Archive for the ‘Budget Deficit’ Category
If you were one of those people who were not persuaded that the U.S. debt level was reaching growth-threatening levels, pat yourself on the back.
One of the major studies supporting the austerity position was a 2010 paper titled Growth in a Time of Debt by two well-known economists, Carmen Reinhardt and Kenneth Rogoff (R & R). As Mike Konczal reports:
Their “main result is that…median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.” Countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate, in fact.
This conclusion, that countries with debt-to-GDP ratios over 90 percent actually suffer negative growth, quickly became a staple in the arguments of those pushing for cuts in government spending.
Well, it turns out that R & R’s work was seriously flawed. Once the flaws are corrected, the conclusion no longer holds; growth remains positive even at debt ratios over 90 percent and the difference in growth rates for countries below and above that level is not statistically significant.
R & R finally agreed to share their data with three professors from the University of Massachusetts at Amherst, Thomas Herndon, Michael Ash, and Robert Pollin (HAP). HAP published their evaluation of R & R’s work in their recently published paper titled Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff.” As Konczal summarizes, HAP found three serious problems with R & R’s work:
First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don’t get their controversial result.
You can read Konczal or Michael Roberts for a fuller discussion of these points. However, just to give you a flavor of how poor R & R’s methodology was, let me briefly summarize the second point. R & R divided up each individual country’s data into several selected debt-to-GDP groupings, and then calculated an average real growth for all the years in the specific debt grouping. Then they determined a global average rate of growth for a given debt-to-GDP level by averaging all the growth rates across countries at that specific debt level.
Konczal gives the following example to illustrate how sloppy this approach is:
The U.K. has 19 years (1946-1964) above 90 percent debt-to-GDP with an average 2.4 percent growth rate. New Zealand has one year in their sample above 90 percent debt-to-GDP with a growth rate of -7.6. These two numbers, 2.4 and -7.6 percent, are given equal weight in the final calculation, as they average the countries equally. Even though there are 19 times as many data points for the U.K.
Now maybe you don’t want to give equal weighting to years (technical aside: Herndon-Ash-Pollin bring up serial correlation as a possibility). Perhaps you want to take episodes. But this weighting significantly reduces the average; if you weight by the number of years you find a higher growth rate above 90 percent. Reinhart-Rogoff don’t discuss this methodology, either the fact that they are weighing this way or the justification for it, in their paper.
As noted above, after HAP adjust for the errors they found, which include an Excel spread sheet error, R & R’s conclusion of negative growth at debt levels over 90 percent goes away. More specifically, they found that “the average real GDP growth rate for countries carrying a public debt-to-GDP ratio of over 90 percent is actually 2.2 percent, not -0.1 percent as [R & R claim].”
Now, have R & R backed off from their conclusion? Well, they admit the mistakes but still claim that the basic point is true. But as Dean Baker notes: “If R&R had produced the correct table in their initial paper no one would have taken seriously their claim that the 90 percent debt-to-GDP ratio presents some sort of cliff. The corrected table in no way supports that view.”
What we have here is politics in command. R & R, as well as other advocates of austerity, continue to argue for cutting government spending despite having based their position largely on a study that is now shown to be wanting. So, it goes.
While some austerity advocates really fear (although incorrectly) the consequences of deficit spending, the strongest proponents are actually only concerned with slashing government programs or the use of public employees to provide them. In other words their aim is to weaken public programs and/or convert them into opportunities for private profit.
One measure of their success has been the steady decline in public employment. Floyd Norris, writing in the New York Times notes:
For jobs, the past four years have been a wash.
The December jobs figures out today indicate that there were 725,000 more jobs in the private sector than at the end of 2008 — and 697,000 fewer government jobs. That works into a private-sector gain of 0.6 percent, and a government sector decline of 3.1 percent.
In total, the number of people with jobs is up by 28,000, or 0.02 percent.
How does that compare? It is by far the largest four-year decline in government employment since the 1944-48 term. That decline was caused by the end of World War II; this one was caused largely by budget limitations.
The chart below, taken from the same post also reveals just how weak private sector job creation has been over the past 12 years.
What follows is a screen shot of a graphic in a New York Times Business Day post. It highlights just how significant the decline in public employment has been in this business cycle compared with past ones. Each line shows the percentage change in public sector employment for specified months after the start of a recession. Our recent recession began December 2007 and ended June 2009. As you can see, what is happening now is far from usual.
It is also worth noting that despite claims that most Americans want to see cuts in major federal government programs, the survey data show the opposite. For example, see the following graphic from Catherine Rampell’s blog post.
As Rampell explains:
In every category except for “aid to world’s needy,” more than half of the respondents wanted either to keep spending levels the same or to increase them. In the “aid to world’s needy” category, less than half wanted to cut spending.
Not surprisingly, this assault on government spending and employment will have real consequences for the economy and job creation. Binyamin Appelbaum writes in the New York Times:
The federal government, the nation’s largest consumer and investor, is cutting back at a pace exceeded in the last half-century only by the military demobilizations after the Vietnam War and the cold war.
And the turn toward austerity is set to accelerate on Friday if the mandatory federal spending cuts known as sequestration start to take effect as scheduled. Those cuts would join an earlier round of deficit reduction measures passed in 2011 and the wind-down of wars in Iraq and Afghanistan that already have reduced the federal government’s contribution to the nation’s gross domestic product by almost 7 percent in the last two years. . . .
Over the last two years, federal consumption and investment declined by 6.9 percent. Including state and local consumption, a larger category that has declined more slowly, the inflation-adjusted reduction since 2011 was 4.9 percent.
But Alec Phillips, an economist at Goldman Sachs, estimated that federal consumption could fall by another 11 percent over the next two years. Mr. Phillips also noted that those earlier rounds of cuts in the 1970s and the 1990s came primarily from the military budget. The sequester is designed to be indiscriminate, cutting everything from air traffic control to nursery schools.
That could increase the resulting pain, because economic research suggests that military cuts are less painful than other kinds of spending reductions.
“It is cutting some of the best spending that government does,” Professor Cowen said of the cuts that would fall on the domestic side of the ledger.
All of this takes us back to the starting point–we are talking policy here. Whose interests are served by these trends?
The so-called sequester appears likely to result in $85 billion in spending cuts this fiscal year. The cuts are ostensibly the result of a political battle over the budget deficit, with Republicans arguing that spending cuts are absolutely necessary to save the economy and the Democrats agreeing that the budget deficit does need to be reduced, but preferring a combination of tax/revenue increases and spending cuts.
The austerity drive appears back in full swing regardless of how the debate turns out. There was a brief period when the Occupy movement turned the spotlight on inequality and jobs, but powerful forces have succeeded in regaining control over the national debate on the economy.
Sadly those powerful forces tend to fly under the radar, with the media happy to portray concern about the deficit arising from the grassroots. In fact, nothing could be further from the truth. The sustained focus on the deficit and the need for spending cuts is to a considerable extent the result of huge spending by wealthy individuals and corporations on campaigns which give the appearance of public support.
Exhibit 1 is the Fix the Debt campaign. A recent New York Times article provides an interesting look into the workings and supporters of this campaign:
When Jim McCrery, a former Louisiana congressman, urged lawmakers last month to pursue entitlement cuts and tax reform, he was introduced on television as a leader of Fix the Debt, a group of business executives and onetime legislators who have become Washington’s most visible and best-financed advocates for reining in the federal deficit.
Mr. McCrery did not mention his day job: a lobbyist with Capitol Counsel L.L.C. His clients have included the Alliance for Savings and Investment, a group of large companies pushing to maintain low tax rates on dividend income, and the Win America Campaign, a coalition of multinational corporations that lobbied for a one-time “repatriation holiday” allowing them to move offshore profits back home without paying taxes. . . .
In recent days, Fix the Debt has redoubled its efforts, starting a new national advertising campaign and calling on Mr. Obama and Congress to revise the tax code and reduce long-term spending on entitlement programs. . . .
While Fix the Debt criticized the recent fiscal deal between Mr. Obama and lawmakers, saying it did not do enough to cut spending or close tax loopholes, companies and industries linked to the organization emerged with significant victories on taxes and other policies. . . .
Sam Nunn, a former Democratic senator from Georgia who is a member of Fix the Debt’s steering committee, received more than $300,000 in compensation in 2011 as a board member of General Electric. The company is among the most aggressive in the country at minimizing its tax obligations. Mr. McCrery, the Louisiana Republican, is also among G.E.’s lobbyists, according to the most recent federal disclosures, monitoring federal budget negotiations for the company.
Other board members and steering committee members have deep ties to the financial industry, including private equity, whose executives have aggressively fought efforts to alter a tax provision, known as the carried interest exception, that significantly reduces their personal income taxes.
Erskine B. Bowles, a co-founder of Fix the Debt, was paid $345,000 in stock and cash in 2011 as a board member at Morgan Stanley, while Judd Gregg, a former Republican senator from New Hampshire and a co-chairman of Fix the Debt, is a paid adviser to Goldman Sachs. Both companies have engaged in lobbying on international tax rules.
Mr. Gregg also sits on the boards of Honeywell and Intercontinental Exchange, a company that has warned investors that a tax on financial transactions would lower trading volume and curtail its profits. The two companies paid Mr. Gregg almost $750,000 in cash and stock in 2011.
In all, close to half of the members of Fix the Debt’s board and steering committee have ties to companies that have engaged in lobbying on taxes and spending, often to preserve tax breaks and other special treatment. . . .
[S]o far, at least, the companies and industries most closely linked to Fix the Debt have been aggressive in defending their narrower legislative interests.
The fiscal deal preserved the carried interest loophole, eliminated most of a large prospective increase in dividends taxes and preserved a tax break, known as the active financing exception, that allows G.E. and other multinational companies to avoid paying United States taxes on overseas profits.
The deal also forestalled large automatic cuts in military spending, a boon to contractors like Honeywell. The company’s chief executive, David M. Cote, is a co-founder of Fix the Debt; the group’s “core principles,” which call for retrenchment in entitlement programs like Social Security, make no mention of military spending, which constitutes about a fifth of the federal budget.
A recent Democracy Now broadcast examined the link between this group and Pete Peterson. Peterson has long worked behind the scenes in an effort to dismantle earned benefit programs like Social Security and Medicare and has personally given almost $500 million to his foundation which attempts to shape popular thinking accordingly.
As John Nichols explains on the broadcast:
And at the core of this is changing the way that we look at retirement in this country, definitely undermining Social Security, Medicare and Medicaid, changing those earned benefit programs into something very different than what they’ve been and something far less reliable, but also making an awfully lot of other cuts in programs that serve the great mass of Americans, while at the same time continuing and even advancing the tax breaks for billionaires and corporations that have helped to make Pete Peterson a very, very wealthy man.
He sold this idea to around 125 other CEOs and very wealthy people. They’ve all chipped in a whole bunch of money, millions and millions, perhaps as much as $60 million for the current campaign, to this “Fix the Debt” group. And this Fix the Debt group is the primary proponent in the United States today of austerity. They want to, quote-unquote, “cut our way to progress,” as President Obama suggested, but in reality, it’s cutting the way toward progress for them and cutting the way toward a real hard hit for the average working American and potentially a slowing of the economy that begins with the sequester but does not end there.
Peterson was also a key player behind the Simpson-Bowles Commission, which was established by President Obama. It was, in fact, President Obama that chose Simpson and Bowles to head the commission. In other words, it was President Obama that provided these people and their ideas with a platform and legitimacy that is undeserved. Now we are reaping the consequences—a policy debate in which the wealthy are likely to win and the people are likely to lose regardless of outcome.
See here for more on the Fix the Debt Campaign.
See here for more on Pete Peterson.
See here for a discussion on what sequestration will mean for people’s lives.
Considering the enormous time spent debating tax policy, it is easy to imagine that the U.S. must have one of the high tax rates in the world. Well, that is not the case.
The following graph is one of them. It shows the personal tax rate paid by people making the equivalent of $100,000 a year in 2012. The U.S. is the 55th ranked country out of 114 in terms of tax rates.
The next graph shows the same thing but for those earning the equivalent of $300,000 a year. The U.S. ranking is similar for this upper income group, 53rd highest out of 114.
Moreover, as Derek Thompson, the author of the Atlantic post, notes:
But these numbers might understate how low taxes have been in the U.S. Unlike most advanced economies, the U.S. don’t supplement personal income taxes with a national sales tax, or value-added tax (VAT). Consumption taxes accounted for about a fifth of total U.S. revenue in 2008 (mostly at the state and local level) compared to an OECD average of 32 percent. In other words, the U.S. relies uniquely on personal tax rates to raise revenue — and we have relatively low personal tax rates.
Finally, here is a look at the U.S. ranking among OECD countries for taxes as a share of GDP in 2008.
So, given that the U.S. doesn’t seem to be a high-tax rate country, why is tax policy so contentious? No doubt the answer has a lot to do with who actually pays the taxes and, perhaps even more importantly, what the revenue is used for.
The media continues to direct out attention to deficits and debt as our main problems. Yet, it does little to really highlight the causes of these deficits and debts.
The following two figures from the Center on Budget and Policy Priorities help to clarify the causes. It is important to note that the projections underlying both figures were made before the recent vote making permanent most of the Bush-era tax cuts.
Figure 1, below, shows the main drivers of our large national deficits: the Bush-era tax cuts, the wars in Iraq and Afghanistan, and our economic crisis and responses to it. Without those drivers our national deficits would have remained quite small.
Figure 2, below, shows the main drivers of our national debt. Not surprisingly they are the same as the drivers of our deficits.
Significantly, the same political leaders that scream the loudest about our deficits and debt have little to say about stopping the wars or reducing military spending and are the most adamant about maintaining the Bush-era tax cuts. That is because, at root, their interest is in reducing spending on non-security programs rather than reducing the deficit or debt.
Some of these leaders argue that the tax cuts will help correct our economic problems and thereby help reduce the deficit and debt. However, multiple studies have shown that tax cuts are among the least effective ways to stimulate employment and growth. In contrast, the most effective are sustained and targeted government efforts to refashion economic activity by spending on green conversion, infrastructure, health care, education and the like.
While Republicans and Democrats debate the extent to which taxes should be raised, both sides appear to agree on the need to reign in federal government spending in order to achieve deficit reduction. In fact, federal government spending has been declining both absolutely and, as the following figure from the St. Louis Federal Reserve shows, as a share of GDP.
In reality, our main challenge is not reducing our deficit or debt but rather strengthening our economy, and cutting government spending is not going to help us overcome that challenge. As Peter Coy, writing in BusinessWeek explains:
It pains deficit hawks to hear this, but ever since the 2008 financial crisis, government red ink has been an elixir for the U.S. economy. After the crisis, households strove to pay down debt and businesses hoarded profits while skimping on investment. If the federal government had tried to run balanced budgets, there would have been an enormous economy wide deficit of demand and the economic slump would have been far worse. In 2009 fiscal policy added about 2.7 percentage points to what the economy’s growth rate would have been, according to calculations by Mark Zandi of Moody’s Analytics. But since then the U.S. has underutilized fiscal policy as a recession-fighting tool. The economic boost dropped to just half a percentage point in 2010. Fiscal policy subtracted from growth in 2011 and 2012 and will do so again in 2013, to the tune of about 1 percentage point, Zandi estimates.
If we were serious about tackling our economic problems we would raise tax rates and close tax loopholes on the wealthy and corporations and reduce military spending, and then use a significant portion of the revenue generated to fund a meaningful government stimulus program. That would be a win-win proposition as far as the economy and budget is concerned.
One of the subthemes of current discussions about how best to reduce our national debt is that we must reign in out-of-control spending on federal safety net programs. The reality is quite different.
The chart below shows spending trends in terms of GDP for the ten major needs-tested benefit programs that make-up our federal social safety net. The programs, in the order listed on the chart, are:
- The refundable portion of the health insurance tax credit enacted in the 2010 health care reform law
- Medicaid and the Children’s Health Insurance Program (CHIP)
- The Supplemental Nutrition Assistance Program (SNAP)
- Financial assistance for post-secondary students (Pell Grants)
- Compensatory Education Grants to school districts
- Assisted Housing
- The Earned Income Tax Credit (EITC)
- The Additional Child Tax Credit (ACTC)
- Supplemental Security Income (SSI)
- Family Support Payments
As Jared Bernstein explains:
for all the popular wisdom that programs to help low-income people are swallowing the economy, the truth is that like so much else that plagues our fiscal future, it’s all about health care spending. The figure shows that as a share of GDP, prior to the Great Recession, non-health care spending was cruising along at around 1.5% for decades. It was Medicaid/CHIP (Medicaid expansion for kids) that did most of the growing.
Regardless, the recent explosion in the ratio of Medicare/CHIP spending to GDP is largely due to the severity of the Great Recession, not the generosity of the programs. The recession increased poverty and thus eligibility for the programs, thereby pushing up the numerator, while simultaneously lowering GDP, the denominator. Moreover, spending on all non-health care safety net programs is on course to dramatically decline as a share of GDP. Even Medicare/Chip spending is projected to stabilize as a share of GDP.
These programs are essential given the poor performance of the economy and in most cases poorly funded. Cutting their budgets will not only deny people access to health care, housing, education, and food, it will also further weaken the economy, in both the short and long run.
The New York Times published a very interesting article on taxes. Most importantly it is accompanied by great graphics illustrating the changing tax burden of households by income bracket over the period 1980 to 2010. The taxes covered include federal taxes, payroll taxes, state and local taxes, and corporate taxes.
The screen shot below highlights the share of yearly income paid in combined federal and state and local taxes by households in different income brackets. As one can see, the tax burden fell for every income bracket, with those at the top enjoying the greatest reduction. There is no getting around the fact that tax rates, at least for the wealthy, must go up if we are to adequately fund necessary programs.
This combined view of our tax burden masks a striking difference between the trends in federal and state and local tax burdens. While the federal tax burden went down over the period 1980 to 2010 for households in every income group, the state and local tax burden rose for households in every income group.
Significantly, and perhaps explaining the strength of the anti-tax movement, state and local tax burdens rose most for households in the lowest income brackets. The same is true for the payroll taxes. The screen shot below shows the trends in both state and local and payroll tax burdens for all income groups.
As the Times article notes, “Public debate over taxes has typically focused on the federal income tax, but that now accounts for less than a third of the total tax revenues collected by federal, state and local governments.” Clearly, tax reform needs to take place at all levels of government. But that is only one side of the picture. Attention must also be given to the pattern and beneficiaries of government spending.
With the election over, the news is now focused, somewhat hysterically, on the threat of the fiscal cliff.
The fiscal cliff refers to the fact that at the end of this calendar year several temporary tax cuts are scheduled to expire (including those that lowered rates on income and capital gains as well as payroll taxes) and early in the next year spending cuts are scheduled for military and non-military federal programs. See here for details on the taxes and programs.
Most analysts agree that if tax rates rise and federal spending is cut the result will be a significant contraction in aggregate demand, pushing the U.S. economy into recession in 2013.
The U.S. economy is already losing steam. GDP growth in the second half of 2009, which marked the start of the recovery, averaged 2.7% on an annualized basis. GDP growth in 2010 was a lower 2.4%. GDP growth in 2011 averaged a still lower 2.0%. And growth in the first half of this year declined again, to an annualized rate of 1.8%.
With banks unwilling to loan, businesses unwilling to invest or hire, and government spending already on the decline, there can be little doubt that a further fiscal tightening will indeed mean recession.
So, assuming we don’t want to go over the fiscal cliff, what are our choices?
Both Republicans and Democrats face this moment in agreement that our national deficits and debt are out of control and must be reduced regardless of the consequences for overall economic activity. What they disagree on is how best to achieve the reduction. Most Republicans argue that we should renew the existing tax cuts and protect the military budget. Deficit reduction should come from slashing the non-military discretionary portion of the budget, which, as Ethan Pollack explains, includes:
safety net programs like housing vouchers and nutrition assistance for women and infants; most of the funding for the enforcement of consumer protection, environmental protection, and financial regulation; and practically all of the federal government’s civilian public investments, such as infrastructure, education, training, and research and development.
The table below shows the various programs/budgets that make up the non-security discretionary budget and their relative size. The chart that follows shows how spending on this part of the budget is already under attack by both Democrats and Republicans.
Unfortunately, the Democrat’s response to the fiscal cliff is only marginally better than that of the Republicans. President Obama also wants to shrink the deficit and national debt, but in “a more balanced way.” He wants both tax increases and spending cuts. He is on record seeking $4 trillion in deficit reduction over a ten year period, with a ratio of $2.50 in spending cuts for every $1 in new revenue.
The additional revenue in his plan will come from allowing tax cuts for the wealthy to expire, raising the tax rate on the top income tax bracket, and limiting the value of tax deductions. While an important improvement, President Obama is also committed to significant cuts in non-military discretionary spending. Although his cuts would not be as great as those advocated by the Republicans, reducing spending on most of the targeted programs makes little social or economic sense given current economic conditions.
So, how do we scale the fiscal cliff in a responsible way?
We need to start with the understanding that we do not face a serious national deficit or debt problem. As Jamie Galbraith notes:
. . . is there a looming crisis of debt or deficits, such that sacrifices in general are necessary? No, there is not. Not in the short run – as almost everyone agrees. But also: not in the long run. What we have are computer projections, based on arbitrary – and in fact capricious – assumptions. But even the computer projections no longer show much of a crisis. CBO has adjusted its interest rate forecast, and even under its “alternative fiscal scenario” the debt/GDP ratio now stabilizes after a few years.
Actually, as the chart below shows, the deficit is already rapidly falling. In fact, the decline in government spending over the last few years is likely one of the reasons why our economic growth is slowing so dramatically.
As Jed Graham points out:
From fiscal 2009 to fiscal 2012, the deficit shrank 3.1 percentage points, from 10.1% to 7.0% of GDP. That’s just a bit faster than the 3.0 percentage point deficit improvement from 1995 to ’98, but at that point, the economy had everything going for it.
Other occasions when the federal deficit contracted by much more than 1 percentage point a year have coincided with recession. Some examples include 1937, 1960 and 1969.
In short, we do not face a serious problem of growing government deficits. Rather the problem is one of too fast a reduction in the deficit in light of our slowing economy.
As to the challenge of the fiscal cliff—here we have to recognize, as Josh Bivens and Andrew Fieldhouse explain, that:
the budget impact and the economic impact are not necessarily the same. Some policies that are expensive in budgetary terms have only modest economic impacts (for example, the 2001 and 2003 tax cuts aimed at high-income households are costly but do not have much economic impact). Conversely, other policies with small budgetary costs have big economic impacts (for example, extended unemployment insurance benefits).
In other words, we should indeed allow the temporary tax rate deductions for the wealthy to expire, on both income and capital gains taxes. These deductions cost us dearly on the budget side without adding much on the economic side. As shown here and here, the evidence is strong that the only thing produced by lowering taxes on the wealthy is greater income inequality.
Letting existing tax rates rise for individuals making over $200,000 and families making over $250,000 a year, raising the top income tax bracket for both couples and singles that make more than $388,350, and limiting tax deductions will generate close to $1.5 trillion dollars over ten years as highlighted below in a Wall Street Journal graphic .
However, in contrast to President Obama’s proposal, we should also support the planned $500 billion in cuts to the military budget. We don’t need the new weapons and studies are clear that spending on the military (as well as tax cuts) is a poor way to generate jobs. For example, the table below shows the employment effects of spending $1 billion on the military versus spending the same amount on education, health care, clean energy, or tax cuts.
And, we should also oppose any cuts in our non-security discretionary budget. Instead, we should take at least half the savings from the higher tax revenues and military spending cuts–that would be a minimum of $1 trillion–and spend it on programs designed to boost our physical and social infrastructure. Here I have in mind retrofitting buildings, improving our mass transit systems, increasing our development and use of safe and renewable energy sources like wind and solar, and expanding and strengthening our social services, including education, health care, libraries, and the like.
Our goal should be a strong and accountable public sector, good jobs for all, and healthy communities, not debt reduction. The above policy begins to move us in the right direction.
A big debate is underway about fiscal multipliers. Sounds esoteric but it is not—it reveals that economics is far from an exact science and the outcome appears to confirm what most working people thought, which is that government spending can help an economy grow.
A fiscal multiplier is an estimate of the economic impact of a change in government spending. The debate was triggered, surprisingly enough, by a small box in the International Monetary Fund’s annual publication, World Economic Outlook. There, the International Monetary Fund (IMF) admitted that its previous estimates of fiscal multipliers were too low.
Here is what the IMF chief economist Olivier Blanchard wrote:
The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.
As part of the attack on the role of government in the economy, many economists, prior to the Great Recession, argued that fiscal multipliers were roughly equal to 1. That meant a 1% reduction in government spending would likely cause a 1% decline in GDP, and a 1% increase in government spending would likely generate a 1% increase in GDP.
As the Great Recession got under way, many economists, including those at the IMF, began arguing for substantially lower multipliers, on the order of 0.5%. On the basis of this reduced value, many forecasters argued for the benefits of austerity. Debt was seen as a major problem and if fiscal multipliers were only 0.5%, a $1 cut in government spending would reduce debt by $1 but GDP by only 50 cents.
Well, after watching how austerity policies collapsed many economies around the world, especially in Europe, the IMF acknowledged that it had badly misjudged the size of the fiscal multiplier. As Cornel Ban explains:
In contrast [to its previous low estimates], the October 2012 WEO found that in fact [fiscal multipliers] ranged between .9 to 1.7 (the Eurozone periphery is closer to the higher end of the range), an error that explained the IMF’s extremely optimistic growth projections for countries who front-loaded fiscal consolidation. Assuming the multiplier was 1.5, a fiscal adjustment of 3 percent of GDP-as much as Spain has to do next year- would lead to a GDP contraction of 4.5 percent. It was momentous finding and those who had been skeptical of the virtues of austerity felt vindicated.
Barry Eichengreen and Kevin H O’Rourke provide additional evidence for large fiscal multipliers, in fact for larger multipliers than those proposed by the IMF. According to them:
The problem is that standard theory doesn’t tell us much about the precise magnitude of the multiplier under [current] conditions. The IMF’s analysis, moreover, relies on observations for only a handful of national experiences. It is limited to the post-2009 period. And it has been criticized for its sensitivity to the inclusion of influential outliers.
Fortunately, history provides more evidence on the relevant magnitudes. In a paper written together with Miguel Almunia, Agustin Bénétrix and Gisela Rua, we considered the experience of 27 countries in the 1930s, the last time when interest rates were at or near the zero lower bound, and when post-2009-like monetary conditions therefore applied (Almunia et al. 2010).
Our results depart from the earlier historical literature. Generalizing from the experience of the US it is frequently said, echoing E Cary Brown, that fiscal policy didn’t work in the 1930s because it wasn’t tried. In fact it was tried, in Japan, Italy, and Germany, for rearmament- and military-related reasons, and even in the US, where a Veterans’ Bonus amounting to 2% of GDP was paid out in 1936. Fiscal policy could have been used more actively, as Keynes was later to lament, but there was at least enough variation across countries and over time to permit systematic quantitative analysis of its effects.
We analyze the size of fiscal multipliers in several ways. First, we estimate panel vector regressions, relying on recursive ordering to identify shocks and using defense spending as our fiscal policy variable. The idea is that levels of defense spending are typically chosen for reasons unrelated to the current state of the economy, so defense spending can thus be placed before output in the recursive ordering. We also let interest rates and government revenues respond to output fluctuations. We find defense-spending multipliers in this 1930s setting as large as 2.5 on impact and 1.2 after the initial year.
Second, we estimate the response of output to government spending using a panel of annual data and defense spending as an instrument for the fiscal stance.
Here too we control for the level of interest rates, although these were low virtually everywhere, reflecting the prevalence of economic slack and ongoing deflation. Using this approach, our estimate of the multiplier is 1.6 when evaluated at the median values of the independent variables.
These estimates based on 1930s data are at the higher end of those in the literature, consistent with the idea that the multiplier will be greater when interest rates do not respond to the fiscal impulse, whether because they are at the lower bound or for other reasons. The 1930s experience thus suggests that the IMF’s new estimates are, if anything, on the conservative side.
Some economists remain unconvinced—in fact, some actually argue that government spending is incapable of creating jobs. The economist Robert J. Samuelson was so upset to read a New York Times editorial which claimed that government spending creates jobs that he had to respond:
In 35 years, I can’t recall ever writing a column refuting an editorial. But this one warrants special treatment because the Times’ argument is so simplistic, the subject is so important and the Times is such an influential institution.
Here is the nub of his argument:
it’s true that, legally, government does expand employment. But economically, it doesn’t — and that’s what people usually mean when they say “government doesn’t create jobs.”
What the Times omits is the money to support all these government jobs. It must come from somewhere — generally, taxes or loans (bonds, bills). But if the people whose money is taken via taxation or borrowing had kept the money, they would have spent most or all of it on something — and that spending would have boosted employment.
In other words, because the government relies on the private sector for the money it spends, the jobs created by its spending cannot be a net addition to the economy. Said differently, jobs supported by public spending are not real jobs. There is a lot that can be said, but here is Dean Baker’s response:
Samuelson tells us that if the government didn’t tax or borrow or the money to pay its workers (he makes a recession exception later in the piece) people “would have spent most or all of it on something — and that spending would have boosted employment.”
Again, this is true, but how does it differ from the private sector? If the new iPhone wasn’t released last month people would have spent most or all of that money on something — and that spending would have boosted employment. Does this mean that workers at Apple don’t have real jobs either?
The confusion gets even greater when we start to consider the range of services that can be provided by either the public or private sector. In Robert Samuelson’s world we know that public school teachers don’t have real jobs, but what about teachers at private schools? Presumably the jobs held by professors at major public universities, like Berkeley or the University of Michigan are not real, but the jobs held at for-profit universities, like Phoenix or the Washington Post’s own Kaplan Inc., are real.
How about health care? Currently the vast majority of workers in the health care industry are employed by the private sector. Presumably these are real jobs according to Samuelson. Suppose that we replace our private health care system with a national health care service like the one they have in the U.K. Would the jobs in the health care no longer be real? . . .
How about when the government finances an industry by granting it a state sanctioned monopoly as when it grants patent monopolies on prescription drugs. Do the researchers at Pfizer have real jobs even though their income is dependent on a government granted monopoly? Would they have real jobs if the government instead paid for research out of tax revenue and let drugs be sold in a free market, saving consumers $250 billion a year?
Robert Samuelson obviously thinks there is something very important about the difference between working for the government and working in the private sector. Unfortunately his column does not do a very good job of explaining why. It would probably be best if he waited another 35 years before again attacking a newspaper editorial.
If people are confused about how our economy works, or doesn’t work, it is no wonder.
Presidential candidate Mitt Romney’s low federal tax rate—14.1%—has called attention to the fact that our tax code favors people who make their money from investments rather than labor. According to the conventional wisdom, this is as it should be. It encourages people, like our job creators, to invest their money, thereby boosting growth and the well-being of all working people. Sounds plausible but the facts don’t support the policy.
BusinessWeek lays out the background and political context for our current low taxation rates on investment income as follows:
Since 1950 capital gains have generally been taxed at a lower rate than income, to spur investment. The rate under President George W. Bush went from 20 percent to 15—the lowest ever—and was billed as a way to stimulate the economy. (If nothing’s done by Jan. 1 to change tax and budget provisions already passed by Congress, the rate will snap back to 20 percent, a scenario both parties hope to avoid.) Mitt Romney wants to ditch capital gains tax altogether for people earning less than $250,000. President Barack Obama, in his Affordable Care Act, increased the rate by 3.8 percent for high earners beginning in 2013, and has proposed the so-called Buffett Rule, which would among other things end an accounting interpretation that allows private equity and hedge fund managers (and Romney) to save money by paying tax on their earnings at the capital gains rate. Neither candidate, though, contests the Bush administration’s basic logic: that a lower capital gains rate encourages investment, which creates jobs and helps the economy grow. That doesn’t mean they’re right.
Leonard E. Burman, a tax expert, took on this issue in recent testimony before the House Committee on Ways and Means and the Senate Committee on Finance. A good place to start is with who benefits from lower capital gains taxes.
Not surprisingly, as the figure below (which is taken from Burman’s testimony) shows, the benefits are extremely concentrated. As Burman noted:
In 2010, the highest-income 20 percent realized more than 90 percent of long-term capital gains according to the TaxPolicyCenter. The top 1 percent realized almost 70 percent of gains and the richest 1 in 1,000 households accrued about 47 percent. It is hard to think of another form of income that is more concentrated by income.
Moreover, as the next figure shows, the concentration of capital gains has grown over time. Given that the rich fund political campaigns, this certainly helps to explain why both political parties are so determined to keep the rate low.
But, to the main question—do lower capital gains taxes actually boost growth? This is what Burman had to say in his testimony:
The heated rhetoric notwithstanding, there is no obvious relationship between tax rates on capital gains and economic growth. Figure 4 [below] shows top tax rates on long-term capital gains and real economic growth (measured as the percentage change in real GDP) from 1950 to 2011. If low capital gains tax rates catalyzed economic growth, we’d expect to see a negative relationship–high gains rates, low growth, and vice versa–but there is no apparent relationship between the two time series. The correlation is 0.12, the opposite sign from what capital gains tax cut advocates would expect, and not statistically different from zero. Although not shown, I’ve tried lags up to five years and using moving averages, but there is never a larger or statistically significant relationship.
Burman notes that he posted this figure on his blog and offered the data to anyone interested, challenging readers to find support for lower rates. “A half dozen or so people, including at least one outspoken critic of taxing capital gains, took me up on the offer, but nobody to my knowledge has been able to tease a meaningful relationship between capital gains tax rates and the GDP out of the data.”
As reported in a previous post, Thomes L. Hungerford, writing for the Congressional Research Service, came to the same conclusion about the lack of any relationship between the capital gains tax and GDP. In fact, he concluded raising the top income and capital gains tax rates would likely reduce income inequality without causing harm to the economy.
So, if we are really concerned with the budget deficit, rather than slashing spending on social programs lets raise the top tax rates. Wonder if this will come up during our presidential debates?