EconoMonitor

Thoughts From Across the Atlantic

Is It Time to Reform America’s Fiscal Institutions?

The United States government spends billions of dollars to protect against attacks by foreign military forces, terrorists, and natural disasters. However, earlier this month it was not prepared for a costly attack on the US economy by domestic forces in Washington: the Senate, the House, and the President. The government was shut down for 16 days and the Treasury came within one day of defaulting on the national debt for the first time in over 200 years. Many private employers who do business with the government also sent employees home. The damage was inflicted entirely by elected officials whose duties include promoting economic prosperity. However, instead of boosting the economy, some observers described Washington officials as the greatest threat to the US economy. The recent pattern of decision and indecision about spending and taxation is best characterized as government by crisis. According to a CNN poll, the public assigns substantial responsibility for the government shutdown and near default to Republicans, Democrats, and the President. Each party blamed the other for refusing to compromise, but an agreement of any kind requires the approval of two parties, and there is plenty of blame for all participants.

DYSFUNCTIONAL FISCAL POLICY

The dysfunctional behavior of government officials who implement fiscal policy contrasts sharply with the conventional normative description of fiscal policy. According to the conventional view, government officials are expected to stabilize the macro economy by using taxation and spending to add to total demand during recessions and reduce demand during business expansions, when there is inflationary pressure. Fiscal policy should be countercyclical. In specific markets the government is expected to provide infrastructure and public goods that would be under-produced by profit-motivated private businesses. However, actual fiscal policy has been very different from the conventional view of fiscal policy. Fiscal policy has become perversely pro-cyclical. Investment in education, research, and physical infrastructure has been reduced relative to entitlements as discretionary spending has fallen relative to automatic spending on entitlements. Inability to agree on total budgets and their composition has resulted in increasing resort to sequestration and continuing resolutions, which are inefficient ways to allocate resources over competing programs. Sequestration and continuing resolutions cut spending across the board, even though some programs have higher benefits relative to costs than others. The result is deadweight losses to the economy that are equivalent to throwing away or destroying valuable resources. Closing national parks and war memorials were graphic examples of the kind of waste that resulted from dysfunctional fiscal policy.

POLARIZATION AND PERSISTENCE OF FISCAL FAILURE

The budget agreement of October 16th reopened the government and avoided a default on bonds, but it did not resolve any of the fundamental fiscal disagreements. Instead it delayed decisions until January 15th when the government is again scheduled to shut down or February 15th when the suspension of the Congressional debt limit ends. The Congress and the public are polarized about spending and taxing issues, and the old ways of making fiscal decisions no longer work. Instead of addressing the long-run fiscal problems of the country, the government stumbles from one fiscal crisis to another as its time horizon continues to shorten. Without action, fiscal problems will get worse as the population ages. Unwillingness to compromise has led to the use of emotional language such as “extortion”, blackmail, “hostage-taking“, even though the same process could be described as “negotiation” and the use of “checks and balances”. These partisan disputes have been part of the political process for centuries, but the outcomes have changed. The debt relative to the size of the economy is at an all time high during peacetime. Delays in making decisions are unprecedented. One bond-rating agency has already lowered the rating on US debt, and others are threatening similar action. The size and persistence of fiscal problems has led more observers to agree that improving the quality of fiscal policy requires fundamental changes in fiscal institutions, including imposing effective fiscal rules on the Congress.

THE NEED TO REFORM FISCAL INSTITUTIONS

The monumental book on the sources of economic growth by Daron Acemoglu and James Robinson stresses the importance of economic and political institutions, and there is growing recognition that the quality of US fiscal institutions is declining. In his recent historical study of the U.S., Niall Ferguson attributed major economic problems in America to the “decay of institutions”, especially fiscal institutions. In their recent study of the rise and fall of great powers from Rome to modern America, Glenn Hubbard and Tim Kane stress the importance of dysfunctional fiscal imbalances in contributing to economic decline. The magnitude of the fiscal imbalance faced by the US today has been documented by the International Monetary Fund. To return debt relative to GDP back to a sustainable level would require a greater fiscal adjustment by the U.S. than by any other high income country, except Japan. While delaying fiscal reform, interest payments on the debt will become a bigger potential future problem. Near zero short-term interest rates provided by the Fed temporarily limits interest payments by the Treasury, but if interest rates return to their historical average, debt service payments will become an increasing share of non-discretionary government spending. For over two centuries U.S. fiscal institutions generated a sustainable debt and a reputation for U.S. government bonds as “riskless assets”. Unfortunately U.S. fiscal institutions have eroded.

EVOLUTION OF FISCAL INSTITUTIONS

Fiscal institutions are those that determine total values for government spending, taxation, and borrowing. They also determine the composition of spending and taxation. The President and the Congress are the main actors, but the public influences them by voting and lobbying. The increasing polarization of Congress mirrors the increase in polarization among voters. Polarization has led Congress to pass fewer budgets and to rely increasingly on continuing resolutions to authorize spending. House-Senate budget committees once met regularly to reconcile budgets produced by the House and Senate. However, they have not met since 2009, since the House and Senate have been so far apart on spending and taxation. Congress distinguishes between discretionary spending, that must be approved annually, and automatic spending (entitlements), that does not. Social Security, Medicare, and Medicaid are important forms of automatic spending. Congress sets the rules for eligibility and pays whatever is necessary to meet the claims for all who declare themselves eligible. Since these key automatic programs are all age-related, they have become a larger share of the total budget, and they will continue to grow in importance unless eligibility rules are tightened. Congressional deadlock led to the current sequestration that reduced government spending in January 2013. The next round of cuts in discretionary spending is scheduled to take effect in January 2014. An unintended result of the stalemate is a lower budget share for discretionary spending and a larger budget share for automatic spending. Nearly all the spending for education, research, and physical infrastructure is in the discretionary category that is being squeezed, and decreasing these investments threatens to reduce the rate of economic growth (Seib). The share of discretionary spending is now the lowest in decades, and it is forecast by the Congressional Budget Office to decrease further.  Some observers have attributed increasing polarization in the House of Representatives to increasing use of Gerrymandering. However, this is questionable, since the Senate (not subject to Gerrymandering) is also polarized. The stalemate has led to excessive levels of debt and greater inefficiency from current government spending. Discretionary programs with potentially high benefits relative to costs are being reduced in favor of automatic programs that include some inefficient and possibly obsolete programs. Congress ignores trade-offs by resorting to deficit finance. What is needed is institutional reform that limits debt relative to the size of the economy in the long-run, but does not magnify the business cycle in the short-run. Such a reform would separate budget deficit and debt problems from the more partisan problems of choosing total spending and the composition of spending. If it were possible to get bipartisan agreement on debt and budget policies, Congress could more effectively focus on the important, but more partisan issues, of the size of the government and the benefits and costs of specific government programs.

FLEXIBLE FISCAL RULES

A useful fiscal rule would place some limit on borrowing, but it would be flexible enough to allow additional borrowing related to economic growth and temporary borrowing related to recessions. Without a limit on borrowing, Congress acts as if it believes in the proverbial “free lunch”. It is subject to fiscal illusion that gives the impression that debt-financed spending is cheaper than it really is. Now when Congress agrees to spend another dollar on a new program, and members cannot agree to reduce spending on other projects or raise tax revenue, they borrow the money by default. Borrowing by default has contributed to the current debt problem, and without an effective debt limit, the problem will become more serious in the future. What is needed is recognition that an additional dollar spent on a new government program could be spent on the next best government or private project. If a debt limit were binding, it would force Congress to finance new spending by either reducing other spending or by raising tax revenue.  The Congressional debt limit is intended to limit government debt in the long-run, but it is a crude and inefficient way to do so. An annually balanced budget is another attempt to deal with the long-run debt problem, but it can contribute to pro-cyclical fiscal policy. A flexible fiscal rule could attract bipartisan political support by providing necessary fiscal discipline, while allowing partisan negotiation over whether to cut total spending or increase total tax revenue. It would also allow Congress to determine the relative merits of cutting discretionary spending versus tightening the eligibility rules for automatic spending programs.  If Congress behaved responsibly with respect to borrowing and debt, there would be no need for a fiscal rule, including the Congressional debt limit. However, Congress has demonstrated that it is now unable to make spending, taxation, and borrowing decisions without a rule with a firm deadline and a strong penalty for inaction.

NOT ALL FISCAL RULES ARE PRODUCTIVE

A flexible fiscal rule would provide a useful framework for fiscal policy, but not all fiscal rules are productive. The popular annually balanced budget that was passed by part of the Congress in 1995 and 2011 (Azzimonti) has well known problems. If a country enters a recession, tax revenue falls and government spending rises. To satisfy the balanced budget requirement, the Government must raise taxes or cut spending, both of which would magnify the recession. However, this problem can be alleviated by requiring budget balance over the business cycle or approximately 5-7 years. Sweden and Chile have had some success with budgets that are unbalanced annually but balanced over the cycle (Dolan). Other European governments are about to phase in similar fiscal rules, including some that require balance in the structural balance. The Congressional Debt Limit is another fiscal rule that has major limitations. First it is expressed in terms of money and does not take account of inflation. Secondly it does not take account of economic growth that changes the size of the economy. As a result it has changed many times and does not seem to be a useful constraint. It could be made more useful by expressing the debt relative to GDP and expressing the target debt ratio as an average over several years.

A PROPOSAL FOR A FLEXIBLE FISCAL RULE

Some specific fiscal rules that meet the above criteria have been proposed by Alan Simpson and Erskine Bowles. Their minimum requirement is for reductions in budget deficits over a ten year period that would be sufficient to stabilize or reduce debt relative to GDP. Useful information about the proposed reforms is available from the bipartisan Committee for a Responsible Federal Budget (www.cfrb.org). Glen Hubbard and Tim Kane have proposed a similar fiscal reform (also advocated by Alex Tabarrok) that they call an unbalanced budget rule (Hubbard and Kane). It would limit government spending to a moving average of actual tax revenue collected over the last seven years. During the seven year transition period, it would require a reduction in the mean fiscal deficit of the previous decade by one-seventh per year. The transition period is intended to avoid a large fiscal shock. Like a balanced budget rule, this rule would limit spending relative to tax revenue in the long-run, but it would allow fiscal deficits in certain years provided they were offset by surpluses in other years. It would take account of economic growth, as tax revenue would rise with growth in GDP for a given set of tax rates.  It would also allow Congress to choose a bigger or smaller government, but Congress would first have to change tax revenue to accommodate proposed spending changes. As with all fiscal rules, this one would have to deal with attempts to circumvent the spending limit by introducing off-budget spending that would be exempt from the limit. It would also have to specify emergency conditions under which the rule would be suspended.

CONCLUSION

Why would Congress or the President accept a binding fiscal rule after it has revealed a preference for lack of discipline? President Obama appointed the Simpson-Bowles Committee, but he ignored their recommendations. The sequestration that began in January 2013 was intended to be so painful, that Congress would be forced to accept a budget compromise rather than endure painful and inefficient across-the-board spending cuts. Instead, Congress stubbornly refused a compromise. The leaders of the budget conference committee, Paul Ryan and Patty Murray, have already indicated their reluctance to make fundamental reforms, often described as a Grand Bargain. They have little time to meet a reporting deadline of December 13, and a committee of 29 members of Congress is a cumbersome body to reach agreement on issues that have proven to be contentious. However, repeated near catastrophes may convince members that business as usual is not sustainable. Both the House and Senate budget resolutions passed this Spring acknowledge a debt problem by putting debt on a downward path relative to GDP. The debt ratio has reached its highest point in peacetime history, and demographic conditions that influence the trend in Social Security, Medicare, and Medicaid payments will inexorably increase the magnitude of the debt problem. Furthermore, increasing interest payments to service the growing debt combined with growing automatic spending will leave a smaller share of government for discretionary spending on items that are popular with the Congress. Major fiscal reform by Sweden and Chile provide some hope that a dysfunctional US congress may reluctantly agree to a fiscal rule that represents fundamental reform. Other EU countries have moved toward fiscal rules, including limiting structural budget deficits. An effective fiscal rule would limit government debt in the long-run. However, it would be flexible enough to allow additional debt related to growth in the economy, and temporary increases in debt during recessions.  An effective fiscal rule could also attract bipartisan support if it were limited to debt issues and allowed the Congress to determine total spending, total taxation and their components. Without reform, the fiscal problem will get bigger, and there will be another crisis in January or February of 2014.

REFERENCES

Acemoglu, Daron, and James Robinson. 2012. Why Nations Fail: the Origins of Power, Prosperity, and Poverty. New York: Crown Business.

Azzimonti, Marina. 2013. “The Political Economy of Balanced Budget Amendments.” Business Review, Federal Reserve Bank of Philadelphia, First Quarter.

Committee for a Responsible Federal Budget Policy. www.cfrb.org

Dolan, Edwin. 2011. “How Smart Fiscal Rules Keep Sweden’s Budget in Balance”. EconoMonitor, July 31, 2011.

Ferguson. Niall. 2013. The Great Degeneration: How Institutions Decay and Economies Die. New York: Penguin.

Hubbard, Glenn, and Tim Kane. 2013. Balance: the Economics of Great Powers from Ancient Rome to Modern America. Simon and Schuster.

Seib, Gerald. 2013. “Liberals Face Spending Dilemma”. Wall Street Journal, March 26.

11 Responses to “Is It Time to Reform America’s Fiscal Institutions?”

benleetOctober 31st, 2013 at 4:04 pm

This analysis lacks important, key facts. We had a total financial system meltdown — a nuclear disaster — because of excessive leverage of major financial corporations. That wiped out the general economy, the worst downturn in 80 years. Housing was complicit, a proximate cause. Some economists argue, and I agree, that inequality of the distribution of income, as the top 1% increased their share of all income over 30 years from 8% too 17%, is the ultimate cause. We have not recovered, still the employment to population ratio has not advanced much at all in 4 years after diving from 63.3% to 58.2%. Between Dec. 2000 and June 2011 there was a net loss in private sector employment, zero new jobs created, while the "working age population" increased by 31 million. The watchfulness should still focus on financial sector debt. The core problem is not federal government spending or lack of taxation. It may be a part. In general in 2000 federal spending and revenue balanced with both at about 20% of GDP. We tax, federally, 15% today, and we spent in 2009 at 25%, a deficit that equaled 10% of GDP. I may be simplifying. The solution posed in this article ignores the central problem, so it is not very practical in my opinion. Economists at the Economic Policy Institute would probably argue the same, as well as the Center for Budget and Policy Priorities, though they advocate a strict reduction in the deficit. The public and concerned individuals are sorting it out, but that may turn on emotional arguments not on reasonable ones. Generating jobs and income in the lower-earning 60% of households is the lasting solution — middle-out growth — the goal being a self-sustaining expansion. The top 1% have more income each year than the lower-earning 60% — that's the key imbalance and economy-breaking fact. Here's a reference for that fact: http://ctj.org/ctjreports/2013/04/who_pays_taxes_
My blog: http://benL8.blogspot.com

jonas_feitNovember 1st, 2013 at 5:06 am

Small point: Technically, there were no recommendations from the Simpson-Bowles Commission for the President to ignore.

Ed Dolan EdDolanNovember 1st, 2013 at 9:04 am

Excellent analysis. It is depressing to observe the long decline in the quality of US fiscal institutions. Some kind of flexible but binding fiscal rules that both avoid procyclicality and ensure long-term sustainability are clearly what we need.

There has been a lot of discussion about how much the recent shutdown cost the country, but most of the analysis has focused on brute losses like businesses closed or employee-hours lost. I think you are right to emphasize, instead, that the greatest burden of fiscal indiscipline is the growth of hard-to-measure, but very real, deadweight losses that arise from the fact that the spending the government does undertake is not rationally prioritized on the most beneficial uses. The random and mindless cuts required by sequestration are a prime example.

There is one aspect of the deadweight loss problem that you don't give much attention to that also needs urgent attention. That is deadweight loss arising from an inefficient tax system. The reluctance in Congress to raise taxes to reflect unavoidable demographic facts arises from the fact that taxes are perceived as burdensome and damaging to the economy. The problem is that our current tax system, characterized by high marginal rates, abundant loopholes, and a narrow tax base makes the economic burden of any given amount of revenue far greater than it needs to be. Rational tax reform could easily (easily in the economic, not the political sense) increase total revenue while reducing the economic burden of federal taxes. We need progress on the tax reform front just as urgently as we do on the spending side.

benleetNovember 1st, 2013 at 1:42 pm

This analysis makes a major error by focusing a solution on a symptom not a cause. We had a total financial system meltdown — a nuclear disaster — because of excessive leverage of major financial corporations. That wiped out the general economy, the worst downturn in 80 years. Housing was complicit, a proximate cause. Some economists argue, and I agree, that inequality of the distribution of income, as the top 1% increased their share of all income over 30 years from 8% too 17%, is the ultimate cause. We have not recovered, still the employment to population ratio has not advanced much at all in 4 years after diving from 63.3% to 58.2%. Between Dec. 2000 and June 2011 there was a net loss in private sector employment, zero new jobs created, while the "working age population" increased by 31 million. The core problem is not federal government spending nor a shortage of taxation, though the Bush era tax cuts should be eliminated. In 2000 federal spending and revenue balanced with both at about 20% of GDP. In 2009 taxes, federally, dropped to 14% and we spent in 2009 at 25%, a deficit that equaled 11% of GDP. I may be simplifying. The solution posed in this article ignores the central problem, the reason for the collapse, so this solution is palliative and not very practical in my opinion. Economists at the Economic Policy Institute would probably argue the same, as well as the Center for Budget and Policy Priorities, though they advocate a strict reduction in the deficit. Generating jobs and income to the lower-earning 60% of households is the lasting solution — middle-out growth — the goal being a self-sustaining expansion. The top 1% have more income each year than the lower-earning 60% — that's the key imbalance and economy-breaking fact. Here's a reference for that fact: http://ctj.org/ctjreports/2013/04/who_pays_taxes_
My blog: http://benL8.blogspot.com

ThomasGrennesNovember 6th, 2013 at 3:09 pm

I agree that the Great Recession contributed to the U.S. debt, but there is also a longer term problem. The current debt is the largest debt relative to GDP in absence of a major war, and demographic trends are contributing to increases in automatic spending that will contribute to greater debt in absence of reform. The recovery from the recession has been slow and incomplete, but an agreement on a reasonable limit to long-run debt would allow more expansionary fiscal policy in the near term. Instead, a prolonged dispute within the Congress has produced a pro-cyclical fiscal policy that has been a barrier to the recovery. Successful fiscal reform would contribute to faster economic growth as well as a lower debt ratio.

ThomasGrennesNovember 6th, 2013 at 3:27 pm

I agree completely on the need to fundamentally reform both the individual income tax and the corporate income tax. With fewer loopholes and a broader tax base, it would be possible to raise more revenue and lower marginal tax rates.Corporate tax rules that allow firms to legally avoid taxes while keeping their earnings abroad are especially bizarre. Since someone gains from every loophole, tax reform will not be politically easy. However, aren't officials elected to deal with difficult choices?

ThomasGrennesNovember 6th, 2013 at 4:00 pm

I recognize hawks that soar through the air seeking victims to devour, but I don't know what a "debt hawk" is. I would support counter-cyclical fiscal policy, especially automatic
stabilizers. As Jeffrey Frankel has argued, it make no sense to support or oppose fiscal austerity without knowing the state of the economy. It is also difficult to defend the shortsighted and procyclical fiscal policy produced recently by the Congress and Presidents.

This posting was about U.S. fiscal institutions, and a 200 year graph (see Henning Bohn) shows the debt ratio rising with wars and falling afterward, except for recent years. There may be something to learn from British history, but during the latter years of the graph US income per capita exceeded British. Did colonial obligations and the way they were financed have an impact?

ThomasGrennesNovember 6th, 2013 at 4:29 pm

Anyone who wants to see the recommendations can find them easily, including the President. The majority of the members (11 out of 18) voted in favor of the report, but the necessary 14 out of 18 that would have sent the report for action by the Congress was not attained. The vote by the members was not binding on the President then or now, but he can accept some or all of them anytime. The President is the only official
elected by the entire country, and his lack of leadership on budget and tax issues contributes to the decline in the quality of fiscal institutions.

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