Two months ago, Cato published a study by economist Benjamin Zycher, a senior fellow at the Pacific Research Institute, that showed that military spending contributes very little to GDP growth, and concludes that cuts would have very little long-term impact on GDP. On the contrary, Zycher estimates that cuts on the order of $100 billion a year would reduce costs in the wider economy by $135 billion per year. I wrote about that study when it was published here.

These findings conflict directly with two studies prepared for the Aerospace Industries Association (AIA) by George Mason University Professor Stephen Fuller. In October 2011, Fuller argued that a reduction of $45 billion in DoD procurement spending would result in a decline of about $86.5 billion in GDP in 2013, and the loss of 1,006,315 full-time, year-round equivalent jobs. Earlier this year, in July, Fuller expanded his research to include the effects of sequestration on both defense and non-defense spending. He concluded that such cuts will reduce the nation’s GDP by $215 billion, and cost 2.14 million jobs. Interestingly, Fuller’s second study concludes that cuts to non-defense spending will have a greater impact on economic activity than defense spending cuts.

As defense spending advocates continue to make the case against sequestration (or, to be more precise, that portion of sequestration that applies to the Pentagon) they have relied heavily on Fuller’s research to buttress their arguments. In his acceptance speech before the Republican National Convention Mitt Romney asserted that the president’s “trillion dollar cuts to our military will eliminate hundreds of thousands of jobs.” The GOP platform claims “Sequestration [would accelerate] the decline of our nation’s defense industrial base,…resulting in the layoff of more than 1 million skilled workers,” and later contends “If [Obama] allows an additional half trillion dollars to be cut from the defense budget,” that would harm “our national security and a struggling economy that can ill afford to lose 1.5 million defense-related jobs.”

There are two problems with these claims. First, they imply that the Pentagon’s budget has already been cut deeply and that the Obama administration’s current plans include even deeper cuts. It hasn’t, and they don’t. The Pentagon’s base budget in 2012 is roughly equal to that in 2011, and total military spending (including the cost of the wars) is near historic highs in inflation-adjusted terms. And current projections call for the Pentagon’s base budget to rise slightly above the rate of inflation; by 2022, it will be 17 percent higher than it was in 2002. Even under sequestration, which President Obama and the Democrats hope to avoid by convincing Republicans to cave on higher taxes, the Pentagon’s budget in 2013 would be roughly equal to what we spent on it in 2007. (I’ll be discussing sequestration with Dan Mitchell at a Cato Hill Briefing next week, Thursday, October 18th. Details here.)

But the more important flaw pertains to the perennial problem of the seen and the unseen. Spending on military hardware, bases, or the salaries of men and women in uniform, is visible, tangible–and, crucially, controlled by politicians. Spending by individuals in the private sector is the true driver of economic activity, but is less visible, largely because politicians have little incentive to call attention to it. No politician can credibly boast that he or she was responsible for my purchases this morning (gasoline and coffee, for the record). Nearly every politician claims credit when my tax dollars fund a new military facility located in his or her district or state, and nearly all of them will fight mightily to prevent bases and plants from closing, and boast about it if they succeed.

I wish that they were equally boisterous when they succeeded in releasing resources–including both tax dollars and talent–back to the private sector. That is what happens, or should, when the Pentagon’s budget declines, and the savings are not simply plowed into other government programs.

This Friday, October 12th, at Noon, Benjamin Zycher and Stephen Fuller will appear together at Cato to discuss their research. They will be joined by the Wall Street Journal’s Stephen Moore. More details available here. It is not too late to register, but you can watch online if you are unable to join us in person. I’m looking forward to a lively and substantive discussion.

I’ve narrated a video on why Keynesian economics is bad theory, I’ve also narrated a video specifically debunking Obama’s failed stimulus, and I’ve put together a post with data from the Minneapolis Fed showing how Reaganomics worked far better than Obamanomics.

But this video from the Center for Freedom and Prosperity Foundation does all that—and more—in only about six minutes.

By the way, for those who like gory details, a previous video in the CF&P Foundation’s Economics 101 series looked at how the so-called stimulus was a rat’s nest of waste and corruption.

Not that anybody should be surprised. Big government facilitates corruption in the same way that a dumpster attracts rats and cockroaches.

My concern is long-term trends. Politicians should be complying with Mitchell’s Golden Rule, which means reducing government spending as a share of GDP (to put it in terms that make economists feel warm and fuzzy, gov’t exp/​GDP should be decreasing).

What irks me about Obama is that he wants to increase the burden of government spending, which means the numerator in the equation is going in the wrong direction. And he wants class-warfare tax policy and more red tape, which makes it even harder for the denominator to move in the right direction.

And if that ratio continues to deteriorate, as both the BIS and OECD are predicting, then it’s just a matter of time before the United States becomes Greece.

A Wall Street Journal article by Arthur C. Brooks, president of the American Enterprise Institute, urges presidential candidate Mitt Romney to acknowledge two “simple facts” about income inequality. One is that “low-income Americans are struggling,” which is surely true by definition. The second is that “economic opportunity is declining.” The author scolds the Republican convention for being too cheerful about the facts, as though Romney never mentioned shrinking median income, or high poverty and unemployment.

That second “simple fact” (declining opportunity) is not simple and not a fact. When Mr. Brooks asserts that opportunity is declining, he means “mobility” supposedly declined before 2006 according to one source—a 12-page brief by Katharine Bradbury of the Boston Fed. But “mobility” is not at all the same as “opportunity,” because studies of this sort treat downward mobility the same as upward mobility. Bradbury is troubled by people making fewer big leaps from one fifth (quintile) to another, which Mr. Brooks likewise defines as declining opportunity; yet her data cannot distinguish ups from downs.

What is ostensibly being measured is the percentage of people in each fifth (quintile) of the income distribution who spend five or six years out of 10 in either the “same or adjacent” quintile. Bradbury compares three 10-year periods: 1976 to 1986, 1986 to 1996, and 1996 to 2006 and finds 27.4 percent remained in the poorest quintile during the earliest period and 25.9 percent in the most recent 10 years. Since that suggests increasing mobility for the poor, she switches to emphasizing how many remained in either the same “or adjacent” quintile. This permits Bradbury to argue that those in the poorest or richest quintiles “did not move very far.”

Switching to “adjacent” quintiles means anyone in the top or bottom quintile would have to leap all the way to the middle to be counted as having moved at all. Since those at the bottom or top can only move in one direction, Bradbury therefore finds (of course) that for “those in the poorest or richest quintile… mobility is quite low.” People in other quintiles can move either up or down, so their “mobility” appears higher by this peculiar definition, particularly during severe recessions.

It is unsurprising that there was greater movement (up and down) between adjacent income groups in 1976–86, since that period included nasty inflationary recessions in 1980–82, followed by four years of 4.8 percent economic growth. The 1986–96 period, by contrast, experienced a barely measurable slump in 1991, while 1996–2006 included the exhilarating tech boom of 1997–2000 and the perilous housing boom of 2004–2006. When the economy is rising steadily there is less risk of falling to a lower quintile, hence less movement (aka “mobility”). Since Brooks and Bradbury define income stability as “declining opportunity,” they would presumably define 1929–33 or 2008–2009 as periods of rising opportunity.

A more serious study of income mobility by Treasury economists Gerald Auten and Geoffery Gee in the June 2009 National Tax Journal found, “considerable income mobility in the U.S. economy over the 1987–1996 and 1996–2005 periods. Consistent with prior mobility studies, the data show that over half of taxpayers moved to a different income quintile and that roughly half of taxpayers who began in the bottom income quintile moved up to a higher income group by the end of each period. By contrast, those with the very highest incomes in the base year [the top 1 percent] were more likely to drop to a lower income group and the median real income of these taxpayers declined in each period. Economic growth resulted in rising incomes for most taxpayers over both time periods.” The largest percentage increases in real incomes were for those initially in the lowest income groups, while the most dramatic downward mobility was among those who had briefly occupied the top 1 percent. This evidence is consistent with my own work showing that rising income shares for the top 1 percent have been associated with falling poverty rates and vice-versa.

A Washington Post investigation found that 73 members of Congress have “sponsored or co-sponsored legislation in recent years that could benefit businesses or industries in which either they or their family members are involved or invested.”

Here’s the part that caught my eye:

When the House and Senate wrote their first set of modern ethics rules in the 1970s, in response to the Watergate scandal, they expressly prohibited members from engaging in legislative activities that would financially benefit them. But both chambers immediately carved out exemptions to the rule.

The greatest latitude was provided to lawmakers whose business interests aligned with major industries within their home states. “If a dairy farmer represented a dairy farming state in the Senate, and introduced, worked for, and voted for legislation to raise or maintain price supports for dairy producers, he would not fall under the strictures of this rule,” the Senate ethics manual says.

In other words, it’s a‑okay for members of Congress to help themselves to the Treasury’s vault so long as they intend to share the loot with the special interests back home.

This new Cato Institute Working Paper by Senior Fellow Alan Reynolds confirms recent studies which find little or no sustained increase in the inequality of disposable income for the U.S. population as a whole over the past 20 years, even though estimates of the top 1 percent’s share of pretax, pretransfer (market) income spiked upward in 1986–88, 1997–2000 and 2003–2007.

It has become commonplace to use top 1 percent shares of market income as a shorthand measure of inequality, and as an argument for greater taxes on higher incomes and/​or larger transfer payments to the bottom 90 percent. This paper finds the data inappropriate for such purposes for several reasons:

• Excluding rapidly increased transfer payments and employer-financed benefits from total income results in exaggerating the rise in the top 1 percent’s share between 1979 and 2010 by 23 percent because a growing share of other income is missing.
• Using estimates of the top 1 percent’s share of pretax, pretransfer income (Piketty and Saez 2003) as an argument for higher tax rates on top incomes or larger transfer payments to others is illogical and contradictory because the data exclude taxes and transfers.
• Using highly cyclical top 1 percent shares as a measure of overall inequality leads, paradoxically, to describing most recessions as a welcome reduction in inequality, because poverty and unemployment rates typically rise when the top 1 percent’s share falls, and fall when the top 1 percent’s share rises.
• Top 1 percent incomes are shown to be extremely sensitive (“elastic”) to changes in the highest tax rates on ordinary income, capital gains and dividends. Although estimates of the elasticity of ordinary income for the top 1 percent range from 0.62 (Saez 2004) to 1.99 (Moffitt and Wilhelm), those estimates fail to account for demonstrably dramatic responses to changes in the highest tax rate on capital gains and dividends.

Reynolds estimates that more than half of the increase in the top 1 percent’s share of pretax, pretransfer income since 1983, and all of the increase since 2000, is attributable to behavioral reactions to lower marginal tax rates on salaries, unincorporated businesses, dividends and capital gains. After reviewing numerous data sources, he finds no compelling evidence of any large and sustained increase in the inequality of disposable income over the past two decades.

In “The $5 Trillion Question: How Big Is Romney’s Cut” Wall Street Journal reporters Damlan Paletta and John D. McKinnon echo, once again, the journalistic convention of contrasting “the nonpartisan Tax Policy Center” with “the conservative American Enterprise Institute.” In the English language, the opposite of “conservative” is not “nonpartisan.” On the contrary, the phrase “nonpartisan” applies equally to the American Enterprise Institute (or Cato Institute) as it does to Tax Policy Center (TPC) — a front for the Brookings Institution and Urban Institute. To be “nonpartisan” does not mean non-ideological, unbiased or even competent. It simply means following a few rules so the IRS will allow the organization to receive tax-deductible contributions. Governor Romney wants to severely curb such deductions (including his own), which does not necessarily make the TPC a disinterested observer, even if there really were one or two closet Republicans (or even non-Keynesians) at the TPC.

The U.S. already cut marginal tax rates across-the-board by more than 20 percent in 1964 and 1984 (the 1981 law, like that of 2001, was foolishly phased-in). In both cases, the Table shows that revenues from the individual income tax were higher than before, as a share of GDP. The economy grew much faster too, raising payroll and corporate tax receipts. Until the TPC can explain how and why that happened, they cannot even pretend to predict that Romney’s more modest tax reform will lose any revenue, much less $5 trillion.  Incidentally, deductions were not significantly curbed in the tax laws of 1964 or 1981, or in the Tax Reform of 1986 (which merely substituted reduced itemized deductions for a much larger standard deduction). If Romney puts a cap on deductions, either as a percentage of AGI or as a dollar limit, the net effect of his plan would raise revenues, particularly from people like Warren Buffett and Mitt Romney (who deduct millions in charitable contributions).

The Tax Policy Center’s fundamental error is to assume no behavioral response at all to lower tax rates – an “elasticity of taxable income” (ETI) of zero. The academic evidence is that ETI is at least 0.4 for all taxpayers, as Martin Feldstein observed, mostly because ETI is above 1.0 for the top 1 percent, as I recently explained in the Journal. Cut top rates and the rich report more income; raise top rates and much of their income disappears — through reduced economic activity and increased avoidance.

In a violation of the 8th Amendment’s prohibition against cruel and unusual punishment, my brutal overseers at the Cato Institute required me to watch last night’s debate (you can see what Cato scholars said by clicking here).

But I will admit that it was good to see Obama finally put on the defensive, something that almost never happens since the press protects him (with one key exception, as shown in this cartoon).

This doesn’t mean I like Romney, who would probably be another Bush if he got to the White House.

On the specifics, I obviously didn’t like Obama’s predictable push for class warfare tax policy, but I’ve addressed that issue often enough that I don’t have anything new to add.

I was irked, though, by Obama’s illiteracy on the matter of business deductions for corporate jets, oil companies, and firms that “ship jobs overseas.”

Let’s start by reiterating what I wrote last year about how to define corporate income: At the risk of stating the obvious, profit is total revenues minus total costs. Unfortunately, that’s not how the corporate tax system works.

Sometimes the government allows a company to have special tax breaks that reduce tax liabilities (such as the ethanol credit) and sometimes the government makes a company overstate its profits by not allowing it to fully deduct costs.

During the debate, Obama was endorsing policies that would prevent companies from doing the latter.

The irreplaceable Tim Carney explains in today’s Washington Examiner. Let’s start with what he wrote about oil companies.

…the “oil subsidies” Obama points to are broad-based tax deductions that oil companies also happen to get. I wrote last year about Democratic rhetoric on this issue: “tax provisions that treat oil companies like other companies become a ‘giveaway,’…”

I thought Romney’s response about corrupt Solyndra-type preferences was quite strong.

Here’s what Tim wrote about corporate jets.

…there’s no big giveaway to corporate jets. Instead, some jets are depreciated over five years and others are depreciated over seven years. I explained it last year. When it comes to actual corporate welfare for corporate jets, the Obama administration wants to ramp it up — his Export-Import Bank chief has explicitly stated he wants to subsidize more corporate-jet sales.

By the way, depreciation is a penalty against companies, not a preference, since it means they can’t fully deduct costs in the year they are incurred.

On another matter, kudos to Tim for mentioning corrupt Export-Import Bank subsidies. Too bad Romney, like Obama, isn’t on the right side of that issue.

And here’s what Tim wrote about “shipping jobs overseas.”

Obama rolled out the canard about tax breaks for “companies that ship jobs overseas.” Romney was right to fire back that this tax break doesn’t exist. Instead, all ordinary business expenses are deductible — that is, you are only taxed on profits, which are revenues minus expenses.

Tim’s actually too generous in his analysis of this issue, which deals with Obama’s proposal to end “deferral.” I explain in this post how the President’s policy would undermine the ability of American companies to earn market share when competing abroad — and how this would harm American exports and reduce American jobs.

To close on a broader point, I’ve written before about the principles of tax reform and explained that it’s important to have a low tax rate.

But I’ve also noted that it’s equally important to have a non-distortionary tax code so that taxpayers aren’t lured into making economically inefficient choices solely for tax reasons.

That’s why there shouldn’t be double taxation of income that is saved and invested, and it’s also why there shouldn’t be loopholes that favor some forms of economic activity.

Too bad the folks in government have such a hard time even measuring what’s a loophole and what isn’t.