Awakening the Giant: Strategies for restarting the U.S. economy

The old advice, “Keep your eye on the ball,” applies to current discussions of the U.S. economy. The country has been diverted from focusing on the immediate issue, which is jobs, to an issue of importance over the longer term—namely, deficits and the national debt. The claim that the national debt will bankrupt the country deserves serious consideration later but not now, in the short term. The claim that the debt hinders economic recovery by crowding out private investment is not currently significant. Private investors are not investing in new capital goods because there is insufficient demand for the output from those capital goods and thus low profit expectations. The reason is not primarily, as some claim, because the federal government is out-competing the private sector for available savings.

There is, however, one argument for making debt reduction a key issue now, and that argument is a psychological one that goes something like this: Investment by businesses, particularly small businesses, is driven by future profit expectations; large federal budget deficits increase uncertainty about the future stability of the economy, with the result that businesses invest less and hire fewer workers. This, in turn, impedes the economy from recovering. What is needed, proponents say, is a firm sign that the debt problem will be addressed. If this is believed, they say, businesses will be willing to invest and hire workers in the expectation that the future will be stable and prospects bright for future profits.

The major problem with this theory is that there is little undisputed empirical evidence to support it as an explanation for growth or the lack thereof. On the other hand, there is evidence to refute it. Ireland, for example, has pursued a deficit reduction program for the past two years, but the Irish economy has not improved at all. Rather, it has declined further than most, averaging 13 percent unemployment at the present time. Nevertheless, a number of European countries are pushing for debt reduction now. The argument cannot be ignored, and I will return to it.

The recession of the past three years has held back growth in income and, as a result, tax revenues. The normal expectation is that there should soon be three or four years of better economic growth, enough to reduce the deficit significantly. But the problem with that expectation is that the economic stimulus of 2009 was too weak, too small to kick-start the economy into a growth path that would absorb the unemployed and provide jobs for new entrants into the labor force. Now Congress (mainly Republicans and Blue Dog Democrats) is resisting any further stimulus on the grounds that it will worsen the deficit.

The undesirable prospect facing the nation is decade-long, Japanese-style stagnation of growth and employment or even a double-dip recession. The primary task at this time, therefore, is to provide further economic measures that will generate jobs and a growth in incomes that will result in increased tax receipts. This in turn will help reduce the deficit, though it will not be enough by itself.

Long-Term Deficit Reduction

In three to five years, attention will have to be given to the structural deficit problem, defined as a deficit at full employment. Continuing economic growth in the United States will require an increase in national savings (defined as personal plus business plus government plus foreign savings) by reducing the chronic federal budget deficit (which is “dis-savings”) to finance private and public investment.

An approach to deficit reduction in the long term that relies on economic growth to increase tax revenues is faced with a chicken-or-egg problem: economic growth is needed to lower the deficit, but deficit reduction is needed to ensure long-term economic growth. Though control of expenditures must be part of the solution, neither “natural” growth nor spending cuts can of themselves eliminate the deficit. It follows that tax increases are also needed. In economic terms, the deficits resulting from the ill-advised tax cuts of the early 1980s and the early 2000s are dis-savings. They have lowered the total national savings available to finance long-term investment in the economy, the source of productivity gains and economic growth.

Except for the last years of the Clinton administration, the continuous deficits over the past four decades have forced a reliance on foreign savings for U.S. domestic investment, resulting in increasing trade deficits.

Fair Tax Increases

One must conclude that while deficit reduction is not the primary problem at this time—creating jobs is—deficit reduction is a serious problem for the long term. The Obama administration would do well to signal now that it is thinking and planning how best to reduce the deficit when the time comes to do so. This is where values are crucial in making the best choices regarding tax increases and cuts in spending.

Since economic institutions and policies have a major impact on human dignity, they raise not only technical concerns but moral concerns as well. As the National Conference of Catholic Bishops argued in the very first paragraph of its 1986 pastoral letter “Economic Justice for All,” every perspective on economic life that is human, moral and Christian must be shaped by three questions: What does the economy do for people? What does it do to people? And how do people participate in it? In addition, the bishops argue that in pursuing the common good, special concern must be given to the economy’s impact on the poor and powerless because they are particularly vulnerable and needy (No. 24). Equity, then, is an important factor in deciding how taxes are to be raised and expenditures reduced.

Two arguments are typically made against raising taxes: first, that citizens are already overburdened and second, that more taxes will reduce incentives to save, invest and work. In fact the available empirical evidence supports neither contention. The United States and Japan have the lowest rate of taxes (federal, state and local) out of income (G.D.P.) among the major industrial countries: 27 percent and 28 percent compared with an average of 45 percent for Europe. The excessive-burden argument against tax increases is therefore unpersuasive.

What about the argument that high taxes work as a disincentive that slows economic growth? When cross-country studies are used to measure economic growth for industrial countries in comparison with tax rates, there is no undisputed relationship. Some high-tax countries grow rapidly; others grow slowly. It is the same for (relatively) low-tax countries. Econometric attempts to tease out a relationship have led to mixed results with no clear-cut outcomes. Some years back Robert Barro of Harvard University found a relationship, and a few others have done so after him; but many studies find no relationship. Empirical studies appear to indicate that higher taxes do have a small effect on investment, but the results are murkier in terms of any effect on savings and work.

Why do Americans resist taxes more than others? The major reason for low tax rates probably has to do with U.S. political culture: Americans have always been more suspicious of government than Europeans. President Ronald Reagan, who had a visceral, ideological distrust of government, played on that suspicion to convince the public that taxes were too high and government spending wasteful. President George W. Bush learned from his father’s election defeat that reducing taxes, not raising them, was a winner. A politician running for office who advocates more taxes takes an enormous risk.

New Revenue Sources

From my viewpoint as an economist concerned for the common good, the Reagan and Bush tax cuts, coupled with dramatic increases in military expenditures, have led not only to persistent structural federal deficits but also to a record widening of the income and wealth distribution between the rich and the poor. In the near future, tax increases will be needed to help close that structural deficit. Increasing the progressivity of the federal income tax is an important step, but other options ought also to be part of the political dialogue.

First is the adoption of a value added tax system for the United States. An exemption for basics (food, housing, medical care) would reduce the regressivity inherent in any such excise tax. The overall level of income taxes could be reduced (while increasing progressivity) as an incentive to accept a VAT. It would be easy to share the VAT revenues with states and local governments to carry out needed programs. An added advantage is that the tax would fall on consumption rather than income, thereby providing some incentive for savings.

Second, increased taxation of gasoline could raise additional revenues and encourage conservation in its use. U.S. gasoline prices are still among the lowest among industrial countries and, in real terms, not significantly higher than they were before the 1973 oil crisis. The following inflation-adjusted gasoline prices are on an annual basis: 1958 $2.24; 1968 $2.11; 1978 $2.16; 1988 $1.75; 1998 $1.35; 2008 $3.23; and 2009 $2.28. If additional gas taxes were used partly to subsidize public transportation, it could be of real help to the poor.

Third, a good case can be made for a securities transfer excise tax. Such a tax could raise an estimated $100 billion a year in revenue and would discourage dubious short-term, speculative practices while fostering a more stable supply of long-run capital funds. Lawrence Summers offered the following opinion on this in an article published in the 1980s: “Such a tax would have the beneficial effects of curbing instability introduced by speculation, reducing the diversion of resources into the financial sector of the economy, and lengthening the horizons of corporate managers.” In a recent interview, however, Summers, currently assistant to the president for economic policy and director of the National Economic Council, has backed away from supporting such a tax, maybe for political reasons as much as for economic ones.

Reduction of Expenditures

If one looks at the 2010 federal budget, one sees that three expenditure items dwarf all the others: Social Security ($695 billion), Medicare plus Medicaid ($743 billion) and military expenditures ($664 billion). Social Security appears politically untouchable at this time, and, in addition, it is paid out of a separate fund that has had a surplus every year and has not required subsidy from the federal budget. In fact, the Social Security surplus has been used to cover the federal budget deficit through the purchase of government bonds. There are real limits to military reductions as long as the war in Afghanistan continues. The new health care bill may or may not reduce medical costs, but reductions are not even calculated to begin until 2014. The belief that expenditure reductions alone can substantially lower the deficit, therefore, is mistaken.

How can federal expenditures be reduced? In the very near term the Social Security fund will move from a surplus to a deficit. Government will have to take corrective measures to restore sustainability—measures like reducing the inflation indexing and fully taxing benefits. The government and the public will have to face up to end-of-life issues in Medicare and Medicaid. Currently, medical expenditures in the last six months of life absorb nearly a quarter of all medical expenditures. Tort reform for medical malpractice suits is needed to stop defensive medical practices. Finally, voters must rethink whether it is necessary or feasible for the United States to carry a defense budget so much greater than those of other nations.

The economic problems confronting the American people are real and extremely serious. In the near term, it is proper for the United States to continue the deficit and even increase it through added stimulus spending. The economy needs policies deliberately aimed at overcoming stagnation and promoting equitable and sustainable growth, while also protecting the environment. In the longer term, however, we cannot achieve any of these goals, nor can we contribute to global economic stability as long as we suffer from the fiscal constraints imposed by the trade and federal budget deficits.

Many Americans are already correctly convinced that there are no painless solutions. In practice, all workable programs will meet opposition from powerful special interests. Yet they must be enacted and carried out despite deep philosophic differences among the American people over such issues as free markets versus government intervention, individual freedom and responsibility versus community obligations and so on. The times, in short, demand real political leadership. As Americans we must expect it and require it of our representatives.

Prof. Wilber will be answering readers’ questions about his article on Thursday October 14. Questions can be posed in the comments boxes below. To read this article in Spanish click here.

This article appears in October 18 2010.