The Federal Reserve's efforts to help the economy recover through quantitative easing (QE), twisting, and tapering have made front page news without fail. Although it has gotten less attention, the Treasury Department has also been changing the way it finances the national debt to take advantage of lower interest rates, inadvertently counteracting some of the intended effect of the Fed's policies on the economy. That's exactly what a new Brookings working paper by Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers argues: during the past 5 years, the Fed and the Treasury have been "rowing in opposite directions."
In 2008, the Fed reduced interest rates to near zero in an attempt to help the economy grow. But nominal interest rates cannot go below zero, so conventional monetary tools stopped working. To further stimulate the economy, the Fed took extraordinary measures and began purchasing long-term government bonds and government guaranteed debt (like Mortgage Backed Securities, or MBS). These measures reduced the amount of long-term debt available for public investors and lowered long-term rates.
But while the Fed was engaging in these unconventional transactions, the Treasury was selling more long-term debt to lengthen the average maturity of the national debt, thereby locking in today's low rates and mitigating the risks of higher interest rates in the future, essentially providing a partial counterbalance to the Fed’s policies.
A new paper suggests that tax cuts that add to the deficit provide little boost to economic growth and may actually hinder it. Last week, the Tax Policy Center (TPC) put out a paper entitled “Effects of Income Tax Changes on Economic Growth,” summarizing the academic literature. According to the authors, Bill Gale from Brookings and Andrew Samwick from Dartmouth, the net economic impact of a deficit-financed income tax cut is either small or negative, with the negative effects of additional debt likely overwhelming the economic benefit of lower rates, particularly over the long term.
Tax cuts have the potential to grow the economy, but their benefit depends on how they are structured and financed. For tax changes to promote growth, changes should encourage work and investment through lower rates, efficiently encourage new economic activity (rather than providing a windfall for previous investments), reduce economic distortions, and create minimal (if any) increases in the budget deficit.
The key question is, how do you pay for tax cuts? If tax cuts are deficit-financed, the negative economic effects of debt will crowd out investment, which can outweigh any positive growth impact from the tax cut. CBO has found that an “Alternative Fiscal Scenario” representing roughly a $2 trillion increase in deficits over ten years would lead to a 7.5 percent smaller economy in 25 years, while a deficit reduction plan of $4 trillion would increase the size of the economy by 2 percent. Increased revenue has been a key part of many bipartisan plans for deficit reduction, including Simpson-Bowles and Domenici-Rivlin.
Importantly, however, the lack of growth from deficit-financed tax cuts is distinct from the effects of either tax reform, which pairs rate reductions with base broadening, or tax cuts that are financed through simultaneous spending reductions to reduce government consumption. Using base broadening to pay for lower rates avoids crowding out other investment, but would likely temper the economic gains because some base broadening can push up effective marginal tax rates on taxpayers who were taking advantage of the closed loopholes.
House Republicans plan to vote this week on a jobs package combining bills that would "build a robust economy and foster job creation." While promoting economic growth should be a top priority after a lackluster jobs report and a slow recovery, policymakers should also be fiscally responsible. Unfortunately, the House Republican approach would make the debt much worse. We've compiled the cost estimates for the various bills, and the package would cost more than $570 billion over ten years, before interest.
The package includes a combination of tax, spending, and regulatory changes, many of which could help to spur short or long-term economic growth. The majority of the costs in the legislation come from permanently extending and expanding a few expired tax provisions which focus on promoting research and investment. Unfortunately, the legislation would include over $570 billion of costs, but only $400 million worth of savings. Without offsets, the package will add substantially to the debt.
This increase in debt isn’t only bad for the fiscal situation; it also works against the exact purpose of the bill. As CBO has noted, a high national debt creates drag on economic growth by crowding out private investment, reducing output, and increasing interest rates. The package's care-free attitude towards increasing the debt will dampen any economic growth that would occur from the legislation.
As we've argued many times, if something is worth having, it is worth paying for. The fact that a package has the potential to promote growth does not mean we should allow it to add to the debt over the long run. In the past, we’ve suggested numerous offsets to pay for unemployment insurance, highway spending, extending tax provisions, veterans health care, or the Medicare "doc fix." Any of those, or any number of others, could be attached to this package to make it more fiscally responsible.
|Provisions in the September 2014 House Jobs Package
|Policy||Ten-Year Costs, 2015-2024
|Expand and make permanent bonus depreciation||$269 billion|
|Expand and make permanent the research & experimentation tax credit||$156 billion|
|Expand and make permanent 2013 levels of small business expensing (Section 179)||$73 billion|
|Change the definition of full-time employment from 30 to 40 hours/week||$46 billion|
|Repeal medical device tax||$26 billion|
|Make permanent two expired tax breaks relating to S Corporations||$2 billion|
|Exempt from the employer mandate servicemembers and veterans who already have health insurance||$1 billion|
|Codify standards for regulations that create private mandates||< $0.1 billion|
|Require agencies to submit a monthly report of proposed and final regulations||< $0.1 billion|
|Require major regulations to get Congressional approval||"significant"|
|Exempt most private equity financial advisors from SEC registration||negligible|
|Exempt certain merger & acquisition brokers from SEC registration||negligible|
|Streamline the process to obtain permits to extract critical and strategic minerals from public land||negligible|
|Permanently ban states and localities from imposing taxes on internet access||$0|
|Increase timber production on federal lands||- $0.4 billion [savings]|
|Total, House Republicans Jobs Package||$572 billion*|
One of the biggest stories in CBO's August budget update was the huge downward revision to expected spending on interest to service the debt, down by $615 billion in total through 2024.
Primarily, this revision stems from lower projected interest rates, resulting in $465 billion less spending over ten years. Another $90 billion came from technical changes (mostly from estimates of payments on inflation-protected debt securities), and $60 billion came from a lower debt burden as a result of all the revisions in the new baseline (a change known as debt service). The interest rate story is the most interesting, though, since it has the largest implications for the federal government's interest burden in the future.
Our analysis of the report noted that interest rates had been revised down both in the short term and the longer term. In 2014, the rate on ten-year Treasury notes is now expected to average 2.8 percent rather than 3.1 percent, and to stabilize by 2019 at 4.7 percent instead of 5.0 percent. CBO made a similar revision to projected three-month T-bill rates. As a result of these changes, interest spending was revised down by more than $30 billion through 2016 and by $50-65 billion annually in the 2017-2024 period.
This downward revision by CBO continues a recent trend of declining projections as interest rates have stayed depressed for longer and the economy has been slower to recover than CBO originally anticipated.
In its release this week of the economic effects of the President's budget, CBO found it would increase the size of the economy, mainly due to immigration reform. As a result, under the President's budget Gross National Product (GNP) would be about 2.1 percent higher in 2024 than before the enactment of the budget, though GNP per capita would be about 1 percent lower. Importantly, higher economic growth would lead to additional revenue collection and lower deficits. Because CBO accounted for certain economic effects of immigration in its analysis of the President's budget, the additional economic effects would actually increase the deficit by less than $100 billion over ten years.
In analyzing the economic impact of the President's budget, CBO finds six main ways in which the budget would affect economic growth:
- Increasing the size of the U.S. population, thus raising the number of workers;
- Increasing federal budget deficits in the short term, mainly through higher government spending, which would boost aggregate demand and the use of labor and capital;
- Reducing federal budget deficits in the long term, which would increase national saving and private investment;
- Raising the marginal tax rate on labor income, thereby discouraging work;
- Raising the marginal tax rate on capital income, thereby discouraging saving; and
- Increasing federal investment in ways that would increase productivity and the skill level of the workforce.
New calculations in the Congressional Budget Office's Long-Term Budget Outlook show that the high debt projected under current law could diminish average annual income by $2,000 within 25 years, and that a $4 trillion debt reduction package would not only prevent that $2,000 hit but could also increase average income in the economy by another $2,000, among other findings.
The report details the economic drag that will be caused by our growing debt once the economy has fully recovered by the Great Recession, if Congress does nothing to address it. Under CBO's "Extended Baseline Scenario," debt would increase from its current 74 percent of GDP to exceed the size of the economy, reaching 108 percent of GDP, by 2040. Yet even the Extended Baseline Scenario is perhaps too optimistic in assuming that some provisions are allowed to expire as scheduled and that Congress won't take any more fiscally irresponsible decisions. CBO also projects an alternative baseline (the "Alternative Fiscal Scenario (AFS)"), which roughly illustrates what would occur if lawmakers continue current policies, keep non-health, non-Social Security spending from reaching historical lows, and do not allow taxes to continually increase as a result of "bracket creep." Under the AFS, debt skyrockets to 170 percent of GDP by 2040, over twice its current level.
CBO's standard budget estimates utilize historical trends of economic growth, inflation, and other variables. They do not, however, incorporate the effects of changing levels of debt on the economy, often called “feedback” or “dynamic" effects. In reality, high and growing debt levels will hinder long-term economic growth. In particular, CBO explains that "higher debt crowds out investment in capital goods and thereby reduces output relative to what would otherwise occur." In other words, high debt harms economic growth.
In its report, CBO has analyzed the harmful effects of debt. If its economic projections are modified to include these negative effects, the economy is 3 percent smaller in 25 years. If lawmakers return to their more profligate ways and follow the policies in the AFS, the economy will be another 5 percent smaller. In contrast, reducing the debt can lead to modest but real gains in economic growth: a 2 percent larger economy within 25 years.
A bigger economy means increased income for each individual. CBO also shows the effects on per-capita GNP, a rough proxy for average income. By 2039, GNP would be $78,000 per person before accounting for the negative effects of high debt levels, in today's dollars. If the economic drag from higher debt is included, per capita GNP drops to $76,000 – a $2,000 cut in income. If Congress continues profligate spending and increases debt to the levels in the AFS, GNP will drop by another $3,000, which means the average income will have dropped $5,000 dollars because of high debt.
In the context of a middling U.S. economic recovery, several commentators have argued that we should ignore deficit reduction in order to pursue growth-promoting policies. This debate, however, overlooks a critical point since both objectives can be achieved simultaneously. A recent report commissioned by the Peter G. Peterson Foundation, authored by economists Janice Eberly and Phillip Swagel, highlights just this point, that economic and fiscal health are not in conflict.
The Peter G. Peterson Foundation held its 2014 Fiscal Summit today, bringing together a number of current and former policymakers, experts, commentators and other prominent figures to discuss the nation's fiscal challenges.
In its February 2014 Budget and Economic Outlook, CBO continued its previous warnings from last year's February outlook and September's long-term outlook: elevated and rising debt level pose serious risks for economic growth and budget flexibility.
In its latest outlook, CBO highlights on page one the consequences of high levels of debt: