Connecting Tax Reform and Defense Spending

by PETER HUESSY May 3, 2017

Washington D.C., is desperately in need of remedial math education.

The question at hand is: "Can we do both tax reform and increase defense spending?"

Conventional wisdom is that tax reform will lose us money. And there isn't enough revenue to begin with to pay for more for defense.

The conventional thinking is wrong.

In fact, let us start with simple math. On a year to year basis, the Federal government takes in an average of $200 billion more each year. In just the past twenty years, despite relatively anemic economic growth, annual revenue is up nearly $2 trillion, from $1.4 to $3.4 trillion.

Now tax reform-especially tax rate cuts-are assumed by deficit hawks to soar the deficit.

Why this inherent intellectual bias against tax rate cuts?

Two tax reform periods-1981 and 2001 occurred during recessions. These recessions lowered-briefly-- expected tax revenue. Thus the assumption tax rate cuts soar deficits.

But in 1981 Reagan came into office with 14% inflation, a 21% prime rate and unemployment increasing, which would eventually top 10%. To wring inflation out of the system, the Fed Chairman Paul Volcker had to tighten the money supply.  A serious recession occurred. Revenue dropped by $17 billion in 1981. Compared to its normal increase of $60-80 billion annually, this popped the deficit by nearly $100 billion annually.

In 2001, similarly, Bush 43 came into office just as a recession was taking hold, following the bursting of the "Dot Com" stock bubble in 1999-2000 which collapsed capital gain revenue. But the conventional wisdom was that revenues were still soaring, the entire national debt would soon be paid off, and the economy was booming. When the incoming President said a tax stimulus plan was needed, he was roundly criticized for "talking down the economy".

When the numbers came in, revenue to the Federal government had indeed suffered, dropping nearly $250 a year comparing 2000 with 2003 as all three shocks-the dot com collapse, the recession and the 9-11 attacks, took their toll.

As for 2008 and 2009, the small tax rebates had little simulative impact on the economy as the housing and job market collapse dropped revenue by upwards of $400 billion a year from 2007-9. However, by 2009-10, revenue growth recovered, albeit slowly. .

So what happened after the recessions?

The Reagan tax rate reductions were phased in and primarily went into effect in late 1982 and early 1983, exactly when the economy started to dramatically improve and with it revenue growth.

As for the Bush era tax rates, they kicked in primarily during 2003. For example the top rate under Bush dropped all of .5 points from 39.6 to 39.1 in 2001 and then to 38.6 in 2002. This 1 point drop was hardly responsible for the precipitous drop in Federal revenue that occurred after the 9-11 attacks. The drop to 35.0 occurred in 2003, with Federal revenue climbing $100 billion a year, matching the 1999 increase. By 2005, revenue growth reached $273 billion in one year.

As for 1996-2000, the capital gain tax rate cuts, the new child tax credit, and expansion of retirement tax reductions all led to higher revenue growth, averaging a robust growth of $140 billion a year.

What is remarkable is that in all cases in the past nearly four decades, tax rate reduction actions subsequently saw a rapid rise in government revenue of $60 billion, $120 billion, $190 billion and $210 billion a year, respectively. For example, under Reagan between 1984 and 1987, revenue climbed $254 billion or 42% more than the base year.  Under Clinton, the tax cuts of 1996 grew revenue by $570 billion from 1997-2000, or by 39% more than the base year. Once the Bush era tax rates kicked in fully in 2004, revenue grew by $788 billion from 2004-7, or by 44% more than the base year including a record amount of $273 billion in 2005 alone. And then following the recession of 2008-9, the Bush and Obama administrations relatively mild tax rebates still saw revenue increase from 2011-14 by $857 billion or 39%.

In just the past decade, revenue has climbed from $2.4 trillion in 2006 to $3.64 trillion in 2016. That is close to a record increase despite during the past decade anemic economic growth, heavy handed health and energy regulations and major overseas wars. But during that same period, the defense budget has gone from $540 billion to $610 billion, a modest 12.5%.

But the main social welfare programs of Social Security, Medicare and Medicaid have skyrocketed by over $325 billion to $1.354 trillion. When all poverty or mean tested programs are reviewed, the increase has been from $675 billion to at least $1 trillion, or a 30% increase. Combined, this social non-defense spending has increased between 2006-16 from roughly $1.5 trillion to $2.3 trillion or roughly 52%. 

Looked at another way, and using 2009-the first Obama year as the base year--defense investments have declined by a cumulative $220 billion even while the use of the American military has increased.

At the same time, on the other hand, using the same year 2009 as the base, means tested poverty and other social welfare programs, as well as Social Security and Medicare have annually increased by at least $800 billion.

America needs critically important defense operations and maintenance, research, development and acquisition spending, all consistent with the current national security strategy. Without which security storms will gather, aggression will increase and bad actors like Iran, North Korea, Russia and China will multiply.

To remedy our defense shortfall looked at retrospectively, of the nearly $1 trillion in annual new revenue over the past decade the Federal government has collected, base defense spending needs 10-15% or roughly $100-$150 billion a year in new revenue. From 1996-2000, the budget was balanced, tax rates were cut, welfare was reformed and most interestingly, defense spending increased from $265 billion to $300 billion, or by 13%. A similar increase in the defense budget today would be a $90 billion increase, relatively equal to what defense hawks say is needed.

Is that too much to ask to fulfill the Constitution's requirement that we "provide for the common defense"? 

Help Us Grow with flower

Peter R. Huessy is President of Geostrategic Analysis and a guest lecturer at the U.S. Naval Academy. He was formerly Senior Fellow in National Security at the American Foreign Policy Council.


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