be different than economies in the 
past and that economic growth might not be shared as equally as 
it has been in the past. There are a number of statistics that 
are consistent with that perspective. Between 2000 and 2006, 
for example, real wages which exclude benefits increased .6 
percent per year while real hourly compensation, which includes 
benefits, increased 1.3 percent per year.
    Additionally, the Census Bureau recently reported that real 
median household income grew only 1.1 percent from 2004 to 
2005. It also reported that this was the first year since 1999 
in which such an increase was reported. These statistics have 
received a great deal of attention in the press, and on their 
face, the data would suggest that ordinary Americans are not 
sharing in the economy's growth, and that would be quite a bit 
of a break from past experience.
    It is important to note, however, that, first of all, these 
measures don't take the Tax Code into account. In my testimony, 
I have a couple of charts from a chapter in a book edited by 
Rebecca Brank and Sheldon Dansinger that I wrote with my co-
author at AEI, Anne Moore. As of 2004, for example, the total 
income and payroll tax liabilities for the two sample families 
in my testimony declined sharply over the last decade, and 
accounting for those changes in taxes is important as we think 
about what is going on for the median person.
    There are also a number of other factors that we need to 
account for when we are thinking about how the middle person is 
doing, because no person stays right in the middle every year. 
Economists have long believed that one of the things to look at 
when you are assessing the welfare of individuals is their 
consumption. Just because GDP has been rising a lot lately, so 
has aggregate consumption. It has grown 17.24 percent since 
2001. This is interesting because consumption very often in the 
statistics is much more equally distributed than income and 
wealth.
    So what my staff and I did is we went back to the consumer 
expenditure survey and took the share of consumption that goes 
to the middle class and then used that share to try to estimate 
their consumption in recent years given the increase in liquid 
consumption. I think that those data reject the view that we 
are evolving toward an economy where we are significantly less 
friendly toward the middle class. Indeed, the rate at which 
consumption by the middle class is increasing has even 
accelerated in recent years. There is a figure in my testimony 
that indicates that.
    I think that we should also recognize as we look at these 
data that we did have an adverse shock to inflation. The real 
growth at the top line consumer price index was 1.7 percent for 
2001 to 2002, but it accelerated all the way up to 3.8 percent 
between 2005 and 2006, marking the highest increase in the last 
15 years.
    Inflation surprises have, of course, occurred before, and 
when they do, we know what happens. Real wage growth is lower 
than expected, but then as those wages are re-contracted as 
workers go back and say, Hey, that deal I made last year wasn't 
so good because of inflation surprised on the up side, then 
their wages catch back up. In addition, energy prices have 
surprised on the down side lately, as was mentioned by Chairman 
Lazear, and those reductions should pave the way for further 
real wage gains, but it is worth emphasizing that the pattern 
that we see in the consumption data is consistent with a view 
that workers recognize that their wages are going to catch up 
and smooth their consumption through the negative surprise.
    In the near-term budget outlook section of my testimony, I 
talk about what has been going on with the near-term budget. 
Figures 5 and 6, I think are notable for thinking about how we 
got to the place we are where we have a deficit. The dotted 
line in Figure 5 shows the latest projections for outlays in 
2006 and compares them to past CBO projections for spending in 
that year. Going back to the first year, such a forecast is 
available, in 1996.
    I think the chart tells an unambiguous story, that spending 
was much higher than projected back at the end of the Clinton 
Presidency or the beginning of the Bush one. While it is 
important to note that these projections keep real 
discretionary spending constant going forward, the numbers are, 
nonetheless, startling. 2006 outlays, for example, were $479 
billion higher than the CBO projected outlays would be, you 
know, for that year back in 2001. Since the 2006 looks like it 
will be 260 billion or so, one could conclude that we could 
currently have a surplus if government had stayed on the 
spending course that was incorporated into that outlook.
    Figure 6 provides a similar comparison, this time for 
revenues. As I am running out of time, I won't go through the 
details, but if you look at the revenue chart, then what you 
see is for some years, revenues are lower than they thought 
they would be in 2006 for some past projections, and for some 
years, they are higher. So there is ample room for debate in 
there between supply side optimists and pessimists about 
whether the tax cuts paid for themselves, but I think that even 
the supply side pessimists would have to concede that relative 
to the times when we had large surpluses, revenues have 
surprised less on the down side than spending did on the 
upside.
    In the remainder of my testimony, I have a discussion of 
the literature on budget rules. I know that members on both 
sides of the aisle in this committee, at least, are in favor of 
some kind of new budget legislation. I think the literature 
suggests that those work.
    In the final section of my testimony, I talk about the 
longer-term outlook and agree with Senator Conrad that it is 
really quite troubling and discuss why I think the 
misconception about what a tax increase or a benefit cut really 
is when we are talking about entitlements might be an 
unnecessary obstacle to bipartisan agreement about how to 
afford. I think not moving forward is not an option and the 
fact that cleaning up these misconceptions might help move 
toward bipartisan agreement, I think is an optimistic sign.
    And that is how I close my testimony. Thank you.
    [The prepared statement of Mr. Hassett follows:]

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    Senator Gregg. Thank you, Doctor. I appreciate that, those 
thoughts.
    Mr. Edwards.

  STATEMENT OF CHRIS EDWARDS, DIRECTOR OF TAX POLICY STUDIES, 
                         CATO INSTITUTE

    Mr. Edwards. Thank you very much, Mr. Chairman, and thanks 
for hold the committee, as with other members, and thanks for 
having me testify today.
    The economy is certainly continuing a solid expansion, and 
we do appear to be in the middle of a long boom like we enjoyed 
in the eighties and nineties. I suspect that a lot of the 
current good economic performance mainly has to do with 
America's entrepreneurs and dynamic global markets and not so 
much with Federal policymakers; however, Federal spending and 
taxation does play an important role in aiding or impeding 
growth.
    The Federal Government extracts $2.7 trillion in taxes and 
borrowing from the private economy every year. That has two 
basic impacts. The first basic impact is that it shifts 
resources from the more productive private economy to the less 
productive government economy. The large increases in spending 
in recent years will reduce growth because current taxes will 
have to be higher than otherwise.
    The second basic impact of all that spending is that the 
method we use to extract the taxes from the economy is 
particularly damaging with a complex Tax Code. So to sustain 
our current strong expansion, I think they need to look at both 
limited spending and going to a simpler, more efficient Tax 
Code.
    Those opposed to recent tax cuts argue that tax cuts 
financed by deficits don't do much for the economy, and it is 
true that recent tax cuts would have had more tick if we had 
limited spending as well and matched tax cuts with spending 
cuts. There is a crucial point to make here though, that all 
tax cuts are not created equal. About 45 percent of recent tax 
cuts since 2001, you can call a social policy tax cut, such as 
the child tax credits. Those sorts of tax cuts do not reduce 
distortions in the Tax Code and don't really have much of an 
impact on GDP. They simply push tax burdens on to future 
generations.
    About 55 percent of recent tax cuts since 2001, however, 
you can call supply side tax cuts, such as the dividend and 
capital gains tax cuts. Those reduce distortions in the Tax 
Code, boost GDP growth, and they also don't lose the Federal 
Government as much money as the static revenue calculations 
suggest.
    The greatly different impacts of different types of tax 
cuts can be seen in a joint committee taxation study last year. 
They did a micro simulation analysis of different types of tax 
cuts to see what the GDP impact would be. They found that a 
corporate tax rate cut boosted GDP growth in the long run twice 
as much as an individual income tax cut, and they found that a 
corporate tax cut boosted GDP four times as much as an 
expansion in the personal exemption, which is sort of like a 
social policy tax cut.
    So if you look at recent tax cuts, there is no doubt in my 
mind that the dividend and capital gains tax cut have helped 
the economy grow strongly and we certainly can see the impacts 
on Wall Street. Dividend payouts by large corporations have 
soared since the dividend tax cut passed in early 2003.
    Regardless of whether one supports recent tax cuts, it is 
clear that we have a gigantic long-term spending problem. The 
GAO, basic GAO, sort of business-as-usual scenario shows 
Federal spending rising from 20 percent of GDP this year to 
about 45 percent of GDP by 2040, and the long-term problem is 
actually really worse than that, because we risk here, moving 
forward, sort of an economic death spiral. If Congress tries to 
jack up tax rates to meet rising spending, that will cause 
greater tax avoidance, slower growth, and less tax revenue, 
perhaps prompting Congress to jack up taxes even higher than 
the GAO numbers indicate.
    So what we need to do is we have got a bleak future here 
for young Americans unless we do some serious spending reforms. 
We need tougher budget rules, and I certainly laud the chairman 
for his SOS bill. I guess it is S. 3521. He has got some great 
ideas regarding limiting entitlement spending and discretionary 
spending. I think an even more basic idea we should consider is 
putting an overall cap on total growth and total outlays by the 
Federal Government every year.
    A number of States have such caps, and it just seems like 
such a simple and obvious idea, we ought to consider it 
Federal. The idea is you would cap total outlays every year by 
some indicator, like personal income, or it could cap total 
outlays with some fixed percentage number, like four or 5 
percent. That would make it very easy for Congress to plan 
their outlays in the future, and it would make it very easy for 
the public and groups in the private sector to see whether 
Congress is cheating or whether they are following their budget 
rules. With a cap in place, Congress could consider their 
annual budget resolution. They would look at where the spending 
cap that is in the statute of law was and it could include 
reconciliation bills in your annual resolution to get spending 
under the cap. If the end of the fiscal year comes around and 
Congress hasn't met the cap, the President would be required to 
sequester spending, sort of like under GRA's role in 1990 in 
the Budget Enforcement Act.
    So it is clear budget rules are clearly not working. We 
have got non-stop deficits. In most years over the recent 
decade, we have had large deficits. We have got these gigantic 
unfunded obligations that have built up. We clearly need to 
experiment with new types of budget rules. I think the ideas in 
the chairman's SOS bill are great, but I also think we need to 
look at a cap on overall Federal outlays.
    Thanks for having the hearing. I am happy to answer any 
questions.
    [The prepared statement of Mr. Edwards follows:]

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    Senator Gregg. Thank you, Mr. Edwards. I appreciate those 
comments.
    Dr. Orszag.

STATEMENT OF PETER ORSZAG, DEPUTY DIRECTOR OF ECONOMIC STUDIES, 
                     BROOKINGS INSTITUTION

    Mr. Orszag. Thank you, Mr. Chairman and Members of the 
Committee.
    Today as a Nation, we are neither paying our way nor 
investing sufficiently in our workers. The Nation's net 
national saving rate is hovering around 2 percent of national 
income. I would say there is no good outcome that comes from 
the world's leading economic power only saving 2 percent of its 
income. It means that we either only invest 2 percent of our 
income, which will starve workers in the future of the 
productive capital that they need to have higher wages, or it 
means that we borrow the difference from foreigners, which is 
increasingly what we are doing. That, however, is not a free 
lunch. We owe the money back. We are mortgaging our future 
income by borrowing such massive amounts from foreigners. 
Roughly half of the public debt now is owned abroad.
    The second problem is stagnant real income and more risk 
for middle class families. Family incomes are basically flat. 
If you look at the consumer expenditure survey itself, which 
Dr. Hassett already mentioned, and just look at consumption 
levels in that survey, consumption levels for the middle 
quintile are also flat. Across a wide variety of indicators, 
outcomes for middle class families look like since 2000 they 
are basically stagnant.
    At the same time, families face increased income risk. The 
probability of a 50 percent decline in income over a 2-year 
period has more than doubled since the early 1970's. So middle 
class families and lower income families are facing both 
stagnant real incomes and increased risk, and we need to 
address that problem too.
    Unfortunately, the tax cuts have exacerbated both problems. 
By 2015, they will have contributed roughly $5 trillion to the 
Nation's debt. That is 25 percent of our GDP, and ultimately 
because the tax cuts have to be paid for, they will reduce real 
incomes for the vast majority of families, more than three-
quarters of families, once you take into account the necessary 
spending reductions or other revenue increases to offset the 
cost of the tax cuts.
    But everyone says, Well, maybe those costs are worth it 
because the tax cuts boost growth, and it is true that in the 
short run, they have had some modest effect on economic 
performance, but we could have gotten that same kick much more 
cheaply if we had pursued other policies; and, more 
importantly, over the long term, the vast bulk of the studies 
suggest that because the tax cuts are deficit financed and 
because they were not particularly well designed to promote 
economic growth, their long-term impact on the economy is 
negative, not positive.
    So we have both problems being exacerbated. Ultimately, the 
tax cuts increase national debt, reduce national saving, impair 
long-term economic performance, reduce incomes for most 
families, and also reduce after-tax income volatility, which 
families are also struggling with. So what should we do instead 
of that approach? And I think Senator Alexander actually 
touched upon it. There is a better way in which we invest in 
education, research, technology, and increase national saving.
    The basic alternative view in which the way to promote 
economic growth, broad-based participation in that growth, and 
improved economic security is the basis for a new project at 
Brookings that I direct called the ''Hamilton Project`` where 
we are putting out a lot of ideas about exactly how to go about 
doing that.
    So what do we need to do? First, increase national saving, 
obviously, we need to get the fiscal deficit under control, 
because the fiscal imbalance is a major contributor to that low 
national saving rate that I mentioned. I am sure we will talk 
about ways to get the fiscal imbalance reduced. Beyond that, we 
need to raise personal saving, and by far, the best way to 
raise personal saving in the United States is to make it easier 
and more automatic for households to save.
    I would note that there was legislation introduced 
yesterday that Senator Conrad was a cosponsor of, along with 
Senator Smith and I believe two or three other Senators on a 
bipartisan basis, to create an automatic IRA so that workers 
that go to work at firms that don't sponsor a pension plan 
would automatically be enrolled in an IRA. The evidence is 
overwhelming that these sorts of ``EZ-Pass'' approaches or 
automatic saving approaches work and we should be pursuing them 
much more vigorously.
    In addition to that, in my written testimony, I provide 
another idea that I think is worthy of attention. We in the 
United States spend roughly $500 billion a year through the Tax 
Code providing incentives for health care, retirement, 
homeownership, and other socially beneficial activities. Almost 
all of that is done in the form of deductions or exclusions, 
which link the size of the tax break to someone's marginal tax 
bracket. Not only does that skew the benefits toward higher 
income households, but it is economically inefficient, because 
unless you think that high income households are more 
responsive to that incentive or generate larger benefits when 
they do respond, it doesn't make any sense to provide a larger 
tax break to one particular set of households than another.
    In a recent paper with Fred Goldberg, who was the IRS 
Commission under the first President Bush, and Lily Batchelder 
of New York University we argued that basically all of those 
tax incentives should be reconsidered and done on a uniform 
credit basis rather than with a deduction or exclusion, which 
would both be fairer and more efficient, and there are very few 
opportunities that we face in the United States to improve both 
equity and efficiency, and I would urge you to seriously 
consider that as an approach.
    So the bottom line is there is a much better way to promote 
economic growth than tax cuts that run up the deficit, reduce 
national saving, and ultimately will impair incomes for most 
families.
    Thank you, Mr. Chairman.
    [The prepared statement of Dr. Orszag follows:]

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    Senator Gregg. That you, Doctor.
    Senate Bunning.
    Senator Bunning. You surprised me, Mr. Chairman.
    Senator Gregg. I thought I would let you start. We are 
going to have a vote here, and I want to make sure everybody 
gets a chance.
    Senator Bunning. Looking to the tax burden as a share of 
GDP, we see a definite trend of receipts heading back to their 
historical levels of about 18 percent of GDP. If we keep the 
tax rates where they are, then the projections are that 
receipts will stay near this historical range; however, if we 
raise taxes by allowing recent tax cuts to expire, the 
projections are that we will see the tax burden rise to over 20 
percent of GDP.
    Can you comment on what impact the tax burden of this level 
would have on the economy? Is, as some of our colleagues 
suggest, the only path to fiscal restraint a return to record 
levels of taxation?
    I ask all of three of you that question.
    Mr. Edwards. I would say the way to think about 
particularly the supply side tax cuts that have been passed in 
2001 and 2003 is that they are long-term reforms that do good 
things for long-term growth in the U.S. economy, and the Joint 
Committee on Taxation study that came out last year that I 
cited in my testimony is a good example of that. A cut to taxes 
on capital income boost long-run growth even taking into 
account other affects, like changes in interest rates.
    Something I would point out about recent tax cuts that have 
been about 2 percent, that account for about 2 percent of GDP, 
I went back and I looked at how big the tax increases in 1990 
and 1993 were. You may remember that.
    Senator Bunning. Yes, I remember that.
    Mr. Edwards. George Bush I and President Clinton both 
increased income tax rates, particularly at the top end. The 
1993 and 1990 tax hikes are essentially a wash with the 2001 
and 2003 tax cuts. They are both about 2 percent of GDP. So one 
way to look at recent tax cuts is that it really is getting 
back to where we were in the late 1980's after the 1986 Tax 
Reform Act. In fact, our top income tax rate is still higher 
than it was in 1986.
    So, you know, looking at this over the long term, we don't 
think recent tax cuts were large in the share of GDP.
    Mr. Orszag. Senator, what I would say is that there are 
obviously two main factors to take into account when evaluating 
the impact of that kind of change on the economy. The first is 
how you raise the money, and the second is what you do with it. 
If we raise the money in an efficient way and we use it to 
invest either in reducing the deficit or in things like 
preschool education, for example, I think the net effect would 
be positive. It is just the flip side of the studies suggesting 
that the long-term impact of the tax cuts is negative. In other 
words, what you ask is the flip side of a tax cut, so consider 
a tax cut that reduces marginal rates. It may have some benefit 
on the economy because it strengthens incentives to work and 
invest, although my view is that evidence on that suggests 
those effects are relatively weak, but to the extent that it is 
financed by a deficit, there is a drag on the economy from that 
deficit, and most of the studies suggest that the net effect 
is, if anything, negative. So you could turn that on its head 
to answer your question.
    Senator Bunning. We all realize if we don't do something 
about automatic spending increases with our Medicare, Medicaid, 
and Social Security, that by the year 2030, we won't have any 
excess money to spend for Federal Government. We will have 
spent everything on entitlement programs, or at least we won't 
be able to defend our country. Do you have any suggestions what 
to do as far as entitlements are concerned?
    Mr. Hassett. I guess Peter has a plan on Social Security 
that I am sure he will be able to talk about.
    Senator Bunning. Well, I have a lot of plans, but I can't 
get anywhere with them.
    Mr. Hassett. I think that the key is that it is important--
the first key is to recognize that it is important to start 
soon, because whatever you are going to do is going to involve 
reducing benefits, reducing net benefits to current recipients, 
and the longer we give individuals a chance to plan ahead for 
that, the more they can change their saving today and be 
prepared.
    I think Senator Gregg's SOS bill has some ideas about how 
to fold the entitlements into the real budget process, and I am 
quite confident that in the end, if we don't double the size of 
government, that we are going to end up adopting a bill that 
looks something like his.
    Mr. Orszag. Senator, I think the real key here is health 
care. That is the major driver of the long-term fiscal 
imbalance. There is both a sort of problem and an opportunity. 
The problem is that I don't think that you are going to be able 
to make a significant change in the health care obligations of 
the Federal Government without a significant change in the rate 
of growth in the private sector health care also. The systems 
are too linked. Costs per beneficiary in public programs have 
tracked cost per beneficiary in the private sector over long 
periods of time, and the patients are being treated at the same 
hospitals. You can't just rip the systems apart.
    The opportunity is that there are significant possibilities 
for restraining cost growth in health care without impairing 
health outcomes. For example, costs vary across the United 
States, different regions of the United States, for reasons 
that don't have anything to do with outcomes. They are not 
correlated with how healthy people actually are or what their 
responsive to health care is. It seems like it comes down to 
things like doctor practice norms in different regions, that in 
some regions, doctors order all sorts of test that aren't 
actually necessary. In other regions, they don't do that.
    Senator Bunning. That is called covering your backside.
    Mr. Orszag. It is, but there are major opportunities for--
basically, we are at the flat part of the health expenditure, 
health outcome curve. So there are major possibilities to 
restrain cost growth without actually hurting people and 
perhaps actually even helping them, and that strikes me as the 
most important thing for the United States to tackle in terms 
of getting our long-term fiscal house in order.
    Senator Bunning. That is my time, but go right ahead.
    Mr. Edwards. I think entitlements ought to be cut and we 
ought to have phase-in cuts to all the major entitlement 
programs. I think Social Security, a simple long-term valued-
added there would be to switch from wage indexing to price 
indexing for initial benefits. That would slowly over decades 
reduce benefits, which I think is a very fair thing to do. We 
know we have got a big problem. If you let young people know 
now that benefits are going to be cut in one, two, three 
decades down the road, they can plan ahead and save more.
    On Medicaid, I think we ought to do the same thing with 
Medicaid that we did for welfare reform in 1996, turn it into a 
Federal block grant. That way, we can control the Federal 
contribution to the program over time. Medicare, I think the 
CBO Budget Options book has a number of good ideas for 
increasing deductibles for Medicare.
    I think all these changes could be made on a progressive 
basis if you want some sort of bipartisan compromise. You could 
have progressive price indexing for Social Security benefits.
    Senator Bunning. You also realize if we mean-tested all of 
these programs, the weeping and gnashing of teeth we would have 
at these seats that are sitting up here. That would be a very 
good solution in every instance if you give a warning out front 
that this is going to happen.
    Thank you all very much.
    Senator Gregg. Thank you, Senator.
    Senate Conrad.
    Senator Conrad. You have heard presentations that I have 
made here about the unsustainable nature of our current fiscal 
policy. I think, basically, in different words, you have all 
basically agreed with it, that long term, we are on a 
unsustainable course. Let me ask you in order, Kevin, starting 
with you, if I could, if you could wave a magic wand to deal 
with the long-term imbalances, can you just give us a couple of 
sentences on what you would do?
    Mr. Hassett. Thank you for the opportunity, Senator. Yes. I 
would take Social Security and, as Chris suggested, index it, 
the prices, so that, again, people have a long time to see the 
reduction in benefits when they retire. On health care, I think 
that what we need to do is move toward a system where copays 
and so on by participants in the program depend their usage of 
health care in the previous year by participants in the 
program. I think we need to build a kind of sense of community 
that when they are seeking health care as an elderly person, 
they are asking something of their community, something that 
you want to provide to others so that you don't consume more 
than you need.
    But I think that we need to move toward a system where the 
health system itself is more--that the fees of it are more 
related to what people do so people can see the effect they 
have on everybody else whether they consume a lot of health 
care. So I would like to tie those two over time, but again, I 
would not want to do it overnight. We would have to move 
gradually toward that system.
    Senator Conrad. Chris.
    Mr. Edwards. One way to think about what the Federal 
Government does is, and there has been a few major studies on 
this in the past, is look at who gets the benefit of Federal 
spending. CBO did a nice study about a decade ago that looked 
at who gets all the benefits of Federal Government spending in 
terms of income distribution. It turns out that the Federal 
Government does not slant its spending toward the bottom end 
like a lot of people think it does. The distribution spending 
is actually right across the board from the wealthiest to the 
poorest.
    So I think the only way to get a good bipartisan compromise 
on spending cuts is cut the corporate welfare, cut the business 
benefit, cut benefits of Medicare, Social Security, etc. for 
higher income people and give people warning that benefits will 
likely be phased down, but it seems to me that is the type of 
approach we need for the long run.
    Senator Conrad. OK. Peter.
    Mr. Orszag. Senator, I would lock you all in a room and not 
let you out until you had come up with a solution.
    Senator Gregg. That is my bill. That is my bill.
    Mr. Orszag. And I can go through my litany of what I think 
you all should do, but I think the main problem at this point 
is one of political will and that if you all got in a room and 
were not allowed out until you actually had a solution, that 
would make far more movement toward an answer than my trotting 
out all by Brookings studies.
    Senator Conrad. Let me ask you, though, if we were locked 
in the room and you were the only advisor allowed in, what 
would you recommend to us be the focus?
    Mr. Orszag. OK.
    Senator Conrad. Where would you start?
    Mr. Orszag. I would start with health care, in order, 
health care, revenue, and then Social Security, and that 
reflects the relative importance of various factors in 
contributing to the long-term deficit.
    So on health care, I would be looking at ways of changing 
those practice norms. I would be looking at more personal 
responsibility, because I think that is an important component 
of improving health outcomes and restraining cost growth. I 
would be looking at preventive care. I would be looking at a 
whole variety of things. We don't have all the answers there.
    Senator Conrad. Let me stop you and ask you how about the 
chronically ill. We know that about 5 percent of Medicare 
beneficiaries use half of the money. It seems to me, you know, 
in business school, I learned to focus like a laser on that 
kind of statistic. How about the notion of focusing on the 
chronically ill to better coordinate their care as a way of 
saving money and getting better health care outcomes?
    Mr. Orszag. Certainly, you know, when looking to close a 
budget gap, it helps to look where the money is, and that is 
certainly an area that would be worthy of scrutiny along with, 
and relatedly, long-term care. I think there is a lot more that 
could be done, for example, with private long-term care 
insurance to make that market work better also. So health care 
is, obviously, a big component.
    On revenues, I think that we could very easily reverse at 
least part of the tax cut and do some other steps on an 
individual income side. I would replace the estate tax with an 
inheritance tax so that Paris Hilton could not inherit hundreds 
of millions of dollars tax free, and I would also re-examine 
the base of the corporate income tax in a world in which 
capital is increasingly mobile. I think there are changes that 
could be made to the corporate tax that would also sure up that 
revenue for the Federal Government.
    Finally, after you have solved all of that, I would be 
willing to let you out of the room, but if you wanted to keep 
going, there are changes that could be made with regard to 
Social Security also.
    Senator Conrad. Would everyone agree that the long-term 
shortfall--this is my last question, Mr. Chairman--the long-
term shortfall in Medicare is far greater than the projected 
shortfall in Social Security? Isn't it really like seven times 
as much?
    Mr. Edwards. It is more a variable too though. For Social 
Security, we know with much greater certainty what the future 
benefit burdens are. Health care, we might be lucky. Technology 
might save us. We don't know for sure.
    Senator Conrad. You know, you can also make an argument 
that technology may increase our costs. When I look at the 
breaking of the genetic code and the new technology that is 
flowing from that, it is incredibly exciting. It extends life. 
It improves quality of life. It also probably is going to 
increase costs, at least in the short run.
    I want to thank the witnesses. I thank all of you. You 
really are thoughtful people, and it is valuable to the 
committee to have you here.
    Senator Gregg. Thank you, Senator.
    I thank the witnesses. The points that you have made, I 
pretty much agree, except for a couple of yours, Dr. Orszag.
    Mr. Orszag. Right.
    Senator Gregg. But, basically, the thematic, if I could try 
to define the thematic statement here, it is that we have got 
to get control over our entitlement accounts. Getting control 
over our entitlement accounts is going to take discipline and 
it is going to take political will and it is going to take the 
primary area of focus on health care and how we deliver health 
care in this country as we move into a generation which is 
going to double the size of retirees.
    Social Security is a very definable world. It only has like 
six moving parts, and they are very correctable. All we need is 
the political will. We know how to correct it. We change the 
benefit. We adjust the COLA so it is an accurately accounting 
to COLA and you address the fact that people are working 
longer, and you have basically solved the problem of Social 
Security.
    But the issue of health care is much more complex and it 
gets to the question which the Senator has made, the point the 
Senator has made, which is you have got a very small percentage 
of the beneficiaries using the vast majority of the resources. 
You have got the technology issues. You have got the matrix, 
which is so complex.
    I have ideas on all these areas, and I appreciate you, 
Doctor, mentioning my SOS bill, which basically goes to what 
you suggested, Doctor, which is that we should have a system 
here where the procedure drives the policy, where you basically 
do put everybody in a room, give us some ideas, and basically 
the people in the room would be us, and then require us to act 
on those ideas. So I agree with that.
    But to get to a couple of philosophical points which were 
made here on tax policy, we have some disagreements. I am 
sensing that some of you or maybe all of you--in fact, you, Dr. 
Orszag, if I understand your position correctly, there are some 
tax cuts which make more sense than other tax cuts, and 
certainly that was the point that was made by other witnesses, 
that there are some tax cuts that make sense from the 
standpoint of growing the country's economy and creating more 
incentive for savings that are better than other tax cuts, and 
so I would like to get your thoughts as if we are going to 
focus on tax cuts which produce more economic activity and, as 
a result, produce a better economy which means more jobs, and 
in my opinion, more revenue. What are the tax cuts that we 
should be focused on and are all tax cuts the same?
    I have a prejudice here. I can give you my answer, but I 
would be interested in your answer. Why don't we start at this 
end and go this way this time.
    Mr. Orszag. Not all tax cuts are the same. I would note, 
though, that the context in which tax changes occur is very 
important. Given the very low level of national saving and 
given the very large fiscal imbalance that we face, it is not 
at all clear to me that tax cuts should be anywhere near the 
top of the agenda at this point, but if you wanted to focus on 
tax changes, what I would actually do is come back to the idea 
that I mentioned before, which is we are spending $500 billion 
a year very inefficiently through the Tax Code in providing 
incentives for retirement and health, homeownership, and other 
things that we are trying to encourage. I would significantly 
re-examine that entire activity.
    Senator Gregg. You said go from deductions to credits.
    Mr. Orszag. I said go from deductions to credits.
    Senator Gregg. Of course, the bottom quintile of the 
taxpayers in this country don't actually pay any taxes. They 
actually get a refund. The bottom 20 percent would not be 
affected by that either. Just as a distributional event, it 
would have no affect on the bottom 20 percent.
    Mr. Orszag. Well, for example, let us take retirement 
savings. On a revenue neutral basis, you could take the tax 
preferences for 401Ks and IRAs and transform them into a 30 
percent match that went into someone's account regardless of 
whether they owed personal income taxes or not, and that would 
raise the incentive to save for over 80 percent of households 
and would be much more effective at actually urging new 
savings.
    Senator Gregg. And the cost would be the same, is what you 
are saying.
    Mr. Orszag. Right.
    Senator Gregg. That is interesting.
    Mr. Edwards. I agree partly with Peter. In fact, the 
approach taken in the two plans under President Bush's tax 
commission, his report that came out, I guess, last November 
was converting a lot of the deductions, like the mortgage 
interest deduction, into credits. I think that is actually a 
pretty good idea, using the revenue that you save to lower the 
tax rate. That would make the Tax Code more efficient. It would 
target some of these deductions and credit that the Congress 
likes to put into the Tax Code at the bottom end to limit their 
cost, and that is reasonable.
    I think looking forward, the big crunches in the revenue 
system in the coming years are the expiration in the Bush tax 
cuts, the gigantic AMP problem, of course; but the third one 
that will become more and more and more important in the coming 
years is the absurdly high corporate tax rate the United States 
has. The data from 2005 show that the average corporate tax 
rate across the 25 European Union countries was 27 percent. Our 
Federal rate is 35 percent. Our State and local rates go up to 
about 10 percent in New York City.
    We have got a terrible problem here. We all know we have 
got problems with the competitiveness of the big corporations, 
the automobile companies, airlines, and others. I think the 
corporate tax rate is really something we really have to look 
at. In look at Senator Kerry, when he was running for 
President, he had a corporate tax reform plan. So I think that 
really is something we need to look at going ahead. Global 
capital will only get more mobile. So the problem will become 
greater and greater over time.
    Senator Gregg. We have an answer that is call New 
Hampshire. There are no sales or income tax.
    Mr. Hassett. Thank you, Senator. I actually agree with both 
Chris and Peter on their main points. I think that if you want 
to think about what a good tax cut is, think a good tax cut is 
one that will help the economy. It is something that lowers the 
margin rate. It is something that moves us toward a consumption 
tax. Right now, the place the U.S. tax policy is most out of 
whack with the rest of the world is the corporate tax code. 
Senator Kerry did recognize that and suggested a reduction in 
the rate. I think that a reduction in the rate that is 
significant is really important, because right now, our firms 
have an incentive to locate their activity overseas to pay a 
lower tax, and you can spend a gazillion dollars in enforcement 
to try to stop that, or you can just lower the rate a little 
bit so we are in line with everyone else.
    I think that the kind of tax reductions that don't have an 
affect on the economy very often are there for other reasons, 
and you might still want to do them. For example, the child 
credit might stimulate fertility, but it is not going to 
stimulate the economy.
    With Peter's $500 billion point, I thought that I would 
finish with a point of, perhaps, rare consensus which I think 
is worthy of note for the committee, and that is that many of 
these base narrowing features of the Code, like the mortgage 
interest deduction, don't really have their intended 
consequence. The mortgage interest deduction really doesn't 
stimulate homeownership, because the people who are going to 
own a home anyway are the ones who take it. So if you think 
that you should have a subsidy in homeownership because you 
want to get people in homes to build communities and make them 
join the school committees and so on, then you need a different 
animal than what we have.
    So I think if we look at our Code right now, it is a mess 
because we have a lot of things that narrow the base that don't 
do what we intend, and that is really an opportunity for 
significant reform.
    Thanks.
    Senator Gregg. Thank you.
    Your testimony has been excellent and very valuable, and I 
hope somebody will take it beyond us, because I think we are in 
agreement with it, and we need to convince other folks of 
taking advantage of it. We are in general agreement with it.
    There is a vote on. So we are going to have to end this 
hearing. Again, thank you for taking the time. Thank you for 
your input. It has been superb. I appreciate it.
    The hearing is adjourned.
    [Whereupon, at 11:56 a.m., the hearing was adjourned.]

                                 
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