[Senate Report 104-200]
[From the U.S. Government Publishing Office]



   104th Congress 1st            SENATE                 Report
         Session
                                                       104-200
_______________________________________________________________________


 
                     THE 1995 JOINT ECONOMIC REPORT

                               __________

                              R E P O R T

                                 on the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES

                                 on the

                          1995 ECONOMIC REPORT
                            OF THE PRESIDENT


                             together with


                             MINORITY VIEWS

 


               December 22, 1995.--Ordered to be printed
                        JOINT ECONOMIC COMMITTEE

[Created pursuant to Sec. 5(a) of 
  Public Law 304, 79th Congress]
     HOUSE OF REPRESENTATIVES                      SENATE
JIM SAXTON, New Jersey, Vice ChairmanCONNIE MACK, Florida, Chairman
THOMAS W. EWING, Illinois            WILLIAM V. ROTH, Jr., Delaware
JACK QUINN, New York                 LARRY E. CRAIG, Idaho
DONALD A. MANZULLO, Illinois         ROBERT F. BENNETT, Utah
MARK SANFORD, South Carolina         RICK SANTORUM, Pennsylvania
MAC THORNBERRY, Texas                ROD GRAMS, Minnesota
FORTNEY PETE STARK, California       JEFF BINGAMAN, New Mexico
DAVID R. OBEY, Wisconsin             PAUL S. SARBANES, Maryland
LEE H. HAMILTON, Indiana             EDWARD M. KENNEDY, Massachusetts
KWEISI MFUME, Maryland               CHARLES S. ROBB, Virginia
   Robert N. Mottice, Executive 
             Director
 Brian S. Wesbury, Chief Economist
Lee Price, Minority Staff Director
                         LETTER OF TRANSMITTAL

                              ----------                              

                                                 December 22, 1995.
Hon. Robert Dole,
Majority Leader, U.S. Senate,
Washington, DC.
    Dear Mr. Leader: Pursuant to the requirements of the 
Employment Act of 1946, as amended, we hereby transmit the 1995 
Joint Economic Report. The analyses and conclusions of this 
report are to assist the several Committees of the Congress and 
its Members as they deal with economic issues and legislation 
pertaining thereto.
            Sincerely,
                                             Connie Mack, Chairman.


                            C O N T E N T S

                              ----------                              
                                                                   Page
Introduction.....................................................     1
Money, Monetary Policy and The Future............................     4
    What Is Money?...............................................     5
    How Money Works..............................................     5
    The Future of Monetary Policy................................     6
    Humphrey-Hawkins and the Federal Reserve.....................     7
    Giving the Fed an Impossible Task............................     8
    The Fed in Today's Economy...................................     9
    Monetary Tools of the Fed: Interest Rates and The Economy....    10
    The Mirage of Growth.........................................    12
    Current Economic Data........................................    12
    The Effects of Easy Money....................................    13
    International Developments, Technology and the Case for Price 
      Stability..................................................    14
    The Impact of a Weak Dollar..................................    16
    The Domestic Economy and the Role of Government..............    17
    Conclusion...................................................    17
Fiscal Policy....................................................    18
    Freeing the Economy: A Policy for the Long Term..............    19
    A Revolution In Constitutional Economics.....................    23
    Institutional Reforms Needed.................................    25
    Fiscal Disorder Erodes Democracy.............................    26
    Postwar Economic Policy and Economic Growth..................    27
    Tax Reform Is Essential For Economic Growth..................    31
Policy Recommendations of the Chairman of the Joint Economic 
  Committee......................................................    33
    Spending Reduction Commission................................    34
    The Flat Tax.................................................    34
    Humphrey-Hawkins Reform......................................    35
    The Future...................................................    36
Getting Back to Prosperity: The Views of Vice-Chairman Saxton....    36
    Introduction.................................................    36
    Lessons from the Reagan Expansion............................    37
    The Burdens of Erroneous Policies............................    38
    The Growth Deficit...........................................    40
    Reduce Spending..............................................    41
    Regulatory Costs.............................................    42
    The Optimal Size of Government...............................    42
    The Budget...................................................    44
    Reform the Tax System........................................    45
    The Problem of Political Will................................    46
    Conclusion...................................................    47
Endnotes.........................................................    47
Minority Views...................................................    49
104th Congress                                                   Report
                                 SENATE

 1st Session                                                    104-200
_______________________________________________________________________


                     THE 1995 JOINT ECONOMIC REPORT

                                _______


               December  22, 1995.--Ordered to be printed

_______________________________________________________________________


 Mr.  Mack, from the Joint Economic Committee, submitted the following

                              R E P O R T

                             together with

                             MINORITY VIEWS

                              Introduction

    November 1994 brought an electoral realignment of historic 
proportions. After 40 years of Democrat domination of Congress, 
Republicans won majorities in both the House and Senate, swept 
into office on the promise of fundamentally changing the way 
government relates to the people.
    In another historic development, the new majority has 
distinguished itself from its predecessors by actually 
delivering on its promises. A plan to honestly balance the 
budget by 2002 was passed only to be vetoed by President 
Clinton, and a measure to give the President line-item veto 
authority was adopted in both Houses. Congressional 
accountability bills and restrictions on unfunded mandates were 
passed and signed into law. The elimination and restructuring 
of entire departments have been suggested, and product 
liability reform has been passed.
    Congressional Republicans are following through on the 
commitments they made. Republicans have faith in the talents, 
knowledge and abilities of the American people and reaffirm 
basic American values. Republicans view their majority status 
as not just an opportunity, but as a responsibility to effect 
the kind of meaningful change that voters demanded. Whether 
this commitment is called the Contract With America or the 
Republican Economic Plan, Republicans stand for a bold new 
vision of limited government.
    For too long, politicians and bureaucrats in Washington 
have seized an ever-growing share of America's resources in the 
mistaken belief that problems are best solved by federal 
programs. The real result of government's ongoing power grab 
has been to make it harder for families to realize the American 
dream.
    The ``1995 Economic Report of the President,'' released in 
February, promoted President Clinton's view that government 
spending is a positive economic force and that deficits are 
acceptable. His first budget echoed that credo: higher 
government spending, huge deficits as far as the eye could see, 
and an appalling unwillingness to take responsibility for its 
actions and even to recognize economic realities. President 
Clinton concluded the new congressional majority meant it would 
be impossible to impose yet another tax increase upon the 
American people, and therefore abdicated any role or duty with 
regard to the budget. His February plan would have generated 
deficits reaching over $400 billion annually in the near 
future, according to the Congressional Budget Office (CBO). 
President Clinton's February plan also did not address the 
crisis in Medicare, which, according to President Clinton's own 
trustees, will go bankrupt in 2002. In fact, President 
Clinton's February plan addressed none of the nation's budget 
problems, instead he endorsed vast increases in government 
regulation and spending.
    After Republicans in Congress filled the void of leadership 
and responsibility left by President Clinton, he issued three 
revised budget proposals, none of which led to balance and none 
of which changed his priorities of higher government spending 
and more government programs. Senator Bill Bradley put it well 
when he said that Democrats prefer ``the bureaucrat they know'' 
to ``the consumer they cannot control.''
    Instead of truly joining the debate on how to reduce the 
growth in government spending responsibly, the President issued 
another budget plan in June which purported to balance the 
budget. However, this plan took longer to balance the budget 
(ten years) than the Republican plan (seven years), assumed 
there would be higher economic growth and lower inflation in 
the years to come when compared with the Republican economic 
assumptions, and, perhaps most outrageously, assumed the budget 
would eventually balance, an assumption which CBO has 
categorically refuted.
    President Clinton revised his June plan in July by changing 
the economic assumptions behind his budget, making them even 
more optimistic than they had been originally. He then claimed 
that his budget achieved balance in nine, not ten, years. CBO 
asserted that, while the President said his path had changed, 
it had in fact stayed the same: $200 billion deficits as far as 
the eye can see. While Republicans produced a CBO-certified 
balanced budget that includes tax relief for families and 
incentives for economic growth, President Clinton simply did 
not do enough to get government spending under control, instead 
hoping that economic assumptions would do his work for him.
    However, President Clinton, undaunted, and not satisifed 
with releasing only three budgets in 1995, came out with a 
fourth version in December, which again 1) uses OMB economic 
assumptions, and 2) does not lead to balance by 2002 according 
to CBO. While those two facts are elements of any version of 
the 1995 Clinton Budget, the December version also contained 
large tax increases for corporations and job-killing 
regulation. In addition, because the President's fourth budget 
plan does not balance by 2002 according to CBO and does not use 
CBO economic assumptions, that plan violates the law that the 
President signed in November. Instead of living up to his word, 
the President has let the American people down.
    Republicans, on the other hand, have resolved to allow 
families to keep more of their own hard-earned income, and 
intend to improve economic growth by reducing government 
spending, taxes on workers and businesses, and burdensome 
regulations. Several studies have forecast increased annual 
economic growth 0.7-2.2 percentage points above the current 
annual trend due to provisions in the Contract With America.\1\
    \1\ See Endnotes, p. 47.
---------------------------------------------------------------------------
    Cutting income taxes will allow families to keep more of 
their own money. The time has come to put an end to the lie 
that if government allows families to keep more of their own 
money, then politicians are giving them a hand-out. Paying less 
in taxes is far different from receiving money from the 
government. Decades of Great Society programs have apparently 
made government forget that the people are sovereign. By 
reestablishing the rightful, constitutional role of the federal 
government, families will reap the benefits of controlling more 
of their own resources.
    All parents hope their children's lives will be better than 
their own, and that their children will have ample job 
opportunities. Economists have forecast that implementation of 
Republican economic policies, including a balanced budget, will 
create millions of new jobs by 2002.
    Thus, Republicans are beginning to reestablish the 
constitutional relationship between the government and the 
people. It acknowledges that old-style, big-government 
solutions are both intellectually and financially bankrupt and 
have exacerbated the very problems they purported to solve. 
Individual responsibility, a smaller government, and lower 
taxes will result in a stronger economy and stronger American 
families.
    Still, this is only a first step. The challenges of the 
21st Century will demand a government far smaller than the one 
championed by the Clinton Administration. Government, as we 
have known it, has become an anachronism. Individual initiative 
must again become the driving force in society. Technology and 
economic growth offer opportunity and inclusion for all 
Americans. A dynamic marketplace of creative ideas--
entrepreneurial, cultural, governmental, and economic--is 
essential to solving society's most pressing problems. As big 
government's increasing irrelevancy and counter-productivity 
become apparent, so, too, will become the inevitability of 
finding a better way.
    In 1946, Congress passed the Employment Act, committing the 
federal government to promoting ``maximum employment, 
production, and purchasing power.'' This was a response to the 
fears of many that World War II had brought only a temporary 
respite from the Depression. While not mandating any specific 
programs for achieving these goals, Congress established two 
advisory panels, the Council of Economic Advisers (CEA) and the 
Joint Economic Committee (JEC), to review economic conditions 
and make recommendations for achieving full employment.
    Under the Democrat leadership that has dominated much of 
their history, the JEC and the CEA have supported activist 
approaches to economic policy, even though the best way for 
government to achieve ``maximum employment, production, and 
purchasing power'' is usually by staying out of the way. Even 
so, government has usually been loathe to cut spending because 
of the powerful political constituencies that develop around 
programs.
    However, this Democrat insistence on harmful economic 
policies has not always been the case. In the late 1970s, under 
the leadership of chairman Lloyd Bentsen, a Democrat, the JEC 
led policy makers in Congress away from the discredited 
Keynesian views of fine-tuning. In its 1980 annual report, 
``Plugging in the Supply Side,'' unanimously approved by all 
Democrats and Republicans on the Committee, the Phillips curve 
tradeoff between inflation and unemployment was rejected, and a 
new model of growth economics that would guide the policies of 
the Reagan Administration was developed. In more recent years, 
Committee Republicans have investigated the analytical problems 
of the CBO and the Clinton Administration.
    The Employment Act of 1946 was a mistaken response to fears 
born of the Depression. Because activist economic policies are 
almost always counterproductive, the Committee recognizes that, 
under Democrat rule, the policies that the JEC has advocated 
have often done more harm than good.
    Therefore, the President, Congress and the Federal Reserve 
should reject any attempts to fine-tune the economy, focusing, 
instead, on fostering long-term economic growth. The Federal 
Reserve should devote itself exclusively to maintaining a 
stable dollar, the President should emphasize raising the long-
term growth rate, and Congress should concentrate on getting 
America's fiscal house in order.

                 Money, Monetary Policy and The Future

    Money and monetary policy play a key role in both the 
short- and long-term development of the economy. Even so, the 
nature of money and the role of monetary policy are often 
misunderstood. Money's value depends on the faith and backing 
of the people whose assets it represents; thus monetary policy 
must focus on maintaining that faith and value. Too often, 
political leaders have lost sight of this fundamental goal and 
tried to manipulate monetary policy in hopes of fine-tuning the 
economy.
    In the United States, mishandled monetary policy has caused 
erratic economic cycles, bouts of double digit inflation, a 
crisis in the savings and loan industry, booms and busts in 
land values, volatile interest rates, and a long-run decline in 
the value of the dollar on foreign exchange markets. This 
economic turmoil has resulted from misunderstanding the nature 
of money in the economy and a misuse of the powers of the 
Federal Reserve.
    As the world moves into the 21st century, the United States 
must understand and respect the role of money. Technological 
advances are forging new links between manufacturers and 
consumers, both domestically and around the world. An 
integrated global economy is no longer a distant promise, but a 
growing reality. Money, which greases the wheels of this new 
economy, plays a more crucial role than ever in facilitating 
smooth international transactions. In order to remain 
competitive, the United States must make price level stability 
the primary goal of its central bank. Only then can America 
hope to achieve long-term economic growth, rising standards of 
living, and job creation.

                             what is money?

    Money is a commodity. It has slightly different 
characteristics than other commodities because it is accepted 
as a medium of exchange and a store of value. It makes lives 
easier by lowering the cost of transactions and facilitating 
commerce by eliminating the necessity of barter. Falling 
transaction costs encourage the division of labor and enhance 
output and productivity. Money also allows resources to flow 
around the globe freely, encouraging international trade.
    Understanding the nature of money as a commodity makes its 
role much clearer. Like any commodity, if too much of it is 
created, its value falls relative to other goods, and if too 
little is created, its value rises. Used properly, money 
enhances economic well-being.

                            how money works

    Money has existed for thousands of years. Almost from the 
beginning, governments have blamed a significant number of 
problems on a ``lack'' of money in the economy. Sometime, 
individuals and politicians have called money ``the root of all 
evil.'' These beliefs have led to the misuse of monetary policy 
and the attempt to use central banks as social policy 
instruments. Adam Smith, in his 1776 book, ``(An Inquiry Into 
the Nature and Cause of) The Wealth of Nations,'' pointed out 
that many people equate more money with more purchasing power. 
For centuries, governments and central banks have printed 
excess money hoping to increase wealth, but, in fact, have only 
driven down the value of their money. Believing that money is 
the root of all evil or that money itself equals purchasing 
power has produced inflation, high interest rates, economic 
uncertainty and untold hardships the world over.
    Governments have learned that when a central bank prints 
money and injects it into an economy, that economy accelerates. 
As a result, they have often turned to monetary policy to boost 
economic activity. As new money flows into the economy, it bids 
up the price of financial assets, causing interest rates to 
fall, which boosts the relative attractiveness of real economic 
goods and results in increased demand for commodities, durable 
goods and investment. This, in turn, leads to higher 
employment, incomes and consumption. This boost in economic 
activity, however, is artificial.
    Eventually, accelerated money growth results in price 
distortions, inflation, and rising interest rates, which bring 
the artificial growth to an end. Then, as the economy readjusts 
its relative prices, a decline in economic activity occurs. 
These booms and busts explain the alternating recovery/
recession phases that have marked America's economic history.
    The only way to keep the economy moving, using monetary 
policy alone, is to continue printing greater and greater sums 
of new money. The result, however, is always the same: 
inflation accelerates and real economic activity eventually 
disintegrates. The United States suffered this experience 
between the late 1970s and early 1980s when double-digit 
inflation and severe recessions created extreme hardship. Even 
so, America has never experienced the kind of hyperinflation 
that besieged Germany following World War I, many Latin 
American countries during the past decades, and some Eastern 
European countries in recent years.
    In each case, runaway inflation and the collapse in 
economic activity resulted from attempts to use money to create 
wealth. Money cannot create wealth. Wealth is created through 
the creativity of individuals producing goods and services that 
other individuals want. The flexibility of the free market is 
enhanced by the use of money, but money itself cannot sustain 
an economy.

                     the future of monetary policy

    As can be seen in the chart below, those countries that 
have experienced the lowest inflation during the past 20 years 
also have the highest standards of living.




    U.S. competitiveness in the 21st century depends on a 
monetary policy that encourages price stability over time. This 
imperative has been recognized by many countries around the 
world. New Zealand, Germany, Great Britain, Israel and Canada 
have enacted legislation that focuses their central banks on 
price stability. These laws range from New Zealand's formal 
policy of keeping inflation between 0 and 2 percent, and 
Germany's more informal policy of price stability as the 
primary objective of the Bundesbank.
    In the United States, a number of ideas about how to 
achieve price stability has been suggested. Many analysts, 
including Federal Reserve Chairman Alan Greenspan, have 
suggested that the United States move back to a gold standard 
so that the world has an anchor for the value of money. Only by 
anchoring money to gold, these analysts suggest, will the 
world's economies truly realize their potential. The increased 
discussion of the role of gold as a tool for directing monetary 
policy indicates that the world-wide understanding of the role 
of money is becoming clearer.

                humphrey-hawkins and the federal reserve

    Sound money is as important to economic development as free 
markets. In 1952, Ludwig von Mises wrote, ``It is impossible to 
grasp the meaning of the idea of sound money if one does not 
realize that it was devised as an instrument for the protection 
of civil liberties against despotic inroads on the part of 
governments. Ideologically it belongs in the same class with 
political constitutions and bills of rights.'' \2\
    But over the last 30 years, a disturbing trend has 
developed in America. First, government has burdened the 
economy with high tax rates, government spending and 
regulation. They, as growth has slowed, it has turned to the 
Federal Reserve to boost growth. But like caffeine, the jolt to 
growth eventually wears off. As history has shown,the Federal 
Reserve cannot boost growth indefinitely without causing 
inflation.
    For most of the past 200 years, monetary policy in the 
United States focused on price stability. Nonetheless, in 1978, 
the Democrat-controlled Congress passed the Full Employment and 
Balanced Growth Act (the Humphrey-Hawkins Act), which holds the 
Federal Reserve responsible for keeping unemployment low, 
telling the Fed do everything in its power to move unemployment 
below 3 percent, even though no serious economist today 
believes it possible. At the time, mainstream economic thought 
held that there was a tradeoff between unemployment and 
inflation in the economy (the so-called Phillips Curve), and 
that policies aimed at lowering inflation would drive up 
unemployment. However, this theory has not stood the test of 
time. Rather, as can be seen in the chart below, if any 
relationship between the two phenomena exists, it is not an 
inverse one. Multiple policy goals for the Fed have led to a 
confusing, inflationary bias in monetary policy, which in the 
end actually have caused higher unemployment.



                   giving the fed an impossible task

    To automatically blame rising unemployment on the Federal 
Reserve is wrong, just as it would be ridiculous to blame the 
resulting unemployment on the Fed if Congress pushed the 
minimum wage to $50 an hour. Yet, every day, government 
mandates, regulations and taxes increase unemployment by making 
it more costly for employers to hire workers. To expect the Fed 
to offset such government interference is both fruitless and 
inflationary.
    In the 1960s and 1970s, following a period of success at 
forecasting economic activity using monetary measures, it was 
widely believed that the Federal Reserve could manage both 
unemployment and inflation. Monetary aggregates such as M1, M2 
or the monetary base, were shown to be very closely linked to 
economic activity.
    However, history shows that efforts at fine-tuning were a 
complete failure. While the Federal Reserve, politicians and 
economists focused on the cyclical ups and downs of economic 
activity, damaging government policies continued to erode 
potential growth and push unemployment higher.
    Every time the Federal Reserve eased monetary policy to 
boost economic activity, inflation accelerated. Eventually 
inflation reached double-digit rates, eroding nearly one-half 
of Americans' purchasing power in the four years between 1978 
and 1982. This clearly showed that monetary policy is not an 
effective tool for promoting long-term growth. Tax and 
regulatory cuts under President Reagan produced stronger real 
growth and declining unemployment, which, combined with a much 
less accommodative monetary 
policy followed by former Federal Reserve Chairman Paul 
Volcker, led to a decline in inflation.

                       The Fed in Today's Economy

    Using monetary policy to fine-tune the economy has 
encountered another problem as well. Changes in financial 
market regulations, the increased use of dollars overseas, and 
the proliferation of money market and mutual funds have led to 
a breakdown in the relationship between measures of money and 
the economy. In the 1970s, M2 growth influenced economic 
activity with a lag of approximately nine to 12 months. Today, 
as can be seen in the chart below, economic growth and M2 do 
not appear to be related at all.
    While the economy has been through both a recession and a 
recovery, money growth has averaged 2.7 percent over the past 
six years, with very little movement from the average as 
measured by M2. In fact, M2 growth was stronger in 1989 and 
1990 (averaging 4.6 percent growth) just before the recession 
of 1990-1991 than it was in 1991, 1992 and 1993 (averaging 2.2 
percent growth), the years leading up to the stronger economic 
growth of the most recent recovery.
    Because of the failure of monetary fine-tuning and the 
breakdown in the relationship between money and gross domestic 
product (GDP), a consensus is developing that the Federal 
Reserve must focus on a single goal: price stability. When 
prices are stable, economic growth is stronger. The best 
environment for improving standards of living, job 
opportunities and competitiveness, is price stability. 
Nonetheless, lower inflation does not guarantee stronger growth 
and lower unemployment.


       Monetary Tools of the Fed: Interest Rates and The Economy

    The Federal Reserve, by expanding or contracting its 
balance sheet, can add money to, or take money from, the 
banking system. When the Fed adds reserves to the banking 
system it causes the federal funds rate to decline; when it 
slows or contracts the growth of the reserves entering the 
banking system, it causes the federal funds rate to rise. The 
link between Federal Reserve monetary policy changes and the 
federal funds rate is so tight that markets and economists 
focus almost exclusively on interest rate changes when judging 
monetary policy.
    When the Fed focuses on bringing inflation down, it 
attempts to constrict monetary growth, which causes the federal 
funds rate to rise. If the Fed is concerned with a slow growing 
economy it then begins to increase monetary growth that leads 
to lower interest rates. In recent years the Fed has engineered 
large moves in short-term interest rates. In 1988 and early 
1989, the Fed was concerned about inflation, and by slowing 
money growth, drove the federal funds rate up to 9.75 percent 
(above the yield on 30-year government bonds). Then, as a 
recession became imminent, the Fed began to lower interest 
rates.




    As the current recovery began, the Fed lowered the federal 
funds rate from 9.75 percent in early 1989 to 6 percent in 
early 1991. Uncertainty about the recovery and its 
sustainability persisted. The current recovery has been 
different from past recoveries in that it started slowly, with 
some dips in activity and then gained momentum. Normally, 
recoveries start out fast and then taper off. The odd nature of 
this recovery can be traced back to tax increases in 1991 and 
1993. The tax hikes in 1991 and 1993, combined with increases 
in regulation and government mandates, have shackled the 
economy, holding it back.
    The slow start to this recovery led the Fed to push 
interest rates down more than necessary and hold them down far 
longer than normal. In the past, the Fed has increased interest 
rates within eight months of the end of a recession (average of 
past six recession/recovery phases). In the current recovery, 
the Fed waited 35 months after the recession trough in March 
1991 to begin raising rates. In fact, the Fed continued to 
lower rates from 6 percent to 3 percent after the recovery had 
already begun.
    At 3 percent, the federal funds rate was essentially equal 
to the rate of inflation. This meant that the real interest 
rate (after adjustment for inflation) was close to zero. 
Holding rates this low artificially boosted the economy. The 
last time the Fed held real interest rates at or below zero was 
in the late 1970s. Economic growth accelerated, but inflation 
also jumped, leading the Fed to raise interest rates in 
response. Eventually, raising rates to stop inflation caused a 
series of recessions.




    The continuation of stimulative monetary policy well into 
this recovery raises the concern that the economic strength 
between March 1991 and this summer was due to monetary policy, 
not to positive underlying economic fundamentals. Disappointing 
growth has become commonplace in the economy. Potential GDP 
growth is widely thought to be 2.5 percent, much lower than the 
4 percent growth of the 20 years following World War II. The 
slowdown in potential GDP growth results from rising taxes, 
regulations and the size of the government relative to the 
economy.\3\ Monetary policy alone is unable to offset 
government burdens and cannot boost growth faster than 
potential without causing inflation. Easy money policies can 
only artificially boost growth for the short-term.

                          the mirage of growth

    The artificial nature of the current recovery can be seen 
in data concerning family incomes and jobs. Even though the 
economy has been recovering, standards of living have fallen 
because the recovery has been weaker than normal. In 1994, the 
Census Bureau reported that real median family incomes were 
statistically unchanged after falling for four consecutive 
years, between 1989 and 1993. In addition, job growth in this 
recovery has occurred at only half the normal recovery pace. 
While the economy is growing, this recovery is hollow for 
American workers. If growth in the economy had resulted from 
good fiscal policies, standards of living would be rising as 
they did between 1983 and 1989.
    In July 1995, as economic data began to point to weak 
economic conditions in the second quarter, the Fed responded by 
lowering the federal funds rate from 6 percent to 5.75 percent, 
the first rate reduction in two and one-half years.

                         current economic data

    In early 1995, the economy slowed sharply, causing many 
private forecasters to predict zero economic growth in the 
second quarter and some to believe that a recession had begun. 
Some attributed the weakness to Federal Reserve interest rate 
hikes during 1994, others attributed it to a buildup in 
inventories. Most likely, the measured weakness was caused by 
the Clinton tax increase passed in 1993 that forced a huge 
boost in tax payment during 1994. Nonetheless, the stock market 
continued to surge (consistently reaching all-time highs) and 
consumer confidence remained high. After picking-up in the 
summer months, the economy dropped off again in the fall with 
retail sales, housing starts, and industrial production all 
showing weakness.
    These signs of a stumbling economy are of great concern. 
Blaming the current stumble in the economy on the Federal 
Reserve misplaces much of the responsibility and continues the 
policy mistakes of the past. Even before the Fed reduced 
interest rates in July, rates were below their March 1991 
levels (when the economy came out of recession), suggesting 
that interest rates may not be excessively high and are not the 
sole cause of the slowdown in economic activity during 1995.
    A better explanation of the renewed weakness in economic 
activity suggests that when the Fed raised interest rates, and 
was no longer artificially stimulating economic activity, the 
economy began to waver under the weight of Clinton tax and 
regulatory hikes. The signs are clear: weak income and job 
growth, combined with intermittent weakness in economic 
activity, shows the economy is suffering from excessive 
government burdens. The economy needs relief from the growth-
stifling policies of the Clinton Administration, not more 
stimulus from the Federal Reserve.

                       the effects of easy money

    Meanwhile, there are signs that inflation is accelerating. 
Producer prices rose at a 2.0 percent rate in the 12 months 
ending November 1995. This is 1.4 percent faster than the 0.6 
percent rate during 1994. Excluding food and energy, producer 
prices rose at a 2.6 percent annual rate in the twelve months 
through November of 1995, versus a 1.0 percent rate during 
1994.
    Other price indicators have also been rising. Gold prices 
remain near $390 per ounce, well above the $350 per ounce level 
of 1993, and commodity prices (as can be seen in the chart 
below) while volatile this year, are up significantly since 
1993. All of these indicators suggest that the Fed created an 
increase in inflationary pressures during the past few years.




    Higher taxes and easy money always lead to higher 
inflation. High taxes, regulation and government burdens cause 
a reduction in the potential output of goods and services and 
underlying weakness in economic activity. Using the Fed to 
boost the economy increases the output of money. More money 
chasing fewer goods is a clear cause of inflation.
    In order to get growth moving forward and incomes rising 
without inflation, good fiscal policy must be followed. Instead 
of exclusively relying on the Fed to lower interest rates, the 
Congress should move forward on its plan to cut taxes and 
regulations and reduce the growth in government spending while 
the Fed focuses on price stability.

international developments, technology and the case for price stability

    Technological innovation and international integration are 
changing the economic landscape and creating greater need for a 
monetary policy focused primarily on price stability. First, as 
technology lowers the cost of information, global financial and 
economic integration are accelerating. Second, the pace of 
economic change is accelerating. As a result, the Federal 
Reserve must operate in an increasingly complicated and 
interrelated environment. Therefore, a stable unit of account 
is more important than ever before.
    Our economy is becoming more integrated with others around 
the world. World trade is growing faster than world economic 
output and financial markets are becoming more sophisticated. 
The London Business School estimates that G7 trade will expand 
by 7.2 percent annually in inflation adjusted dollars between 
1994 and 1998, while G7 real GDP will expand by only 2.7 
percent annually.\4\ In the United States, trade is rising 
dramatically as a percentage of GDP. Imports and exports have 
grown from near 4 percent of GDP in the 1950s to over 12 
percent last year. As can be seen in the chart below, the 
growth of trade and its importance to our economy accelerated 
dramatically in the 1980s.




    The growth in world trade, while impressive, is small 
compared to the growth in international opportunities. The 
stock market capitalization for emerging markets reached $1.9 
trillion in 1993, over three times the $612 billion in 1990.\5\ 
Investors in the United States and in other countries are 
turning to foreign stock and bond markets for diversification 
and opportunity.
    The explosion in world-wide investment trade can be traced 
to two key trends begun in the early 1980s. First, the 
technology boom surrounding personal computers, faxes and 
cellular telephones has caused a tremendous drop in the cost of 
information. For example, sales staffs can disseminate price 
lists around the world by fax faster than they could drive them 
across town just 20 years ago. Second, the world-wide trend 
toward lower taxes, privatization and free markets, begun under 
the leadership of President Reagan, is bearing tremendous fruit 
for those countries willing to follow free market policies.




    The integration of world markets and economies brings with 
it a need for sound and stable money. Sound money is essential 
to increasing the confidence of international investors. 
Unstable money policy leads to volatility in currency markets 
and weakens those economies who misuse monetary policy. Mexico 
is the clearest example of the damage that can be done with 
monetary policy.
    By growing its monetary base over 20 percent during 
1994,\6\ the Mexican government undermined the peso. The 
devaluation of the peso, high inflation and soaring interest 
rates that the easy-peso policy caused have led to a severe 
contraction in the Mexican economy, a drop in the value of 
Mexican investments and a withdrawal of much needed foreign 
private capital. Highlighting the integration of world markets, 
American exports to Mexico have fallen by 25 percent in 
1995,\7\ leading to lost U.S. output and jobs.
    Another complication caused by world markets is a change in 
the connection between money and inflation. In an integrated 
world economy, inflationary pressures may not be seen as 
quickly in the price of goods and services because prices are 
determined by world supply and demand. This does not mean that 
printing money causes no problems. Instead, inflationary 
pressures are visible in a decline in the value of a currency 
on world markets.




    A decline in the value of the dollar means a reduction in 
U.S. purchasing power and a fall in relative income for 
American citizens. A decline in the value of a nation's 
currency is literally a drop in the ownership of world assets. 
As can be seen in the chart below, the dollar has weakened 
considerably in the past 23 years, with the exception of the 
Reagan growth years in the early to mid-1980s, versus the 
German mark and the Japanese yen following the breakdown in the 
Bretton Woods agreement and the closing of the gold window. The 
decline in the dollar translates directly to a reduction in 
purchasing power in world markets.

                      The Impact of a Weak Dollar

    In recent years, Americans' real incomes have stagnated as 
the dollar has declined. With international competition holding 
the prices of goods and services down, inflationary pressures 
have affected wages. Even though U.S. inflation has been 
subdued, the effect of falling incomes equates with a rise in 
the relative prices of goods and services. The decline in real 
incomes during recent years signals that inflation poses a 
greater problem than conventional wisdom has suggested.
    In addition, with world markets becoming more important, a 
weak dollar increases the cost of participating in global 
growth. Students pay more for travel to foreign countries while 
investors and businesses pay higher prices for investments and 
face higher import costs. If America is to lead the world 
toward realizing its potential in the next century, the United 
States must defend its purchasing power in world markets. A 
falling dollar lowers America's share of world output and, by 
definition, lower U.S. ownership in world assets. This trend 
must be reversed in order to defend competitiveness in the 
years ahead and boost standards of living.

            The Domestic Economy and the Role of Government

    As technology has lowered the cost of information and 
transportation, the domestic economic environment has also 
changed. Just-in-time inventories, computerized check-out 
counters, a boom in air-freight and specialized production runs 
have, in effect, decreased the distance between manufacturer 
and consumer. As a result, manufacturers respond to changes in 
consumption patterns much more quickly than ever before. In 
this environment, economic activity may behave like a traffic 
jam, with stopped traffic interrupted by short bursts of faster 
movement (known as the slinky effect).
    This may explain why the economy has gone through a series 
of mini-cycles in recent years. The economy experienced the 
``triple-dip'' during 1991-1993. Now, in 1995, the economy has 
gone through another dip in activity, which the Fed responded 
to by lowering interest rates. However, immediately following 
the Fed's action, economic data began to improve, suggesting 
that the Fed may have acted prematurely. Consequently, bond 
yields rose, indicating some heightened fear of inflation.
    By reacting to uneven economic growth patterns and 
attempting to fine-tune the economy, the Federal Reserve could 
aggravate business cycles over time, leading to more volatility 
in economic activity and higher inflation. Fine-tuning is more 
dangerous today than ever before and the faster pace of 
economic activity creates a heightened need for the Federal 
Reserve to focus on the single-goal of price stability.
    In addition, the government must create the best 
environment for economic growth. Like shrinking the number of 
lanes on a highway, high tax rates, an inefficient tax system, 
burdensome regulations and mandates constrict the ability of 
the economy to grow. In order to break up the traffic jam and 
allow growth to proceed as smoothly and quickly as possible, an 
environment of less taxes, less spending and less regulation is 
necessary.

                               Conclusion

    Only by focusing monetary policy on price stability can we 
be assured that the United States will achieve its maximum 
sustainable long-term economic growth rate. Congress should 
replace the Humphrey-Hawkins Act with legislation that makes 
price stability the primary goal of the Federal Reserve.
    The Fed should be asked to define price stability, tell the 
public how it will measure it, announce the target date for 
achieving price stability and explain at semi-annual hearings 
the economic variables that guide its progress. In this way, 
citizens can plan for the return to price stability that 
characterized the economy during most of the 19th and early 
20th centuries.
    It has been estimated that interest rates could tumble at 
least one or possibly two percentage points if markets believed 
that the Federal Reserve was following a credible path to price 
stability.\8\ Lower interest rates would make home-ownership 
more viable for millions of citizens who now cannot afford to 
buy, reduce the costs of investment and lower interest payments 
on the national debt. These benefits alone should be enough to 
move the Fed to a primary responsibility of price stability.
    Price stability and the knowledge that price stability is 
the primary goal of the Federal Reserve are vital to maximizing 
economic growth and employment, minimizing interest rates and 
stabilizing the economy. By focusing monetary policy solely on 
price stability, we can guarantee a solid dollar and are create 
the best environment for increasing American competitiveness 
around the world.

                             Fiscal Policy

    Fiscal policy, as employed during much of the past four 
decades, is an anachronism. Characterized by government's 
taxing and spending authority to manipulate the economy in the 
short run, fiscal policy has proven to be largely ineffective 
at best, counterproductive at worst. Today's economy is 
complex, with economic power distributed across too wide a 
spectrum of individuals to be effectively manipulated by a 
cumbersome centralized government.
    The unbroken quarter-century string of federal budget 
deficits is the most visible legacy of fiscal policy attempts 
to fine-tune the economy. Yet the most damaging result of past 
fiscal policy efforts has been the steady growth of government 
and the reduction in economic growth that has accompanied it.
    Since the mid-1960s, the growth of government has exceeded 
the growth of nominal GDP. This has corresponded with a 
slowdown in real economic growth to an average of 2.6 percent 
from 4.0 percent before that time. Had economic growth merely 
continued at the pace established before the mid-1960s, the 
economy would be $2.66 trillion stronger today, meaning that 
1994, inflation-adjusted, per-capita GDP would have been 
$10,300 higher.
    The federal government's fiscal policy should be limited to 
fostering an economic climate that promotes growth. Policies 
that attempt to modify the behavior of economic actors in the 
short run, to smooth out fluctuations in the business cycle, or 
to engineer a distribution of income and wealth have failed in 
the past. Future fiscal policy should recognize these 
limitations and respect the decentralization of economic 
decision-making that enables economic growth and wealth 
creation to emerge from individual freedom, not government 
decrees.
    Proper fiscal policy should be built on these three 
principles:
          (1) Policy should focus on the long run. Attempts at 
        short-term manipulation, or fine-tuning, are unworkable 
        and detrimental to the economy. Fiscal policy must 
        concentrate on creating a climate that allows the 
        private economy the necessary freedom to achieve the 
        highest long-term economic growth. The most successful 
        efforts of economic policy, in the early 1960s and the 
        early to mid-1980s, were characterized by fiscal policy 
        focused on tax cuts and monetary policy focused on 
        price stability.
          (2) Spending must be restrained by institutional 
        limits. Twenty-five years of federal budget deficits 
        have created a widespread public consensus that the 
        budget must be balanced and the growth in spending must 
        be reduced. Even so, elected officials face political 
        incentives to expand the deficit and the size of 
        government, not to shrink it. Consequently, 
        institutional restraints on spending, particularly a 
        balanced budget amendment to the Constitution, as well 
        as other efforts to set limits on the discretionary 
        ability of elected officials to spend money, are 
        necessary.
          (3) Tax policy must be fundamentally reformed. 
        Despite periodic changes, the present tax code distorts 
        economic decision-making and limits economic growth to 
        a fraction of its potential. Tax reform ideas are 
        hardly scarce. Currently popular proposals include a 
        flat rate income tax and other consumption-based or 
        sales taxes. From the standpoint of generating broad-
        based economic growth to be shared by the most 
        citizens, the flat tax promises the least distortion 
        and burden of any of the popular reform proposals.

            freeing the economy: a policy for the long term

    During 1994 the economy grew by a robust 4.1 percent, 
outperforming 1993's growth rate of 3.1 percent.\9\ Yet, 
despite this apparently vigorous economy, Americans were uneasy 
and felt themselves falling behind in the struggle to improve 
their financial situation. November 1994 produced the largest 
political realignment in 40 years, confounding historical data 
showing that when voters approve of the economy's performance, 
little electoral turnover is likely.\10\ How could the economy 
look so strong but leave so many people feeling left behind?
    The key to this paradox is a decline in the standard of 
living. Despite gains in real GDP, real median family incomes 
fell by 1.9 percent in 1993, and rose a statistically 
insignificant 0.7 percent of 1994.\11\ To put the rarity of 
this paradox in perspective, the last time real median family 
incomes fell while real GDP rose by more than 2.5 percent was 
1979, during the stagflation and malaise of the Carter 
Administration.\12\
    In trying to understand how standards of living can fall 
even as economic growth appears strong, it is useful to note 
that since 1966, the economy has under-performed its long-run 
growth potential to a staggering degree, as noted in Chart 1. 
During this time, government grew much faster than the economy. 
Looking at government spending plotted against total economic 
growth (Chart 2), two important trends become clear. First, 
from 1947 to the mid-1960s, government spending increased at 
the same rate as nominal GDP. Second, government spending began 
to outstrip economic growth with the imposition of the ``Great 
Society'' programs of the Kennedy-Johnson era.




    Between 1965 and 1994, nominal GDP grew at an average rate 
of 8.1 percent,\13\ while total federal government spending 
averaged 9.1 percent growth.\14\ Of course, government spending 
did not exceed economic growth in every year: between 1982 and 
1988, the economy outpaced government spending.\15\ But in 1988 
the trend reversed, and since then government spending has 
again grown faster than GDP.\16\ Like federal spending, state 
and local government spending has also outpaced GDP.\17\
    The impact on American families has been terrible. Milton 
Friedman has calculated the aggregate cost of direct and 
indirect government expenditures at a staggering 50 percent of 
national output.\18\ It should surprise no one that the economy 
is showing signs of stress from dragging so much dead weight.




    Real GDP measures the total supply of goods and services 
produced in the economy. Entrepreneurs will supply those goods 
and services only as long as there is a chance for profit. 
Through confiscatory taxes, onerous regulations and mandates, 
and other impediments to entrepreneurship, government makes 
profits harder to come by, and, in turn, slows economic growth 
and the creation of wealth. Thus, because total government 
spending drains resources from the marketplace, it is a worthy 
measure of the disincentives to wealth creation.
    In addition to government spending, the assault on the 
American economy has been waged from a second front: government 
regulations pose a further impediment to the economy's 
potential. According to Thomas D. Hopkins of the Rochester 
Institute of Technology, government regulation costs the 
economy over $600 billion annually and, on average, costs each 
American household $5,000 every year.\19\
    The size of the Federal Register is a good gauge of the 
expansion of federal regulations and of overall government 
growth. As noted in Chart 3, the Federal Register exploded from 
roughly 17,000 pages in 1965 to 87,000 pages in 1980. 
Regulations were brought under control in the Reagan years, and 
the Federal Register shrank to 53,480 pages in 1985. But it 
grew to nearly 70,000 pages by 1994.\20\




    Since the mid-1960s, the economy has fallen farther and 
farther behind. Real GDP grew at an average annual rate of 4.0 
percent between 1947 and 1966, but since then growth has only 
averaged 2.6 percent.\21\ This 1.4 percentage point gap has led 
to a huge shortfall in real output. As suggested earlier, 
today's economy would be more than $2.7 trillion larger if only 
the economy had continued growing at the 1947-1966 rate, 
meaning that 1994 real per-capita GDP would have been more than 
$10,000 higher.\22\
    While some have suggested that it is unfair or impractical 
to judge the growth of today's economy against the historical 4 
percent average, not long ago such growth was considered 
entirely plausible. In January 1962, John F. Kennedy wrote in 
his Economic Report of the President, ``Increasing our [real 
potential] growth rate to 4\1/2\ percent a year lies within the 
range of our capabilities during the 1960's.'' \23\ In 1965, 
Lyndon Johnson wrote in his Economic Report of the President, 
``our potential [real output] is also speeding up. Estimated at 
3\1/2\ percent a year during most of the 1950s, it is estimated 
at 4 percent in the years ahead; and sound policies can and 
should raise it above that.'' \24\
    Even so, since the early 1960s, 4 percent growth has never 
been sustained for long. Instead, growth has cycled between 
periods of extreme malaise (such as the late 1970s through 
early 1980s) and relative vigor in which the economy came very 
close to the 4 percent goal (1982 through 1989).\25\ Over time, 
the United States has consistently lost ground to the 4 percent 
pace, and expectations have diminished. Unless fundamental 
changes are made, the future looks no brighter. As Alan 
Greenspan and other economists have noted, the estimated 
noninflationary growth potential of the economy is now 
appreciably below 4 percent, and most likely near 2.5 
percent.\26\
    Even with tremendous gains in productivity and technology, 
real median family incomes have not made any dramatic or 
sustained improvement. The average manufacturing-sector work 
week has lengthened dramatically. Workers are working harder 
for little or no real improvement in their incomes.\27\ Slower 
economic growth has impeded efforts to help the truly needy. 
Congress has responded counterproductively, intervening even 
further while claiming to provide things individuals can no 
longer afford for themselves. Despite massive efforts by the 
government to promote jobs, unemployment has risen from an 
average of 4.9 percent from 1948 to 1965, to an average of 6.3 
percent from 1966 to today.\28\
    So government programs have piled up, each promising 
prosperity, while Americans' standards of living have stagnated 
or even worsened. This slow deterioration of incomes can be 
difficult to see and has often been intentionally obscured for 
political purposes. The Federal Reserve may lower interest 
rates to induce artificial growth, but when rates climb and a 
recession occurs, ``greedy'' business people or indebted 
consumers get the blame.
    Without the political will to restrain and restructure 
government, and without replacing the failed welfare state of 
the 1960s with explicit pro-growth economic policies, the 
United States will continue down a path of diminishing 
expectations. But given the courage to fulfill its mandate for 
change, America stands poised to reclaim the strong, long-term 
economic growth of its not-so-distant past. Since government 
has created the barriers to growth, Congress can remove them by 
reducing spending, balancing the budget, eliminating onerous 
regulations, and reducing tax rates so that the private sector 
can again grow faster than government, incomes can improve, and 
standards of living can increase for all Americans.
    Shrinking government, thereby shifting resources back to 
businesses and families, will reduce government intrusion in 
the economy and in the countless family and individual 
decisions that it presently dictates. Shifting decisions back 
to states, where individuals have greater influence, and 
spending is limited by law, will encourage political 
participation. Americans want relief from the burden of 
excessive federal taxes that impede their efforts to save for 
the future.

                a revolution in constitutional economics

    Recent advances in economic theory bode well for the 
support of this smaller government. Much of this progress is 
associated with two economists, both Nobel Laureates, James 
Buchanan and the late F. A. Hayek, who have improved society's 
understanding of the constitutional limits to government.
    Though using different approaches, both have reached 
conclusions in keeping with the spirit of the Federalist 
philosophy embraced by most of the Founding Fathers. That 
spirit acknowledges human fallibility in government and 
supports the principles of limited government, individual 
freedom and equal justice under law.
    James Buchanan is considered the father of modern public 
choice economics, an approach that applies the principles of 
microeconomic analysis to political decision-making. Hayek has 
made a number of critical contributions to both economics and 
political science, including an analysis of why government 
attempts to manage the economy end in failure, as well as a 
comprehensive analysis of constitutional issues, in ``The 
Constitution of Liberty,'' and other works.
    As many economists have noted, a balanced budget rule was 
implicitly part of an unwritten ``fiscal'' Constitution from 
the beginning. It was only after neo-Keynesian economics and 
its endorsement of deficit spending became accepted in the 
early 1960s, that deficit spending became the rule instead of 
the exception.
    According to the neo-Keynesian view, the main object of 
government policy should be to balance the economy, not the 
budget. It was argued that government policy could ``fine-
tune'' the economy to achieve targeted levels of economic 
growth, unemployment, and inflation. Although this view was 
later embodied in the Humphrey-Hawkins Act, the attempts to 
fine-tune the economy failed, and resulted in the simultaneous 
rise of inflation and unemployment in the late 1970s, breaking 
the back of the Phillips Curve.
    As Hayek pointed out, the rationale of such policies as 
``fine-tuning'' was based on the assumption that government 
officials possess more information than they actually have; he 
calls this the ``pretense of knowledge.'' Hayek's insight 
harkens back to ``The Federalist,'' in the recognition of 
limits in human nature shared by public officials.
    Modern public choice economists have also noted the fact 
that the ``fine-tuning'' approach assumes a degree of 
omniscience and disinterest among public officials and their 
advisers that is totally unrealistic. This also legitimizes a 
concentration of power in government that although well-
intentioned, is extremely dangerous and runs against the whole 
spirit of ``The Federalist.''
    The broadly perceived failure of fine-tuning has undermined 
the belief in government's ability to manage the economy. 
However, by breaking what Buchanan has called the traditional 
taboo against deficit spending, this neo-Keynesian thinking 
left a legacy of unconstrained spending. No longer did 
increases in spending remain within the level set by expected 
revenues, but could exceed them whenever policy-makers deemed 
it desirable.
    Without this balanced budget constraint, it is very 
difficult for members of representative institutions to resist 
pressures for additional spending. The benefits of federal 
spending programs are typically concentrated among program 
beneficiaries, while their costs are diffused among all 
taxpayers. This asymmetry means there is usually more intense 
and focused political pressure brought to bear in favor of 
specific programs than that reflecting the interest of all 
taxpayers in opposing program spending.
    This modern perception of public choice economics is very 
similar in spirit to Madison's observations about the need for 
institutional safeguards to constrain the dangers of 
``faction.'' The point here is not to allege shortcomings among 
members of the legislature, but simply to identify the 
tremendous pressures for additional spending they so often 
face. If the current structure of our political institutions 
makes resistance to such pressure in the public interest more 
difficult, then this suggests the need for institutional 
reform.

                      institutional reforms needed

    We need to restore constitutional order by making the 
balanced budget rule a written part of the Constitution. 
However, other reforms will also be needed to successfully 
implement any such constitutional restoration.
    To achieve its constitutional purpose in limiting 
government, the balanced budget amendment will likely need some 
mechanism to at least assist the achievement of fiscal balance. 
The balanced budget rule as an abstract concept cannot, in and 
of itself, provide the appropriate budgetary decisions needed 
to bring federal outlays and receipts into balance by the 
fiscal year 2002.
    Congress, acting in the budget process, may make 
significant strides towards this objective, but may well fall 
short. An institutional safeguard is needed to backstop the 
political system and ensure that the job is finished. This 
could be the role of a spending reduction commission, modeled 
after the Defense Base Closure and Realignment Commission.
    In the absence of this kind of institutional reform, there 
would be valid reasons for concern about the ability of 
Congress to balance the budget. As Madison pointed out, the 
power of coalesced factions, or special interest groups, is 
immense, and they will resist any effort to reduce spending 
growth in their favored programs. Public choice economists have 
also identified a kind of legislative myopia, called fiscal 
illusion, which is facilitated by deficit spending.
    The benefits of program spending are all too visible, while 
the costs they impose through debt financing are much harder to 
identify. The legislative consideration of new spending is 
distorted by fiscal illusion. Fiscal illusion, via deficit 
finance, can be addressed by the balanced budget amendment, but 
the problem that spending benefits are more concentrated than 
their costs to taxpayers remains.
    What is needed to redress the balance is a single-minded 
focus on the spending side of the budget. The current fiscal 
problem originates from the failure of spending to remain 
within the bounds set by revenues. Historically, revenues have 
oscillated around 19 percent of GDP regardless of how high tax 
rates were set (Chart 4). Unfortunately, spending has climbed 
far above this level, and is currently estimated at about 22 
percent of GDP.




    Institutional constraints such as a spending reduction 
commission and the line-item veto would help Congress maintain 
its attention on the spending side of the federal budget. 
Congressional actions to reduce federal spending growth would 
not be adversely affected in any way, but any shortfalls in 
achieving the glide path to a balanced budget would be covered 
by institutional spending constraints.
    Given the intense pressures brought to bear by special 
interest groups and the procedural obstacles that could be 
invoked, some back-stopping of the normal budget process is 
clearly needed. Institutional constraints are essentially an 
insurance policy in which the American taxpayer is the 
beneficiary.
    It is essential that the path to a balanced budget be 
followed by reductions in spending growth, not tax increases. 
Tax increases would increase both the economic and political 
cost of excessive government. Moreover, Joint Economic 
Committee research suggests that such attempts would be futile 
and self defeating, since in the postwar period studied, each 
$1 of taxes raised by Congress resulted in $1.59 of new 
spending. Institutional spending constraints would avoid this 
counterproductive path of tax increases.

                    fiscal disorder erodes democracy

    Unchecked deficit spending has permitted the federal 
government to expand far beyond any achievable political 
consensus. The German economist, Wilhelm Roepke, an architect 
of the German post-war economic boom, predicted the effects on 
unchecked government in eerily prophetic terms over 30 years 
ago:

          The power of the state grows uncontrollably, yet, 
        since powerful forces are at the same time eroding its 
        structure 
        and weakening the sense of community, there is less and 
        less assurance that the administration and legislation 
        unswervingly serve the whole nation and its long term 
        interests. Demagogy and pressure groups turn politics 
        into the art of finding the way of least resistance and 
        immediate expediency or into a device for channeling 
        other people's money to one's own group. Government, 
        legislation, and politics of this kind are bound to 
        forfeit public esteem and to lose their moral 
        authority.

    A balanced budget amendment that does not limit the size of 
government will do little to prevent this outcome, so evident 
in the previous Congress. The program with the federal 
government today is that its size and range of activities lack 
legitimacy because they exceed the wishes of the governed and 
of the taxpayers.
    Moreover, big government exceeds its competence in the 
sense that in an attempt to do everything, it does nothing 
well, even those functions supported by a broad range of 
opinion. Thus a new fiscal regime that will constrain 
government will also limit the power of special interest 
pressures to distort the political process and undermine the 
legitimacy of democratic institutions. This constraint will 
also help the government adequately perform those functions 
broadly agreed upon.

              Postwar Economic Policy and Economic Growth

    A touchstone of previous Democrat administrations was that 
the economy's tax generating potential is essentially 
limitless, given careful management of monetary and fiscal 
policy by the government. As discussed earlier, President 
Kennedy's first ``Economic Report of the President'' committed 
his administration to achieving a 4,5 percent annual growth 
rate. Moreover, President Johnson's 1965 ``Economic Report of 
the President'' insisted that rapid economic growth was a 
primary goal of policy. He further indicated that ``sound 
policies'' could achieve growth rates well above 4 percent.
    By contrast, most Republican Administrations have tended to 
be more restrained in their view of government's ability to 
influence the rate of growth. For example, President Eisenhower 
warned in his 1955 ``Economic Report of the President'' against 
economic stimulus. ``The wise course for Government in 1955,'' 
he said, ``is to direct its program principally toward 
fostering long-term economic growth rather than toward 
imparting an immediate upward thrust to economic activity,'' 
President Ford warned in 1976 that there was ``no simple 
formula for single act that will quickly produce full economic 
health.'' He indicated that is would take ``several years of 
sound policies to restore sustained, non-inflationary growth.''
    The Reagan Administration believed that government could 
positively impact economic growth. But unlike the Kennedy and 
Johnson Administrations, it did not believe that macroeconomic 
finetuning was the answer. Rather, the key to growth lay in 
scaling back government interference with the private market. 
Hence, reducing inflation, taxation and government regulation 
were thought to be the best means of encouraging long-term 
growth. As the Reagan Administration's last ``Economic Report 
of the President'' put it: ``The goal of this Administration 
has been to reinvigorate the private sector by limiting the 
size of the federal Government, improving incentives through 
tax cuts, improving market flexibility through deregulation, 
avoiding new structural rigidities, and encouraging non-
inflationary monetary policy.''
    While the Reagan Administration saw a greater potential for 
economic growth, the Clinton Administration sees the economy's 
growth potential as severely constrained. Its latest ``Economic 
Report of the President'' argues strongly that real GDP growth 
will be limited to 2.5 percent per year for the foreseeable 
future, regardless of what actions the Administration might 
take.
    To encourage long-term economic growth and job creation, 
conditions must be favorable to long-term investment and 
capital formation. Capital formation generates the productivity 
improvements that result in more production per given input of 
resources. Higher productivity saves resources (i.e. increases 
economic efficiency), increases jobs, reduces inflation and 
improves the well being of America's citizens.
    Growth in output per worker, which contributes to increased 
productivity, is essential to economic growth, job creation and 
rising wages. Yet productivity enhancing capital was for many 
years taxed on the realized increases of its nominal value, 
much of which often reflected inflation. Such policies penalize 
and discourage capital investment and savings. Capital taxation 
policy, along with regulatory policies, including patent policy 
and the protection of intellectual property rights, is a major 
determinant of innovation in our society. For too, long, 
capital has been taxed heavily in order to create the 
appearance of punishing the rich while ignoring those who have 
jobs as a result of the capital.
    Capital taxation is usually characterized as a concern only 
of the ``rich,'' yet it most often catches middle class 
Americans when they sell a single major financial asset such as 
family homes or farms. By penalizing families in all income 
groups, capital gains tax policy has hurt economic growth.
    The Dow Jones Industrial average has soared 165 percent 
over the past nine years as new markets, products, and 
technologies have boosted the earnings potential for the 
economy.\29\ With this tremendous boom in asset values, capital 
gains tax revenues could be expected to soar. Yet they have 
not. Capital gains realizations have stagnated as investors 
have refused to sell in the face of high capital gains tax 
rates.
    The slowdown in capital gains realizations is directly 
related to the misguided 1986 increase in the capital gains tax 
rate. The Joint Economic Committee estimates that more than 
$1.5 trillion in capital gains are locked-up in the economy, 
awaiting a reduction in the capital gains tax rate. The capital 
gains tax compels resources to remain in old technology 
industries by locking investors up in old investments. In 
addition, high capital gains tax rates force investors to 
forego flexibility in investment strategies by pushing them 
into tax-free investments such as pension funds, 401(k)s, IRAs 
and trusts.
    The effective real capital gains tax rate, even at very low 
levels of inflation, can be higher than 100 percent because 
taxes are levied on both real gains and the illusory gains due 
to inflation.\30\ Since many foreign countries tax capital 
gains very slightly, if at all,\31\ American companies must 
take drastic steps to insure a great enough return on equity 
investment in order to attract capital. To achieve such 
returns, companies in old industries are often forced to rely 
on cuts in payrolls and expenses to maintain an acceptable 
level of profitability. At the same time, new industry, which 
tends to add the most new jobs in the economy, must fight for 
capital and pay more for it.
    Cutting the capital gains tax rate and then indexing it for 
inflation would boost economic growth, job creation, and 
government revenues. Lowering the capital gains tax will raise 
government revenue and shift locked-up capital from old to new 
investments. The higher revenues and investment shifting may 
take place immediately or may be stretched over a number of 
years. Nonetheless, government revenues, even with the lower 
tax rates, should be significantly higher than in recent years 
and could easily rise above currently forecasted budget numbers 
much as they did following the 1982 capital gains tax cut.
    Because capital gains result only from the sale of assets, 
once investors decide to sell, the capital gains tax is a 
voluntary tax. While investors make decisions based on many 
different inputs, historical data on capital gains realizations 
show that tax rates are a significant factor. After the capital 
gains tax rate was cut to 20 percent in 1982, capital gains 
realizations during the four years from 1983 to 1986 totaled 
$763 billion, more than double the $369.2 billion in 
realizations during the previous five years.\32\
    Part of this dramatic gain was due to a surge in 1986 when 
capital gains realizations shot up 90.6 percent as investors 
took gains in advance of the announced tax rate increases in 
1987. Since 1987, capital gains realizations have fallen back 
to levels 35 percent below those of the three years before the 
capital gains tax increase. Even if the 1986 jump is excluded, 
capital gains realizations are still 11.5 percent below the 
pre-tax-hike levels of 1984 and 1985.\33\ This decline occurred 
despite record-setting gains in the stock market.
    In effect, the key to investment and economic growth was 
discarded in 1987 when the capital gains tax rate was 
increased. Between 1985 and 1994, the S&P 500 increased by 146 
percent.\34\ If capital gains realizations had merely kept pace 
with the S&P 500, there would have been $2.7 trillion in 
realizations between 1987 and 1994. Instead, using any 
reasonable estimate of actual realizations for 1994, there were 
less than $1.2 trillion.\35\ This suggests that at least $1.5 
trillion in capital gains realizations are locked-up or forced 
into inflexible tax-free investment strategies. Obviously, 
investors are refusing to sell in the face of punitive tax 
treatment.
    Joint Economic Committee analysis shows the shortfall in 
capital gains realizations suggested by stock market gains 
(Chart 5). These estimates used 1985 realizations as a base, so 
that the artificial boost in realizations during 1986 did not 
lead to an overstatement of potential gains.




    Entrepreneurial talent requires resources, and today's 
opportunities are better than they have been in decades. New 
technology is opening the door to productivity gains and new 
products at a rate not seen since the Industrial Revolution. By 
reducing the capital gains tax rate and indexing it for 
inflation, the $1.5 trillion in locked-up gains can be released 
to fund investment opportunities which create jobs and growth 
as new investors, both overseas and at home, are enticed into 
investing in America.
    New companies are attracting capital in spite of the 
current tax system. Nonetheless, given all the new market 
potential and the tremendous rise in the stock market during 
recent years, total venture capital investment remains below 
1986 levels. Such investment in 1994 was $2.7 billion, only $60 
million higher than in 1985 and $501 million below 1986.\36\ 
And, while initial public offerings (IPOs) have increase as the 
stock market has reached new highs, the 1994 IPO total of 646 
is still below 1986's 728.\37\
    The benefits to Americans from cutting the capital gains 
tax rate are many. Increased investment in new technologies 
will boost productivity, jobs and living standards. At a time 
when Congress is getting serious about balancing the budget, 
cutting the capital gains tax rate has the potential to boost 
federal revenues by more than $225 billion ($1.5 trillion 
multiplied by a 20% tax rate, adjusted for offsetting losses) 
above current estimates (which amounts to seven years of 
capital gains tax revenue at the current pace). These revenue 
estimates reflect only actual capital gains and do not attempt 
to measure any boost to economic growth that would ensue.
    High capital gains tax rates have led to a dramatic decline 
in realizations and new investment despite gains in the stock 
market and the potential of new technologies. These locked-up 
capital gains point to higher revenues and more investment in 
new technology if only the capital gains tax rates are cut.

              tax reform is essential for economic growth

    There is a large and growing consensus among economists, 
lawmakers, and taxpayers that our current income tax system has 
become a tremendous obstacle to economic growth and Americans' 
standard of living. After eight decades of misuse by lawmakers, 
lobbyists, and special interests, the tax system is unfair, 
complex, costly, and punishes work, saving and investing. 
Simply stated, today's onerous tax system is unfit to carry the 
nation into the 21st century, and threatens the promise of a 
better future for all Americans.
    Since being enacted in 1913, the income tax has fallen prey 
to a multitude of unintended purposes, including income 
redistribution, social engineering, and government micro-
management of saving, investing, and spending decisions. As a 
result, it treats individuals unfairly, extracts tremendous 
administrative and compliance costs, and hinders the economy 
from realizing its full productive potential. In fact, the 
current system hinders Americans' potential for a higher 
standard of living.
    The only legitimate purpose of any tax is to provide 
revenue to cover the cost of government. Taxes should allow 
taxpayers to clearly see the price of government spending, and 
thereby determine how much government they are willing to pay 
for. In order to make the tax system more equitable, efficient, 
and pro-growth, the following principles must be followed:
          All taxpayers must be fully informed on exactly what 
        is being taxed, how they are being taxed, and what 
        their true tax liability is.
          Taxes should be as visible to the taxpayer as 
        possible. ``Hidden'' taxes mask the true cost of 
        government.
          The tax system should explicitly treat all 
        individuals equally under the law. Deliberate 
        differentiations in tax liabilities based on the 
        sources or uses of income should be avoided.
          The tax system should provide the same tax treatment 
        for similar economic actions and transactions rather 
        than taxation based on the attributes of the taxpayer.
          Multiple layers of taxation should be avoided. Income 
        should be taxed once and only once.
          The tax system should be simple. Complexity makes the 
        system expensive, punitive, and results in an 
        efficiency loss to the economy.
          The tax system should aim for neutrality in economic 
        decision making. The tax system should not interfere 
        with the free-will economic choices and decisions of 
        individuals, households, or businesses.
          A low tax rate across a broad tax base creates the 
        least distortions in the economy. High marginal tax 
        rates damage economic growth by reducing the incentives 
        to work, save and invest.
          Changes in the tax law intended to raise revenues 
        should not be retroactive. All taxpayers must have 
        confidence in the code as it exists when planning and 
        entering transactions.
          The tax code must be competitive with other 
        industrialized nations. It should in now way impede the 
        free flow of goods, services and capital across 
        borders.
    Unfortunately, our current tax code violates these basic 
principles. The complexity and unfairness of federal taxes has 
led to proposals for simplification. Along with lower rates, 
simpler filing and ease of compliance are desired. Businesses, 
concerned about the financial burden on their companies and 
employees, similarly resent high taxes. Families and businesses 
are still taxed on inflation, because assets, like many homes 
and family farms, are usually held for long periods, often 
through generations. Much inflation, as well as real capital 
appreciation, is captured because current nominal sales prices 
are used as the basis of taxation when long-held assets are 
sold. Personal exemptions for family members have not kept up 
with inflation, compared with their value in 1950. The 
purchasing power of the exemption, in constant dollars, should 
be restored by increasing the exemption amount.
    To protect families and businesses from tax increases 
caused by future inflation, exemptions and asset purchase 
prices must be fully indexed. To offset present inflation, cost 
recovery should be enhanced by allowing expensing or 
accelerated depreciation. Simple low rates provide long-term, 
stable incentives for businesses and households to increase 
their future activity, their future income and, if successful, 
their future tax burdens.
    Tax burdens and the cost of regulation often force families 
to send both parents into the workforce. On average, taxes of 
all kinds claim almost 40 percent of Americans' incomes. Thus 
today's parents often work nearly as much to support the 
government as to support their families, unlike previous 
generations who paid relatively low federal taxes. Paying these 
higher taxes has become much more complicated for many 
taxpayers, and indirect taxes push effective rate even higher. 
Moreover, government increasingly imposes taxes that citizens 
can not explicitly see and are not itemized on any tax bill, 
such as the federal gasoline tax.
    Economists broadly agree that increasing savings and 
investment is essential to capital accumulation. This, in turn, 
allows new machinery and technology to increase workers' 
productivity. Ready sources of capital are needed to allow 
businesses to invest in such equipment. Low savings rates make 
capital more expensive for private enterprise, and yet the 
interest from savings is taxed punitively as well. Thus, low 
savings undermines capital investment.
    The manner in which income is taxed must be re-thought, 
therefore, in order to be equitable, efficient, and pro-growth. 
Tax tinkering, or simply reshuffling the existing tax burden is 
not genuine tax reform. A new tax structure must be created 
that allows everyone to benefit from economic growth while 
preventing today's anti-growth tax system from ever re-
emerging.
    Today's major tax reform proposals, a flat rate income tax, 
a national sales tax and other consumption-based taxes, 
encompass this new thinking and fundamental change needed to 
create a fair, simple, and progrowth tax system.
    While many of these proposals would help correct the 
inequities and complexity in our current tax system, the most 
important reason to undertake fundamental tax reform is to 
improve the standard of living. If tax reform fosters just a 
0.5 percent increase in GDP growth, the typical American family 
after five years would have incomes more than $3,000 higher 
then they would be under current tax law.
    Current tax reform proposals are such a fundamental change 
from the way government does business today that there are no 
economic models which can fully calculate their impact on 
economic growth. Nobody, not the Congressional Budget Office, 
not the Administration's Office of Management and Budget, not 
the Treasury Department, not the Joint Committee on Taxation, 
has predicted the dynamic potential of full-fledged tax reform.
    No doubt, typical static income distribution and revenue 
models used to trumpet so-called tax ``winners'' and ``losers'' 
will be used in an attempt to scare us into preserving the 
status quo. However, these models cannot encompass the real 
essence of fundamental tax reform: the potential to make 
everyone better off through economic growth and increase 
incomes across all classes. Any static comparison of what one 
pays in taxes today to what they will pay under a reformed tax 
system simply fails to capture many important aspects of 
meaningful tax reform. For example:
          Would families be better off under a tax reform that 
        lowers interest rates on mortgages, credit cards, and 
        auto loans?
          Would consumers be better off with a tax reform that 
        reduces inflation?
          Would families be better off under a tax system that 
        would now allow a spouse to enter the work force or get 
        a raise without pushing the family into a higher tax 
        bracket?
          Would families be better off under a tax system that 
        would let them save and invest for their future without 
        punishing these decisions with high tax rates and 
        double taxation?
    Static analysis has been proven wrong time and time again. 
Eliminating destructively high marginal tax rates would boost 
investment, productivity, wage growth, and the standard of 
living, and, in turn, the Treasury would see an increase in 
revenues. This is not ideal speculation. When Presidents 
Kennedy and Reagan lowered marginal tax rates, the economy 
boomed and tax revenues increased.
    Today, the graduated income tax system grabs an increasing 
share of the fruits of people's hard work and success. it's no 
wonder Americans feel they are working longer and harder with 
nothing to show for it. They are.
    For too long, the tax code and fiscal policy have grown to 
accommodate the demands of special interests. Fiscal policy 
that addresses the economic concerns of typical taxpayers 
should be instituted by reversing government's tax and spend 
habits and by promoting economic growth.

 Policy Recommendations of the Chairman of the Joint Economic Committee

    November 8, 1994 marked a new beginning for America. Voters 
rejected politics as usual and demanded real change. They said 
they want a smaller federal government that will leave them 
alone to make the best lives they can for themselves and their 
families.
    Congress must justify the faith the American people have 
placed in us to create a smaller, simpler and smarter 
government. To reach that goal, I propose three common-sense 
changes to the way government now does business: a Spending 
Reduction Commission to make government smaller, a Flat Tax to 
make government simpler, and Humphrey-Hawkins reform to make 
government smarter.

                     spending reduction commission

    Even if Congress can agree that 25 years of deficit 
spending has smothered our economy, and we decide to honor the 
wishes and demands of the American people by passing the 
Balanced Budget Amendment, we are still left with the daunting 
task of actually balancing the budget.
    In 1992, my dealings with the Defense Base Closure and 
Realignment Commission led me to conceive a Spending Reduction 
Commission to perform the same hard analysis on overall 
government spending, and force Congress to make the choices 
that it has fought so long and hard to avoid. It would act as a 
fail-safe mechanism to ensure American taxpayers that the 
budget will be balanced through reductions in the growth of 
spending, not tax increases.
    The Congressional Budget Office says that if we 
cumulatively reduce the growth in spending by less than $50 
billion in each of the next six years, the budget will be 
balanced by the year 2002. Under my plan, if Congress is unable 
or unwilling to restrain the growth of spending enough through 
its normal budget process in a given year, the Commission would 
create a package of additional restraints to meet the target. 
That package, without any amendments, would receive a straight 
up or down vote, so individual members would be effectively 
prohibited from protecting their prized political pork without 
publicly attacking the entire package.
    An old saying goes: the reason the men at the Alamo fought 
so bravely is that there was no back door. The Spending 
Reduction Commission would nail the back door shut, and force 
Congress to cut the growth of spending one way or another. It 
would provide an ironclad guarantee that the budget gets 
balanced through spending restraints, not tax increases.

                              the flat tax

    When the 16th Amendment, which established the federal 
income tax, was ratified in 1913, the maximum legal tax rate 
was 7 percent, and less than one of half of one percent of the 
population even had to file a tax return. By the 1960s, the 
United States had a top marginal tax rate over 90 percent. 
Thanks to John Kennedy and Ronald Reagan, that rate was 
eventually cut by more than half. But in 1993 President Clinton 
and his allies in Congress began pushing the top rate up once 
again.
    Not only is the tax burden on American families now at a 
record high, but taxpayers spend $190 billion and 6 billion 
man-hours just to comply with our burdensome tax code. To put 
that last figure in perspective, producing all the cars, trucks 
and airplanes made in America each year also takes 6 billion 
man-hours.
    But even if we somehow choose to ignore this incredible 
waste, we can't ignore the way high tax rates combined with 
double, or even triple taxation of income punishes success, 
stifle work, discourage saving, and push investment into 
unproductive tax shelters. In short, the tax system we have 
today dangerously erodes the productive potential of our 
economy, and reduces every American's standard of living.
    Under a flat tax, everybody who pays income tax faces the 
same rate. Today's high tax rates would be drastically reduced, 
and Americans would realize major tax savings up front. The 
system would be both simpler and fairer. Appropriate individual 
allowances and dependent deductions would ensure that the flat 
tax is not regressive. In fact, low-income families would be 
removed from the tax rolls altogether.
    As the new rate is implemented, the tax loopholes and 
giveaways that now go to special interests would be eliminated. 
There will surely be howls from those who want to preserve 
their own favorite deductions and tax benefits. However, as 
things now stand, the governmental takes a huge chunk of 
peoples' incomes, and then tries to bribe them with their own 
money through government-approved deductions and allowances. A 
low-rate flat tax would allow everyone to keep more of what 
they earn from the start, so individuals could decide for 
themselves how to use their own money.

                        humphrey-hawkins reform

    In 1978, Congress passed and President Carter signed into 
law the Humphrey-Hawkins Act. Humphrey-Hawkins is every big-
government, tax-and-spend liberal's dream. It gives the federal 
government responsibility for simultaneously promoting full 
employment and reasonable price stability. Of course, it had 
little support from anyone who had ever actually created a job 
in a real business.
    By forcing the Fed to focus on employment and growth, 
Humphrey-Hawkins set up the age-old conundrum of serving two 
masters. In trying to satisfy both, neither is pleased. As a 
result, the Fed often must make decisions in the short-run that 
are not good for the economy in the long-run. The Fed may boost 
employment in the short run, but always at the expense of 
inflation. History shows that stable prices provide the best 
environment for long-term economic growth and increases in 
standards of living.
    The Fed should have only one focus: controlling inflation. 
By following sound money policy, it can create the stable 
environment that businesses need to make sound decisions. 
Protecting the value of Americans' income, savings, and 
investments from the ravages of runaway inflation will bring 
dramatically lower interest rates, stronger economic growth and 
permanent increases in employment.
    Humphrey-Hawkins is a classic piece of Washington 
arrogance. It ignores the fundamental economic realities that 
government cannot legislate prosperity, that businesses create 
jobs, and that free markets lead to economic growth. Government 
should help foster an economic environment of low taxes, free 
markets, stable prices, and a respect for private property in 
which individuals can prosper. Congress and the President 
should work to keep taxes low and markets free, while the 
Federal Reserve should maintain a stable value for our money.
    All three of these proposals, the Spending Reduction 
Commission, the Flat Tax, and Humphrey-Hawkins reform, would 
change government for the better. But even so, they only fix 
mistakes of the past. Turning to the needs and opportunities of 
the future, I look forward to a much smaller government, a 
dynamic and growing economy, and the ascendancy of the 
individual.

                               the future

    Americans own their government. That means government works 
for us, and as employers, we have to ask if our employee is 
doing the job. If any other employee did such shoddy work for 
exorbitant wages, insisted on spending his time doing what he 
though was important rather than what he promised he would do, 
showed disrespect, and even contempt, for both his customers 
and employers, and spent more time worrying about feathering 
his own nest than increasing the bottom line, he would be 
fired. Rightly so.
    The time has come to confine the government to those duties 
specified in the Constitution. For too many Americans, the 
government acts not as a helpful servant, but as an insensitive 
master. Shrinking the government would put responsibility and 
opportunity back where it belongs, in the hands of the people. 
Freed from the oppressive weight of taxes and regulation, our 
economy will grow and all Americans will benefit. Individuals 
must be allowed to realize their dreams.
    America is entering a new age. Futurist author Alvin 
Toffler calls it the Third Wave. With tremendously expanded 
access to information--educational, vocational, and even 
entertainment--the technology revolution is changing how we 
work, how we play, how we team, and even how we think. This 
revolution will give individuals the ability to control their 
lives and provide for their families in ways they could not 
have dreamed of until now. the future holds promises only our 
children will be able to imagine.
    America is the beacon of freedom and opportunity for all 
the world. But unless we dedicate ourselves to keeping the 
beacon shining brightly, it will surely dim and die. Only 
government can stop us from realizing our dreams by stifling 
our creativity, taxing away our incentive, pitting us against 
one another, and simply making life harder than it has to be.
    The battle to make government smaller, simpler and smarter 
is one we can not afford to lose. Our success will usher in an 
age of unparalleled prosperity and unprecedented expansion of 
freedom. This is the real promise of the 1994 elections. 
Working together, we can offer our children a future with less 
taxes, less spending, less government, and more freedom.

     Getting Back to Prosperity: The Views of Vice-Chairman Saxton

                              introduction

    Our Nation stands at a rare historical crossroad. For the 
first time in forty years, American citizens are being 
presented with a real alternative to big-government taxing, 
spending, and regulating. The Republican majority in Congress 
is offering a strategy to expand the economy and let taxpayers 
keep more of their income.
    In the Republican Views section of last year's ``Joint 
Economic Report,'' it was shown that the Clinton 
administration's policies of high taxation, regulation, and 
spending would be deleterious to the economy. The predictions 
of ``robust economic growth to come'' made by supporters of the 
administration's policies (many of whom have since been voted 
out of office) have not come to pass. In fact, just the 
opposite has occurred, and the question foremost in people's 
minds today is, ``how soon before today's economic slowdown 
turns into a recession?''
    Last year, the JEC Republicans predicted that the 
combination of high taxes and monetary contraction would 
imperil the economy. The administration ignored the advice and 
continued its misguided policies. The situation is even more 
precarious for long-term economic growth.
    Investment is crucial to raise the wages of workers and to 
provide the foundation of economic growth. Due to the 
unfortunate policies of the Clinton administration, Americans 
are not investing enough to provide for future prosperity. In 
the ``Economic Report of the President'' 1995, the 
administration admits that its policies cannot raise real 
economic growth above 2.5 percent per year. Though the 
administration's economists are unable to offer a solution, 
they correctly, if unwittingly, identify the problem--higher 
taxes. Because the President's tax increase burdened successful 
entrepreneurs, the administration's economists say that these 
income earners ``are presumably more likely to make the [tax] 
payments out of savings.'' \38\ Reducing savings to pay taxes 
destroys investment. Tax relief on investment is important for 
robust economic growth.
    Economic expansions do not die of old age. Rather, they are 
killed off by misguided government policies. The combination of 
Clinton's tax increase and tight monetary policy in the 
aftermath of loose monetary policy, in 1991, 92, and 93, is 
slowing the economy. Congress thus must respond to limit the 
economic damage. The Contract With America and the House 
Republican budget are just the first steps to restore sanity to 
public policy.

                   lessons from the reagan expansion

    The 1980s taught a very valuable lesson. The experience of 
the Reagan revolution demonstrated that the economy performs 
admirably when government reduces its size and scope.\39\ The 
evidence from domestic affairs is bolstered by the experience 
of other countries that have reduced the size of government, 
such as Chile, New Zealand, and Great Britain.
    On the other hand, the failures of the economies of Central 
and Eastern Europe demonstrate the perils of excessive 
government intervention. The current economic discord in Japan, 
Germany, Sweden, and other countries with large government 
bureaucracies also shows the need to drastically downsize the 
government in mixed capitalist economies. International 
evidence further substantiates the argument that large 
government harms the economy and that the economy benefits from 
reducing government's size.
    When President Reagan reduced taxes and began to chip away 
at the layers of federal bureaucracy, the economy responded 
with the longest peacetime expansion in U.S. history. 
Unfortunately, those lessons were ignored by the Bush 
administration. Although President Bush started well by 
promising no new taxes, his ultimate capitulation to 
congressional Democrats on higher taxes, more federal spending, 
and increased regulation created significant economic 
difficulties which in conjunction with destructively tight Fed 
policy, culminated in the recession of 1991.\40\
    President Clinton benefited politically from the failed 
economic policies of President Bush and the Fed. The recession 
was an important factor aiding his election. However, Clinton 
chose to ignore the lessons of the Bush and Reagan 
administrations. The Clinton and Bush administrations were too 
narrowly focused on the deficit. They both succumbed to the 
temptation to solve the problem of the deficit on the backs of 
American taxpayers rather than by reducing government spending. 
The economic performance of both administrations has failed to 
match the standards of earlier periods of U.S. economic 
history.
    Incomes rose for all income classes while Reagan was 
President, contrary to the rhetoric of the Clinton 
administration (Chart 1). In 1993 and the first three quarters 
of 1994, the economy grew but the median family income fell. 
The last time the economy grew and median incomes fell was when 
Jimmy Carter was President. The November elections that swept 
Republicans into control of the Congress were largely a 
response to the failure of the administration to improve the 
lives of American families. Yet, the Clinton policies have not 
changed during the first two-and-one-half years of the 
administration.




                   The Burdens of Erroneous Policies

    The administration still argues that its tax increases have 
not hurt the economy. Two points need to be stressed when 
talking about Clinton's tax increases. First, when taxes are 
raised in the midst of an economic recovery, the result may be 
to retard growth, 
not necessarily produce an immediate recession. Second, the way 
the Clinton tax increases were implemented, the depressing 
economic effect was delayed. The current expansion has been 
fairly poor compared to earlier expansions. Chart 2 
demonstrates the poor job performance compared to earlier 
periods.




    The expansion has been wounded by the 1993 Clinton tax 
increase. The effects of the tax increase can be seen in income 
statistics. While nominal incomes rose in April 1995, real 
disposable incomes (income left after taxes) fell 1.1 percent. 
Real disposable income fell for two reasons.
    First, payment on the 1993 tax increase came due for many 
Americans on April 15, 1995. Second, the Clinton economic plan 
failed to lower interest rates as forecast by administration 
supporters. Too many Americans are seeing their incomes 
consumed by taxes and higher interest rates due to Clinton's 
economic policies.
    Fiscal policy is only one area where the government can 
affect economic growth. Monetary policy has an important impact 
on short-term growth, and no recounting of Clintonomics would 
be complete without a full description of the Fed's role.
    The Federal Reserve expanded the money supply dramatically 
in 1991, 1992 and 1993. Total bank reserves grew by as much as 
20 percent annually in 1992 and continued to grow by 10.6 
percent throughout 1993. The result of this monetary expansion 
was to create an artificially strong economy in 1994--a false 
prosperity.
    The Fed has created a dilemma. Excessive monetary expansion 
in 1991, 1992, and 1993 masked the impact of the 1993 tax 
increase. Now the Fed is reacting to its own past policies with 
excessive restraint. If the Fed governors continue unwarranted 
monetary restraint now by artificially propping up interest 
rates in combination with Clinton's tax increase and regulatory 
excesses, it will surely deliver a recession.
    Sound fiscal policy can, in part at least, overcome 
inconsistent, stop-and-go monetary policy. The Republicans have 
made the ``Contract With America'' an important part of the 
solution to the economic woes of the country. The economic 
policies of the ``Contract'' recognize that short-term economic 
difficulties require the same policies as those that maximize 
long-term economic growth. Government spending needs to be 
reduced. Taxes need to be decreased. And regulation needs to be 
limited.

                           the growth deficit

    The current difficulty in the U.S. economy reinforces a 
larger and more disturbing long-run trend. There is a gap 
between potential economic growth and the economic growth 
actually realized in the 1970s and 1990s which has been labeled 
the ``growth deficit.'' The evidence demonstrates that the 
growth deficit is caused by large, invasive government.
    The ``Contract'' begins to address the need for increased 
economic growth. The most important measures in the 
``Contract'' dealing explicitly with economic growth are the 
tax cuts. Contrary to Laura Tyson's assertion that there is no 
relationship between tax burdens and economic growth,\41\ 
reducing the tax strain on private citizens is vital to future 
prosperity. The ``Contract'' includes tax breaks for families 
with the $500-per-child tax credit, capital gains tax reduction 
and neutral cost recovery to spur investment, and elimination 
of Clinton's tax of Social Security benefits. Reducing the tax 
burden is always the first step for revived economic growth.
    Many critics of tax cuts have argued that deficit reduction 
takes priority over tax breaks. In fact, deficit reduction, 
when placed in its proper perspective, is viewed as a desirable 
artifact--a good by-product of more fundamental changes, 
smaller government, lighter and less-intrusive taxes. Most 
Americans recognize that government is too large and invasive. 
Chart 3 demonstrates the extraordinary burden government has 
become. Reduction of taxes is vital to restore the proper role 
of government--to serve its citizens.
    The ``Contract'' is the first attempt since the aborted 
Reagan revolution to restore the proper relationship between 
the government and the governed. Republicans recognize that 
they are the servants of the people and need to respond to the 
needs of citizens. However, the ``Contract'' is simply a first 
step in the process to restore American prosperity. The future 
requires a government that is much smaller and less intrusive.




                            reduce spending

    The next step taken by the Republican majority was to 
propose sufficient spending restraint to balance the budget. 
Spending has jumped from $210 billion to $1.6 trillion in 25 
years. Congress's budget recognizes the problem of this 
excessive spending. The projected Republican budget would 
reduce the share of GDP spent by the federal government to 18 
percent, still too large, but it is the first Congressional 
attempt in forty plus years to balance the budget by limiting 
the size of government, not by raising taxes. The President's 
proposal to balance the budget is deficient on each of its 
critical dimensions: it increases spending, it raises taxes, 
and it fails to balance the budget.
    Federal government spending has risen too rapidly to 
maximize economic growth. It is instructive to compare the 
growth of federal spending to private spending on items of 
importance. Since 1970, federal spending as a percent of GDP 
has risen from 19 percent to 22 percent. During the same period 
spending in vital areas of food, automobiles, and clothing has 
fallen; for food, from 13 percent to 10 percent; for 
automobiles, from 4.2 percent to 3.7 percent; for clothing, 
from 4.7 percent to 3.7 percent. Private spending on housing 
rose from 9.3 percent of GDP in 1972 to 9.8 percent in 1994 
primarily due to the explosion in the number of families in 
recent years. Moreover, in the one area of the private economy 
that has experienced the greatest amount of federal 
intervention over the years, medicine and health care, private 
spending is increasing as a share of GDP and, under current 
administration policies, is expected to rise even further.

                            regulatory costs

    Regulations and mandates on the private economy have 
increased as well. The impact of regulations is very hard to 
quantify. Thomas Hopkins has attempted to quantify their costs 
(Chart 4). The cost of regulations is triple the deficit and 
half the cost of taxation. Thus, the total burden of the 
federal government is $2.1 trillion. The federal government's 
burden is one-third of the U.S. GDP. 130,000 bureaucrats work 
to devise and enforce these regulations. The Federal Register, 
the list of federal regulations, has mushroomed from 44,812 
pages in 1986 to 64,914 last year.\42\




    Regulatory costs are not spread evenly throughout the 
economy. Regulations force higher costs on industries like 
timber, pharmaceuticals, and automobiles. At its current rate, 
the federal government will be testing pesticides until the 
year 15000 A.D. just to comply with current regulations. The 
federal government for too long has adopted these regulations 
without any consideration of the costs and benefits.

                     the optimal size of government

    The increase in federal spending, absolutely and 
relatively, would not be so alarming if increased government 
spending added to the general welfare; if the benefits of 
increased spending outweighed the costs of extracting funds 
from the private sector. However, careful research by 
distinguished economist Gerald Scully points out that 
government is too big in the U.S. to obtain full growth 
potential. Scully suggests that reducing spending of all levels 
of government in the economy by a third (from its current level 
of about 33 to 22 percent or less) would unleash economic 
growth. 
Chart 5 illustrates the research findings of Dr. Scully. The 
federal government would have to fall to a maximum of about 15 
percent of GDP to be able to reap the greatest rewards from 
spending policy changes or fall even further if states and 
localities shoulder more of the burden of government. The size 
of government must fall further than Scully suggests if 
regulation grows.




    But it isn't just economic science or meaningless 
manipulation of numbers, it is common sense. Curtailing federal 
spending confers benefits now to taxpayers and brings dividends 
of faster economic growth later. Since federal spending entails 
some combination of federal taxing, borrowing, and money 
creation, curtailing spending will lead to a lessening of 
burdens on taxpayers, or on credit markets, or a reduction in 
inflation, or some combination of all three.
    As the relative share of government declines, private 
citizens will put a smaller portion of the income they earn to 
taxes, less of their savings will go to government borrowing, 
and wealth accumulated in the form of money will not be eroded 
as quickly because inflation will be lower. In short, slowing 
the growth in federal spending sufficiently will leave more 
funds in the private sector to allow the economy to grow more 
rapidly over time. As private citizens retain more income and 
economic growth accelerates, the federal government will, in 
the long run, mazimize revenues.
    If there is one thing most Americans are now aware of, it 
is that the federal government has grown so large and its 
powers appear so great that ordinary citizens have no say in 
setting policies. This must change. The goal should be to catch 
up to our growth potential by freeing the economy to function 
to its fullest.
    The solution to the years of federal mismanagement is to 
build an economy capable of rapidly expansive growth. Chart 6 
demonstrates how the government would receive much larger 
revenues by enacting pro-growth policies. The deficit is much 
easier to solve if economic growth is maximized.




                               the budget

    Present budgetary reforms are aimed at holding the line on 
the relative amount that government spending takes from the 
economy by curtailing the growth in the absolute amount of 
spending. Taking this one step further toward meeting longer-
term goals, the Congressional budget, projected to be balanced 
in 2002, keeps spending increases to a minimum across-the-
board. Also, it proposes ways to slow the rate of increase in 
rapidly expanding programs, such as Medicare and Medicaid, by 
enacting market-based reforms. However, to unleash the full 
potential of private markets and to make up for lost economic 
ground, it is necessary to eliminate burdensome regulations and 
mandates on the economy the costs of which may swamp many of 
the possible benefits from reduced spending. Unleashing private 
markets is vital so that the economy can grow closer to its 
full potential.
    It is now possible to build coalitions to pursue the goals 
of higher economic growth and a lower relative share of federal 
spending. Tax cuts to spur investment will go to entrepreneurs. 
At the same time, it may be possible to reduce federal spending 
on the more than 125 programs that subsidize corporations. In 
fiscal year 1995, more than $85 billion will be spent on these 
programs. Business interests will support removing their own 
subsidies if they recognize the benefits of economic growth 
with a small government and less burdens from taxation and 
regulation. If welfare reform is designed to limit how long 
recipients can be eligible for federal funds, it makes common 
sense to limit the duration of all subsidies to private 
business or to put an end to corporate welfare as we know it.

                         reform the tax system

    Many areas require a reevaluation of the role of government 
but nowhere is this more needed than in the area of taxation. 
The current tax system is incredibly burdensome and costly. The 
government's attempt to collect the income tax is too intrusive 
into the lives of American citizens. The complexity of the 
income tax makes it almost certain that most Americans are 
making significant errors in their tax preparation. The income 
tax allows too many people to evade their fair share of the 
burden.
    Ten million people are delinquent ``non-filers.'' It takes 
5 billion man-hours to administer and comply with the income 
tax. That is more man-hours than it takes to produce all the 
cars, trucks, and vans in America. The Internal Revenue Code is 
thousands of pages and the regulations and court decisions 
interpreting the law are hundreds of thousands more. In 1992, 
Money magazine had 48 professional tax preparers figure out the 
taxes owed by a hypothetical family and received 48 different 
answers ranging from $16,219 to $48,564. Only a few were close 
to the right answer of $26,619. Recently, the chief tax 
accountant of Mobil Corporation testified before the House Ways 
and Means Committee. He said the company spends 57 man-years 
and $10 million dollars just to prepare one year's tax 
return.\43\
    A recent GAO study found that more than forty percent of 
returns that claim an earned income tax credit (EITC) are 
incorrect or fraudulent. It is estimated that corporations 
spend $300 billion per year just to comply with tax laws. All 
of the time, cost, and effort individuals spend preparing their 
tax returns is a loss to the economy. In order to release the 
full potential of the economy, Congress and the President must 
consider changing the tax system to a flat rate consumption or 
sales tax that removes the problems of the current system. If 
government reform seeks to take the country to a more rapidly 
growing economy with a lesser relative role played by the 
federal government, the tax system must be changed to 
facilitate this growth and to reduce the tax burden on all 
Americans.
    Moreover, recent developments in smart-card technologies 
and electronic money show the handwriting on the wall of the 
IRS. Either the income tax as it currently exists will self 
destruct as anyone who chooses to do so will be able to escape 
taxes on interest, dividends, and capital gains with virtually 
no danger of being caught; or the tax-collecting bureaucracy 
will become increasingly oppressive in a futile attempt to 
collect the income tax in a manner totally incompatible with a 
free society.
    Currently, taxes on capital inhibit economic performance. 
To get higher economic growth in the future, taxes on capital 
must be cut dramatically as soon as possible. The House has 
provided for four provisions of the ``Contract'' that will cut 
taxes on capital and boost investment: capital gains tax 
reduction, neutral cost recovery, estate and gift tax reform, 
and increased expensing for small businesses. All of these 
measures serve to remove the onerous tax burden on investment 
which is limiting the growth of the economy.
    In rethinking tax policy, it is important to understand the 
analytical context for change. Cutting the tax on capital 
serves to encourage its use. More capital will lead to higher 
wages, higher real incomes, and greater real tax receipts over 
time. Unintentionally, ``soak the rich'' taxes and higher taxes 
on capital income have hurt lower income and less skilled 
workers the most. Rather than ``punishing'' higher income 
people, taxes on the rich have served to discourage further 
investment thus retarding productivity and real wage growth. 
Continuing down this path--to tax the ``rich'' even to 
``compensate'' for tax cuts for others--is unacceptable. It is 
no wonder that many economic forecasts are so pessimistic. 
Current tax policy lacks the right stuff to raise real hope.
    One overlooked benefit to cutting taxes on capital is its 
potential to reduce income inequality over time. By raising 
real wages, reducing taxes on capital encourages greater 
workforce participation and spurs investments in human capital, 
education, and training. Typically, prolonged periods of 
economic growth result not only in higher real wages, but also 
in less unequal income distributions. Whenever we enlarge the 
economy's stock of physical and human capital, the relative 
income shares of those already wealthy decline. As a result, 
the gains from economic growth are spread more evenly across 
the population.

                     the problem of political will

    It should be the case that common sense and good economic 
sense will make for good political sense. But it is politically 
difficult to legislate actual spending cuts in almost all 
federal spending programs. The reason is that regardless of the 
benefits to society, there are well-organized constituencies 
working for every federal dollar spent. These special interests 
are trying to augment, or at least maintain, their current 
levels of funding.
    Every legislator who wants to be re-elected must defend 
certain spending programs that benefit a particular 
constituency's affairs. However, legislators' attempts to 
benefit their political constituencies are often to the 
detriment of the broader economy. The greatest success of this 
Congress, with its Republican majority, is that legislators are 
putting aside narrow interest to benefit the whole national 
economy to a greater degree than before. But the reform process 
must continue. Too many programs have excessive funding levels 
or have outlived their usefulness.
    The Clinton administration is doing its best to thwart the 
reform efforts. Administration officials do not seem to 
recognize that many programs are economically harmful. 
Currently, for example, the Department of Labor is attempting 
to direct pension managers to invest in areas politicians and 
bureaucrats deem ``socially beneficial.'' The administration 
has inappropriately deemed these investments ``economically 
targeted investments.'' The administration is really attempting 
to force pension managers to invest in a politically correct 
manner to the detriment of pensioners. Saving and investment is 
already depressed artificially by perverse government 
incentives, and the administration's attempt to undermine 
pensions would only further exacerbate the low level of 
savings. The Republican majority in Congress recognizes the 
perils of the Clinton administration's pension policy and will 
prevent pension funds from being diverted into politically 
misguided investments.\44\
    There are voices from several places that claim that the 
economy cannot grow too fast without igniting inflation. There 
is no economic rationale why economic growth cannot exceed the 
pessimistic view found in the 1995 ``Economic Report of the 
President.'' Economic growth does not cause inflation. Rather, 
inflation comes from too much money chasing too few goods and 
services. If the nation embarks on a course that raises the 
amount of goods and services, this serves to retard inflation. 
A given amount of money will be chasing more goods and 
services, and inflation will subside. If Congress commits 
itself to reducing the costs of producing goods and services by 
removing economically harmful regulations, this too will cut 
back on inflationary pressures since the costs of regulation 
are embedded in the price of every good and service sold.
    In the notion that the economy isn't what it used to be is 
accepted and if it becomes conventional wisdom that nothing can 
be done to revitalize it, no progress will be possible. America 
has fallen too far behind its potential and economic policy 
must change course quickly to provide future Americans their 
chance at the American dream.

                               conclusion

    The U.S. economy has largely been spared the ravages of 
statism that have plagued other industrialized countries. The 
result is the largest, most productive economy in the world. 
However, if Americans follow the lead of the President and 
become resigned to ``two-something'' growth as the best that 
can be hoped for, the nation's wealth will continue to 
erode.\45\ For too long now, government has squandered the 
hard-earned fruits of workers' labor and stifled the spirit of 
entrepreneurs. The Republican majority seeks to redirect 
government policy so that government can provide an environment 
for economic growth. The guiding principle to achieve this 
``prosperity-friendly'' environment is to make government 
smaller and less invasive.
    The American dream is eluding too many Americans. The 
combined weight of forty years of government bureaucracy and 
taxation has shifted dollars from families to policy makers. by 
restoring the proper role of government, the Republican 
majority in Congress will start the economy along the path to 
greater prosperity.

                                Endnotes

    \1\ DRI/McGraw-Hill, ``Growth and Budget Repercussions of the 
Republican Contract with America,'' February 1995.
    \2\ Von Mises, Ludwig, ``The Theory of Money and Credit,'' 
published by The Foundation for Economic Education, Inc., New York, 
1971, page 414.
    \3\ Wesbury, Brian S., ``Freeing the American Economy,'' Joint 
Economic Committee, May 1995.
    \4\ London Financial Times, August 4, 1995, ``Growth in Trade Will 
Lift World Economy, Say Forecasters.''
    \5\ International Finance Corporation, ``Emerging Stock Markets 
Factbook 1995,'' June 1995.
    \6\ U.S. Department of the Treasury.
    \7\ Ibid.
    \8\ Angell, Wayne, ``Flights of Fancy,'' The Global Spectator, Bear 
Stearns, August 1, 1995.
    \9\ Department of Commerce, Bureau of Economic Analysis, annual 
averages.
    \10\ Milton C. Cummings and David Wise, ``Democracy Under 
Pressure,'' Harcourt Brace Javanovich Publishers, 1985, pp. 349-350.
    \11\ Department of Commerce, Bureau of Economic Analysis; also 
Bureau of the Census.
    \12\ Ibid.
    \13\ Department of Commerce, Bureau of Economic Analysis.
    \14\ Ibid.
    \15\ Ibid.
    \16\ Ibid.
    \17\ U.S. Department of Commerce, Bureau of Economic Analysis.
    \18\ Milton Friedman, Ph.D., ``Statement before the U.S. Congress 
Joint Economic Committee,'' January 20, 1995.
    \19\ Thomas D. Hopkins, Ph.D., ``Statement before the U.S. Senate 
Committee on Governmental Affairs,'' February 8, 1995, based upon and 
updating Hopkins' ``Federal Regulatory Burdens: An Overview,'' RIT 
Public Policy Working Paper, Rochester Institute of Technology, 1993.
    \20\ Victor A. Canto and Arthur B. Laffer, ``The Ubiquitous 
Regulatory Wedge,'' published by A.B. Laffer, V.A. Canto & Associates, 
La Jolla, California, March 13, 1992, and updated with data from Marvin 
Zonis and Associates, Chicago, Illinois.
    \21\ United States Department of Commerce, Bureau of Economic 
Analysis, 1947 3Q to 1966 Q1 then Q1 1966 to Q4 1994.
    \22\ United States Department of Commerce, Bureau of Economic 
Analysis; Bureau of the Census, ``Current Population Reports.''
    \23\ ``Economic Report of the President 1962,'' p. 9.
    \24\ ``Economic Report of the President 1965,'' p. 4.
    \25\ U.S. Department of Commerce, Bureau of Economic Analysis, 
Quarterly Statistics 82:4 to 89:1 = 3.9 percent.
    \26\ Federal Reserve Chairman Alan Greenspan, ``Statement before 
the U.S. House of Representatives Banking Committee,'' February 22, 
1995.
    \27\ U.S. Department of Labor, Bureau of Labor Statistics.
    \28\ Ibid.
    \29\ Haver Analytics.
    \30\ Joint Economic Committee Economic Policy Update, ``Capital 
Gains Tax: Fairness?'' by Brian Wesbury and Jeffrey Given.
    \31\ Price Waterhouse, ``Individual Taxes, A Worldwide Summary,'' 
1994 edition.
    \32\ U.S. Department of the Treasury, Office of Tax Analysis.
    \33\ U.S. Department of the Treasury, Office of Tax Analysis; Joint 
Economic Committee.
    \34\ Standard & Poor's.
    \35\ The $2.7 trillion figure is based on 1985 realizations growing 
by the same percentage as the S&P 500 on a year-to-year basis. The $1.2 
trillion comes from the U.S. Department of the Treasury, Office of Tax 
Analysis (along with a Joint Economic Committee estimate for 1994).
    \36\ Securities Data Company.
    \37\ Ibid.
    \38\ ``Economic Report of the President,'' 1994, pp. 74-75.
    \39\ See Barro, Robert J. and Sala-I-Martin, Xavier. 1995. 
``Economic Growth.'' p. 7.
    \40\ Only Ten Republicans voted for OBRA 1991 which enacted the 
Bush tax increases.
    \41\ Los Angeles Times, June 6, 1992.
    \42\ U.S. News and World Report. February 13, 1995. p. 70-72.
    \43\ Morgan Reynolds, ``The Texas Republic,'' forthcoming.
    \44\ H.R. 1594, sponsored by Rep. James Saxton with strong 
leadership support and over 90 co-sponsors.
    \45\ ``. . . the consensus view that the sustainable rate of growth 
is about 2.5 percent per year is slightly more optimistic than a purely 
mechanical reading of recent experience would warrant.'' ``Economic 
Report of the President,'' 1995. p. 96.
                             MINORITY VIEWS

                              Introduction

    ``There is always an easy solution to every human problem--
neat, plausible, and wrong''--H.L. Mencken, 1949.
    Many Americans have been justifiably dissatisfied with the 
performance of the economy over the past twenty years or so. 
Many workers' wages have not even kept up with the modest 
inflation we have experienced over the past decade. Families 
have faced a dilemma. Either they have had to live with a 
stagnant material standard of living, or they have had to work 
longer hours or take a second job, sacrificing time at home or 
in the community in order to shore up their family finances. 
More children and more full-time workers are living in poverty.
    With the elections of 1992, Democrats took control of both 
the White House and Congress for the first time in twelve 
years. With no Republican support, Democrats made tough and 
complex budget decisions that saved half a trillion dollars of 
red ink over five years. Long term interest rates declined and, 
after two years of a ``jobless recovery'' in 1991 and 1992, the 
economy came to life. Between January 1993 and November 1995, 
almost 7.7 million new jobs were created. Production of goods 
and services grew faster in each of the past three years under 
Clinton than it had during any of the previous four years under 
Bush.
    Reducing the deficit and moving the economy into the 
expansion phase of the business cycle were two important 
components of the Democrats' program to reverse the fiscal 
excesses of the Reagan administration and the economic policy 
drift of the Bush administration. A third was to reinvent and 
reinvigorate government to play an appropriate role in 
fostering strong, sustainable economic growth--growth that 
would restore the expectation of American families in a 
steadily rising standard of living.
    Democrats have not offered an easy answer or a quick fix to 
this dilemma. We know that it takes time for deficit reduction 
and government investment to pay off in better long term 
economic performance and rising living standards. Still, it is 
hard to blame the average American family if they have remained 
concerned about their economic future and impatient with 
Washington economic policy, even as the economy has shown 
impressive short term results.
    With the elections of 1994, Republicans took control of 
Congress and offered a very different version of economic 
policy. Far from a constructive reform of government to 
preserve and strengthen what is good while winnowing out 
programs that are low priority, the new Republican majority has 
adopted a slash and burn approach to many important government 
programs. Heedless of the lessons of the 1980s, when large tax 
cuts ushered in an era of $200-300 billion annual budget 
deficits, they have again proposed large tax cuts, most of 
whose benefits will go to those who are already very well off.
    No Democrat on the Joint Economic Committee believes that 
government is the answer to all this Nation's economic problems 
or that every existing government program represents the wisest 
possible use of our scarce budget resources. But we do believe 
that in their zeal to slash spending and eliminate agencies, 
many Republicans have lost sight of the enduring problems that 
the programs they want to dismantle were created to address.
    As recently as the 1989 Joint Economic Committee annual 
report, Republicans and Democrats struggled to offer a 
bipartisan analysis of the Nation's economic challenges within 
a common policy framework. Now, Republican leaders in Congress 
are proposing changes to fundamental aspects of previously 
bipartisan national economic policy. Coming under attack are 
such economic policies as:
          Requiring monetary authorities to be concerned about 
        growth as well as inflation,
          Designing fiscal policy to stabilize the business 
        cycle and invest for future growth,
          Imposing taxes according to ability to pay,
          Assisting those less able to help themselves--
        particularly children and the elderly, and
          Assuring that those who work can escape poverty, 
        through a decent minimum wage and earned income tax 
        credit.
In each case, the framework of current policy was forged with 
strong Republican support for Democratic initiatives. Yet in 
each case, current Republican leaders have proposed overturning 
the long-term policy with ``neat, plausble, and wrong'' 
solutions.
    Many hard-working Americans have come to fear either that 
our economy is on longer prospering or that they have been left 
out of whatever prosperity there is to share. The central 
challenge for national econmic policy today is to restore hope 
to those people. As we consider the new Republican initiatives 
to overturn current policies, we should ask this question 
``Will this proposal permit more Americans to share in economic 
prosperity or will its benefits accrue to a privileged few?''

  Democratic Policies Lay Foundation for Three Years of Strong Growth

    The past three years have registered among the best 
performances for growth and jobs during the post-war period. 
The economy has performed better under the policies of the 
Clinton administration than it did under those of his immediate 
predecessor, George Bush, as all acknowledge. But the economy 
has also done better--and this is less well known--than under 
the Reagan administration, a time that the Republicans consider 
a ``golden age'' of economic policy.
    One of the underlying themes of the prevailing Republican 
rhetoric is that the budget and regulatory policies of the 
Clinton administration have weakened the American economy, 
resulting in inadequate economic and job growth. They long to 
take us back to the policies of deregulation and tax cuts for 
the rich which make the Reagan era, in their minds, an economic 
golden age. This Republican story bears no relationship to the 
facts.
    Economic Recovery under Clinton. As Table 1 shows, GDP has 
grown faster under Clinton than either Bush or Reagan, job 
growth has been stronger, productivity growth is higher, and 
inflation is lower. The economy, in fact, has done better by 
virtually every important economic measure under Clinton than 
under any post-war Republican administration. Indeed, one has 
to go back to the Kennedy-Johnson administration to find a 
better economic performance.

  TABLE 1.\1\--ECONOMIC PERFORMANCE UNDER THE CLINTON, BUSH, AND REAGAN 
                             ADMINISTRATIONS                            
                              [In percent]                              
------------------------------------------------------------------------
                                          Clinton      Bush      Reagan 
------------------------------------------------------------------------
Average Annual Growth of Real GDP......        3.6        1.3        2.8
Average Annual Growth of Jobs on                                        
 Nonfarm Payrolls......................        2.4        0.5        2.1
Average Annual Increase in Output per                                   
 Worker................................        2.4        1.3        1.2
Average Annual Inflation Rate..........        2.7        4.2        4.2
------------------------------------------------------------------------
\1\ The Reagan administration is measured from the first quarter of 1981
  through the first quarter of 1989 or January 1981 through January     
  1989; Bush from first quarter 1989 through first quarter 1993 or      
  January 1989 through January 1993; Clinton from first quarter 1993    
  through third quarter 1995 or January 1993 through November 1995.     

    Most other economic indicators also report ``Advantage: 
Clinton.'' The Republican contention that the economy has 
performed poorly under Clinton is simply wrong. Their 
conclusion--that the economic policies of the Clinton 
administration have hurt the economy--is also wrong.
    A brief overview of economic history under the Clinton 
administration is in order. During its first two years, the job 
of the Clinton administration was to restore the economy from 
the disappointing performance of the Bush administration. It 
was widely recognized as Clinton took office that a substantial 
period of strong economic growth and job growth would be 
required to bring the economy back to its potential and reduce 
the lingering unemployment.
    And this is in fact what happened. Growth was far stronger 
under Clinton than Bush. From the first quarter of 1993 through 
the fourth quarter of 1994, real GDP grew at an annual rate of 
4.0 percent, or triple the growth rate under Bush and about a 
third faster than the postwar average. Growth during 1994, in 
fact, was the strongest in ten years as Figure 1 shows. This 
strong economic growth closed much of the gap between actual 
and potential GDP that was inherited from the Bush 
administration.






    In addition, during 1993 and 1994 the number of jobs on 
nonfarm payrolls rose by 267,000 per month. This was five times 
the rate of job growth under the Bush administration and about 
double the post-war average. As a result, the unemployment rate 
fell from 7.1 percent in January 1993 to 5.4 percent in 
December 1994. By the end of 1994, the economy was performing 
close to its long-run peak. The Clinton administration had 
substantially accomplished the goal of restoring the economy 
from its poor performance under the Bush administration.
    Although wage growth is still inadequate, as we mentioned 
at the start of this report, the precipitous decline in real 
average hourly earnings under the Reagan and Bush 
administrations has stopped and a small increase has been 
recorded under the Clinton administration. During the Reagan 
administration, real earnings fell at a rate of 0.1 per year, 
followed by a steeper decline of 1.0 percent per year during 
the Bush administration. By contrast, since January 1993, real 
wages have risen 0.3 percent per year. This is not yet good 
enough but at least we have turned the corner.
    But not everyone was happy about the improvements in the 
economy.
    Monetary Policy and the Economic Slowdown. As the economy 
strengthened during 1993 and 1994, the Federal Reserve reacted 
by tightening monetary policy and raising interest rates. This 
was done, according to the Federal Reserve, to head off 
inflationary pressures before they could gather steam. As 
Figure 2 shows, the Federal Reserve increased the target 
Federal Funds rate from 3.0 to 6.0 percent in seven steps 
between February 1994 and February 1995.




    This was one of the largest and most rapid increases in the 
Federal Funds rate engineered by the Federal Reserve during the 
post-war period. It was unprecedented for a time of low and 
falling inflation. Research by the Joint Economic Committee 
showed that whenever the Fed raised the Federal Funds rate by 3 
percentage points or more within a 12-month period, the economy 
would soon go into a recession. Of course, such an increase 
would not necessarily cause a recession--many other factors 
also contribute to recessions--but the fact that the Fed was 
willing to take the chance indicates the strength of its desire 
to slow the economy.
    The data for 1995 show that the Fed has substantially 
succeeded. So far this year, the economy has grown at an annual 
rate of 2.7 percent compared to 4.1 percent last year. And as 
Figure 3 shows, the consensus of economists calls for slower 
growth to continue into 1996. The rate of new job growth has 
also declined to an average of only 135,000 per month this 
year, or about half the rate of job creation during 1993 and 
1994.



    1993 Deficit Reduction and the Economy. This slowdown in 
economic growth during 1995 was not the result of Clinton 
administration policies, as the Republicans are so eager to 
claim. Republicans often suggest that the tax increases on the 
wealthy in the 1993 budget accord caused the slowdown. In fact, 
at the time Congress was considering the Clinton deficit-
reduction program, the Republicans shrilly forecast that it 
would precipitate a dreadful recession. Quite the opposite 
actually occurred. Many economists have concluded that the 
reduction in the Federal deficit contributed to the strong 
growth last year by helping to lower long-term interest rates 
during 1993. During the six quarters following the budget 
agreement, economic growth averaged a robust 4.0 percent annual 
rate, about one-third faster than the average growth rate in 
the post-war period.
    In testimony before the Joint Economic Committee, Federal 
Reserve Board Chairman Alan Greenspan explained how the 1993 
budget agreement actually helped strengthen the economy:

          The actions taken last year to reduce the federal 
        budget deficit have been instrumental in creating the 
        basis for declining inflation expectations and easing 
        pressures on long-term interest rates. * * * What I 
        argued at the time is that the purpose of getting a 
        lower budget deficit was essentially to improve the 
        long-term outlook, and that if the deficit reduction is 
        credible, then the long-term outlook gets discounted 
        up-front. Indeed, that is precisely what is 
        happening. * * * I think a substantial part of the 
        improvement in economic activity and the low rates of 
        inflation can be directly related to a changing 
        financial expectation that we might finally be coming 
        to grips with this very severe problem (January 31, 
        1994).

    Is there any evidence that the tax increases on the wealthy 
in the 1993 deficit reduction package were responsible for the 
recent slowdown in the economy? The answer is no.
    The most compelling evidence to support this notion would 
be a significant reduction in spending on products purchased 
predominantly by upper-income households, such as luxury 
automobiles and higher-priced homes. The facts, however, show 
just the opposite--spending on luxury cars and higher-priced 
homes actually rose after enactment of the 1993 deficit 
reduction program.
    According to ``Ward's Automotive Report,'' sales of luxury 
automobiles during the first six months of 1995 were nine 
percent higher than during the comparable period of 1993. By 
comparison, total car sales were up only two percent, while 
sales of less expensive small cars were down by sixteen 
percent. This rise in sales of luxury cars is precisely the 
opposite of what would be expected if the Republican claims 
about the 1993 deficit agreement were correct.
    In the housing market, the same pattern prevailed. 
According to the Census Bureau, sales of new homes with a price 
of $200,000 or more were up eight percent during the first five 
months of 1995 compared to the first five months of 1993. By 
contrast, sales of new homes priced $150,000 or lower were down 
over the same period by almost three percent. Again, this 
pattern is just the opposite of what the Republicans would 
predict.
    A recent survey of economists by Blue Chip Economic 
Indicators also provides compelling evidence that the 
Republicans are barking up the wrong tree. When a panel of 50 
of the nation's top economic forecasters was asked to list the 
factors that are most likely to hold down economic growth in 
1996, the top two responses were (1) the lagged effect of past 
and possible future tightening of monetary policy and (2) the 
Republican's own government spending retrenchment efforts. 
Other factors mentioned were the continuing high level of 
consumer debt and lower demand for new homes and consumer 
durables. None of the responses by any of the panelists 
suggested, or even hinted, that the 1993 deficit reduction 
program would be a likely cause of slower economic growth.
    The Republicans also held that the 1993 program would 
reduce investment in new plant and equipment by cutting 
invectives for the wealthy to save. Again, they were wildly off 
the mark. Under Clinton, business spending for equipment has 
soared to new records, as Figure 4 shows, while spending for 
structures has also recovered somewhat from the lows of the 
Bush years.
    Lacking both evidence for their charges and support from 
the community of professional macroeconomists, Republicans' 
efforts to blame the 1995 slowdown in the economy on the 1993 
deficit reduction program is little more than a smokescreen to 
justify the Republicans' own radical economic policies.
    Instead, the virtually-unanimous consensus among economists 
who follow broad movements in the economy, both in academia and 
on Wall Street, is that the slowdown in the economy this year 
was caused by the increases in interest rates engineered during 
1994 and early 1995 by the Federal Reserve.




    Just as the Fed's policy of raising interest rates has 
resulted in a slowdown of economic growth, a policy of reducing 
rates would stimulate stronger growth.
    A Time for Lower Interest Rates. On July 6, the Fed carried 
out a small one-quarter cut in the Federal Funds rate. Two 
factors contributed. First, there were signs during the spring 
that the economy was in danger of slipping into recession. Many 
of the important economic indicators did, in fact, turn 
negative during the second quarter, raising a warning signal 
that the Fed may have overshot as it raised interest rates last 
year. Second, inflationary pressures appeared to be easing. An 
inflation scare during the first few months of 1995 passed 
uneventfully. This provided an opportunity to cut the Federal 
Funds rate, as the Federal Reserve explained in its July 6 
press release.

          As a result of the monetary tightening initiated in 
        early 1994, inflationary pressures have receded enough 
        to accommodate a modest adjustment in monetary 
        conditions.

    The July 6 rate cut appears to have averted a recession. 
Growth in the third quarter was 4.2 percent, which represented 
a significant step up from the second quarter performance of 
1.3 percent.
    But the most recent economic data indicate that the economy 
may be weakening again and that interest rates may still be too 
high. Recent data for both inflation and growth suggest that 
another rate cut soon would be an appropriate course for 
monetary policy.
    We find the same absence of inflationary pressure that the 
FOMC noted when justifying its rate cut in July. During the 
past year, prices at the consumer level have risen 2.6 
percent--the first time in three decades that inflation has 
stayed below 3 percent for four straight years--while producer 
prices have risen only 2.0 percent. Labor cost pressures are 
also virtually non-existent, with the employment cost index 
still trending downward. At the same time, unit labor costs 
have risen just 0.3 percent, well below the recent inflation 
rate.
    The growth indicators also suggest that the Fed has kept 
interest rates too high for too long, particularly in light of 
recent signs of weakening in manufacturing, housing and retail 
sales.
    In manufacturing, where cyclical changes in the economy 
often have their most striking impact, there has been a 
slowdown during 1995. Industrial production in manufacturing 
has grown at an annual rate of less than half a percent so far 
this year, compared to 7.2 percent during 1994. With capacity 
rising at an annual rate of 4.3 percent, output could grow 
substantially faster without threatening inflation. Since March 
the number of jobs on manufacturing payrolls has fallen by over 
250,000, equivalent to losing one Fortune 500 firm each month 
for the past 8 months. Recent surveys by the National 
Association of Purchasing Managers reinforce the impression 
that manufacturing is growing too slowly. This important sector 
of our economy clearly needs the lift of a rate cut.
    The housing sector has also weakened this year in response 
to the high interest rates, with housing starts down 8 percent 
so far from last year's rate. New home sales are off 2 percent 
from last year. In October, total spending on residential 
building after inflation was down 4.0 percent from a year ago. 
This sector could also use a boost from lower interest rates.
    Another indicator that gives us some concern is the current 
weakness in consumer spending and retail trade. Smoothing out 
the volatile monthly movements, we can observe a dramatic 
slowdown. Retail sales for the last three months stood only 3.2 
percent higher than the level for a year earlier, virtually no 
gain in real terms, while some early December figures show an 
actual decline from a year ago.
    On Tuesday, December 19, the Federal Open Market Committee 
recognized the need for a cut in interest rates and reduced the 
target for the Federal Funds rate by 25 basis points. The 
Federal Funds rate is now half a point below its peak level at 
the start of this year. Although this latest cut in interest 
rates was welcome and appropriate, recent trends in economic 
indicators suggest that the Federal Reserve should remain ready 
to make further adjustments in rates if the economy continues 
to soften.

                 Dangers of The Republican Budget Plan

    ``Taxes are what we pay for civilized society.''--Justice 
Oliver Wendell Holmes, Jr.
    ``Don't tax you, don't tax me, tax the fellow behind the 
tree.''--Senator Russell Long.
    ``. . . especially if he or she is a low- to moderate-
income worker.''--Republicans' 1995 addendum to Senator Long.
    Cutting taxes is part of the overall Republican assault on 
government. The Republicans' common refrain, that cutting taxes 
lets people keep more of their own money, reveals a deep 
disdain for the services that the public expects the government 
to provide. Democrats do not share that disdain. We recognize 
that government provides services that the private market 
cannot do as well and that those services must be paid for by 
taxes. We Democrats want taxes as low as possible but we 
recognize that, as Justice Holmes explained, taxes are the 
admission price to ``civilized society.''
    Whether taxes should be as low as possible to cover the 
costs of government is not a substantive issue between the two 
parties. Rather, the two fundamental economic debates between 
the two parties concern (1) the form of taxes to be imposed and 
(2) the choice of services that government should provide to 
assure a `civilized society.'
    This chapter will examine the tax proposals and spending 
cut proposals in this year's Republican budget. It will show 
that, in each case, these proposals fail the acid test: they do 
not permit more Americans to share in economic prosperity but 
instead benefit only the privileged few.

                        republican tax proposals

    Even Republicans recognize that people do not buy national 
defense at Wal-Mart. Democrats, like most Americans, believe 
that government has a larger role to play in the economy than 
just providing national defense. But whatever size government 
we decide is appropriate, we must ultimately raise enough taxes 
to pay for what we get. The mistake we made in the 1980s was to 
stop paying, but keep spending. The result was large deficits, 
lower national saving and investment, and mounting debt.
    George Bush was right in 1980 when he called the economic 
rationalization for these policies ``voodoo economics.'' 
Current Republican tax proposals are deja-voodoo economics. 
They are bad public policy for at least three reasons. First, 
they make meaningful deficit reduction harder. Second, they are 
poorly focused to encourage new saving and investment that will 
help the economy grow faster in the future. And third, they are 
highly skewed toward giving relief to high income taxpayers. 
The net result endangers true deficit reduction.




    Tax Cuts and Deficit Reduction. The urge to cut taxes is a 
major barrier to deficit reduction. It is hard enough to make 
the substantial cuts in government spending needed to bring the 
budget into balance by 2002 without having to make room for a 
tax cut as well. It is no longer possible to pretend that the 
budget can be balanced simply by eliminating waste, fraud, and 
abuse. Meaningful deficit reduction requires real cuts in real 
programs affecting real people. By insisting on large tax cuts, 
Republicans have had to propose spending cuts that go beyond 
what most Americans consider reasonable, thereby threatening 
the public support and political resolve necessary to balance 
the budget.
    The tax proposals in the latest Republican budget are less 
irresponsible than those in the original Contract with America. 
Yet they still contain some troublesome gimmicks and ticking 
time bombs that would lose substantial revenue outside the 
current 1996-2002 budget planning horizon. Large future revenue 
losses are especially dangerous in light of Congressional 
Budget Office projections that the baseline budget deficit is 
expected to worsen significantly after 2002.
    Overall, the scaled-back Contract with America tax 
provisions in the reconciliation bill would lose $245 billion 
in revenue over the 1996-2002 period. But they would lose over 
$170 billion in the first three years after 2002, with mounting 
losses into the indefinite future. The capital gains and IRA 
provisions are especially troubling. Figure 5 illustrates how 
these provisions are structured to obscure their true revenue 
costs within the budget planning window, while exploding after 
2002. For example, the capital gains indexing provision is 
structured to provide a temporary revenue increase in 2002, but 
it loses substantial revenue after that. The IRA provisions 
start out with a few years of modest revenue losses, but then 
lose increasing amounts of money. The net effect from these two 
provisions is an average loss of less than $6 billion per year 
between 1996 and 2002 and an average loss of almost $20 billion 
a year over the next three years.
    Tax Cuts and Economic Growth. The primary economic 
objective of deficit reduction is to increase national saving 
and investment and boost future economic growth. Yet the 
Republican tax proposals are very poorly focused to encourage 
new saving and investment. Tax cuts for families and seniors, 
whatever their other merits, are more likely to encourage 
consumption than saving. Capital gains tax cuts and other 
changes generally confer large tax windfalls based on past 
saving and investment that spur greater consumption while they 
provide very small incentive effects for new saving and 
investment. Deficit reduction is generally recognized as far 
more effective in this regard. It is therefore highly ironic 
that a tax cut that loses money, adds to the deficit, and 
increases consumption at the expense of investment should be 
the ``crown jewel'' of the Republican program.
    We should not repeat a major mistake of 1980s economic 
policy and exaggerate the impact of tax cuts on economic 
growth. Economists recognize that a change in the relative 
attractiveness of work over leisure and saving and investment 
over consumption increases the incentive to work, save, and 
invest; when people work more, save more, and invest more, the 
economy grows faster. But an honest assessment of both the 
economic theory and the empirical evidence regarding how tax 
cuts affect behavior suggests that the likely effects are 
small.
    On the theory side, a lower marginal tax rate on labor 
income means that a worker can keep more of each additional 
dollar she earns. This makes it more attractive to take a paid 
job or work longer hours, other things equal. But a higher 
after-tax wage means she would not have to work as many hours 
to earn the same amount of income. This makes it attractive to 
cut back a little on the number of hours worked and enjoy a 
little more free time or family time.
    The same argument applies to saving. A higher after-tax 
return on saving makes it more attractive to save, other things 
the same. But a higher after-tax return on saving means fewer 
pretax dollars need to be saved to achieve the same after-tax 
savings. This theoretical ambiguity about how taxes affect 
economic incentives is reflected in the empirical evidence. As 
summarized in a Congressional Research Service analysis:

          While evidence on the effect of tax cuts on savings 
        rates, and thus, economic growth, is difficult to 
        obtain, most evidence does not indicate a large 
        response of savings to an increase in the rate of 
        return. Indeed, not all studies find a positive 
        response.

The empirical evidence on work effort is similarly ambiguous.
    These findings do not suggest that a poorly designed tax 
system cannot discourage productive economic activity or that a 
well-designed tax system cannot encourage it. Democrats are not 
opposed to tax reform or even, when the time is right, tax cuts 
that would contribute to strong, stable, and shared growth. But 
they do oppose cutting taxes willy-nilly and justifying those 
cuts with exaggerated claims about how they will stimulate 
growth. Such tax cutting is bad economics and bad public 
policy.
    Tax Cuts and Fairness. Republicans are forced to exaggerate 
the economic growth effects of their tax cut proposals, because 
the static distributional effects of these proposals are so 
embarrassingly tilted toward those who are already very well 
off. This was especially true in the original Contract with 
America tax cut, but it remained so in the November 1995 
Reconciliation Act.
    The centerpiece of Republican tax proposals is the $245 
billion Contact with America tax cut they awarded themselves, 
based on slashing spending enough to achieve a balanced budget 
in 2002. But because they could not balance the budget through 
spending cuts alone, Republicans enacted a number of revenue 
raisers. Included in these are troublesome changes in the 
Earned Income Tax Credit (EITC).
    The EITC provides tax relief for low income workers and, 
until recently, enjoyed widespread bipartisan support. Because 
the EITC is a refundable credit, part of the savings from the 
proposed changes are treated as outlay reductions rather than 
tax increases in formal budget presentations. But in effect, 
all the proposed changes in the EITC represent a tax increase 
on low income workers.
    The bulk of the tax cut for middle income taxpayers comes 
from the family tax credit. Although advertised as a tax cut 
equal to $500 per child, the full tax credit only goes to 
families with enough income to owe more than $500 per child in 
income taxes. Unlike the earned income tax credit, which is 
refundable and provides cash to low income working families, 
the Republican family tax credit is neither refundable nor 
usable as a credit against payroll taxes, which represent the 
primary tax liability of low income working families. Fully a 
third of the nation's 71 million children live in families that 
would receive no family tax credit. Another three million live 
in families that would receive less than the full credit.
    Upper income tax payers will gain more from capital gains 
preferences than from the family tax credit. Some defenders of 
the capital gains preference argue disingenuously that it is 
unfair that capital gains subject to tax are not indexed for 
inflation. In fact, capital gains receive favorable tax 
treatment now and they would receive even more favorable tax 
treatment under the Contract with America tax cut. According to 
analysis by the Congressional Budget Office, the marginal tax 
rate on wages for most middle class workers is 31 or 32 
percent. The marginal tax rate on capital gains for taxpayers 
with incomes above $100,000 is 28 percent. The Contract with 
America tax bill would reduce this rate even further, to 19.8 
percent.
    Capital gains enjoy the further advantage of tax deferred 
reinvestment. In other words, a saver who earned 5 percent per 
year on an ordinary savings account would have to pay taxes on 
the interest each year and could only reinvest the after-tax 
interest. Capital gains, by contrast, are only taxed when they 
are realized. After 10 years, a person with $1000 in a savings 
account earning 5 percent and subject to a 28 percent tax on 
interest each year would receive $423 in interest net of taxes 
if he redeposited his after-tax interest each year. A 
shareholder with $1 million in stock that appreciated at the 
same 5 percent would net $453,000 after paying a 28 percent tax 
on the $629,000 of capital gains that would accrue over ten 
years. The person with the capital gain would have the higher 
after-tax rate of return irrespective of the inflation rate.
    In addition to the advantages of lower marginal tax rates 
and tax-free accrual of unrealized gains, capital gains can 
escape taxation altogether. For one thing, no capital gains 
taxes are paid on assets that are passed on to heirs and no tax 
liability is passed on to heirs. In the above example, if the 
stock market investor died ten yeas after the investment was 
made, the full $1.629 million value of the asset would pass 
into the estate and no capital gains taxes would be paid. The 
financial press has recently reported on an apparently 
widespread practice of stock-swapping to postpone or avoid 
capital gains taxes even after gains are realized. Tax 
preferences for capital gains also encourage people to make 
inefficient economic decisions that reduce tax payments by 
converting ordinary income into capital gains. Further widening 
the differential between the tax rates on capital gains and on 
ordinary income will encourage more inefficient tax-dodging 
schemes.
    During the 1980s we observed a failed experiment with 
trickle-down economics. Substantial tax cuts for businesses and 
high income individuals not only failed to translate into an 
improved standard of living for most Americans, they also 
failed to raise the private savings rate. Disappointing trends 
in the distribution of income and wealth were aggravated by 
policies that favored the well-to-do. No matter how Republicans 
try to obfuscate or deny the issue of fairness, Democrats are 
troubled by these trends and are skeptical that conferring 
large tax breaks on high income taxpayers will produce economic 
growth whose benefits are widely shared by ordinary Americans.

              Republican Proposals to Cut Social Programs

    During the decades since the Great Depression, many social 
programs have been put into place to provide for the economic 
well-being of the most vulnerable members of our society, 
including children, the elderly, the disabled, and the 
involuntarily unemployed. These initiatives include some of our 
most successful government programs, such as the Social 
Security system. Programs such as Medicare, Unemployment 
Insurance, School Nutrition programs and even the Food Stamp 
Program also receive widespread public support. We believe that 
few Americans want to see our children and seniors left 
vulnerable to the kind of destitution and want that many 
experienced during the Great Depression, before the enactment 
of this social safety net.
    Support for our basic cash welfare program for families 
with children, the Aid to Families with Dependent Children 
(AFDC) program, has recently been much less strong, however. 
Many Americans have come to believe that welfare payments 
undermine recipients' motivation to achieve economic self-
sufficiency. Accordingly, many support reforming the welfare 
system to create a greater focus on moving its recipients off 
of the welfare rolls and into the workforce.
    While the goals of broader social support programs such as 
Social Security are more widely supported, the Republicans 
argue that it is necessary to cut back on entitlement programs 
providing benefits to individuals almost across the board. 
About 40 percent of the total savings needed to produce a 
balanced budget by the year 2002 under the Republican plan, for 
example, would come from the Medicare and Medicaid programs. In 
all, the Republicans propose to cut $420 billion from these two 
programs over the next seven years.
    How would the cuts in social programs proposed by the 
Republicans affect families? We believe that they would impose 
much harsher than necessary reductions on programs for the poor 
and the elderly, causing real hardship. In addition, by 
reducing incentives and opportunities to work, by imposing new 
burdens on low-incomes families with children, and by punishing 
most severely those seniors with the gravest health problems, 
these cuts also run the risk of producing very negative 
unintended results. Some of the worst of these proposals in 
welfare and in health care, are highlighted below.
    Welfare Reform. The need for some reform of the welfare 
system as it exists today is agreed upon the Democrats and 
Republicans alike. In the last Congress, President Clinton 
submitted an ambitious reform plan calling for a complete 
redesign of the system, and reform of the welfare system has 
been one of the highest priorities under the Republicans' 
``Contract with America.'' Although there are of course 
differences in the specifics of the welfare plans that have 
been proposed by the Administration and by the Republicans, 
there is some consensus that welfare reform should encourage 
work and personal responsibility while protecting our neediest 
children and seniors from extreme destitution.
    Welfare Reform Under the Republican ``Contract.'' How would 
the welfare reforms proposed under the Republican ``Contract'' 
go about achieving these goals? While the legislation proposed 
by the Republicans makes many major changes in specific welfare 
programs and in the welfare system as a whole, the general 
approach has three important features:
          Imposing strict limits on the amount of time people 
        can spend on welfare;
          Converting most welfare programs into block grants to 
        states instead of paying benefits directly to 
        individuals and families; and
          Restricting eligibility for benefits in a number of 
        programs, including the Food Stamp Program (FSP) and 
        the Supplemental Security Income (SSI) Program for 
        disabled children.
    Imposing Time Limits on Welfare Recipiency. The time limits 
on receiving benefits that would be imposed under the 
Republican plan would apply only to the Aid to Families with 
Dependent Children (AFDC) program. Although AFDC is the program 
that people tend to think of when they think about welfare, it 
actually accounted for less than 10 percent of the total funds 
spent by the Federal government on means-tested programs in 
1994. The program provided benefits to an average of about 14 
million people per month last year--considerably less than half 
of the population who lived in poverty. The average benefit in 
1994 was about $375 per month for a mother with two children, 
which would put a family relying on AFDC benefits alone at 
about 40 percent of the poverty line. Nevertheless, concern 
about long-term AFDC recipiency has been a major feature of the 
welfare reform debate for some time, and the Republic plan 
addresses this concern by proposing a lifetime maximum of five 
years of benefits for most AFDC recipients.
    Are time limits on welfare recipiency a good idea? 
Proponents argue that if recipients know there is an absolute 
cutoff date beyond which they cannot receive benefits, they 
will be more motivated to find and stick with a job and will 
become more self-sufficient, a major goal of welfare reform. 
Indeed, the Administration's welfare reform proposals also 
include some time limits, although poor mothers subject to the 
limits would be given more help in finding in keeping a job 
than under the Republican plan.
    This help is needed because unfortunately many welfare 
recipients experience substantial barriers to increase their 
self-sufficiency. Although more than half of those receiving 
benefits within a given year also have some earned income, most 
have very low wages and relatively unstable jobs. A recent 
study of 2.8 million mothers who received welfare over a two-
year period found that although 70 percent worked at least some 
of the time, their average earnings when employed were just 
$4.29 an hour. And unfortunately, the jobs that these mothers 
did get--as maids, cashiers, waitresses, nurses' aides and 
child care workers, for example--frequently lasted for less 
than a year at a time and typically did not include health 
insurance or other benefits.
    If such mothers are to become economically self-sufficient 
without plunging their children even further into poverty, many 
will need some help in finding and training for a job. Most 
mothers who enter AFDC leave the program is less than five 
years, but those with very low skill levels and those who live 
in high-unemployment areas are likely to be on the program 
somewhat longer that the average. For mothers who cannot find a 
job, time limits alone with not increase self-sufficiency. Only 
if such limits are coupled with programs to provide job 
training, job placement assistance, and, in the last resort, 
public jobs, will they allow families to leave welfare for a 
better economic future.
    Unfortunately, the AFDC changes proposed by the Republicans 
impose time limits on recipients without guaranteeing them 
access to a job. Funds for existing job training and job 
placement programs for welfare recipients would be cut, and if 
states wished to continue these programs they would have to 
find new ways to fund them. Unlike the existing program, this 
act offers nothing to encourage or help recipients to find jobs 
before the expiration of the time limit. And when recipients 
hit the time limit under this act, they would lost eligibility 
for welfare whether or not there was a job available for them 
(unless the state chose to include them in the small number of 
recipients it would be allowed to exempt from time limits). 
This bill would not only do nothing to prepare recipients for 
work or to help them find jobs, in other words, but would also 
gut the work programs for welfare recipients that states 
already operate. If job training and placement assistance are 
not offered and there no jobs available, strict time limits on 
recipiency may reduce welfare roles, but at a high cost to poor 
children and their families.
    Converting Welfare Programs to Block Grants. Under current 
law, most benefits for low income families are provided 
directly to the families and individuals who are intended to 
benefit from them. Program such as the Food Stamp Program, the 
AFDC program, and the Supplemental Security Income program send 
checks or food coupons directly to qualifying families once 
they have established their eligibility for the program. All 
families meeting the eligibility criteria for a given program 
can apply for and receive benefits, and the total amount paid 
out each year depends on the number of eligible families that 
apply. As a result, total benefits paid out tend to go up 
during recessions, when jobs are harder to find and more 
families apply, and down during periods of high employment. 
Programs like food stamps thus provide some buffer for working 
families when times are bad.
    Under the Republican budget plan, however, federal payments 
for most welfare programs would be frozen at a fixed level in 
advance, and would be given to each state in an annual ``block 
grant.'' States would then set their own rules for distributing 
these funds to needy families. Eligible families would not be 
guaranteed a benefit, as they are now. If a state ran out of 
block grant funds in July, for example, people applying for 
benefits in August could only receive them if the state added 
more of its own funds to the program. These additional funds 
would not be matched by the Federal government, as they are 
under current law, any overrun would be solely the state's 
problem.
    Proponents argue that providing benefits in a lump sum paid 
to states in advance will prevent welfare programs from 
growing, as they do now during recessions, and will give states 
more discretion in designing the programs to fit local needs. 
Under the House Republicans' welfare reform proposals, however, 
states are expressly forbidden to provide benefits to certain 
categories of people, such as teen mothers living alone, legal 
aliens, and children born while their mothers are on welfare. 
And because funding is reduced under the block grant as 
compared to current law, most states will either have to find 
substantial new funds or cut off benefits to many recipients.
    Even more unfortunately, because the block grants are fixed 
for five years at a time, states with worse-than-average 
economies during those five years will have to come up with 
more additional funding (or reduce benefits more), while more 
fortunate states with low unemployment rates may actually save 
money on their welfare programs. Substituting block grants for 
the current funding system would effectively redistribute 
funding from states with rapidly growing needs to those whose 
needs are declining. Further, it would undermine the 
countercyclical nature of the current program. Currently, 
countercyclical spending on welfare programs in states with 
declining economies helps to dampen the effects of the 
recession, encouraging faster recovery. Under a block grant 
system, spending for benefits would no longer rise 
automatically in states that are falling into recession--in 
fact, as state revenues fell, spending would also have to be 
curtailed.
    Allowing complete state discretion in cutting benefits 
could also force states to compete with their neighbors to 
provide the least attractive benefit package in order to 
minimize their own welfare costs. Eligibility and benefit 
levels could vary even more from state to state than they do 
now, and states which contributed substantial funds to their 
welfare programs would run the risk of attracting additional 
beneficiaries from less generous states.
    Finally, while increased state discretion may work to 
improve some programs, there is some evidence that states may 
not always be better than the Federal government at identifying 
needs and meeting them. Among the programs that would be turned 
into block grants under the ``Personal Responsibility Act,'' 
for example, are child protection programs such as Foster Care 
and Adoption Assistance. Currently, 29 of the 50 states are 
operating their child protection programs under court orders, 
because the courts found their existing programs inadequate. 
Removing all federal standards for child protection programs 
could leave abused and neglected children at even greater risk.
    Restricting Eligibility for Benefits. A major argument for 
introducing block grants in AFDC and related programs has been 
that states need more discretion in running these programs. 
However, in many cases savings would be achieved under the 
Republican welfare plan by introducing more Federal 
restrictions on program eligibility. States would no longer be 
allowed to provide benefits to certain categories of disabled 
children, for example. Teenage parents could not receive 
benefits unless they lived with their own parents. States would 
generally be prohibited from spending funds on families who 
have been on the rolls more than five years, no matter what 
their circumstances, and benefits could also be denied to all 
children born while their mothers were on welfare--again, no 
matter why. These and other restrictive mandates to states have 
been opposed by many, including right-to-life activists who 
believe such rules may provide greater incentives for 
abortions. In any case, such restrictions on state actions do 
not seem consistent with an argument that states need greater 
flexibility and freedom in administering their welfare 
programs.
    Although cutting off benefits to long-term welfare 
recipients is the feature of the Republican welfare bill that 
has received the greatest attention, it is not the source of 
the greatest cost reductions. In fact, most of the savings over 
the next seven years would result either from denying benefits 
to immigrants, legal or otherwise, or from implementing new 
measures to restrict benefits under the Supplemental Security 
Income (SSI) program for severely disabled children.
    Cash payments now received by severely disabled children in 
low income families would be eliminated for all new recipients 
except those who are so disabled that their families would have 
to institutionalize them in the absence of a cash payment. Some 
of those now on the program would also lose their cash 
benefits. A set of reduced block grants would be given to the 
states, with instructions to provide medical services and 
equipment such as wheel chairs for these children. States could 
choose to divide this money up any way they want--there is no 
guarantee that all or even most low-income disabled children in 
the state would be served under the block grant. In fact, just 
about the only thing states wouldn't be able to do with these 
funds is give them directly to low-income families with 
disabled children.
    The reasoning behind this new set of restrictions is that 
under the old SSI program for disabled children some children 
may have been ``coached'' to behave badly and to make their 
disabilities seem worse then they really were. Republicans 
argue that eliminating cash benefits would make it less 
attractive to try to game the system this way.
    Many studies of this issue have been carried out, both by 
the Social Security Administration and by private groups, and 
all have found that the incidence of such fraudulent benefits 
claims in SSI is very low indeed---less than 2 or 3 percent of 
all cases. Rather than address this problem directly, however, 
the Republicans have chosen to throw the baby out with the bath 
water by denying benefits to thousands of very severely 
disabled children whose families are struggling to maintain 
them at home, against very heavy odds. In the long run, this 
not only creates major hardships for these children and their 
families, but is likely to cost even more money, as low-income 
families give up the struggle and place their severely disabled 
children in publicly funded institutions.
    Health Care Cuts. Although welfare programs are widely 
believed to need some reform, our health care system currently 
provides a high standard of care. President Clinton's proposals 
to extend that care to the uninsured and to hold down the rate 
of increase in medical care costs were opposed and defeated by 
the Republicans last year, with the argument that the changes 
would lessen individual control over health care decisions and 
reduce the quality and accessibility of care. Nevertheless, 
without proposing any specific health care reforms nor any 
safeguards to protect the availability and quality of care, the 
Republican budget as passed in the Reconciliation Act would cut 
the Medicare portion of Social Security by $226 billion over 
the next seven years.
    Medicare Cuts. Under the cuts proposed in the Republican 
budget, the Medicare program will be almost 20 percent smaller 
in 2002 than it would be under current law. Although these are 
very large changes, the Republicans have done little to 
safeguard the quality and accessibility of care for Social 
Security recipients if such draconian cuts are enacted.
    The Republicans argue that their proposals aren't really 
cuts, just reductions in the rate of growth for Medicare 
spending. They argue that even spending per person will go up. 
What they don't mention is that people's medical needs will be 
rising even faster, so that Medicare recipients will be left 
with ever-higher out-of-pocket medical costs to pay. To see how 
misleading the Republicans argument is, we have only to look at 
the factors behind the projected spending growth.
    The Republican argument makes it sound as if Medicare is 
expanding every year, in the sense that people are becoming 
entitled to new services or that new people are being served or 
that doctors and hospitals are having a higher share of their 
costs reimbursed. None of these things is true. The cuts the 
Republicans want to make would come out of the amount that 
would be needed just to keep benefits and reimbursement rates 
comparable to those of today.
    Medicare costs are projected to increase over the next 
seven years, of course--and so are all other health care costs. 
Spending increases in Medicare are projected to occur at about 
the same rate as in other health care spending--unless the 
Republicans succeed in cutting the share of health care dollars 
going to Social Security recipients under Medicare.
    What's behind these rising health care costs? These costs 
go up over time for a number of different reasons. Two of the 
most important are:
          New technologies are invented--saving lives but also 
        increasing the number and cost of services that may be 
        provided to patients.
          The population is aging--so that more people are 
        falling into the age groups where they are likely to 
        need more medical services.
    What do the Republicans propose that we do to prevent such 
cost increases? Tell Medicare patients, ``Sorry, you can't have 
that new test for cancer, because it wasn't invented when 
Medicare agreed to pay your health care costs, so it's not 
covered in your insurance?'' Are doctors supposed to check 
before they use new technologies or prescribe new drugs to make 
sure that the patient has supplemental insurance to pay for 
it--because Medicare can't pay for health care improvements? 
Will we tell our seniors, ``Sorry you're not allowed to be any 
sicker this year than you were last year--Medicare can't cover 
the costs of growing older?''
    Few would advocate such a policy. And yet, that is just 
what these Republican proposals amount to--cutting the Medicare 
program so that it no longer comes close to covering the health 
care costs of Social Security recipients as well as today. 
Under these proposals, Social Security recipients would pay 
$3,500 more apiece for their health care out of their own 
pockets over the next seven years. Out-of-pocket costs for 
seniors will rise by more than $1,000 in 2002 alone. Almost 83 
percent of Medicare benefits go to seniors with less than 
$25,000 per year in total income. How are such people going to 
pay these additional health care costs?
    And the additional payments that would be required from 
Social Security recipients aren't even the whole story. If 
reimbursement rates for doctors and hospitals under Medicare 
are also cut, it will be increasingly difficult for seniors to 
get access to quality medical care. Rep. Archer--the Republican 
chair of the House Ways and Means Committee--raised this issue 
last year with regard to much smaller proposed Medicare cuts. 
He said, ``I just don't believe that quality of care and 
availability of care can survive these additional cuts.'' Just 
what do the House Republicans think is going to happen to the 
quality and availability of care for Social Security recipients 
under their much larger proposed reductions in Medicare 
spending?
    Recently some Republicans have argued that it is necessary 
to cut Medicare in order to save it--cuts that would have been 
unthinkable in better times are needed now to prevent the 
Medicare Trust Fund from being exhausted. It is true that the 
Medicare Trust Fund now looks shakier than it did in the recent 
past--partly because of Republican changes that reduced taxes 
on higher income Social Security recipients, which had been 
earmarked for Medicare. But the cuts in Medicare proposed by 
the Republicans go far beyond what is needed to maintain the 
Trust Funds over the next several years. And in fact, many of 
those cuts would have no direct impact on Medicare solvency at 
all, because they would affect a part of the Medicare program 
that is not financed through the Hospital Insurance Trust Fund, 
the fund that is now in trouble. The real point of the large 
cuts in Medicare called for by the Republicans is not to help 
the Trust Fund, but rather to pay for a larger tax cut that 
will mostly benefit the well-off.
    In the long run, it is necessary for us to control the rate 
of increase in health care spending. But the way to do that is 
through a comprehensive plan that addresses health care 
spending as a whole--not through a series of massive cuts that 
unfairly target those receiving Medicare.
    Cuts in Medicaid. The Republicans are also proposing to cut 
more than $130 billion over the next seven years out of the 
Medicaid program for poor and medically needy families. This 
would reduce the program by more than one-fourth compared to 
current law by the year 2002. Again, the Republicans say they 
are just holding spending down--not really cutting. And again, 
this is very misleading. Under these proposals, poor and near-
poor people who qualify for Medicaid will get fewer medical 
services then they get now.
    The Republicans do not specify which medical services 
they're going to cut, or which poor people won't receive 
services. Instead, they are proposing to turn the whole program 
into a set of block grants to states, but with substantially 
less funding than the states would need to maintain current 
Medicaid services. That leaves the entire problem up to the 
states, who will be caught in a no-win situation. Either they 
can stop providing services altogether to some poor Medicaid 
recipients, or they can further restrict which services poor 
people in general will receive. Most states will probably have 
to do some of each.
    Like the block grants proposed for the AFDC and SSI 
programs, the Medicaid block grants would be fixed in advance 
for a period of time. If a state experienced unusually hard 
times, causing higher unemployment and loss of private medical 
insurance, its Medicaid allocation would simply have to be 
spread over more people. No more funds would be available from 
the federal government, and presumably state tax revenues and 
other income sources would also be falling at the same time. 
States would be left with the choice of refusing medical 
services to needy children and seniors, or running up deficits 
in their own budgets. Meanwhile, states with higher levels of 
employment would simply get to keep the windfalls that they 
would experience as the result of fewer than expected demands 
on publicly funded health programs. Does it make sense to put 
so many burdens on states that are already in economic 
difficulties, while allowing large budget windfalls to states 
lucky enough to have booming economies?

            Who Would Be Hurt by Republican Budget Proposals

    As the last section discussed, Republican proposals in both 
the tax and spending areas pose significant dangers to the 
American economy and to American society. Overstating the 
impacts of tax cuts on growth, as the Republicans have 
consistently done, allows them to give tax breaks to high-
income Americans without facing the impacts these cuts will 
have on the budget as a whole. Reducing spending by cutting aid 
to needy children and seniors without providing adequate child 
care or job training programs will simply increase the 
hardships suffered by poor Americans without helping increase 
their self-sufficiency. For moderate income families, the 
proposed spending cuts are likely to mean higher health care 
bills, more spent on day care, less money for college, a more 
uncertain retirement, and a larger share of family income and 
assets being eaten by the costs of aged parents' long term 
health care needs. And all of these changes would come on top 
of an existing set of income trends that already strongly favor 
the rich at the expense of middle and lower income families. 
This section examines those trends and discusses the impacts of 
the Republican proposals in light of them.
    Trends in Income and Poverty. Over the past two decades, 
household income in the United States has grown much more 
slowly than it did in the period between World War II and 1973, 
and the growth that has occurred has been much more heavily 
concentrated among those at the upper end of the income 
distribution. Between 1948 and 1973 average income (adjusted 
for inflation) approximately doubled, since 1973 average income 
has risen only 13 percent. In the 1950s, 1960s, and even in the 
1970s, incomes up and down the distribution grew at 
approximately the same pace as average income. More recently, 
however, incomes at the top of the distribution have grown 
faster than the average, while incomes in the middle and bottom 
have grown more slowly.
    Poverty Rates. In 1994, 38.1 million Americans, 14.5 
percent of the U.S. population, were officially classified as 
poor. Poverty level income varies according to family size and 
composition. For example, an elderly widow living alone is 
counted as poor in 1994 with income less than $7,100, but a 
family of four (mother, father, two children) is poor if their 
income is less than $15,109.
    Both the poverty rate and the number of poor people in the 
United States remain high today by the standards of the past 
twenty-five years. The poverty rate at the last business cycle 
peak, 1989, was 12.8 percent, and almost 7 million fewer 
Americans were poor. The rate was 11.4 percent in 1978 and 11.1 
percent in 1973. Since 1990, in contrast, the rate has remained 
over 13 percent, peaking at over 15 percent in 1993. Although 
1994 poverty figures show some improvement, there has been very 
little progress against poverty over the last decade as a 
whole.
    Family Income. Medium household income has also lagged 
recently; it was just $32,264 in 1994. The median is the 
midpoint of the distribution: half the households in the 
country had incomes below $32,264 and half had incomes above 
$32,264. For families at this midpoint, there has been little 
growth in real income over the past two decades. Income at the 
midpoint of the distribution was actually 2.2 percent lower in 
1994 than it had been in 1973, and real income levels also fell 
over the entire distribution below the midpoint. By contrast, 
income at the 95th percentile (the dividing line between the 
richest 5 percent of households and everyone else) was up 
almost 23 percent. In other words, poor households and low 
income working households were worse off in 1994 than their 
1973 counterparts, whereas the highest income households were 
substantially better off.
    Wages. Wages constitute the bulk of income for most 
families, and wages show the same trends as incomes. Average 
wages have grown much more slowly over the past twenty years 
than they did in the earlier postwar period and the 
distribution of earnings has become more unequal.




    Average hourly compensation approximately doubled in the 25 
years between 1948 and 1973, but it has risen only 7 percent in 
the 22 years since then. Unlike the income measures discussed 
above, the compensation measure includes fringe benefits. One 
broad measure of the money wage of ordinary workers, the real 
average hourly earnings for production and nonsupervisory 
workers, covers four-fifths of the nation's workforce. This 
measure took a nosedive over the past fifteen years, falling 
from $12.48 an hour in 1978 to $11.12 last year (measured in 
constant 1994 dollars). Other measures of labor costs confirm 
that fringe benefits have increased more rapidly than money 
wages over the same period. Average money wages for the other 
fifth of the workforce (those in administrative, professional, 
and technical jobs) have done better than the hourly earnings 
measure.
    As with the income data, averages conceal large differences 
between what is going on at the top of the distribution and 
what is going on with everyone else. Studies of wage inequality 
have found the same tendency toward rising inequality that 
shows up in the household income data. They also tend to show 
failing wages for workers at the middle and bottom of the wage 
scale, with the bulk of earnings growth concentrated in the 
upper reaches of the distribution.
    What's Behind the Trends? A slowdown in productivity 
(output per hour) after 1973 is the main reason for slower 
growth in average wages and incomes. But no consensus has 
emerged to explain the productivity slowdown or why despite 
productivity gains real wages continue to fall. Nor are the 
causes of rising inequality in incomes and earnings 
particularly well understood. Analysts point to technological 
change, increasing international competition, lower 
unionization, and a falling real minimum wage as factors that 
have reduced the earnings potential of some kinds of workers 
while raising that of others. On balance, however, economists 
have no simple or fully worked out analysis of how changes in 
wages and incomes and their distribution interact with complex 
underlying structural changes in the economy.
    Government tax and spending policies do not appear to be 
the primary cause of slow wage and income growth. However, 
well-targeted investments in the health, education, and 
training of workers, in roads, bridges and other public 
infrastructure, and in generating new knowledge through R&D can 
enhance productivity. Cutting such government investment 
programs hurts productivity, and hence wages and incomes, 
unless those cuts translate into greater and more productive 
private investment. And further, cutting programs such as 
education and training that are most likely to help lower-
income workers get a leg up and improve their situations makes 
little sense in a time when income inequality is already 
growing.
    Similarly, government tax and spending policies do not 
appear to be the primary cause of rising inequality. This too 
stems from underlying structural changes in the private 
economy. Nevertheless policy changes that make the tax code 
less progressive or reduce the value of transfer programs like 
Medicare or food stamps exacerbate rather then offset any 
underlying tendency toward greater inequality in market 
earnings. Because that trend is already so pronounced, policies 
that will further exaggerate it should face close scrutiny.
    Impacts of Republican Budget Proposals on Families at 
Different Income Levels. Unfortunately, there is little doubt 
that the Republican budget policies will further exaggerate 
current trends toward increasing inequality in incomes. In 
order to meet its goals of goals of balancing the budget by the 
year 2002 while also cutting taxes, the Republican majority in 
the Congress had to find over $1.2 trillion in budget savings 
over the 1996-2002 budget planning horizon. Some of these 
savings may come from cutting waste or improving efficiency, 
but most will come from cutting programs that provide real 
benefits to real people. In some cases, these cuts represent a 
direct loss of cash or benefits by identifiable people 
(increase out-of-pocket medical costs for seniors, for 
example). In other cases, the loss is more intangible, less 
direct, or harder to measure (less basic research generating 
fewer new ideas, for example). And, of course, those at the top 
of the income distribution who get a tax cut end up with more 
after-tax income even if they receive fewer program benefits.
    A recent study by the JEC Minority Staff confirms that the 
Republican plan will cost the poor and benefit the rich. Budget 
cuts that effect people directly will fall disproportionately 
on families with below-average incomes, while the tax cuts will 
accrue disproportionately to those with above-average incomes.
    The 20 percent of families with the lowest incomes will 
bear half the program cuts. (See Figure 7) They will experience 
average losses of more than $2000 per family by the year 2002. 
To add insult to injury, many of these families will face 
higher tax bills as well.
    The 20 percent of families with the highest incomes will 
bear less than 9 percent of the program losses, while reaping 
nearly two-thirds of the total tax cut. (See Figure 8) They 
will gain tax benefits worth almost $1000 per family in 2002 
while incurring less than $400 per family in program cuts.
    Because of cuts in the Earned Income Tax Credit, the bottom 
20 percent of households will face a small net tax increase. 
The middle 60 percent of families will lose direct program 
benefits of nearly $600 per family on average in 2002, but will 
receive a much smaller tax cut--about $200 per family in that 
year.




    These overall net impacts do not tell the entire story, of 
course. Specific families within each income category will 
experience different actual losses or savings. In general, the 
working poor, low-income people with major medical expenses, 
and retirees will be the biggest losers, while those with high 
unearned incomes will gain the most.
    And, because this study allocates all of the proposed tax 
cut in 2002, but only part of the savings from reductions in 
spending, it probably over-estimates the net benefits to 
families that will occur as a result of these changes. Cuts 
affecting health care providers, local school budgets, bridge 
and highways funds and so forth cannot be allocated to people 
in any particular income category with any degree of certainty, 
but many of these cuts will also have a negative effect on the 
quality of people's lives.




    Reducing the budget deficit cannot be a painless exercise--
sacrifices will be required. But these sacrifices do not have 
to come so disproportionately from those at the bottom of the 
income distribution, nor is it necessary that those at the top 
be asked to do so little. Historically, we have had a somewhat 
progressive Federal tax and expenditure system, with the 
burdens of paying for government rising as the ability to pay 
rises. But even a proportional distribution of the costs of 
bringing down the deficit would look very different from the 
Republican plan.
    For example, if every family in the country were asked to 
make sacrifices equal to the same share of their incomes to 
reduce the deficit, a contribution of less than one percent of 
income would be required from each family to match the $64 
billion of deficit reduction from individual benefit cuts and 
tax changes in the Republican plan for 2002. Under such a plan, 
those in the lowest fifth of the income distribution would lose 
less than $100 in income and benefits in 2002--not the $2200 
they will lose under the Republican plan. And those in the top 
fifth of the distribution would pay about $1300 more, instead 
of getting an average net windfall of almost $1000 as under the 
Republican plan.
    Some Republicans argue that very high income taxpayers 
deserve a larger share of any tax cut, because they have been 
paying a growing share of total taxes. But the reason that the 
tax payments of the well-to-do have risen over the past decade 
is largely that their incomes have also risen. Because almost 
all of the income gains of the last decade have gone to higher-
income households, they naturally have had to pay a larger 
share of total taxes. The proportion of income paid in taxes by 
those in the top 20 percent, however, is just about what it was 
in 1980.
    Republicans imply that the market will take over all the 
important functions that the government will be giving up under 
their proposals, and no doubt some functions will be replaced 
by the private sector. But markets respond only to the demands 
of people with money to spend. The Republican tax and 
expenditure cuts will help to ensure that people at the top of 
the income distribution have an even larger share of our total 
spending power than they do today. As a result, the needs of 
lower and middle-income Americans in basic areas such as health 
care are likely to remain unmet.
    What Should We Do? Alternative Policies to Aid Low Income 
Workers. Rising inequality has been a hallmark of the past 
decade or more. This is bad for our society in a number of 
ways.
    First, it is divisive. When the gap between rich and poor 
grows too wide and increasing numbers of people feel that 
America is no longer a land of opportunity for them, the social 
fabric of the country is at risk. Those at the bottom may begin 
to feel they have less of a stake in the continuity and growth 
of our society.
    Second, too much inequality hinders economic growth. As 
those who are less well-off get poorer and fall farther behind, 
their access to education and training and their opportunities 
for improvement tend to be reduced. And in the end that means 
that the nation as a whole is less well-off because growth of 
the U.S. economy is held back by a less qualified workforce.
    Third, abandoning those who are less well-off just isn't 
the American way of doing things. America has been and must 
continue to be a land of opportunity for all Americans, not 
just for the lucky few at the top of the income ladder.
    Income gains to those at the top are to be applauded, but 
more needs to be done to make sure that low- and moderate-
income workers also see some income gains. A number of policies 
could be implemented to make sure that income gains are spread 
fairly across the whole distribution of income, and not 
experienced only by those at the top. Two of the most 
important--and in some ways, the easiest to implement--would be 
increasing the minimum wage and investing in the education and 
training of American workers.
    The Minimum Wage. One factor in the falling relative 
incomes of lower income families and workers has been the 
decline in the real value of the minimum wage. Today, a minimum 
wage worker who works full-time, year round, does not earn 
enough money to keep a family of two out of poverty. Until the 
early 1980s, the minimum wage was high enough to keep the 
average three-person family out of poverty.
    The Fair Labor Standards Act (FLSA), originally enacted in 
June 1938 under President Roosevelt, established a minimum wage 
of $0.25 an hour, effective October 24, 1938. Since then, under 
Presidents Truman (1949), Eisenhower (1955), Kennedy (1961), 
Johnson (1966), Nixon (1974), Carter (1977) and Bush (1989), 
the FLSA has been amended to raise the minimum wage. Though the 
minimum wage has been raised sporadically, until 1981 it 
consistently fell between 45 and 55 percent of the average wage 
of nonsupervisory and production workers. When President Reagan 
became the first elected President to fail to increase the 
federal minimum wage since its establishment, it fell to below 
40 percent of the average wage of nonsupervisory and production 
workers.
    Because the minimum wage sets a floor for wages that had 
been changed to keep pace with other wages in the economy until 
the 1980s, those at the bottom of the wage distribution gained 
along with other workers until then, as Figure 9 shows. Since 
then, however, low-wage workers have increasingly fallen 
behind.
    The negative effects of the falling value of the minimum 
wage goes beyond just those workers making the minimum wage or 
close to it. The JEC Democratic staff has identified a set of 
jobs whose wages change with the minimum wage, in contrast to 
jobs where wages seem to move with changes in other wages in 
the economy. Workers in the first set of jobs are said to be on 
the ``minimum wage contour,'' or ``MWC.'' Holding down the 
value of the minimum wage depresses the wages of workers on the 
MWC.
    Workers whose skills and other characteristics seem similar 
to those in minimum wage contour jobs, but who have the good 
fortune to hold non-MWC jobs, make around 30 percent more.
    In other words, even after extensive information related to 
productive capacity is examined, there remains a 30 percent 
wage gap between those holding MWC jobs and comparably 
productive workers holding non-MWC jobs. One reason could be 
that MWC workers have fewer options to give them bargaining 
power with their employers. For example, the ranks of the 
minimum wage work force are disproportionately female, and 
discrimination against women workers remains in the labor 
market.




    When the minimum wage rises, some balance is restored to 
the equation and low-wage workers are made relatively better-
off. When we increased the minimum wage from $3.35 in 1989 to 
$4.25 in 1991, the wage gap between minimum wage contour and 
non-minimum wage workers shrank. Also, the gap between the 
wages of women and men shrank.
    Because many employers link the wages they pay to the 
minimum wage, the fall in its value has also meant declines in 
other wages for low-wage workers. One result of falling wages 
at the bottom of the earnings distribution has been a rise in 
the share of families with children living below poverty. 
Figure 10 shows the relationship, from 1978 to 1994, between 
the value of the minimum wage, and the share of the poor who 
work full-time, year-round.
    The years when the real minimum wage was higher were also 
years with a lower share of full time workers making incomes 
below the poverty line. For instance, the highest value of the 
minimum wage during the period shown in Figure 10 was in 1978 
when the minimum wage was worth $5.76 an hour in today's 
dollars. That was also the year the share of the poor who 
worked full-time, year-round was the lowest, 7.7 percent. 
Conversely, the highest share of poor workers working full-
time, year-round was 10.5 percent in 1994, when the minimum 
wage was at one of its lowest values.




    The reason the minimum wage is so important in figuring the 
number of workers who are poor is because it affects the 
earnings of many low-income families. Minimum wage workers are 
often misperceived to be predominantly teenagers or middle-
income women earning extra money. However, most minimum wage 
workers today are adults with substantial attachment to the 
labor market, 74.4 percent are adults, and 47.2 percent are 
full-time workers.
    The relationship between the minimum wage and the ability 
to use work to escape poverty suggests a net positive effect on 
income of a higher minimum wage. It would appear that the 
higher earnings of low-income workers under an increased 
minimum typically more than offset any losses from decreases in 
total employment. The Report of the Minimum Wage Commission, 
looking at studies through 1979, showed that any negative 
effects on total jobs of increasing the minimum wage were 
limited to teenagers. Studies that include data from the 1980s 
show an even smaller job-loss effect than previous studies.
    As the purchasing power of the minimum wage falls, the 
share of the work force receiving the Earned Income Tax Credit 
and/or benefits from means tested entitlement programs such as 
the Food Stamp Program rises. Failure to increase the minimum 
wage to keep pace with other wages, therefore, also increases 
demands on the Federal budget. Using the minimum wage and the 
EITC together to insure that working families avoid poverty, as 
has been done since 1975, means that when the purchasing power 
of the minimum wage falls, the size of the EITC must rise. The 
sharp drop in the real value of the minimum wage has also 
increased demands from working families for help with health, 
nutrition, and other needs.
    Largely because of changes in the EITC, the average federal 
tax rate (income, payroll, and excise taxes) for families in 
the lowest fifth of the income spectrum declined from 10.4 
percent in 1985 to 5.1 percent in 1994. Even as their before-
tax income has been falling, the working poor with children 
have enjoyed a significant offsetting gain from the EITC. The 
Republican budget proposals would remove many families from 
eligibility for this crucial protection for working families, 
and increase the marginal tax rate for others. The bill would 
also roll back provisions adopted by Democrats in 1993 to 
expand the EITC.
    The President has proposed, and legislation has been 
introduced in the House and Senate by Democrats, to increase 
the minimum wage from $4.25 to $5.15 in a two-step, two-year 
process. At two JEC hearings on this issue early this year, 
several points emerged.
    (1) Most economists find no significant difference in the 
effect of changing the minimum wage on the employment of 
African American youth compared with white youth.
    (2) Economists are less certain of the effects of the 
minimum wage on employment; and
    (3) Estimates of potential job loss resulting from minimum 
wage increases have gotten smaller.
    Surprisingly, there was agreement on this last point 
between economists asked to testify by the JEC Republicans and 
Democrats. The testimony of two economists invited by the JEC 
Republicans was particularly interesting.
    Dr. Daniel Hamermesh (University of Texas--Austin) said:

          * * * I have argued in the press that I would be 
        happy to see the minimum wage raised by a small amount 
        and then indexed forever, so in the future you and your 
        successors haven't got to waste your time and the 
        public doesn't have to waste its time worrying about 
        this issue.

    Dr. David Neumark (Michigan State University), coauthor of 
an April 1995 article published in the ``Journal of Business & 
Economic Statistics,'' said:

          A striking feature of most of these studies 
        (including ours) is that simple comparisons, or 
        regressions controlling for exogenous shifts in labor 
        demand, do not reveal disemployment effects of minimum 
        wages for teenagers.

    As even the Republican witnesses agreed, therefore, a 
reasonable increase in the minimum wage to allow it to keep 
pace with average wage gains would have few negative 
consequences for employment. Passing this legislation is a 
simple step that we can take now to improve incomes for low-
wage workers and their families.
    Education and Training. Equalizing the pay of equally 
qualified workers is one way to address growing income 
inequality. Another way is to address inequality in training 
and education levels among workers. There has been a growing 
gap between the earnings of more and less educated workers. 
There has also been a growing gap in the employment of more and 
less educated workers.
    Among industrial nations, the U.S. has under invested in 
labor market policies aimed at training workers, getting young 
workers into the labor market, and supporting workers who lose 
their jobs with income maintenance. Our expenditures on labor 
market programs (including training, income maintenance, and 
others) for workers who are displaced or at risk of being 
displaced are much lower, as percentages of gross domestic 
product (GDP), than those of most other industrialized nations 
such as Germany or Canada.\2\
    \2\ This can be verified from the data on public expenditures on 
labor market programs in Organization for Economic Co-operation and 
Development (OECD), ``Employment Outlook,'' July 1991, pages 239, 241, 
and 249.
---------------------------------------------------------------------------
    Labor market policies in the United States are not as 
prepared to handle shifts in industrial structure, as happens 
for other industrial nations. U.S. spending on labor market 
policies reflects the type of shift U.S. public policy is 
designed to handle--cyclical downturns. U.S. labor market 
policies have not been designed to address shifts in technology 
or trade.
    Education, employment and training programs are public 
investments. They have positive returns many times their 
expense. For instance, while one year of Head Start costs 
$5,400, participation in Head Start increases the earnings over 
a child's adult work life of $696 a year. So it is not 
surprising that a study by an economist at the Richmond Federal 
Reserve Bank shows that federal dollars spent on education, 
employment and training increase GDP, and by more than 
investment in physical infrastructure or defense.
    A bipartisan effort in Congress, following the lead of the 
President with his ``G.I. Bill for America's Workers,'' has 
tried to bring the American training system up to date. The 
proposed legislation, now in conference, does this by 
consolidating and refocusing many education and training 
programs. Those are movements in the correct direction to make 
the programs more efficient. Still, however well intended these 
efforts are, the reduced funding for education and training 
proposed in the Republican House and Senate appropriations for 
education and training undermine the programs' effectiveness.
    Cuts of more than $700 million have already occurred in 
employment and training programs because of the fiscal year 
1995 rescission. The House appropriation for education and 
training for fiscal year 1996 is a cut in program level, in 
nominal dollars, from the reduced fiscal year 1995 level. Thus, 
because these cuts ignore the effects of inflation and growth 
in the youth and displaced workers needing assistance, there 
will be a significant reduction in the number of workers and 
youngsters served.
    For instance, the elimination of the Summer Jobs program 
for youth will mean more than 600,000 youth will not find jobs 
this summer. Other job training programs for disadvantaged 
youth will be cut 54 percent compared with the fiscal year 1995 
appropriation level. The House proposes cutting dislocated 
worker assistance 34 percent below its fiscal year 1995 
appopriation level. As a result, 193,000 fewer workers will be 
helped finding jobs. Because those programs function as block 
grants to states, there are no savings of administrative costs 
to be realized, these are simply reductions in the number of 
youngsters and workers America will be investing in.
    In education, the House proposes to reduce Title I grants 
for disadvantaged students in fiscal year 1996 by $1.1 billion 
below the fiscal year 1995 level. More than $2 million in cuts 
from fiscal year 1995 are proposed in the fiscal year 1996 
appropriation for adult literacy. These programs represent 
necessary investments in bringing those the farthest behind in 
our economy up to a level playing field.
    Clearly, the Republican appropriations reflected in their 
budget, exacerbate both the under investment America is making 
in its work force, and the income inequality that is stifling 
low income Americans. The Republican's disinvestment in low-
wage and less-educated workers, given the difficulties those 
workers have in the current labor market, contrasts with the 
agenda of the President and Democrats in Congress to positively 
address these problems.

                               Conclusion

    Starting in 1993, Democrats laid the economic policy 
foundation for solid growth that ended several years of 
economic recession and stagnation. Compared to January 1993, we 
have 7.8 million more jobs and unemployment down from more than 
7 percent to 5\1/2\ percent.
    For the longer term, Democrats have also pursued policies 
to strengthen ordinary working Americans' earnings which have 
languished for more than two decades. Democrats expanded public 
investments in training and education which take time to bear 
fruit in higher earnings. We expanded the Earned Income Tax 
Credit (EITC) to assure that those who work full time can 
escape poverty.
    The new Republican majority has proposed an economic agenda 
in 1995 that would dramatically change priorities in ways never 
discussed during the elections of 1994. Many programs that 
assist low to moderate income working families (such as the 
EITC) would be scaled back sharply. In addition, those least 
able to fend for themselves, the elderly and children, would 
suffer some of the deepest cuts in federal assistance. 
Meanwhile, Republicans are insisting on massive tax cuts for 
which the benefits would flow primarily to those already 
prospering.
    The elections of 1994 brought back divided government and 
ignited a debate over some fundamental differences in economic 
policy. That debate promises to continue at least through the 
elections of 1996. We Democrats are confident that, after 
comparing the priorities set by the Democrats with those set by 
the Republicans, the public will favor the policies set by the 
Democrats.

                                
