So Who's Afraid of a Deficit? Economic sense in an age of superstition.

The Bush economic plan will help the economy, but the way the administration is selling it risks doing serious harm. Probably the most important element of the Bush plan is the proposed reduction in marginal tax rates. These cuts account for just 31 percent of the $1.6 trillion revenue cost of the entire Bush program, but GOP publicists keep stressing the huge $1.6 trillion figure instead of the relatively inexpensive-but economically crucial-marginal-rate cuts.

Why has the administration downplayed one of its most valuable initiatives, one that would strengthen the economy for years to come? What accounts for this miscalculation? The answer is to be found in psychology: an irrational fear of budget deficits and an equally irrational obsession with chronic surpluses-that is, an obsession with overtaxing Smith for no reason except to buy back Treasury bonds owned by Jones. The Republican party has hamstrung itself with meaningless economic slogans that sanctify perpetual budget surpluses. Some have even maintained this reverent attitude toward surpluses while simultaneously entertaining the contradictory hunch that any crackpot rebate scheme that wastes a lot of money is equivalent to serious tax reform as a "fiscal stimulus."

The current political correctness of perpetual budget surpluses originated in the Clinton Democrats' unusual embrace of the archaic ideology of Eisenhower Republicans. President Clinton never stopped telling us that the 3.9 percent annual growth of the economy from 1993 to 2000 was vastly superior to the 4 percent annual growth from 1983 to 1990, solely because the '80s were a period of deficits. But what is it, exactly, that is so wonderful about budget surpluses?

Over the past 15 years, prominent macroeconomists promised that switching from budget deficits to surpluses would result in several miracles. Taking more money from taxpayers and giving it to the IRS was supposed to raise the national savings rate and thereby push real interest rates lower. That, in turn, would supposedly rid us of the evil "twin deficits"-because the trade deficit was sure to vanish as soon as budget deficits receded. These predictions were based on an Eisenhower-era variant of Keynesian reasoning, and they were thoroughly bipartisan. In 1987, future Clinton Treasury secretary Larry Summers wrote that "changes in the government's fiscal posture are the most potent and reliable way to increase national savings . . . It may be necessary for the federal government to run chronic budget surpluses in coming years." In 1995, former Reagan adviser Martin Feldstein argued that "with a lower level of current and expected future government borrowing, real interest rates would decline and the dollar would come down with them. . . . A lower budget deficit would thus reduce our trade deficit."

Not one of these bold promises and predictions came true. National savings did not rise, real interest rates did not fall, and the trade deficit became much larger rather than smaller. Consider the facts:

--The national savings rate averaged 17.4 percent of GDP from 1993 to 2000, down slightly from 17.6 percent in 1983-90, as the budget swung from deficit to surplus. Even with growing surpluses in 1998-2000, combined public and private saving was still no greater than it had been in 1984-85, when budget deficits were 5 percent of GDP.

--The real prime interest rate, after subtracting inflation, averaged 6.7 percent from 1997 to 2000, up from 6.2 percent from 1985 to 1989. Real interest rates are always lowest in recessions and highest when the economy is strong-because the real return on borrowed funds is most promising when the economy is healthy, and the Fed raises rates when the economy is booming and lowers rates during slumps.

--From 1993 to 2000, as economic expansion moved the budget from deficit into surplus, the current account deficit grew steadily larger, topping 4 percent of GDP by 2000.

The promises and predictions of Keynesian economists who advocated chronic budget surpluses in the years 1987-95 have now been thoroughly tested-and disproved. Remarkably, however, the theology that perpetuation of budget surpluses must have "the highest priority" outlived the discredited economic fallacies that spawned it. Fed chairman Alan Greenspan, for example, continues to testify solemnly that budget surpluses boost national savings and hold down real interest rates. (Tell it to Japan, where the budget deficit is 6 percent of GDP but interest rates have long been near zero simply because the economy is going nowhere.)

The hoax that surpluses reduce real interest rates made it possible to turn Keynesianism on its head, and assert that balancing the U.S. budget was the cause (rather than the consequence) of the 1996-2000 technology boomlet. Yet the same Democrats who claimed surpluses were the cause of prosperity in the Clinton years now claim the economy needs the "fiscal stimulus" of a $60-85 billion one-time "rebate" (i.e., silly little checks distributed randomly and written at the expense of the upper-income taxpayers funding the surplus). Surpluses stimulate economic growth, yet smaller surpluses stimulate even more?

In reality, budget deficits and surpluses have no reliable connection with economic growth, real interest rates, trade balances, inflation, or anything else of practical importance. The awkward reality that deficits and surpluses explain nothing has always encouraged Keynesian theorists to say deficits and surpluses explain everything. If the economy slumps, that is said to be because budget deficits crowd out investment. If the economy booms, that is because deficits stimulate demand. If the dollar goes up, that is because deficits attract foreign investment. If the dollar goes down, that is because deficits create fears of inflation. If prices go up, that is because deficits are inflationary. If prices go down, as in Japan, that is because the deficit is not large enough. Keynesian answers are always the same; only the questions change.

In reality, government borrowing is no different from any other sort of borrowing. Nobody assumes there is anything inherently imprudent or sinful about home mortgages or corporate bonds, yet many are eager to concoct higher standards for government bonds. For governments, as for households and firms, it makes sense to borrow to acquire assets that yield benefits over many years, and to borrow during tough times. If the government could literally never borrow a dollar, tax rates would always have to be increased during recessions. Sensible taxpayers would then try to realize most income during prosperous years, which would worsen the cyclical ups and downs. Borrowing during recessions, whether by consumers or governments, can smooth things out a bit. Hard times are rarely the best times to be paying off old debts.

If the economy performs poorly, the government's budget will suffer along with the budgets of taxpayers. If the economy performs well, the budget will too. We cannot possibly evaluate the benefit of lower tax rates merely by their static effects on the budget, because the actual effect depends on the effects of lower tax rates on the economy. Whenever the tax future looks brighter, however, that improves the economy and the stock market immediately, by lifting expectations about future opportunities. As a side benefit, an improved economy and stock market happen to be enormously helpful to the government's budget.

Politicians often have a hard time believing that good economics is also good politics. Republican politicians, in particular, have often been easily intimidated by the notion that those who pay the most in taxes are least deserving of tax relief. As a result, Republicans have worked especially hard since 1981 to exempt lower incomes from the income tax-by enlarging personal exemptions and the earned income tax credit, and by promoting and enlarging the child tax credit. This is fine as far as it goes, yet it may have unanticipated consequences: If Democrats grab every chance to raise tax rates on high incomes, while Republicans repeatedly settle for reducing only the lowest tax rates on the lowest incomes, the effect must be to make the tax code progressively more "progressive"-that is, more punitive toward extraordinary effort and success.

Exempting more and more taxpayers from the income tax also shrinks the political constituency most likely to support restraint on taxes and spending. Opinion polls rarely show a majority being terribly concerned about high tax rates-largely because the majority now pays either no income tax at all, or a gentle 15 percent rate on the fraction of their income above the phased-out exemptions, deductions, and credits. By contrast, only 6.1 percent of individual returns in 1998 reported incomes above $100,000-but that tiny group bore nearly 58 percent of the burden.

But the politics are somewhat more complicated than this. Those who pay little or no income tax, for example, are literally indifferent to the issue. That means they will not be swayed by such pandering as $300 rebate checks or a 10 percent rate on the first $12,000 of income. What they do care about is how the economy performs. Many people of temporarily modest means, particularly the ambitious young, are far more aware than most politicians that lower marginal tax rates (on "the rich") have always been followed by better job opportunities and more valuable pensions for everyone.

Furthermore, those facing tax brackets of 28 and 39.6 percent are far more likely than non-taxpayers to be politically agitated by what the administration and Congress do about high tax rates. The percentage of tax returns affected by tax rates of 28 percent and higher jumped to more than 44 percent this year, by my estimate, up from fewer than 36 percent in 1993. And the percentage of voters directly affected by higher tax rates is higher than the percentage of tax returns-because two-earner households and small businesses are commonly reported on a single tax return with one high income, and because those with higher incomes are far likelier to vote. At least half of likely voters have probably been shoved into the top four tax brackets by now. In major metropolitan areas, where incomes look higher because the cost of living is higher, voters affected by the top four tax rates constitute an overwhelming majority. These people will be acutely aware of the Bush administration's success or failure in rolling back marginal tax rates.

If tax rates were brought down to 25-33 percent this year or next, Republicans could grab the credit. Democrats understand this, and that's why they have been willing to say and do almost anything to obstruct the one change they fear most: a prompt and permanent rate reduction in the higher tax brackets. The swing voters could very well swing to the GOP-if only Republicans would stop overtaxing them for the sake of the discredited sacred cow known as the federal surplus.