Monday, January 31, 2011

Economic Outlook (Part 3) -- Fiscal Policy

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here.

Federal tax receipts are now rising at double-digit rates, which is typical following a recession, as incomes and profits rise and more people go back to work. The federal budget could be balanced in 5 years if spending just stops growing.

Deficits of 9% or more of GDP are a serious drag on the economy. Government spending is the problem, more so than the deficit. When government spends money it does so much less efficiently than the private sector, thus squandering the economy's scarce resources. Contrary to popular (Keynesian) thinking, large deficits are not stimulative, they are contractionary. Reducing government spending would likely provide a big boost to the economy, since it would reduce the future expected burden of taxation and it would make the economy more efficient and productive.

There is no necessary connection between tax rates and tax revenues. In this chart, we see that a huge reduction in top tax rates (from 90% prior to 1955, to 28% in the late 1980s) did not reduce tax revenues as a % of GDP at all. Lower rates coupled with fewer deductions and a broader tax base are far more efficient ways of collecting taxes. Reducing the top marginal rate for as many people as possible is the best way to use the tax code to encourage work, investment, and risk-taking.

The level of federal debt has correlated negatively to interest rates for most of post-war history. Interest rates are primarily determined by the rate of inflation, which is the purview of the Fed. Only recently has the Fed been engaged in monetizing the federal deficit, and not coincidentally, there are signs that the level of debt and interest rates are more positively correlated now than at any time in the past. Should inflation rise, interest rates will likely follow, and the combination would make the debt burden much more serious than it already is.


W.E. Heasley said...

“Reducing government spending would likely provide a big boost to the economy, since it would reduce the future expected burden of taxation….”.

A much under appreciated point. Tax-time-horizons have a grand effect on expectations.

Public Library said...

This last chart is the canary in the coal mine....

J said...

Come on now, the UK under austerity just printed a negative GDP. Nobody is forcing "investors" (primary dealers) or the Federal Reserve to loan the U.S. government money.

Benjamin Cole said...

Fiscal austerity? Maybe it will work. Willing to try.

Monetary austerity? No way, Jack.

Japan has tried that for 20 years, and it ruined the nation.

BTW, if you want fiscal austerity, try contacting the USDA, VA, State Department, Transportation, Commerce, Interior, and Department of Defense. Good luck with your efforts to cut spending.

randy said...

The data points on the first chart showing spending and receipts as a percent of GDP are understated according to some experts that believe tax preferences should be treated as spending. See recent testimony from Tax Policy Center:

Spending-like tax preferences pose a challenge for how we think about the size of government. Analysts usually invoke official budget measures—revenues and outlays—when trying to measure the federal government. For example, we often hear that federal revenues have averaged about 18.1 percent of gross domestic product (GDP) over the past four decades, while outlays have averaged about 20.7 percent. But those measures are incomplete—and potentially misleading—if some tax breaks are effectively spending programs.

In some preliminary research, my Tax Policy Center colleague Eric Toder and I (2011) have tried to estimate how large the government is when we recognize that many (but not all) tax preferences are effectively spending programs. For fiscal 2007, we estimate that spending-like tax preferences amounted to 4.1 percent of GDP. Adding that to official outlays yields a broader definition of spending, 23.7 percent of GDP in 2007, about a fifth larger than the official 19.6 percent. Similarly, our broader definition of revenues—official revenues plus revenues foregone through spending-like tax preferences—is 22.6 percent of GDP rather than the official 18.5 percent.

These figures illustrate that conventional budget measures understate the extent to which federal fiscal policy affects economic activity. They also suggest that some policy proposals that increase revenues, as conventionally measured, may nonetheless reduce the size of government. If policymakers reduce the tax preference for employer-provided health insurance, for example, that would increase federal revenue but reduce the government’s role in private insurance markets. Advocates of smaller government are often skeptical of proposals that would increase federal revenues. When it comes to paring back spending-like tax preferences, however, an increase in revenues may actually mean that government’s role is narrowing.

Scott Grannis said...

randy: thanks for raising the issue of tax preferences. I agree wholeheartedly that we should do away with as many as possible. A broader tax base would not only give a lot more taxpayers some "skin in the game" when it comes to the size of government, but also would go a long way to making the economy more efficient. But as to whether we should reclassify tax preferences as spending or not is not going to change the fundamental problem, which is that the government is too big, too meddlesome, and is distorting the normal workings of the economy.