1. Jeffrey Frankel Harpel Professor of Capital Formation & Growth Back to School on the Budget: History & Arithmetic Senior Executive Fellows March 14, 2011

2. In September 2010, the NBER Business Cycle Committee announced that the trough of the recession came in June 2009 which marked the end of the longest & most severe recession since the 1930s. As usual, we were attacked both for not having declared the obvious trough earlier, based on the rule of 2 consecutive quarters of positive growth, and also for not waiting until the economy was better which showed we were “out of touch with reality.”

3. 3 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction Quarterly dates are in parentheses Peak to Trough August 1929 (III) May 1937 (II) February 1945 (I) November 1948 (IV) July 1953 (II) August 1957 (III) April 1960 (II) December 1969 (IV) November 1973 (IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV) March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 2001 (IV) 43 months 13 8 11 10 8 10 11 16 6 16 8 8 18 Average, all cycles: 1854-2001 (32 cycles) 1945-2001 (10 cycles) 17 10 June 2009 (II)

4. National output shows the trough Peak Trough

5. 5 Danger of a double-dip? There could always be new shocks: There could always be new shocks: Sovereign debt contagion, Sovereign debt contagion, spreading from Greece, Ireland… spreading from Greece, Ireland… Hard landing for the $ Hard landing for the $ Geopolitical/oil shock… Geopolitical/oil shock… I put the odds of a double dip recession as small. I put the odds of a double dip recession as small.

6. 6 Time to enact return toward fiscal discipline The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. Tax revenue Tax revenue Let President Bush’s tax cuts expire for the rich in 2013 Let President Bush’s tax cuts expire for the rich in 2013 Introduce a VAT or phase in auctioning of tradable emission permits Introduce a VAT or phase in auctioning of tradable emission permits Curtail expensive and distorting tax expenditures Curtail expensive and distorting tax expenditures E.g., Tax-deductibility of mortgage interest E.g., Tax-deductibility of mortgage interest All politically very difficult, needless to say. All politically very difficult, needless to say. Any solution requires: Any solution requires: Honest budgeting (e.g., Iraq war on-budget, etc…) Honest budgeting (e.g., Iraq war on-budget, etc…) Regime of Shared Sacrifice Regime of Shared Sacrifice Wise up to politicians who insist on doing it entirely on the spending side & but who raise overall spending when they get the chance. Wise up to politicians who insist on doing it entirely on the spending side & but who raise overall spending when they get the chance.

7. Short fiscal history: The 1980s In 1981, the newly elected Ronald Reagan complained he had inherited (almost) $1 trillion of national debt, as $1,000 bills stacked up, the debt would reach 67 miles high. Reagan’s policy: sharp tax cuts (& rise in defense spending) The claim: budget surpluses would result. The reality: record deficits that added to the national debt a 2 nd trillion in his 1 st term a 3 rd trillion in his 2 nd term a 4 th trillion when G.H.W. Bush initially continued the policies (“Read my lips, no new taxes.”)

8. Fiscal history, continued : The 1990s The deficits were gradually cut, and then converted to surpluses by the end of the 1990s. How was this accomplished? Regime of “Shared Sacrifice” --3 key policy steps. 1990: GHW Bush agreed spending caps, taxes, & PAYGO 1993: Clinton extended the policy. 1998: As surpluses emerged, “Save Social Security first.” Strong growth in late 1990s.

9. Fiscal history, continued : The 2000s The Shared Sacrifice regime ended the day G. W. Bush took office in 2001. He returned to the Reagan policies: Large tax cuts together with rapid increase in spending (triple Clinton’s) Not just in military spending (e.g., Iraq & Afghanistan), but also domestic spending: discretionary + Medicare drugs benefit. Just like Reagan, he claimed budget surpluses would result. Just like Reagan, the result was record deficits: The national debt doubled. I.e., GWB left more debt than his father + Reagan + 39 predecessors

10. On what basis do “fiscal conservatives” claim that tax cuts lead to budget surpluses? (1) Tea Party logic: Claim: We can do it by cutting Head Start & foreign aid. I.e., repeal the Laws of Arithmetic. (2) The Laffer Hypothesis: Claim: Tax rate cuts raise income so much that tax revenue goes up. (3) “Starve the Beast” Claim: Tax revenue decline will force spending cuts. “Congress can’t spend money that it doesn’t have.”

11. Goal of eliminating budget deficits Threats of a government shut-down, either when a continuing resolution is needed to keep the government operating, or when an increase in the national debt ceiling is required. Description of showdown as a high-stakes game of chicken is right. But at least some of the Tea Partiers say that their goal is literally to avoid an increase in the debt ceiling – not just as a bargaining ploy or abstract goal, but they want to cut spending so sharply that there is no more need to borrow. Similarly, Senators Mike Lee (Utah) & John Kyl (Ariz.) have revived proposals for a balanced budget amendment.

12. How far can we get by cutting spending? Total federal spending = $3 ½ trillion in round numbers. That spending minus tax revenue left a budget deficit of $1.3 trillion in FY 2010. Most Republican congressmen want to exempt defense & senior-related spending (Soc.Security & Medicare), to make all the cuts in non-defense discretionary spending. That was their official platform in November’s election. Aside from Ron Paul, a genuinely sincere libertarian. How much would we have to trim non-defense discretionary spending to balance the budget?

13. How far can we get by cutting spending? continued Start by eliminating all foreign aid. Foreign aid is only about 1% of total outlays, not 25% as people think. Next imagine zeroing out all of veterans’ benefits and all federal spending on education & transportation. That includes programs so popular that the congressmen voting for them would lose re-election. But some of the freshmen say they are willing to pay that price. We are only up to 6% of total outlays. Now eliminate all non-defense discretionary spending: parks, weather service, food safety, SEC, FBI, border patrol, politicians’ salaries… everything ! Does that close the gap? It only gets you half way there! Conclusion: Domestic discretionary spending is not where the big bucks are.

14. These 4 categories = 6% of outlays

15. The arithmetic works out quite simply. Of the $3 ½ trillion in federal outlays, 1/5 is non-defense discretionary spending. Another 1/5th is defense. Social security is the third 1/5th. Medicare is the fourth 1/5th slightly less now, but far far more in the future. The last 1/5th is interest on the debt (which will also grow enormously in the future) plus other entitlements.

16. 1/5 + 1/5 + 1/5 + 1/5 + 1/5

18. The arithmetic works out quite simply, continued. Numerically speaking, we would have to eliminate not just all non-defense discretionary spending, but also all defense. Or else all social security spending but still collect the payroll taxes that are supposed to fund it! Or else all Medicare spending. The unmistakable implication: a solution to our long-term fiscal problems must involve some sharing of sacrifice among each of these 5 categories, and increased tax revenue as well.

19. Admittedly, the Republican leadership’s goal for the current fiscal year was to reduce domestic spending by “only” $100 billion. But the freshmen’s position: this goal is not enough. At the same time, they can’t come up with that much in specific cuts that they are willing to put their names to, let alone enough to offset the Dec. extension of Bush tax cuts, let alone anything like budget balance. Why? The familiar reasons: domestic discretionary spending is not where the money is.

20. Reasonable medium term goals: raise taxes as a share of GDP at least to 18%, = what it was during the Reagan administration, & lower spending to 23% = what it was then as well. Of course these two numbers still leave us with a deficit of 5% of GDP, = Reagan’s record. It will take us much longer to get back to the fiscal rectitude of Clinton. It is not possible to eliminate the need to borrow, in the short run.

22. Ten years ago, if the country thought it was important enough to protect any single category against belt- tightening in the long run - say social security or taxes - it would have been arithmetically possible, by making the cuts elsewhere. But we no longer have the luxury of such choices after the legacy of the last decade — after the effects of mammoth tax cuts (2001 & 2003), two wars (2001, 2003), the Medicare prescription drug benefit (2003), and the severe financial crisis & recession (2008). Starting from our current position, each of the 5 components must play a role, along with taxes.

23. The US public discussion is framed as a battle between conservatives who philosophically believe in strong budgets & small government, and liberals who do not. “ Conservatives, ” “ liberals, ” & the media all use this language. Not the right way to characterize the debate. [1][1] (1) The right goal should be budgets that allow surpluses in booms and deficits in recession. (2) The correlation between how loudly an American politician proclaims a belief in fiscal conservatism and how likely he is to take genuine policy steps < 0. [1][1] Never mind that small government is classically supposed to be the aim of “ liberals, ” in the 19th century definition, not “ conservatives. ” My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “ illiberal. ” “ Republican & Democratic Presidents Have Switched Economic Policies ” Milken Inst.Rev. 2003. “ Republican & Democratic Presidents Have Switched Economic Policies ” Milken Inst.Rev.

24. Three pieces of evidence to support the claim that “ fiscal conservatives ” are not: (i ) The voting pattern among the 258 Congressmen who signed an unconditional pledge not to raise taxes: As of 2004, they had voted for more spending than those who did not sign the pledge. [2] [2] (ii) The pattern of spending under different presidents. [3] [3] (iii) The pattern of states whose Senators win pork & other federal spending. [4] [4] [2] William Gale & Brennan Kelly, 2004, “ The ‘ No New Taxes ’ Pledge, ” Tax Notes, July. [2] The ‘ No New Taxes ’ Pledge [3] JF “ Snake-Oil Tax Cuts, ” EPI, Briefing Paper 221. 2008. [3] “ Snake-Oil Tax Cuts, EPIBriefing Paper 221 [4] JF Red States, Blue States and the Distribution of Federal Spending, 3/31/2010. [4]Red States, Blue States and the Distribution of Federal Spending

25. Vs. the 1990s: The Shared Sacrifice approach succeeded in eliminating budget deficits, importantly by slowing spending. (ii) Spending & deficts both rose sharply when Presidents Reagan, Bush I, & Bush II took office.

26. (iii) States ranked by federal spending received per tax dollar paid in 2005 versus party vote ratio in preceding election Republican states take home significantly more federal $ (relative to taxes paid) than Democratic states “red” states “blue” states low inflow of US $ big inflow of US $

27. U.S. fiscal policy in 2010-2011, continued How does one take steps today to lock in future fiscal consolidation? Not by raising taxes or cutting spending today (see above); nor by promising to do so in a year or two (not credible). There are lots of economically sensible proposals for spending to eliminate, more efficient taxes to switch to, and “ tax expenditures ” to cut.

28. U.S. fiscal policy in 2010-2011, continued One big reform might work best: pass legislation today to put Social Security on a sound financial footing in the long term. It would consist of a combination of raising the retirement age just a little (in proportion to lengthening life spans) and slowing the growth of benefits for future retirees just a little (perhaps by “ progressive indexation). If Washington could fix Social Security, it would address the long-term fiscal outlook, yet would create no drag for the current fragile recovery.

29. 29 Spending Spending Cuts in farm subsidies for agribusiness & farmers, incl. ethanol Cuts in farm subsidies for agribusiness & farmers, incl. ethanol Cut unwanted weapons systems (a rare success: the F22 fighter) Cut unwanted weapons systems (a rare success: the F22 fighter) Cut manned space program… Cut manned space program… Social security Social security Raise retirement age – just a little Raise retirement age – just a little Progressively index future benefit growth to inflation Progressively index future benefit growth to inflation Raise the cap on social security taxes. Raise the cap on social security taxes. Health care Health care Encourage hospitals to standardize around best-practice medicine Encourage hospitals to standardize around best-practice medicine to pursue the checklist that minimizes patient infections, to pursue the checklist that minimizes patient infections, avoid unnecessary medical tests & procedures, avoid unnecessary medical tests & procedures, & standardize around best-practice treatment. & standardize around best-practice treatment. Lever: making Medicare payments conditional on these best practices. Lever: making Medicare payments conditional on these best practices. Curtail corporate tax-deductibility of health insurance, Curtail corporate tax-deductibility of health insurance, especially gold-plated. especially gold-plated.

30. When will US adopt the tough measures to get back to fiscal sustainability? Ideally, we would begin soon adopt measures that would begin to go into effect in 2012 and over the coming decades – repeating the 1990s success. Otherwise, in response to future crises, when it will be much more painful !

31. Appendix: More on the budget The two-part strategy that would have made sense at the end of 2010 What changes in American fiscal policy would be desirable if politics were not an obstacle? On the one hand, the economy is still weak. On the other hand, the U.S. can ’ t wait until the recovery is complete to tackle the long run fiscal problem. A two-part strategy: Steps to extend the fiscal stimulus, designed to maximize bang for the buck. Simultaneous steps to lock in future progress back toward fiscal discipline in the long run.

32. U.S. fiscal policy in 2010-2011, continued Maximizing bang for the buck ≡ fiscal stimulus that gives the most demand per $ added to long-term debt. Example that would minimize bang for the buck: proposal to make permanent the 2010 estate tax abolition. Almost as poorly targeted: proposal to prevent the Bush tax cuts from expiring in 2011 for those households > $250,000. If the stimulus has to take the form of tax cuts, then the best options are: extending President Obama ’ s “ Make Work Pay ” tax cuts, fixing the Alternative Minimum Tax, and extending the Bush tax cuts for those households < $250,000. Some business tax cuts could also give high bang for the buck. such as temporary credits for investment or hiring.

33. U.S. fiscal policy in 2010-2011, continued But spending boosts demand more than tax cuts do, because the latter are partly saved. Extend elements of the Obama stimulus such as infrastructure investment and giving money to the states so that they don ’ t have to lay off teachers, policemen, firemen, subway drivers & construction workers.

34. The national debt as a share of GDP Source: CBO, March 2011

35. Projected shares of budget in 2021 Source: CBO, March 2011