Tax Reform Solves Defense Spending Dilemma

by PETER HUESSY October 11, 2017


The chances are improving that we will finally increase the defense budget to a much-needed higher level. This will be welcome relief. If successful, the ability of our armed forces to quickly end conflicts and "win" the wars we set out to fight will improve markedly. And the manifold deficiencies now causing increased numbers of casualties in peace time training accidents can be repaired, saving lives and improving military readiness.

What's the new development?

Tax reform.

Let me explain.

First, we must make the case that defense spending should go up.

Remember all those claims saying the United States spends more on defense than the next dozen countries combined? And the accompanying narrative that as such there was no reason to increase the defense budget because we have all our national security bases covered?

As the Heritage Foundation recently explained, our two major military adversaries-Russia and China-when combined and adjusted for purchasing power actually spend an equal amount for their defense as the United States.

Heritage concludes "The cost of generating and sustaining relevant combat power is more expensive for the United States than for nearly any other country, especially when compared to major competitors like Russia and China. U.S. concerns for the safety, health, and financial security of its workforce; recruiting, training and sustaining a skilled labor force; and the impact of industrial operations on the environment impose costs not borne by most other countries"

In fact, the United States pays its soldiers, sailors, airmen and Marines far more than Russia and China. Our training and operational costs are greater primarily because when we put our military men and women in harm's way we better protect them. As well as civilian non-combatants. Both in a manner unparalleled in military history.

Thus, roughly two-thirds of our defense budget does not buy weapons nor research the new weapons over the horizon, but supports pay, readiness, and operations. 

Another key factor is our adversaries cleverly hide key parts of their defense budgets. China for example publishes nothing about the cost of its nuclear weapons and space operations. Russia, too, cooks its defense books.

On top of which, while our adversaries have been increasing their defense budgets and the power of their armed forces, the United States has over the past 8 years cut $1.2 trillion in defense cuts says former United States Senator and defense expert James Talent.

As a result, if the United States must surge its military force to protect our allies in Eastern Europe or the Republic of Korea, fully half of the Air Force airplanes will not be available. We don't have enough pilots and the planes are not sufficiently maintained. As a result, any fight will take much longer to win, cost more and see more casualties.

And it is not just our ability to wage war against ISIS for example that has suffered. Most ominously, for the past 27 years particularly since the end of the Cold War, the United States went on a prolonged procurement holiday and failed to modernize our most fundamental force-our nuclear deterrent.

What does that mean?

As USAF Maj Gen Garret Harencak explained, we avoided buying those upgraded nuclear technologies and equipment necessary to deter our nuclear armed adversaries. Our nuclear capable bombers are aging and will face increasingly formidable air defenses. Our Ohio-class submarines are scheduled to be at sea a record number of years and must then over time be taken out of service and replaced. And our land based Minuteman missiles are nearing a half century in service and need upgraded accuracy and enhanced reliability.

As the United States government repeatedly kicked the nuclear modernization can down the road, our leadership-with few exceptions--remained oblivious to the fact that our top enemies were modernizing their nuclear forces with great speed.

According to the Vice Chairman of the Joint Chiefs of Staff General Paul Selva, Russia will complete modernizing all three legs of its nuclear forces by 2021, some 6 years prior to the United States deploying the first of its new submarines, bombers or land based missiles.

The bad news is that all the US nuclear forces must be rapidly sequentially replaced and modernized over the next twenty years or we will go out of the nuclear deterrent business. The good news is that for the first time in nearly four decades, the United States has an approved plan to go forward with the nuclear deterrent modernization effort.

But the additional bad news is the pending and projected defense budgets are not adequate to support the plan.

That is why we need more for defense.

Both the Senate and House Armed Services Committees in Congress passed bills that in fact add to the defense budget the necessary funding to get the United States back on track. The full House and Senate overwhelmingly approved the legislation as well. Again, that is good news.

But there is a 2010 budget law that caps defense spending at a very low level. Even with an upward adjustment in 2014-5 of some $30 billion for defense over the caps, the shortfall remains, the readiness of the force continues to deteriorate and modernization is significantly curtailed.

And without a new budget agreement, defense spending has to remain seriously constrained as the Congressional appropriations committees-unlike the authorizing committees-- cannot pass any budget not consistent with the budget caps.  

The situation is further complicated due to the just completed fiscal year deficit approaching $600 billion annually, although projections show the debt may drop to $440 billion in the current fiscal year.

If Congress approves needed infrastructure investment and the significant billions now needed for Hurricane relief, it is not surprising that the accepted narrative is no budget relief for the military is possible.

However, what if this conventional wisdom is wrong? What if tax reform could secure more revenue not less? And with more revenue generated by greater economic growth, could not sufficient jobs be created so that when coupled with welfare and immigration reform, revenue available could more than meet our defense needs as well as simultaneously cut the deficit?

Let us first look at the history of tax reform for some clues.

When President Coolidge reduced the top tax rate to 24% from 77%, the boom in the economy lowered unemployment to less than 3%, balanced the budget and reduced our nation's total debt by half.

When in 1982  President Kennedy's proposed (enacted in 1964) to cut the top rate from over 90% to 70%, and all other tax rates by 20%, similarly the economy boomed and grew annually at more than 5% for 8 more years.

Unemployment dropped to 3.8%. Revenue to the government surged and in fact the budget was balanced by 1969.

These two tax reform efforts had two things in common: they were enacted while the economy was growing.  

Now the Reagan and Bush 43 tax reform efforts differed in that before the tax rates were cut, the economy was in a recession and thus the federal government was already losing revenue.

The conventional assumption has thus been that tax rate reductions (not the recessions) caused all the subsequent loss in revenue. So unless other taxes are raised or government spending is curtailed, tax reform that cuts tax rates is thought of as a sure revenue loser.

But is this narrative true? No, it is not.

For example, in 1981 Reagan cut the top tax rate from 70% to 50% and then subsequently in 1986 to 28%. All other tax rates initially cut 30%. During the 1983-89 recovery, revenue to the US government doubled.

The associated economic boom also created 20 million net new jobs, and stabilized the annual deficit at $150 billion a year in each of the administration's last three fiscal years. The economy on average grew at more than 4% a year, a significant improvement over the stagflation of the 1970's.

Under President Bush 43, tax rate reductions were also phased in between 2001-3 but prior to their taking effect, a recession had begun. First, there was the 2000-2 collapse of the high-tech stock market, then an economy slowdown late in 2000 and then third, the attacks of 9-11. Revenue to the Federal government dropped precipitously due to these three factors.

However, with tax reform rates kicking in over 3 years starting in late 2001, government revenue surged. Between 2003-7 tax revenue increased from $1.7 trillion to $2.6 trillion, with one year the growth exceeding $275 billion. This run-up in revenue remains the largest increase in revenue over any 48-month period in American economic history.

One further historical note. There was also another tax reform effort from 1996-2000. The Clinton administration and the Speaker Gingrich-led majority in Congress combined to cut tax rates on capital gains, institute a child tax credit, expand the earned income tax credit, and lower taxes on retirement programs.

Combined with welfare reform, revenue surged, the government balanced its books for the first time in three decades, jobs increased significantly and at the same time defense spending was restored from $265 billion up to $300 billion, or a 13% increase.

Taking these historical lessons into account, could tax reform be combined with restoring military spending all the while curtailing the deficit?

A first step would be to drop the assumption that economic growth can only average 2% for the next decade. Already, the 2017 second quarter economic growth beat expectations and grew at 3.1%. By comparison, the Reagan growth reached a peak of 7.4% annually and the Clinton era averaged 4%. So 3.1% is better than the gloomy 2% but certainly not out of line compared to previous robust recoveries.

As we noted earlier, the 2003-7, average growth in federal government revenue was $212 billion a year, and hit $275 billion in 2004-5. But that was at a growth rate of around 2% in the country's GDP.

According to CBO, says the Center for Budget Priorities, a growth rate of 3% over the next decade would generate an additional $300-350 billion a year in revenue. That compares to current projected growth in revenue of $200 billion a year which CBO predicts will continue for the next decade because they also assume economic growth will average a weak 2%.

If tax reform can juice the economy to grow at 3% a year, $150 billion a year in more revenue kicks in.

What if CBO, for example, can adopt such a dynamic look at the economy in making future projections of the effect of a tax cut? It is true that traditionally the CBO has adopted a relatively doom and gloom outlook when examining the impact of tax reform.

But that has changed. House Speaker Paul Ryan succeeded when he was House Budget Committee chairman in getting the revenue and economic growth estimates done by CBO to use what is known as "dynamic scoring". This is known as considering how changing tax rates, welfare rules, and other government policies affect the growth in the United States economy rather than assuming everything will remain business as usual no matter what are the tax rates or welfare rules.

This is very important. To pass tax reform with a simple Senate majority vote, a process of "reconciliation" must be used. This means that any tax changes cannot increase the deficit after an initial ten-year period. Otherwise tax rate cuts expire.

That is why the tax rate reforms of 2001 expired in 2010.

As part of the 2010 debate to extend certain tax rate cuts, a budget control act was also passed. This froze defense spending at relatively low levels for ten years in the hopes that some deficit reduction would be achieved, even if entitlements and the rest of the budget remained on automatic pilot.  

Adding to the gloomy deficit projections were the new heavy-handed health care and banking regulatory costs from the Affordable Care Act and Dodd-Frank. The result was despite a cumulative $10 trillion in deficit spending by 2016, and $28 trillion in total spending, economic growth averaged only 2% for all of 2009-16, the weakest recovery since World War II.

So why can't the Congress reasonably estimate that tax rate cuts will expand government revenue and allow the defense budget to get well?

Unfortunately, there remains a widely held assumption that tax rate reductions must consequently reduce revenue to the government. Thus, it is assumed deficits will increase unless tax reform is "revenue neutral".

And under the budget control act, getting rid of the budget caps requires that simultaneously the future projected deficits come down at least $100 billion a year-through both more revenue and less spending.

So, if anything, the political pressure would appear to be to increase tax rates under the assumption this would raise more revenue and then reduce deficits.

But I believe there are five unique circumstances today that allow tax reform and higher defense spending to work together. 

First, there is $2.5 trillion in American business profits parked overseas earned on sales abroad. Taxes have already been paid to the host country.

These funds have not been brought here for investment because the United States tax code would take another (on average) 42% of the profits. Unlike every other industrialized country in the world, the United States double taxes overseas business profits. In addition, our business income tax rate of 35% is already the highest in the industrialized world.

A new tax deal could significantly lower a one-time tax on the transfer of this $2.5 trillion windfall to the United States economy. In return, business could use the funds for new plant and equipment and infrastructure bonds, both of which would boost the economy and job growth significantly.

The second unique circumstance is that millions of small businesses in America pay tax at the personal rate (because business income passes on to the individual tax returns), they do not pay at the higher business income tax level.

But if the business tax is reduced to 15-20%, millions of small business owners will file tax returns paying the lower business income tax and not the higher personal rate. As a result, a surge in hiring and investment would occur as the United States became one of the best places to do business in the entire industrialized world for large and small business entrepreneurs alike.

Third, combine tax reform with reform of the Affordable Care Act and Dodd-Frank and health care and banking regulatory impediments to job growth disappear helping to further boost tax revenue.

Fourth, the GAO (Government Accountability Office) says that there is annually $144 billion in payments from Medicare and Medicaid and from IRS for fraudulently claimed health services and tax credits, respectively, which are increasing by $19 billion annually. Reducing a reasonable percent of this fraud would significantly boost revenue as well.

On top of that, and fifth, adopting a work requirement for welfare and replacing those aliens working illegally off the books with Americans working on the books, could increase government revenue and decrease government expenditures a combined $100 billion a year.

So how do the numbers add up?

CBO projects revenue of $43 trillion over the next ten years even with a low 2.1% average economic growth rate. Revenue starts at $3.4 trillion increasing to $4.99 trillion from 2017-2027, an annual growth in revenue of $160 billion to $212 billion.

But with 3% GDP growth, achievable with good tax reform, CBO says government revenue would grow annually on average by $350 billion a year, reaching well over $6 trillion and in fact bringing the budget into near balance based on current spending projections.

Add the benefits of lower spending due to immigration, welfare and regulatory reform, and certainly upwards of $100 billion a year in government spending can be eliminated.  

Then add in a notional but reasonable reduction of 30% in the tax fraud identified by GAO and an additional $43 billion in federal spending is avoided.

Adding these notional elements together yields $493 billion a year in combined less government spending and greater government revenue.

This is more than adequate to pay for the annual increase in our growing Medicare and Social Security entitlement programs, all other domestic non-defense government programs, and "pay for" the proposed tax reforms using unrealistic static scoring preferred by CBO and the gloom and doom media brigades.

What about defense? An increase of $60-70 billion a year in new defense spending above the FY17 level can also be accommodated by using just 12-14% of the new revenue generated by a growing US economy each year coupled with government reforms outlined here.

This is compatible with the 13.2% increase in defense spending Congress approved on a bi-partisan basis between 1997-2000 when the country also reformed welfare, balanced the budget and cut tax rates.

To attract sufficient Senate votes, we probably should couple defense spending increases with needed additional funding (private and government) for cyber and border security, long term health care research at NIH and nation-wide infrastructure. A notional $30 billion increase in such spending could be offset with other cuts.

And finally, under current law, any tax agreement must also for the next decade and beyond, reduce the deficit by at least $100 billion a year.

 Combined, all these elements-tax rate cuts, maintaining entitlement obligations, defense spending increases, border security and infrastructure funding--would utilize $360 billion out of the $486 billion in available new revenue or less spending.

This would certainly allow significant additional debt reduction.

Most importantly, we could finally rid ourselves of the presumption that tax rate cuts mean only that government revenue is lost. Instead, we can see tax reform as a transfer of revenue from the US Treasury to the pockets of American workers-who earned it in the first place.

And it is not as if the money will not be spent or invested. The money would still be spent but American workers would decide how to do so, not government bureaucrats. But with the consequent growth in the US economy from investment, newly employed Americans would be sending money to Washington for the first time while criminal fraud and wasteful spending can be curtailed.   

Thus, if we are smart, we could simultaneously reform welfare and change the immigration laws to protect our security, build an infrastructure worthy of a 21st century industrialized economy, while putting millions of Americans to work. Would not this help transform much of America's poverty stricken-urban environment, its decaying rust belt and stagnating rural landscapes?

And in short, make America great again!

Peter R. Huessy is Director for Strategic Deterrent Studies at the Mitchell Institute for Aerospace Studies as well as President of Geostrategic Analysis, a defense consulting firm he founded in 1981. He is also a guest lecturer on nuclear deterrent policy at the U.S. Naval Academy and formerly Senior Fellow in National Security at the American Foreign Policy Council and JINSA.


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