I hate to drag you away from your fascination with Herman Cain's 999 plan and Rick Perry's flat tax, but if we are going to make real progress, we can't fixate on every overhyped, half-baked tax slogan that comes along. Sooner or later we must get back to basics. Here's the main question: Should taxes be cut, raised, or reformed without changing overall revenue? The answer is that taxes should be cut in the short term, raised after we are clearly out of our cyclical downturn, and then reformed only after we have settled on the magnitude of tax increases needed for deficit reduction.
Step 1: Short-Term Tax Cuts
Though it has been three-and-a-half years since the economy began its tailspin, we still need stimulus. Throughout modern history, politicians have been notoriously -- and sometimes disastrously -- slow in implementing fiscal stimulus. But this downturn has been so deep and long that getting the timing right is no more difficult than stepping onto a department store escalator. The unemployment rate is 9.1 percent and is unlikely to get below 8 percent before 2013.
Even more to the point, there is a lot of excess capacity in the economy. The Congressional Budget Office estimates that the "output gap" -- the shortfall in aggregate demand relative to aggregate supply -- is about 5 percent of GDP (CBO, "Confronting the Nation's Fiscal Policy Challenges," Sept. 13, 2011, Doc 2011-19401, 2011 TNT 178-45). This estimate implies that government policies could increase demand by approximately $750 billion and still not crowd out aggregate private spending or increase inflation. The amount of stimulus needed depends on the multiplier effect. For example, a well-designed stimulus could have a multiplier of 2. That would mean $375 billion would be needed to close the output gap.
OK, you say, maybe there is need to increase demand. But that doesn't mean government policy can actually do it. After all, hardly a day passes that you don't hear that the Obama stimulus has been a complete flop. And doesn't our recent experience prove that stimulus doesn't work? You have been told wrong. There's a lot in the stimulus to dislike -- from the false promise of shovel-ready projects to the politically expedient but economically inefficient targeting of pet Democratic causes. But, as certain as anything can be in economics, the $787 billion American Recovery and Reinvestment Act of 2009 prevented a total collapse of demand and probably warded off a second Great Depression.
Stimulus is not an economic policy for all seasons. But conditions now, unfortunately, are perfect. Inflation is low. Unemployment is high. Confidence is shot. Interest rates have hit rock bottom, and still business and consumers are not spending. We are in a classic liquidity trap. Fed policy cannot get the economy going. It is like pushing on a string. If monetary policy cannot stimulate demand and if the private demand on its own won't use untapped capacity, the government should step up to the plate until confidence improves. That is why the CBO and most mainstream economists have argued that the Obama stimulus has had a significant positive impact. (See CBO, "Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output From April 2011 through June 2011," Aug. 2011, Doc 2010-18832, 2011 TNT 165-25 .)
Why has anti-recession stimulus -- the most important tool in economists' job creation tool kit -- been marginalized when job creation is supposed to be policymakers' top priority? There are many reasons.
First, it has always been true that activist fiscal policy, especially its incessant urging for more government spending, is closely identified with liberal politics. Over the last three decades, the political center of gravity has swung decidedly to the right.
Second, as a result of the recession-induced spike in government deficits, the public fear of increasing government debt has gone prime time. After years of being ignored, deficit hawks are loath to muddle their message by arguing that deficits should be increased to provide short-term stimulus.
U.S. and U.K. GDP Since 2006 (adjusted for inflation)
Sources: Department of Commerce, Bureau of Economic Analysis, National Income and Product Account tables, available at http://www.bea.gov/national/index.htm//gdp: and U.K. Office of National Statistics, Quarterly National Accounts tables, available at http://www.ons.gov.uk/ons/publications/re-reference-tables.html?edition=tcm%3A77-224276.
Third, in the economics profession the prestige of anti-recession fiscal policy has plunged. While it has been a mainstay of undergraduate economics courses, the notion that fiscal policy can stop recessions is openly derided by theoretical economists who are the high priests of the profession. (Thomas Sargent of the University of Chicago, recently announced winner of this year's Nobel Memorial Prize in economics, is a leading proponent of non-intervention.) Economics professors have become fixated by "Ricardian equivalence." Named after British economist David Ricardo (1772-1823), the idea is that individuals will not be fooled by short-term stimulus into spending more because they understand that government must increase taxes in the future to pay for it. Although the idea has little empirical support, it has been implanted into two generations of economists who are reluctant to go against the professional grain.
Fourth, even though Congress and the president in 2009 enacted stimulus of unprecedented proportions, unemployment is still above 9 percent. That leads many to conclude stimulus does not work. This is an incorrect and perhaps tragic conclusion. We cannot know what would have happened in the absence of stimulus, so we cannot make conclusions about its effect based on what we can observe. Many supporters of stimulus argued the package was not large enough, and this claim too is consistent with what we observe.
The chart above should give doubters of fiscal policy some pause. It compares inflation-adjusted GDP in the United States and the United Kingdom over the last five years. Before the recession, the two economies moved in lockstep. But their fiscal policy response to the recession was very different. Obama and Congress pumped $787 billion into the U.S. economy. In the United Kingdom, the coalition government led by Conservative Prime Minister David Cameron installed a program of austerity -- raising taxes and cutting government spending. After three-and-a-half years, U.S. GDP is just about returning to the pre-recession peak. That's awful. But it is far better than the U.K. experience, in which GDP is still 5 percent ($750 billion in U.S. terms) below its pre-recession peak. Of course, a variety of factors other than fiscal policy could explain the differences. (For example, the impact of the European financial crisis is greater on the U.K. economy than the U.S. economy.) But the chart shows that casual observation can make a case for stimulus just as well as it can make a case against it.
Stimulus can come in the form of increased government spending or tax cuts. Why do we argue here for tax cuts? The choice between the two is not based on economics. In fact, economics would probably push you in favor of spending increases over tax cuts because of their larger stimulative effect. Given that both are decent options, it is not so bad to let political considerations determine the choice. If Obama had made more concessions to Republicans on the composition of stimulus in the 2009 legislation, he would not have condemned the approach to the policy backwaters. And certainly if there is any chance that much-needed stimulus is enacted before the 2012 election, politics will require most of it to be in the form of a tax cut.
Step 2: Tax Increases Once Jobs Are Back
The United States is not like Greece. The U.S. economy is stronger. Tax evasion here is not out of control. The U.S. government controls its own currency. And its debt level as a percentage of GDP is significantly lower than Greece's. We can afford to increase the deficit now to fight unemployment. Unfortunately, the Greeks cannot.
But there is no reason for complacency. Just as sure as the sun rises every morning, U.S. government finances and the U.S. economy will collapse sometime in the next few decades if we continue on our unsustainable path. Excessive levels of public debt threaten financial instability. And after the economy recovers from recession, deficits will crowd out domestic job creation. Whether the deficit is reduced by spending cuts or tax increases is not critically important.
That's the economics. Let's talk politics. First, if by some miracle our leaders could hammer out an agreement for a timely short-term stimulus, it would be absolutely necessary for Democrats not to gloat but to instead increase their resolve to reduce long-term deficits. They would need to do this not only to reassure the understandably skeptical markets, but also because the size of the post-stimulus fiscal gap would be even larger. Just because deficits are justified by short-term necessity (e.g., war, natural disaster, economic emergency) does not mean their negative long-term effects disappear.
Second, the fastest and most credible plan for deficit reduction will be the product of bipartisan compromise. Just as Democrats must concede a major role for tax cuts in any stimulus plan for the sake of achieving compromise, Republicans must concede a role for tax increases in any deficit reduction plan.
Step 3: Tax Reform Last
Deficit hawks have one hope: They can convince Republicans that cutting tax expenditures is the same thing as cutting outright spending. That is a noble cause. It is absolutely true that Republicans have been irrational in their nearly unconditional support for spending through the tax code. And if Republicans ever agree to tax increases, cutting tax expenditures will be the option that is at the top of their list. But this would require Republicans to agree to a tax increase or to change their definition of a tax increase. This would be a monumental change in position for the GOP. Even if leaders like House Speaker John A. Boehner, R-Ohio, are game, it is not a detail that would go unnoticed by the Tea Party. It would be a breach of faith far worse than George H.W. Bush's broken promise in 1990.
Republicans like to remind us that tax reform creates jobs. Aren't they correct? Certainly, yes, if reform meets specific economic design requirements and therefore necessarily takes on entrenched special interests. The ignored difficulty with tax reform, like all Republican job creation plans, is that it is a supply-side response to our economic problems. Yes, we need supply-side reform. It is a quality product, but the salespeople won't tell you about the delivery time. Supply-side economics does not provide the quick relief from unemployment the public wants and politicians are implying they can deliver. We can get people to spend more relatively quickly. It can take years for the economy to restructure to a more efficient production mix.
This would all be harmless chatter -- or perhaps even healthy debate -- if it was not a huge distraction from our taking steps to solve our more important economic problems. In 1993 President Clinton raised taxes to reduce the deficit. It was disappointing to perennial enthusiasts of tax reform that he took the easy way out and just raised corporate and individual rates instead of broadening the tax bases. The now-famous Clinton deficit reduction plan passed by just one vote in both the House and Senate. If he had included tax reform, it would have done nothing to lubricate the process. Clinton wisely put tax reform aside to achieve deficit reduction.
Tax reform is one of the most difficult legislative tasks possible -- something reserved for popular second-term presidents with a growing economy and a good working relationship with Congress. Until a couple years ago, that was the conventional Beltway wisdom.
Now it is seen as the proverbial low-hanging fruit -- something that both liberals and conservatives can agree on. Well, the absolute difficulty of tax reform has, if anything, become greater. It is only relative to our new and more intractable tasks -- tackling joblessness and skyrocketing debt -- that tax reform looks easy. And as for bipartisan consensus, that's all bunk. Each side only wants its own version of tax reform. Conservatives want revenue-neutral rate reductions for all and tax reduction for big business. Liberals want tax increases targeting high-income taxpayers. Moreover, each side is adamantly opposed to the other's version of reform.
It would have made a lot of economic sense to push for tax reform five years ago when few of us were concerned about job creation. Way back then, the federal debt was a problem for the next generation. Tax reform will again make sense when unemployment and debt are under control or, at a minimum, there is political consensus on the general approach for getting there.
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