Ed Dolan's Econ Blog

Austerity Bomb? Don’t Panic. Keep Your Eyes on the Prize.

“Austerity bomb” is the metaphor of the day. First introduced by Brian Beutler, it has now been endorsed by Paul Krugman as a replacement for “fiscal cliff.” Both are bad metaphors. They invite us to think that the most important thing on the national agenda is to avoid the cliff or defuse the bomb before disaster strikes. Instead, we need to stay calm keep our eyes on the prize, that is, on real reform of our muddled fiscal policy. Unless we are willing to look beyond what happens at the end of the year, we risk being panicked into a deal that will leave us in an even worse fiscal mess than we are in now. Here are the three long-term considerations that should be at the center of budget negotiations:

1. How Big a Government do we want?

The first question we should be asking is how large federal government we want. As the chart shows, over the past 50 years total federal government expenditures have averaged about 21.5 percent of GDP. During the recent presidential campaign, GOP candidate Mitt Romney proposed holding them at 20 percent. In an earlier budget plan, his vice-presidential running mate Paul Ryan had proposed an even lower target. During the upcoming budget negotiations, Republicans will apply a lot of pressure to reach a deal that includes a spending cap of 20 percent or less.

Here are two good reasons to think that 20 percent is not enough.

One is that federal spending at 20 percent of GDP today would not provide the same level of services that U.S. citizens received in the 1960s and 1970s, when spending was last at that level for an extended period. In 1960, the elderly dependency ratio—the number of people 65 and older per 100 people of working age—was 15. Today it is 22. In in ten years it will be 29. It is simple arithmetic to see that government spending of 20 percent of GDP today will either provide a much lower level of support to senior citizens than in the past, or a much lower level of spending on courts, education, infrastructure, military and the rest of the budget. In short, 20 percent would not mean a return to the normal post-World War II level of government services, as is often said, but rather, something much below that level.

The second reason is that there is little evidence that a majority of voters of either party are willing to accept a federal government capped at 20 percent of GDP. Romney and Ryan ran on that platform in the 2012 election and lost. In fact, Republicans have lost the popular vote in five of the last six presidential elections. The votes their party do get come disproportionately from older voters. How long will they go on voting for a party whose platform is based on cutting their benefits?

Furthermore, in past periods when Republicans controlled the White House, and sometimes Congress, as well, federal spending regularly exceeded the 20 percent target. Spending averaged 22.7 percent of potential GDP during the Reagan years and 21 percent during the administration of George W. Bush. The reality is that the GOP coalition includes spenders as well as cutters—spenders on military hardware, on farm subsidies, on entitlements for the loyal ranks of senior Republican voters, and more. When push comes to shove, the spenders prevail.

It would be worse than pointless to accept a deal that, explicitly or implicitly, imposes an unrealistically low spending cap as the price for defusing the austerity bomb. Any such deal would just have to be redone in a few years, by which time the budget would be in worse shape than it is now. Yet that is just what is being offered by conservatives as the price for reaching an agreement by the end of the year.

Negotiators endlessly obsess over the ratio of spending cuts to revenue increases. Republicans are, reluctantly, allowing that they will accept some small revenue increases, but only if they get three or four dollars of spending cuts per dollar of revenue. During the pre-election debates, President Obama hinted that he might go along with such a formula. That kind of a deal just doesn’t add up. For fiscal year 2012, spending will be about 24 percent of GDP and tax revenue about 16 percent. Starting from that benchmark, even a one-to-one ratio would leave an unrealistically low level of spending. My advice: Don’t go there.

2. Focus on tax structure, not tax rates

The second focus of the budget negotiations should be the structure of the tax system. Far too much time is spent talking about tax rates. Rates are a side issue. Yes, the pending expiration of the Bush tax cuts and the resulting increase in top-end tax rates gives the Democrats a useful bargaining chip—but it is only a chip. Higher tax rates are not an end in themselves. The real  goals should be broadening the tax base by closing loopholes and returning the distribution of the tax burden among income groups to something like its historical norm.

Some people are saying that there is not enough money to be had by broadening the tax base, but that is a myth. It is true only if base-broadening is limited to timid measures like the proposed cap on personal deductions for high-earning households. True, such a cap would yield only moderate revenues, but there is real red meat out there if budget negotiators were only willing to go after it. For starters, here are three big-ticket items that I have argued for in the past:

  • Tax all capital gains and dividends as ordinary income. If accompanied by appropriate reforms to the corporate income tax doing so could increase revenues and simultaneously reduce the distortions and disincentives to investment decisions that are built into the present system for taxing capital income. (See details on taxing capital income here and the corporate tax here.)
  • Completely eliminate the home mortgage deduction for all income groups. The goal should be equal tax treatment of housing and other forms of investment. Unequal tax treatment of housing encourages speculative behavior, increases price volatility, and crowds out more productive forms of investment, all to the detriment of growth and macroeconomic stability. Contrary to popular belief, the mortgage interest deduction is not a middle-class benefit. A study by the Tax Policy Center found the deduction to be worth an average of $5,393 per year to households in the top 1 percent  but just $215 per year for those in the middle 20 percent. (See details of the case against the mortgage interest deduction here.)
  • Completely eliminate the charitable deduction. Contrary to popular belief, less than a third of giving that qualifies for the deduction goes to genuinely charitable purposes. Furthermore, the bulk of charitable giving comes from middle- and lower-income families who do not even itemize deductions. The charitable deduction is an expensive boondoggle through which high-income taxpayers finance special-interest nonprofit ventures that masquerade as charity. (See details of the case against the charitable deduction here and here.)

Would these and other changes put an unfair share of the tax burden on upper-income taxpayers? Not by historical standards. According to CBO data, from 1979 to 2007, the share of income received by the top 1 percent of taxpayers increased by 275 percent while the share of taxes paid only doubled. Reforms like the three outlined above should be viewed not as measures to soak the rich but to restore a reasonable balance.

3. Focus on the structural balance, not the current balance

We have heard said again and again that the middle of a weak and incomplete recovery is a bad time to be balancing the budget. True—if we are talking about the current budget balance. Not true—if we are talking about the structural balance.

We fear the austerity bomb because its abrupt tax increases and spending cuts could throw the economy back into recession. That is a genuine worry. Austerity programs in Europe stand as a case in point. Keeping that in mind, the goal of negotiators should be to implement structural changes to budget policy that allow the recovery to continue and begin to bite only when the economy approaches full employment.

The economics of that kind of reform are straightforward. There is broad agreement on a simple rule of thumb that would ensure the long-run sustainability of fiscal policy. Briefly, the rule calls for a small structural primary balance.  (The primary balance of the budget is the surplus or deficit excluding interest payments; the structural primary balance is the primary balance that would prevail when the economy is operating at potential GDP. See here for all the wonky details.) The required small primary surplus would be consistent with a small deficit of the overall budget averaged over the business cycle.

As of 2012, the structural primary balance of the federal budget is in deficit by almost 6 percent. That is why we need to make aggressive adjustments to be made to both spending and revenue, as described above. However, those adjustments do not have to come into force immediately. They should instead be agreed to now and phased in over time.

The difficulty comes not from the economics of fiscal consolidation, but from the politics. How can we guarantee that our political leaders will use the unique moment of bargaining power provided by the “austerity bomb” to make realistic, lasting fiscal reforms rather than to concoct another set of short-term fixes that will soon become unfixed? How can we be sure that policymakers will stick to the program when times turn good again, rather than squandering their boom-time surpluses as they did in the past decade? Those of us not involved in the negotiations can only offer advice, then sit nervously on the sidelines and hope.





15 Responses to “Austerity Bomb? Don’t Panic. Keep Your Eyes on the Prize.”

princess1960November 16th, 2012 at 10:25 am

allways complication with tax system .
i am agree with you .
thank you
see tax system Japan (for me is more right than Canada or UK)

SchofieldNovember 16th, 2012 at 2:19 pm

How on earth under the political system arrangements operating in the United States can anyone determine what the people's mandate is for the level of federal government spending when the House of Representatives is controlled by the Republican Party and Senate and Presidency controlled by the Democratic Party ( not to mention both parties doing the bidding of the Kleptocracy rather than Main Street anyway)? The desired ratio of spending to GDP is a matter of pure speculation. No wonder the country's in decline.

Ed Dolan EdDolanNovember 16th, 2012 at 2:48 pm

Of course, you're right there is no real "people's mandate." What strikes me from the chart, though, is how little the total has varied over time despite changes in control of the White House and Congress. That could be interpreted as some kind of implicit mandate, I think.

RationalistNovember 16th, 2012 at 5:03 pm

We will never be able to ensure politicians will not undo tomorrow what they agreed to do today. The fact the fiscal cliff tax and spending measures – which the President and most of the current Congress enacted into law – will not be implemented as enacted is proof enough. We can simply try to enact a sensible plan now and deal with the inevitable backtracking later. But Professor Dolan, are there spending cuts or adjustments you would recommend? I see a sea of red ink going forward and large tax increases for just about everyone without significant spending limitations.

Ed Dolan EdDolanNovember 16th, 2012 at 6:45 pm

"We will never be able to ensure politicians will not undo tomorrow what they agreed to do today." Yes, that is an inevitable fact of democracy. There are three ways to try to deal with it, none of which are perfect. One is to elicit promises from politicians that are so explicit that it will be politically costly to break them (an admittedly weak approach). The second is to use procedural devices like constitutional amendments that make it difficult (although still not impossible) to undo decisions. That helps sometimes but it also runs the risk of making it harder to react to truly unforeseen circumstances. The third is to elect politicians with a sufficient degree of maturity and discipline that they will look beyond the nearest elections when formulating policies. That is up to voters like you and me, I suppose.

Spending cuts? There are lots of small-change items like ending flood insurance and farm subsidies that I would endorse. The really big item on the expenditure side is to find a way to deliver health care at a cost and level of quality similar to that of other rich nations, say, Japan, France, Germany. That will take some fundamental changes in healthcare policy. Just saying that the government should stop paying for health care and shifting the burden to individuals is not a solution as long as total costs remain as high as they are. High private insurance premiums caused by bad healthcare policy are just as much a "tax" as anything the government collects directly.

RationalistNovember 16th, 2012 at 11:41 pm

As a self-employed person paying $25,000 per year in health insurance premiums (with a potential $4,000 deductible), I feel the "tax" of which you speak! Thanks as always for interesting posts.

SchofieldNovember 16th, 2012 at 11:42 pm

"Of course, you're right there is no real "people's mandate." What strikes me from the chart, though, is how little the total has varied over time despite changes in control of the White House and Congress. That could be interpreted as some kind of implicit mandate, I think."

I don't really agree with that argument because if Main Street had more control over its income generation together with government economic policy entitlement spending might actually shrink and consequently government spending in general reduce relative to GDP.

Ed Dolan EdDolanNovember 17th, 2012 at 10:30 am

Well, you are within your rights to to want smaller government. I am sure there are many people like you who would be quite comfortable with a smaller government. Personally, I would not suffer. I am healthy, had parents who made sure I got a good education, have always been employed, started putting money in my retirement account when I was young, live in an area that has never been struck by disaster, do not want my government always to be looking for a foreign war to fight, etc., so yes, I personally am your typical white male take-care-of-myself guy who is happy with the size of government as long as the bridges don't fall down. However, I also recognize that control over government is and should be shared by "main street" guys like me and others who expect or want more from government, whether that is FEMA, ARRA, defending the Persian Gulf, or whatever. So what I mean by my argument is that I think that is why we don't get a federal government that is 18 or 19 percent of GDP.

SchofieldNovember 17th, 2012 at 3:19 pm

I'm just making a pre-distribution point. Why double-hand the means to our well-being if you can avoid it? I do acknowledge that for some they'll never even get near the mechanism for pre-distribution and for some they'll lose access from time to time for a variety of acceptable reasons including times of natural and man-made disaster. As for defense spending I see it as fairly neutral being a cross-party thing because human nature is tribalist.

BogwoodNovember 17th, 2012 at 7:25 pm

What about state and local expenditures plus the healthcare "tax",often covered by governments elsewhere and mandated to be exorbitant by federal meddling? Unfunded mandates in education, mostly federal related have raised the cost way beyond the rate of inflation. This puts government "spending" up to 65 percent.The federal government could easily be halved in size,including mandates with an immediate benefit to the private economy. Median Man is in government imposed agony.
There are five cabinet level departments which would not be missed. All growth stops,let us stop voluntarily rather than in crisis.
But no argument on the mortgage deduction and the charitable deduction. How about losing the dependent deduction and the corporate income tax, also boondoggles? Why should single taxpayers subsidize someone else's child? Retirement is a flawed concept.
Children should be doing something useful from the age of six. (That is part of the reason some immigrants are successful). One more fantasy, strictly reciprocal immigration and no more multilingual state schools.

Valli GenevieveNovember 18th, 2012 at 3:22 pm

Mr. Bogwood, there is really no way to answer you. There are two major philosophical viewpoints here. One is a philosophy of the the common good and that government is meant to serve all Americans, ensuring each has a fair shot at success given his/her health, luck, and perseverance. The other, the one you so sadly present, is "might makes right", I have mine, "I owe nobody nuthin".

To me it seems to be a very cramped, constipated viewpoint, one that works for a healthy, unattached man, but not for the old, the sick, the young, pregnant woman or children. Since all of us fit into one or more of those categories at several points in our lives, a more expansive view of community and government will be the preferred choice of most Americans, most of the time. We will see that even more clearly if your party were willing to say what you believe out loud rather than within closed doors with like-minded members.

ThomasGrennesNovember 19th, 2012 at 3:57 pm

I agree that the current fiscal problem is much bigger than the fiscal cliff of December 31, and I offer some minor points. Why does 20% of GDP result in fewer services to an older population? Aren't there any offsetting savings from fewer young people such as less spent on schools, maternity care, etc.? Focusing on the structural balance is an improvement that could also be expressed in terms of government debt relative to GDP. On the cost of health care services, there are many opportunities to increase competition in health services. There are numerous restrictions on the size and number of medical schools and on the substitution of nurses and other professionals for medical doctors.

Falk BurgerNovember 20th, 2012 at 10:28 am

nice to hear a little sanity on this hyped-up issue. The general pretense seems to be that there are no policy options to manage the sequester; a media-induced sense of helplessness prevails. Obama is true to form, already he's using Republican talking points and referring to the Bush cuts sunset as a "tax increase". I've got a bad feeling about this, and it's not fiscal – it's mental.