Fiscal Policy and Its Impact on Productivity Growth Chapter 18 Fiscal Policy and Its Impact on Productivity Growth

Economists disagree about the size of the Federal government, the relative proportions spent on national defense and social welfare, and the amount of progressivity in the tax code. We will not solve these problems to everyone’s satisfaction either. Nonetheless, there is still a basic core of principles with which almost all economists agree.

Core Rules of Fiscal Policy 1. The Federal budget should be balanced over the cycle, running deficits in recessions and surpluses during periods of overfull employment. 2. If that rule is followed, the size of the national debt is almost irrelevant. 3. Whatever taxes are collected, they should be levied in such a way to minimize economic distortion.

Core Rules, Slide 2 4. The private sector is inherently more productive than the public sector. Some fields, such as national defense or public safety, will always be proper government functions. Other fields, such as utilities, transportation, and communications, are proper private sector functions, although regulatory oversight may be needed.

Core Rules, Slide 3 The gray areas are found primarily in education and health care. Keeping these in the public sector creates inefficiencies, boosts costs, and in many cases delivers inferior services. Keeping them in the private sector means that many low-income people cannot receive the proper amounts of these services, and the profit motive may cause some to cut corners.

The Case for Vouchers One solution to these areas would appear to be ”vouchers”, in which everyone is given a certain amount of money to spend on these services. Although most economists favor vouchers, many politicians do not. Vouchers, in the form of food stamps, have generally worked well. The concept could be expanded to education and medical care; the size of the voucher could be reduced as income increased. Part of the medical care voucher could be used to buy insurance for catastrophic medical care; routine costs would be paid for directly by individuals, hence reducing the costs of paperwork.

What Kind of Tax Structure? The other controversial item is the progressivity of the tax structure. A flat tax is more efficient. But many believe it is also unfair. Yet the fact of the matter is that when social security taxes are included at the low end of the income scale, and exemptions and loopholes are included at the high end, the current system is very close to a flat tax. However, there are obviously too many vested interests who favor keeping the current structure.

Automatic and Discretionary Stabilizers Throughout this book we have stressed the importance of the fundamental identity I = S, and shown that recessions start when I falls below S on an ex ante basis. When that happens, much of the adjustment occurs through a decline in government saving. As a general rule, every 1% decline in the growth rate boosts the Federal deficit ratio by about ½%.

Automatic Stabilizers, Slide 2 Thus, for example, a drop in real growth from 4% to -2%, which is fairly typical for an average recession, would transform a balanced budget into a deficit equal to about 3% of GDP. This is a very positive development. If it did not occur, recessions would be much longer and more severe.

Discretionary Stabilizers If automatic stabilizers are a good idea, then perhaps discretionary stabilizers – temporary tax cuts or public works programs – are an even better idea. Yet they haven’t worked nearly as well. If tax cuts are temporary, they don’t change consumer or business spending very much. Public works projects have several drawbacks. First, they generally take a long time to get started. Major public works projects tend to stretch out into the boom. Also, they often turn out to be pork-barrel projects. By comparison, automatic stabilizers have the great advantage of disappearing as the economy picks up, and returning the budget to balance as full employment is approached again.

State and Local Budgets Unlike the Federal government, these must be balanced every year. So when the economy slumps, either taxes must be raised or expenditures must be cut. That is counterproductive in terms of ending the recession. The change is not quite as severe; during a recession, the total ex ante state and local government deficit ratio rises about 1%, compared to 3% for the Federal government. To balance the budget, taxes are raised, and many needed public services are cut. So why doesn’t the Federal government extend the concept of automatic stabilizers to the state and local level?

State and Local Budgets, Slide 2 The U.S. government tried Fiscal Federalism and revenue sharing in the 1980s, but it didn’t work. Much of the money went to wealthy suburbs who used it for frivolous projects. How about giving it to those facing the biggest deficits? That just encourages profligate spending. How about giving it to those most in need, defined as the poverty level or something. That encourages them not to tax themselves. How about only giving it to those who have made a valid effort to tax themselves first? That encourages too big a public sector. Apparently there are no easy answers, so nothing gets done. If the politics could be worked out, though, it would be a good idea from an economic viewpoint.

The Full-Employment Budget In 1961, the Council of Economic Advisors came up with the idea of a “full employment balanced budget” in order to emphasize that the budget should be in deficit during recessions as long as it “would have” been balanced at full employment. The idea was distorted by Nixon to create deficits at full employment, and since then has fallen into disfavor. Empirically, it is difficult to measure. Theoretically, though, the idea that the size of the deficit should be related to the gap between actual and full employment is still valid.

Who Will Pay for Social Security and Medicare When We’re All Old? Demographic trends are inexorable; the ratio of older to younger people will continue to rise. People live longer and use more new “miracle” drugs and life-extending procedures. Who pays for all this? That’s obvious. Our tax dollars. And yet it’s not quite that simple. Suppose the government ran ever-increasing deficits forever to meet these rising costs. By now everyone knows there is “no free lunch”. So what’s the catch?

Who Pays the Bills? First, let’s forget about the silly argument that the government will “run out of money”. The government never runs out of money. Second, higher deficits need not lead to higher inflation. We saw that in the 1980s in the U.S., and we see the same thing now in Europe and Japan, both of which have large budget deficit ratios but virtually no inflation. Actually the answer is simple. If the U.S., or any other country, spends more on consumption – including public sector consumption – it spends less on investment. That means capital stock does not grow as fast, and hence productivity growth is retarded. The standard of living does not rise as fast, or in an extreme case it actually declines.

Who Pays The Bills, Slide 2 The argument that “some day” we must pay back the national debt is also unsupportable. Every nation in the world has a sizable national debt; some are very healthy and some are very weak, but they all have national debts. The economic impact of the national debt is found elsewhere: the larger the deficit relative to GDP, the slower the productivity growth rate. It is the deficit that has this negative impact, not the debt per se.

Maximizing Productivity Growth From an economic viewpoint – as opposed to a political or social welfare viewpoint – the government sector should be structured to maximize productivity growth. In particular that means: Balanced budget over the cycle Smallest size consistent with political requirements Tax code should stimulate saving and investment rather than consumption Tax code and regulations should generate minimal distortion of economic incentives Enforce the rule of law, financial transparency, and economically sound antitrust laws.

Tax Code Incentives for Saving and Investment These would seem to be a good idea, but they should work in the sense that they really do increase saving and investment. They should not just be a series of tax shelter gimmicks that reduce taxes and leave saving and investment at the same amount that would have occurred. There is generally a tradeoff in the sense that (say) a targeted investment tax credit would boost the deficit and raise interest rates, hence partially offsetting the beneficial impact on investment. The two sides must be balanced.

The Economic Impact of Long-Term Capital Gains Tax Reduction Accounts for only a very small proportion of total Federal revenue. The main question is the degree to which capital gains tax reduction boosts the stock market, capital formation, productivity, real GDP – and hence government revenues; the so-called feedback effect. In the past, capital gains tax reduction has paid for itself by increasing the growth rate – one of the very few tax cuts for which that is true. The main opposition to this tax cut appears to be centered on the grounds that it will serve as just another tax break to the rich, who don’t need it.

Radical Tax Reform Flat Income Tax. All personal and corporate income, including forms of income that are now exempt, gets taxed once. No more deductions for health care, mortgages, charitable contributions, or anything else, except for a low-end income deduction. Value added, or national sales tax. Only consumption get taxed, saving does not. Some necessities, such as medical care, some food, rent, and mortgage payments, are exempt.

How a Flat Tax Works In 2003, before the Bush tax cuts, Federal personal and corporate income taxes would have been about $1 trillion. Total personal and corporate income would be about $10 trillion. Assume a low-end income deduction of $9,000 per person, which is about $2.5 trillion. That means $7.5 trillion is taxed. To raise the same amount of revenue, the tax rate on all income would be 13.3%. Assuming all states followed the same scheme, the flat state tax rate would be 4%.

Pros and Cons of a Flat Tax Admittedly, whether this sounds appealing or not depends on your income bracket. However, it is not true that the very rich would pay more; most of them receive most of their income from capital, which is already sheltered. The major beneficiaries would be those who earn relatively large salaries. Of course, accountants, lawyers, and mortgage brokers are dead set against it. That is to be expected. It is more puzzling why so few economists have endorsed the concept, since it would appear to end economically useless tax shelters, sharply reduce cheating, and end the current burden of paperwork.

The Value Added or National Sales Tax Total consumption is currently about $8 trillion (capital goods would remain exempt). However, almost half of that would probably be exempt, leaving a taxable base of $4 trillion. Hence the national sales tax rate would be about 25%. That is in addition to state and local sales taxes, so the total sales tax burden would be about 30%. On items such as cars, the tax would probably be paid. But there would probably be widespread cheating on personal services, and barter would increase sharply. Also, such a tax would be much more regressive than a flat income tax.

“Saving” Social Security The best way to pay for social security is by boosting the growth rate. At 4% growth, the system remains solvent; at 2 ½%, it runs out of money by mid-century. These facts are not in dispute; the argument is about how fast one can reasonably expect the economy to grow, and what role fiscal policy has in determining that growth rate.

Using Fiscal Policy to Boost Real Growth Rationalizing the tax structure to encourage saving and investment and reduce tax avoidance Modernizing the infrastructure A more economically defensible energy policy Rationalizing regulations on pollution abatement and control and occupational health and safety