Thursday, November 27, 2014

Avoiding a New American Recession

CAMBRIDGE – The United States may be headed for a recession in 2013. Even if the country avoids going over the “fiscal cliff,” a poorly designed political compromise that cuts the deficit too quickly could push an already weak economy into recession. But a gradual phase-in of an overall cap on tax deductions and exclusions (so-called tax expenditures), combined with reform of entitlement spending, could achieve the long-run fiscal consolidation that America needs without risking a new recession.

The US economy has been limping along with a growth rate of less than 2% during the past year, with similarly dim prospects in 2013, even without the shock of the fiscal cliff.  That is much too weak a pace of expansion to tolerate the fiscal cliff’s increase in tax rates and spending cuts, which would reduce demand by a total of $600 billion – about 4% of GDP – next year, and by larger sums in subsequent years.

President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2% of earners, who now pay more than 45% of total federal personal-income taxes. His budget would also increase taxes on corporations, and would end the current payroll-tax “holiday,” imposing an additional 2% tax on all wage earners.

Together, these changes could lower total demand by nearly 2% of GDP. And the higher marginal tax rates would reduce incentives to work and to invest, further impeding economic activity. All of that could be fateful for an economy that is still struggling to sustain a growth rate of less than 2%.

The Congressional Budget Office and the Federal Reserve predict that going over the fiscal cliff would cause a recession in 2013, with Fed Chairman Ben Bernanke recently saying that the Fed would be unable to offset the adverse effect on the economy. He could have said the same thing about the fiscal drag that would be created by Obama’s budget proposal.

Although Congressional Republicans rightly object to raising tax rates, they appear willing to raise revenue through tax reform if that is part of a deal that also includes reductions in the long-run cost of the major entitlement programs, Medicare and Social Security. Although some Republicans would like to see revenue increased only by stimulating faster economic growth, that cannot be achieved without the reductions in marginal tax rates and improvements in corporate taxation that the Democrats are unlikely to accept. Raising revenue through tax reform will have to mean reducing the special deductions and exclusions that now lower tax receipts.

The potential recession risk of a budget deal can be avoided by phasing in the base-broadening that is used to raise revenue. A desirable way to broaden the tax base would be to put an overall cap on the amount of tax reduction that each taxpayer can achieve through deductions and exclusions. Such an overall cap would allow each taxpayer to retain all of his existing deductions and exclusions but would limit the amount by which he could reduce his tax liability in this way. An overall cap would also cause many individuals who now itemize deductions to shift to the standard deduction – implying significant simplification in record-keeping and thus an improvement in incentives.

A cap on the tax reductions derived from tax expenditures that is equal to 2% of each individual’s adjusted gross income would raise more than $200 billion in 2013 if applied to all of the current deductions and to the exclusions for municipal-bond interest and employer-paid health insurance. Even if the full deduction for charitable gifts is preserved and only high-value health insurance is regarded as a tax expenditure, the extra revenue in 2013 would be about $150 billion. Over a decade, that implies nearly $2 trillion in additional revenue without any increase in tax rates from today’s levels.

Extra revenue of $150 billion in 2013 would be 1% of GDP, and could be too much for the economy to swallow, particularly if combined with reductions in government spending and a rise in the payroll tax. But the same basic framework could be used by starting with a higher cap and gradually reducing it over several years. A 5% cap on the tax-expenditure benefits would raise only $75 billion in 2013, about 0.5% of GDP; but the cap could be reduced from 5% to 2% over the next few years, raising substantially more revenue when the economy is stronger.

Slowing the growth of government spending for Medicare and Social Security is necessary to prevent a long-term explosion of the national debt or dramatic increases in personal tax rates. Those changes should also be phased in gradually to protect beneficiaries and avoid an economic downturn.

America’s national debt has more than doubled in the past five years, and is set to rise to more than 100% of GDP over the next decade unless changes in spending and taxes are implemented. A well-designed combination of caps to limit tax expenditures and a gradual slowing of growth in outlays for entitlement programs could reverse the rise in the debt and strengthen the US economy. America’s current budget negotiations should focus on achieving a credible long-term decline in the national debt, while protecting economic expansion in the near term.

Read more from our "Fiscal Cliff Notes" Focal Point.

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    1. Commentedarnim holzer

      I often find that focusing on facts and symptoms can distract from the fundamental issues that must be resolved in crises. The fact is that this fiscal and debt crisis was not simply a policymakers doing. In the US, as it was in Greece and other countries, there were too many lenders willing for a myriad of reasons, to lend at below justified rates to our government despite strong evidence for the past 8 years that fiscal matters were moving in the wrong direction. Whether because of mercantilist currency policy or blatant moral hazard and greed, the fundamentals of the bond markets have been askew for almost a decade. When both borrowers and lenders absorb risk in equilibrium the signals of the credit markets operate to create a feedback loop of functional behavior. This feedback loop is operating very poorly with the equity markets serving as 'vigilantes' and the bond market 'vigilantes' having given their proxy to the Fed. While all the discussions of policy adjustments are critical to economic performance, my fear is that the fundamental dysfunctionality of the borrower/ lender relationship has created a poor foundation from which to finance the next much needed wave of global growth. Namely, the developed slower growing highly indebted countries will need to cede some leadership to the faster growing developing countries in order to bargain for a policy of currency strengthening in these faster growing countries. This would allow some economic support to the slower growing countries and in return would diminish the real cost of the debt on a global basis. As the Euro Zone is learning, any solution to the fiscal crisis that does not address the value of the debt in lenders' hands won't be a satisfactory long term solution.

    2. CommentedMichael Muoio

      Our recklessness can only be fixed by the "cliff" as it took 32 years to get to where we are.

      In 1980 Reagan adopted “supply side economics” or “trickle down economics” and the philosophy that budgets never needed to be balanced.

      Tax cuts were put into place that were based on expanding our debt from $809 Billion in 1980 to $5 Trillion in 2000 to $10 Trillion in 2008 and $16 Trillion in 2012.

      We also entered diabolical free trade agreements with tax incentives that encouraged manufactured product imports and job exports.

      We deregulated the financial sector and freed Wall Street to be “creative”. This destroyed $16 Trillion of our collective wealth.

      Following the 911 attacks, we committed $4 Trillion off budget to occupy terrorist nations.

      We implemented Medicare Drug Plan D at a cost of $180 Billion a year.

      Student loans total over $1 Trillion as our public and private universities took advantage.

      We have concentrated wealth to levels not seen since 1929.

      The reduction in marginal income tax rates is outrageous. Rates have been reduced from 70% in 1980 to 35%. In 1964 they were 91%.

      Our capital gains tax was reduced from 39.9% in 1978 to 15% currently. The 100-year average on capital gains is 26.9%.

      We reduced corporate income tax from 46% in 1980 to 35% today. The 100-year average on corporations is 46.7%.

      We enjoy the lowest marginal tax rates since 1929 and we have only felt the first blow of this reckless behavior.

      The GOP position on all of this was in favor as Hoover led us into the Great Depression.

      We either fix it now with minimal pain or we will suffer for another 10-15 years all the while pointing bleeding fingers at each other.

        CommentedLee Hubbard

        It is amazing to me that some people still have the nerve to fling the epithet "trickle down economics" around when it has been "deluge down" spending on social welfare that has brought us to bankruptcy.

    3. CommentedJames Edwards

      Mr Feldstein

      You are correct that we may headed for recession in 2013 and that is, by designed, poorly thought out plan just to win elections and to save face.

      As Rogoff has stated that the economy was in that stage for quite sometime before the financial crisis hit in 2007 which is why the growth has been enemic.

      As you may know that many of the entitlement programs are on automatic pilot (meaning taken without a vote) while both sides fight over the 40% of discretionary spending thinking they both have the right answer to solving the problem.
      The Republicans have kept arguing that the trickle down without any proof that it has stimulated growth because the CBO has stated much of the deficit stemmed from events prior to the Great Recession meaning the 2001 & 2003 tax cuts that cause the revenue go lower than what it was under Reagan.
      The spending has increased due to the taxpayer giving no rider money to the banks for the mess they created with the help of both parties.

    4. CommentedVictor Morris

      Leadership has value when the Generals can't be bought.Looks like kicking the can down the road is the only possible compromise, unfortunately.

    5. CommentedJohn Brian Shannon

      Hi Martin,

      Great read and right on target from the first sentence!

      Economist and former senior federal economic policymaker, J. Antonio “Tony” Villamil, the dean of the business school at St. Thomas University, who served as U.S. undersecretary of Commerce for economic affairs during the George H.W. Bush administration, commented in the Miami Herald on America’s debt situation in June.

      "The federal debt/GDP ratio is on an unsustainable path, with the federal debt held by the public surpassing 100 percent of GDP in a few short years, according to the non-partisan Congressional Budget Office (CBO). If we desire stronger economic and employment growth, we need a market-credible, long-term fiscal plan that places the federal debt/GDP ratio on a declining scale."

      "[Fundamentally]… at this stage of an economic cycle, the economy should be expanding at a 3-percent to 4-percent annual rate, not at the tepid 2 percent or less, as is the case today." – Prof. Tony Villamil

      Read the entire article here:

      Proving that thoughtful Conservatives such as Professor Tony Villamil and some thoughtful Democrats are on a similar path.

      Professor Martin Feldstein's suggestion to limit tax expenditures and phase in tax increases over time, should strike a chord with those thoughtful Conservatives and Democrats.

      If ever a deal was crying out to be had, this must surely be it!

      Now that we see the U.S. economy may be stuck at 1.5% growth for 2013, it does not leave much room for error, to say the least.

      Until substantial growth takes hold throughout the economy, there is on need to drive over any fiscal cliff, nor is there a need to give up on deficit reduction, nor is there a need to abandon America's 47%, or any other percent, for that matter.

      Every U.S. citizen (and frankly any citizen, anywhere the economy relies on U.S. economic growth) should be sending Martin's wonderful article (link) to the White House website or to Members of Congress. It's THAT important.

      Best regards, JBS

    6. Commentedprashanth kamath

      This is not an economic analysis of the problem.
      What is wrong with the US macroeconomics - no answer.
      How to fix the deficit - one can fix it by looking at it like an economist or as an accountant.
      For an economist deficit indicates some imbalance in the economy and a solution will be based on such an analysis.
      An accountant would add up figures and give a solution.
      Reads like an accountant look at economics.

    7. CommentedProcyon Mukherjee

      While the Table-1 of Hungerford's report clearly articulates, "neither the top marginal tax rate nor the top capital gains tax rate are strongly correlated with saving, investment, labor productivity, and GDP growth
      controlling for other covariates", the report has also shown that top rates have gone through astounding corrections over time, in an environment where neither savings nor investments in the domestic economy gives a strong 'back-stop' that high debt levels could be sustained in the long term.

      In an environment of high debt as a percent of government earnings, the enfeebled revenue side adds to the woes where fiscal rectitude cannot continue to keep a blind eye; especially when private sector waits far too long before decisive investments to boost employment is undertaken on a broad base.

      Procyon Mukherjee

    8. Commentedcraig mitchell

      I agree with Dr Feldstein. The only way to get the growth that is needed and to increase tax revenues is to reduce taxation, regulation and spending. The spending cuts must come from social programs, which is the lion's share of the budget. This continual increase of debt can only cause our economy to slow down further.

    9. CommentedDavid Harry

      "Although some Republicans would like to see revenue increased only by stimulating faster economic growth, that cannot be achieved without the reductions in marginal tax rates.."etc. I would appreciate Dr. Feldstein's opinion on Hungerford's recent CRST report that demonstrates rather decisively (IMHO) that since 1945, there has been essentially no correlation between GDP and top marginal tax rates.

    10. CommentedThomas Haynie

      I'm reading a justification for trickle down thinking in this work. I'm not a fan of the whole liberatopian view point. At what point do you accept that you've tax cut yourself out of a country worth living in?

      The assumptions about tax rates adn GDP/ Unemployment don't seem to bear honest scrutiny in my opinion.

      I think the most important thing is the expectation of change. There may be a short term adjustment but eventualy it would even out and the long term result would be greater fiscal health.

      End of the world it would not be.

    11. CommentedMarc Freed

      The Republican mantra that "the top 2% of earners ... now pay more than 45% of total federal personal-income taxes" is really a canard unless presented in context. First, what percent of income do these earners receive? Second, what percent of private assets in the country do they own? And on the other end of the scale, what percent of income do lower earners pay to the government in combined payroll, medicare and income taxes?

      A large part of this problem is the different perceptions that different groups of people have about payroll and medicare taxes. The greater one's income, the more likely it is that payroll and medicare taxes seem like insurance payments for benefits one may collect later in life. For lower earners who spend a very high percentage of their incomes, these same payments feel no different than income taxes. That may not be accurate, but it may well be the way they see it, and that would explain differences in the way they hear these arguments and respond to them with their votes.

      Since Medicare is the real issue in this entire discussion, we ought to be discussing the real rate at which we would have to tax people to make it self-sustaining. Since this is already a separate tax, it would take the focus off income tax rates and put it where it belongs. Then perhaps both sides could find some common ground on the costs we are willing to incur and the benefits we want to have delivered.

    12. CommentedVictor Stern

      America is going to have to stop paying doctors whatever they ask.

      At some point medical expenditures stop benefiting society as a whole more than the other spending or saving that is avoided by directing money into medicine. At that point government should be out of the medical business.

      The current open-ended medical entitlement is poorly designed because medics can invent an infinite amount of ways to improve and maintain health and stave off death at an infinite cost. There is no theoretical limit to the resources that could be committed to complying with a doctor's ethical obligation to the patient.

      The ethical dimension is making it very difficult to reform the medical entitlement. However, we need to face the fact that at some point we have to let the sick and the old die.

        CommentedAndrew N Mason

        As crude as it sounds, I think you are right.

        Humans too will always do whatever possible to keep their loved ones alive even for one more week, even if that leaves them broke. We are completely willing to do that, and that is a good thing, since it speaks well of hour values and our non-materialistic assessment of the world.

        Yet, what alternative is there? How can we be moral and at peace with our decisions, and yet not cause collateral damage to us, our loved ones and society as a whole?

    13. CommentedGeoffrey Burns

      Instead of discussing cuts to Medicare and Medicaid we should be expanding reforms to health care. Compared to the other wealthy nations of the world we could potentially effect government savings of $300 billion a year while providing true universal access. The Affordable Care Act, as it stands, is estimated to save the government only about $11 billion a year. Beyond the potential government savings, the yearly private sector spending in this country is a staggering $1 trillion a year more than if our system performed on a par with other first world nations. If the average American realized that the $8,000 to $10,000 a year thay spend on health insurance is unnecessary waste, there might be the political will to meaningfully reform the system. Sadly, no one is telling them.

    14. CommentedVan Poppel charles

      why is there no money to develop & maintain welfare in peace time , but there is always plenty of money for making war with his neighbour( cf. JM Keynes in 1932)

    15. CommentedCarol Maczinsky

      The United States is locked but an intervention in Iran could help to jumpstart the economy with bipartisan support. It is sad that the United States are unable to win consensus for elementary social insurance, that shows: the US is too large and too ethnically diverse.