It's About How and When, Not Just How Much

We noted earlier this week that CBO's current law economic assumptions in the near-term do not look very stellar, especially in 2013 when the economy is scheduled to absorb a large fiscal shock as a large number of tax cuts expire and the "sequester" resulting from the failure of the Super Committee cuts spending automatically across-the-board. As a result of these abrupt changes, CBO estimates a paltry 1 percent growth in real GDP between 2012 and 2013 and it estimates the unemployment rate will actually increase.

At face, these estimates highlight the potential pitfalls of deficit reduction, but in fact they highlight the need to enact a smart and thoughtful plan to reduce the debtas opposed to a stupid and mindless plan. While current law deficit reduction would put a damper on short-term growth, CBO finds that it would improve growth over the long-run -- by 0.1 to 0.2 percent annually in 2022 alone over the alternative scenario. Meanwhile, CBO makes it quite clear that our current policy track is unsustainable, explaining that:

"[Under current policy assumptions] the amounts the federal government would be required to borrow would be unsustainable...Large budget deficits and burgeoning debt would reduce national saving, thus leading to higher interest rates, even more borrowing from abroad, and less domestic investment—which in turn would suppress output and income in the United States...[and] also would boost the likelihood of a sudden fiscal crisis."

If policymakers limit themselves to either continuing current policies or else allowing the tightening under current law to take effect then they face a trade off between short and long-term prosperity. But there is a third option: we can enact a smart and well-thought out deficit reduction plan today which phases in gradually and has an eye toward economic growth; in doing so, we could balance the short and long-term needs of the country.

Last September, we called for the Super Committee to come up with a deficit reduction plan that would not only "Go Big," but also "Go Smart". That means focusing on at least two things -- the timing of the deficit reduction and its composition.

 

The Timing

When it comes to deficit reduction, timing is (almost) everything. When the economy is weak -- and particularly in the near-term -- too much deficit reduction can cause some contraction. Over the longer term, however, deficit reduction is necessary in order to avoid "crowding out" productive investment -- the result of deficit reduction is a marked increase in economic activity.

In analyzing the effects of continuing current policy -- that is cancelling the sequester, renewing all the tax cuts (including AMT patches), and freezing Medicare physician payments to avoid a 27 percent cut -- CBO shows a near-term improvement (relative to current law) but a weakened economy over the medium and long term.

Effect of Continuing Current Policy on Current Law Economic Projections
  2012 2013 2022
Change in Real GDP Growth (Q4 to Q4) 0.5% 1.6% -0.2%
Change in Real GDP Level 0.5% 2.1% -1.0%
Change in Unemployment Rate (Q4 Level) -0.2% -1.1% 0%

 

But why is the short-term economy projected to be so much weaker under current law? Basically, because current law hits the economy with all the deficit reduction at once. In 2013, alone, the plan would reduce the deficit by two percent of GDP in 2013 (relative to CRFB's Realistic Baseline). Policymakers could instead realize the economic gains of debt reduction over the medium and long-term while mitigating the short-term impacts on growth by gradually phasing in savings.

This isn't a groundbreaking approach, but one that many debt reduction plans have relied on, including the Fiscal Commission. That plan would do more to reduce the deficit in 2022 and over the longer term than current law would, but would avoid the pitfall of a huge immediate change in government tax and spending levels.

 

Note: Savings are rough and calculated from realistic projections of future deficits.

 

While savings should be gradually phased in, they should be enacted today. This is true for at least two reasons. First of all, most policy changes are best implemented through gradual change -- and the sooner we start the faster we can achieve savings once the economy recovers. More importantly, this country has a credibility gap it has to face. Markets must be reassured that the government has the capacity and willingness to pay down its debt over the long-term -- otherwise we run the risk of needlessly provoking a possible fiscal crisis. The risk of something like that probably doesn't impact CBO's economic forecasts, but it's a valid concern nonetheless.

Most economists think that by putting place a plan today, we can actually provide some help to the short-term economy through and announcement effect, and this effect can in turn buy us time to make changes more gradually.

 

The Composition

Timing is critically important, but so is the composition of a debt reduction package. Not only would current law call for sharp immediate spending cuts and tax increases, but it would do so in perhaps the worst way possible. On the spending side, cuts would be across-the-board within the discretionary budget and a small number of non-discretionary programs. Because of the exemptions under the sequester, these cuts would fall largely on government purchases and investments -- and would be made to each program irrespective of its economic value.  Don't get us wrong, discretionary cuts will need to be part of the solution -- and likely beyond what has already been enacted. But cutting deep into these programs while ignoring entitlements is no way to control long-term deficits nor promote economic growth.

On the tax side, meanwhile, current law revenue comes in large part from increasing marginal rates. In fact, the expiration of the 2001/2003/2010 tax cuts will mean higher tax rates at almost every level and for almost every activity. To be sure, the difference between a 35 percent top marginal rate and a 39.6 percent top marginal rate is not by itself going to tank the economy; but this method of revenue generation will have negative growth effects by reducing the incentive to work. Meanwhile, increased taxes on capital gains and dividends will reduce investment incentives -- putting further downward pressure on growth.

A "Go Smart" deficit reduction plan would avoid indiscriminate discretionary cuts and marginal rate increases and instead focus on finding the best ways to promote growth. Deficit reduction, in and of itself, would get us part of the way there -- for example CBO estimated that $2.4 trillion (over ten years) in generic deficit reduction would increase the size of the economy by 1 percent -- but we can and should go much further.

The current tax code is a mess, and can be improved to both generate revenue and promote growth. The Fiscal Commission, the Domenici-Rivlin task force, and others have all proposed tax reform plans which would substantially lower individual and corporate rates while generating revenue from repealing or reforming the many deductions, exclusions, and other tax expenditures in the code. According to a 2006 JCT study, a plan like this could increase the size of the economy by between one and two percent over the medium term.

On the spending side, meanwhile, we should be looking to cut various programs which are believed to hurt economic growth -- for example agricultural and other spending that lead to a misallocation of resources. We should also look to reduce spending in a way which will encourage work and investment. CBO recently studied the economic impacts of gradually raising the Social Security and Medicare eligibility ages, noting that a combined effect of raising them could boost the size of the economy by two percent by 2035 and by three percent by 2060.

Average Real GDP/GNP Increases from Various Reform Measures

First Five Years
Second Five Years 2035
$2.4 Trillion in Deficit Reduction  -0.1% 0.8% Unknown*
Individual Tax Reform (Top Rate of 27%) 0.8% 1.5% 1.6%
Reduction in Corporate Tax Rate (Top Rate of about 28%) 0.1% 0.3%  0.5%
Increase Medicare Eligibility Age to 67 by 2025   Unknown 0.1%^
Increase Social Security Normal Age to 70 by 2035 1.0%^
Increase Social Security Early Age to 64 by 2025 1.0%^

Sources: CBO and JCT.
*CBO states that in 2021, real GNP is 1 percent larger but that it grows over the long-term.
^CBO estimates that the combined effect of raising the three eligibility ages would be about 3 percent by 2060. 

But it's not just about savings. A huge upside of a comprehensive debt reduction plan is that it can create the budgetary space for lawmakers to increase investments in specific areas while finding savings in others, so long as savings are sufficient to also stabilize and reduce the debt trajectory. Investments in areas like education, infrastructure, and R&D can produce large economic payoffs down the road, and could be protected or even enhanced in a comprehensive fiscal plan.

* * * * *

We have made the point before that reducing the deficit isn't just about the magnitude of the plan, but also about the details of the plan. CBO's economic projections demonstrate that the "when" matters a great deal, and it is clear that the "how" is equally important as well. Economic growth will not solve our debt problems alone -- we need real policy changes for that -- but we have every reason to promote it to aid in debt reduction and in expanding economic opportunities for future generations.

Policymakers have a choice. They can rely on "mindless" and indiscriminate cuts with no regard for creating priorities and figuring out how to pay for them, or they can craft a well-thought-out debt reduction plan that sets the economy on a stronger economic path. Somehow, saying it's an obvious choice doesn't quite capture it.

Tasx Reduction

Why pick on folks who have worked forty or fifty years??   Stop giving money to oil companies - Raise taxes on companies that have assets overseas - reduce military spending - stop building military bases overseas - stop selling arms to other countries our kids will probably have to war against in the future - stop contracting with companies that force bad products on the government - convert all those tanks and planes sitting in the desert.

 

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